Crisis in China: decoding the Shanghai stock exchange crash

QUICK PILL

Crisis in numbers

• Shanghai Composite is the world\'s third largest stock market. It\'s domestic market capitalisation value is $5.9 trillion.
• Nearly half of the 2,776 companies trading in China have chosen to pull their shares out of the stock market.
• Over $3 trillion have been wiped off the stock market since the economic slowdown.
• This is the size of the French stock market; over 60% of Japan\'s market and higher than UK\'s GDP in 2013.

The diagnosis

• Government encouraged people to invest in the stock market, which grew by 149% during the first half of the year.
• 80% were small scale investors. When share prices fell in June, they withdrew in panic, creating a crisis.
• China\'s economy is at its slowest since 2009.

Looking ahead

• Worst case scenario is a drastic fall in the market value of listed companies, including Chinese banks.
• China is the world\'s largest economy and trades with many countries. A crisis there is bound to have ripple effects.
• The communist regime will have to take steps to build the confidence of domestic and foreign investors.

Since 12 June this year, China has witnessed large fluctuations in the stock market and predictions about an impending fall in the Shanghai Composite and Shenzhen stock market have been doing the rounds for some time now. Shanghai Composite is the world's third largest stock market. Its domestic market capitalisation value reportedly stood at $5.9 trillion towards the end of May, just behind New York Stock Exchange ($19.7 trillion) and Nasdaq OMX ($7.4 trillion).

Why did the crash take place?

The Shanghai stock market grew by 149% during first half of this year, largely attributed to the Chinese government encouraging people in 2014 to buy more stocks to boost the market. The exhortations were successful with the entry of a large number of new investors in the market, including opening of new accounts in April-May.

Reports indicate that about 80% of the investors are small-scale individuals hoping to make a quick buck and the huge drop of over 30% in the prices of company shares on the Shanghai stock exchange and drop of around 40% in the Shenzhen market since mid-June this year has injected panic among millions of such individuals worried about the fate of their investments. Analysts have pointed out that small time investors in particular tend to make decisions on "a herd mentality" leading to a domino effect and a large-scale exodus.

Furthermore, nearly half of the 2,776 companies trading in China have chosen to pull their shares out of the stock market. And, this number continues to increase. Over $3 trillion have been wiped off the country's stock market since the slowdown. To get an idea of the sums we are talking about, this is the size of the entire French stock market; over 60% of Japan's market and higher than the UK's GDP in 2013 of $2.7 trillion.

Seen as the biggest economic crisis of this decade in Asia, this is attributed to a sharper rise in the share prices, compared to a slower growth rate of the Chinese economy - at its slowest since 2009 - and the decreasing profits of companies since 2014.

Many remedial steps have been taken by the Chinese governmental bodies, including a sharp cut in the interest rates by the People's Bank of China to boost liquidity and a proposed establishment of a 120-million Yuan fund to prop the stock market. Many steps are also being taken by stock market insiders, such as commitment from the brokerages and fund managers to buy shares worth billions, announcements by the China Securities Regulatory Commission (CSRC) to suspend any new Initial Public Offerings (IPOs) and a relaxation in the margin trading.

Stock regulators have also gone to the extent of blaming the critical views put forward by the media and some experts - who are sceptical of any immediate recovery from this crisis - for intensifying the situation. The whole point behind these measures is to keep investor's trust in the market so that mass selling of shares can be prevented.

Less than 10% of Chinese households have shares in stock exchange, which minimises the scale of a market crisis

Nevertheless, despite the drastic fall, the Shanghai stock exchange still remains 20% higher than it was in January 2015. Also, less than 10% of Chinese households have shares in stock exchange in China, whereas this number stands at over 20% in developed countries on an average, which minimises the scale of a market crisis compared to the one in any developed world.

Is there any need to worry?

Though these measures are yet to show the results, there are huge questions regarding the health of China's economy. First, does it have any impact on people's confidence in the government's ability to remedy the market? Clearly, if quick results do not materialise, there is bound to be a negative impact on mass perception and possibly social stability.

Second, does it signal a dip in the influence of the Chinese Communist Party (CCP) in the near future? Not really. Though huge sums from people are at stake in this roller-coaster ride within the stock market, people still see the stock market as a means of short-term profit generation, and this crisis might slow down the progress in the government's bid to reduce the role of Government in economy.

Third, do we need to worry about this? Not really. Though it is a major economic crisis in Asia, the Chinese stock market is relatively isolated and it does not appear to have an impact beyond Chinese territories - relatively small numbers of foreign investors have put their money in the Chinese stock market, which is less than 2% of Chinese shares.

The issue of concern is, however, not the dip in Shanghai Stock Exchange Composite and fluctuating stock market overall, but its consequent impact on the Chinese economy - the world's largest, and which has trade relations with every other country in the world.

Fourth, what would be the worst case scenario if their stock market continues to fall? It could result in a drastic fall in the market value of its list companies, which not only include manufacturing companies but also a huge number of Chinese banks. The decrease in the value estimate of these companies could further create a situation of bankruptcy in the near future and have an adverse impact on the Chinese economy in terms of manufacturing market and its exports, if investor's confidence in the stock market keeps falling.

Though the current situation appears to be not that dangerous for foreign markets and trading countries, a further drastic fall in the stock market would impact many economies dependent on imports from China. However, it is unlikely that the Chinese state would let that happen.

The Chinese stock market remains volatile and highly unpredictable, even after a number of measures. It might take a while for it to regain its high index. But until then, certain questions about the effectiveness of the measures taken do need to be raised. This calls for long term remedies.

The world's attention would be focussed on Chinese leadership's attempts to come up with a solution that revives the trust of not only domestic investors but also the confidence of foreign investors and China's trading partners.