The Chinese equity market had suffered a three-week plunge. The index tumble began on June 12 after the Shanghai Composite Index climbed to 5,178 points, and by July 7, it had nosedived to a low of 3,507 points, declining more than 33 percent. This was the biggest three-week slump for the A-share market since 1992, and constituted a severe stock-market crisis. To cope with the crisis, the Chinese government had to launch full-scale measures to rescue and stabilize the market. On July 8, the Shanghai Composite Index finally snapped its losing streak to close at 3,709 points. After the turbulent corrections, this is likely to mark a new starting point for the A-share market to re-embark on its continuous surging trend.
To understand why the stock market crisis occurred, it is a must to know and analyze the reasons behind the massive surge before the free fall. An important factor behind the market rally was that the Chinese government wanted to follow the example of the US financial market and wanted to shore up the sagging economy, which has been driven by the real estate industry, through a bullish stock market. The launches of such policies as reductions in interest rates and reserve requirement ratios and the Shanghai-Hong Kong Stock Connect program were all meant to foster a bull stock market.
The A-share market, however, is different from the US equity market. On the one hand, the Chinese stock market is still far from matured and well-developed; on the other hand, the Chinese institutional structure and fundamentals are also greatly different from those of the United States. Under such circumstances when the Chinese government had the intention of fostering a government-intervened “national bull market,” stocks investors all developed strong anticipations for surges in the stock market, and the A-share market, for the third times in about 10 years, became a risk-free hedging market.
The Shanghai Composite Index, from the end of June 2014, rose from 2,039 points to 5,178 points in mid-June this year, surging by more than 150 percent with only some minor adjustments and corrections. Such a fast rise or frenzy gave rise to an illusion among the investors that stock investment would be risk-free, and that even blind purchases of stocks would lead to handsome gains and they could make big money through excessive leverage of margin trading.
With the prevailing illusion or fantasy of a risk-free stock market, many investors resorted to high leverage to borrow money to bet on the stock market, particularly with the inflows of excessively leveraged borrowings from the “gray or shadow lenders” or the non-official channels. Pushed by massive inflows of capital, Chinese stock market indexes successively surged to new highs in a short span of time, and along with the market rally, risks were also rapidly accumulating and magnifying. Against such a background, the market regulators had to strictly regulate and curb excessively leveraged financing. The stock market then began to tumble.
The massive slump not only exposed stock-market risks brewed by high leverage financing, but also led to the burst of illusions about the “risk-free market”. With the tightening regulation and supervision and in order to mitigate huge risks that were likely to occur with stock-index plunges, panic ensued and anxious investors all wanted to dump their holdings as quickly as possible. This further worsened the declining stock market, and the sell-off rush also magnified risks of the equity market, and ultimately led to the stock-market crisis.
With dangers from the stock market lurking, the Chinese government, at the beginning, overestimated its capabilities in managing the market, and chose to believe that it was capable of controlling and managing the risks to a reasonable range. The government failed to realize that this round of market frenzy, triggered by high-leverage financing, would likely lead to greater dangers or even an equity-market crisis when “deleveraging” measures were implemented. Although the government took a series of measures to rescue the market shortly after the tumble began, these measures produced very limited effects. Only when a full-scale crisis happened, did the government finally have to intervene with a heavy hand.
To rescue the market should be part of government’s responsibilities. In any country, the government should be the final credit guarantor for the financial market, a kind of quasi-public product. At a time of crisis, the government is always obligated to guarantee market stability. After the financial crisis in 2008 in the United States, the US regulatory departments swiftly and resolutely adopted measures to limit tremendous risks of the stock market to the minimum levels, and resolutely prevented possible spillover and contagion, and made financial stability a priority. When the Chinese stock market continued to tumble and a crisis evolved, the Chinese government also had the responsibility to rescue and stabilize the market, so as to guarantee market stability and rebuild confidence. In the face of a crisis, it was therefore justified for the Chinese government to take measures to shore up and stabilize the market.
But the methods and degree for government rescue and intervention should be appropriate, otherwise they would be subject to suspicions and questioning from the market. Judging from the current circumstances, the Chinese government’s market rescue measures are unprecedentedly extensive and resolute, and the main purpose was to stabilize the market and restore confidence. The government has realized that both the massive stocks rally and slump in the past year, to a great extent, were associated with the government’s policies towards the stock market, the government’s understanding about the nature of the financial market, the blind introduction of various financial derivative tools from the matured and developed markets, and a simple and blind comparison of the Chinese financial market to that of the US. After the restoration of stability, therefore, the Chinese government will probably have to seriously reflect, redefine and re-position the stock market, and these reflective measures are likely to serve as new driving forces for reforming China’s stock market. Otherwise, after this round of government rescue measures, it will give rise to a speculation that the market-oriented reforms would be abandoned and the government will frequently intervene and meddle in the stock market in the future. Such a speculation will produce negative impacts on the reform and opening of the stock market. Therefore, it is widely believed that the government will likely deepen reforms so as to reassure the market players and dispel doubts and uncertainties. It is certain that the market-oriented reforms of the Chinese financial markets will continue and will never backtrack.
Despite this unprecedented slump in the stock market, the Chinese government’s strategy in developing the equity market was not changed, and the government will continue to foster a healthy development of the stock market through applying market-oriented reform policies. Therefore, the surging trend in the Chinese stock market will continue in the second half of the year. From the point of view of the government, as long as the economy is still in the process of struggling to return to the road of healthy and sustainable path, the government will continue to drive up the stock market to aid the real economy, otherwise the economy will likely slow down further.