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How China's stock market bubbled ... then burst

·Editor in Chief

As you may have noticed the Chinese stock market has been going haywire lately, causing stocks in the U.S. and around the world to gyrate wildly. Why did the Chinese market go up so much and then go way down? Why is it affecting the market here? How much damage could Chinese turbulence cause to the U.S. And where do Chinese stocks go from here?

Much of the turmoil is actually the result of the Chinese making huge changes in their economic policy and financial regulations.

“The Chinese government is trying to undertake a great number of reforms at once,” says Bob Hormats, a former Goldman Sachs (international) vice-chairman and a one-time Under Secretary of State for Economic, Business, and Agricultural Affairs. “They want market forces to have an bigger role (in) driving their economy and in that process there’s bound to be some big bumps in the road.” By big bump Hormats is referring to the recent wave of selling in Chinese stocks highlighted by an 8.5% plunge this past Monday. The Chinese government has tried to stop the slide by buying stock in Chinese companies and by limiting the sales of shares. Perhaps that plan worked, perhaps not. In any event the Chinese market has stabilized by midweek. But traders fear that more selling is in the offing and that government action could prove to be ineffective. On the other hand, maybe Chinese stocks are due for a run up. Did I mention that before the selloff, Chinese stocks had been on an absolute tear?
To understand how the Chinese market came to this place, here’s some context:  First, when you hear commentators talk about the Chinese stock market, they usually mean the Shanghai Stock Exchange, now one of the world's biggest—ranked by the total value of the companies on each exchange. (China has two other exchanges, the older Hong Kong Exchange and the smaller Shenzhen Exchange, but let’s stick with the Shanghai because that’s where the action has been.) The Chinese government founded the Shanghai Exchange in 1990 as part of that overall strategy of opening up its financial markets. Over the years the exchange has had a number of crazy spikes and huge drops, not surprising for a burgeoning market. But now China is the second biggest economy in the world and so when it’s stock market goes crazy, there are global implications.
The Chinese government had several objectives when it created the exchange; it wanted to give ordinary Chinese citizens a homegrown place to put their money other than banks or real estate and it wanted to provide Chinese companies with a source of funding other than banks. But the government wanted to control the exchange, so it limited the amount that foreigners could invest and the amount of money investors could borrow to purchase stock. The plan was to loosen those regulations gradually to make the market more open. And in fact the Chinese did slowly loosen the reins, but more recently they accelerated the process, which is when the trouble came in. 

“It’s almost a contradiction in terms,” says Nicholas Platt a former US Ambassador to Pakistan and the Philippines who as a young diplomat accompanied Richard Nixon on his historic 1972 trip to China. “It’s a free stock market in an economy that the state is really trying to control.” I pondered how much China has changed in those forty-plus years and asked Platt what Chairman Mao would have thought about China’s wild and crazy stock market.  “He would have found it extremely distasteful,” Platt told me.
In early November 2013, Chinese President Xi Jinping convened what is called the Third Plenum, which is the third meeting of the Communist Party’s Central Committee. (There is usually one Plenum per year, and the third is the most important because it is often the showcase for a new leader’s agenda, as it was in this case.) President Xi introduced a number of political, social and economic reforms, including measures that accelerated the opening up of the Shanghai Exchange. More foreigners could invest, and more borrowing was allowed too.

The result was that the Shanghai Composite, which tracks shares trading on the exchange, began to climb. Slowly at first, and then on November 17 2014 a critical measure was implemented that allowed $3.8 billion in daily cross-border orders between the Hong Kong and Shanghai exchanges. That set off a frenzy of buying. Between that day in November to its peak in mid-June, the Shanghai Composite roared ahead 110%, meaning it more than doubled in eight months. This while U.S. stocks rose a paltry 1.1% and while the rate of growth of the Chinese economy was actually slowing down.
The Chinese government realized they had a problem. They had created a monster in the Shanghai Exchange by allowing hot money to flood in. Traders, realizing the run-up was unsustainable, rushed to the exits sending the Shanghai Composite down a gut-wrenching 32% in 18 days despite China's best efforts to stem the selling. A market rout of this magnitude naturally caused nervousness in markets around the world, which is why stocks took a hit in all major markets including the U.S. The actual damage to the U.S. markets and economy is more psychological than anything else, unless the decline in Chinese stocks causes the Chinese economy to fall off a cliff, which both Hormats and Platt think is unlikely.

“Only a small portion of Chinese own stocks,” says Hormats, so the effect is limited. And the market is still way above where it was last year at this time. But he says, “You can bet the Chinese are working furiously to figure it out. One thing’s for sure, they will learn from this.” Still no one knows where Chinese stocks are headed.
The long-term implications for the Chinese government could be risky. “If you’re focusing on freeing the economy and have an authoritarian government, sooner or later if your economic reforms are successful, it will [increase] pressure for political reform,” says Platt. “That need not take the form of a multiparty system, but it means the system will have to be more open and more directly responsive.”

The Chinese may find out that there are limits to how much a government can control. Or they may teach us that they know a thing or two about balancing acts.