China’s Stock Market Woes Could Determine Communist Party’s Fate

July 5, 2015 Updated: July 10, 2015

A last-ditch struggle for the Chinese Communist Party’s legacy and legitimacy could be playing out on the nation’s stock markets, as the regime desperately tries to prop up the last bright spot in the Chinese economy.

After a huge market rally over the last 12 months, China is in the midst of the world’s worst equities selloff in years. Shares tumbled again the week beginning July 6, even as Beijing introduced multiple new programs to plug losses.

The benchmark Shanghai Composite Index dropped 5.9 percent on July 8 alone, and it is more than 32 percent off its recent peak on June 12, wiping out more than $3.25 trillion in value. The smaller Shenzhen Composite plunged 16.2 percent the week beginning June 29, while the startups-heavy ChiNext declined 10.8 percent. Both of those exchanges are more than a third lower than their recent highs last month.

It’s easy to look at the Chinese market collapse and say it was just a matter of time before the bubble burst. On the ground, this is a tragedy.

Given the state’s hand in controlling China’s financial markets, a total stock market collapse will be a catastrophic defeat for the Chinese Communist Party.

Market regulators and the People’s Bank of China met over the weekend of July 4 to hammer out stock market bailout provisions, including halting all IPOs and providing unlimited funding to the state-directed margin finance firm, China Securities Finance Corp.

Heading into 2015, Beijing was facing its worst economic growth outlook in more than two decades. Manufacturing activity slowed and the once-booming construction sector deflated, displacing millions of migrant workers.

Encouraging Stock Purchases

The regime saw a burgeoning stock market as a lifeline. A stable, gradually increasing stock market pushes the economy forward. Rallying stock prices can alleviate companies’ financing crunch, and allows local governments and banks to refill their coffers. It also enriches investors and serves as a distraction for the unemployed, all of which promotes social stability.

China proceeded to loosen its monetary and fiscal policy. It also did what it knew best: Beijing instructed its state media to promote investing. During 2014, Xinhua and regime mouthpiece People’s Daily newspaper published daily commentaries encouraging the world’s largest population to buy more stocks. In an article from Aug. 31, 2014, Xinhua said that “economic and social development will bring precious confidence and strong support into the stock market.”

A Chinese investor looks at his smartphone displaying the Shanghai Composite Index at a stock brokerage house in Jinan city, east China's Shandong province, 24 June 2015.  Chinese stocks headed for their biggest two-day gain in three weeks on Wednesday (24 June 2015), led by energy and power companies, as funds flowed back to the equities market after a flood of new share offerings last week. The Shanghai Composite Index climbed 2.48 percent to 4690.15 at the close, extending Tuesday's 2.2 percent jump. The gauge plunged 13 percent last week, the worst weekly loss since the 2008 global financial crisis. Funds started returning to the stock market after an estimated 6.7 trillion yuan ($1.08 trillion) of liquidity was locked up due to initial public offerings last week.
A Chinese investor looks at his smartphone displaying the Shanghai Composite Index at a stock brokerage house in Jinan city, east China’s Shandong province on June 24. (ImagineChina via AP Images)

And the Chinese populace did just that. Money flowed in from the property markets. The number of new brokerage accounts opened in the first four months of 2015 was more than 2012 and 2013 combined. The Shanghai Stock Exchange exceeded 200 billion yuan ($33 billion) in average daily turnover, or the total value of shares exchanging hands, for the first time in four years on Nov. 28, 2014. That figure ballooned to 1 trillion yuan ($161 billion) in late April 2015.

From Aug. 1, 2014 to June 12, 2015, the Shanghai Composite more than doubled, gaining 136 percent.

Most new investors in China were consumers with very little financial experience. Many joined because it was the latest fad, their friends all bought stocks, and the media and government promoted it. Others, sensing opportunities to compound earnings, used margin credit to borrow money from brokerages to buy more shares.

The meteoric rise in the stock market wasn’t grounded in fundamentals, and Chinese shares became some of the most overvalued in the world. On June 24, the Shanghai Composite traded at a trailing price-to-earnings ratio, a measure of the relationship between the stock price and its past earnings, of around 20 times.

Desperate Measures

But during the stock market downturn in the last two weeks, some of the same mechanisms the Chinese regime employed to boost the markets failed to work.

On June 27, China’s central bank cut benchmark interest rates. After those measures did little to lift sentiment, on July 1 the China Securities Regulatory Commission (CSRC) eliminated certain margin trading restrictions it had previously put in place to discourage speculation. After the market declined again on July 2, Chinese regulators announced last Thursday that it would investigate and prosecute short sellers.

Those efforts failed to stanch the bleeding, as the Shanghai Composite tumbled another 5.9 percent on July 8.

But some of the recent rule changes reek of desperation.

The new margin rules implemented July 1 allowed investors to use real estate as an acceptable form of collateral on their margin loans. In effect, investors are literally gambling their lives away by betting their house on the stock market.

A recent announcement of investigating short sellers was largely a nationalist PR stunt, apparently in response to rumors circulating on social media forums about certain “hostile foreign capitalist forces” who stand to benefit from short selling (Goldman Sachs and George Soros?). In reality, outside of institutional investors shorting to hedge their long positions, there are very few naked short sellers in China, a fact confirmed by a CSRC posting on June 30.

‘It’s a Vicious Cycle’

The root cause of the selloff is the preceding boom. Investors are spooked—the same investors who piled into the stock market are now selling their shares. They are selling shares to salvage their portfolios. Finance fundamentals tell us that when there are more sellers than buyers in the stock market, the bid-ask spread widens and prices will eventually drop.

What exacerbates the situation in China is the 2.2 trillion yuan ($350 billion) in margin debt. Independent estimates cited by Reuters peg the real debt at around $645 billion including the shadow banking sector. Such debt is collateralized by the underlying stock holdings, and as stock prices fall (thus decreasing the value of collateral), investors must sell even more shares to meet margin calls.

“The panic is spreading as more investors are forced to liquidate due to leveraged funding. The further the market declines, the more investors are forced to liquidate. It’s a vicious cycle,” Zhou Xu, an analyst at Nanjing Securities, told the Wall Street Journal.

Losing Grip

It’s easy to look at the Chinese market collapse and say it was just a matter of time before the bubble burst. On the ground, this is a tragedy.

Ordinary Chinese looked to the Party, which directed them to steer their savings into the stock market. And now they stand to lose, big time.

The Chinese, traditionally, are hard-working folks who save the majority of their earnings. A large portion of the millions of new Chinese investors are migrant workers, retirees, and the uneducated. They looked to the Chinese Communist Party, which directed them to steer their savings into the stock market.

And now they stand to lose, big time.

On July 4, China’s State Council, its central bank, and the CSRC convened in an emergency meeting and decided to halt all new initial public offerings. Separately, more than 21 state-owned brokers including Citic Securities Co. announced that they would invest 15 percent of their net assets, or no less than 120 billion yuan ($19 billion), for direct stock purchases.

The PBOC on July 5 injected 100 billion yuan ($16 billion) into China Securities Finance Corp., and announced unlimited funding support, allowing the agency to provide further margin loans to finance additional stock purchases. This in theory could alleviate having to unwind trades to meet margin calls, at the cost of worsening China’s existing bad debt problem.

These are some options of the last resort, and Beijing better hope these measures work. A public letter from five finance professors on how the Chinese regime should deal with the stock market crisis, posted on Xinhua on July 2, called the government’s stabilization efforts last week “inexplicable.” The letter also warned that any stock market crash would be catastrophic to the middle class and the “Chinese Dream,” which shouldn’t be taken lightly.

Capital and wealth is one of the Chinese Communist Party’s only remaining grips on power. A stock market collapse could very well spell its doom.

After all, with more than 90 million stock investors in China as of June 30, there are now more “capitalists” than Communist Party members.