Let’s go back to the June-August 2015 period when the news about the Chinese Stock market crash made the headlines. In this article, we will attempt to link the basic principles of economics to the stock market crash. Subsequently, we will try to explain how the Chinese government’s measures to tackle the problem traces its roots to the fundamentals of this discipline.
The basic principle at work in the stock markets is: Excess demand for stocks leads to a rise in prices. This is reflected by the rise of the stock market index. Excess supply of stocks to be sold (analogous to deficient demand) leads to a fall in stock prices.
So here goes the story! The Communist government in China had relaxed restrictions on margin trading. Margin trading means that the investor can used borrowed money (from the broker) to purchase stocks. So, in a way, the government made this easy. The consequences were not surprising. Innumerable new accounts were opened and guess who these new investors were! 67% of these new investors had not even graduated from high school. This was revealed by the China Household Finance Survey conducted across 4000 households at the end of 2014. This shows that 2/3rds of the new investors were not even adequately qualified to analyze the stock market. This aggravated volatility in the Shanghai stock exchange.
Apart from encouraging margin trading, the government used state- run media to induce optimism among its citizens to invest in state owned shares. This earned blind trust of the citizens since the state backs the returns on these shares. Eventually, it culminated in reckless domestic investments. This is where the principle of excess demand comes in! Prices of shares started rising. This created an economic bubble. In this context, a bubble refers to artificially inflating the value of an asset relative to its actual value. The stock market index starts soaring high. But where is the catch? Like every bubble, this was expected to burst and pave way for the ultimate havoc.
The stock market crash of 24th August was inevitable. The infamous ‘Black Monday’ is what it came to be called. The Shanghai Index fell by around 8.5% showing that the frenzy among investors did culminate in excess supply as they were eager to get rid of their ticking time bombs! Brokers received margin calls from investors asking them to hurriedly sell their shares.
The Chinese state came up with quick fix solutions rather than looking at the bigger picture. When panic was created in the stock market, the investors rushed to sell their shares before it was too late. This created excess supply. The government took measures to prevent the selling of shares since it could (and it did) lead to a drastic fall in the stock prices. The state suspended trading in shares of companies that together accounted for 40% of shares in the stock market. It banned selling of shares by company executives who held more than 5% of company share. The Communist state kept pumping money in the economy by lowering interest rates thereby making credit cheaper. This enabled brokerage firms to continue buying the shares. An economic stimulus of $40 billion was announced by the government. It stopped any new corporations from going public. In other words, it prevented any IPOs. All this was done to contain the volume of trading.
However, the stock market crash did not have a significant impact on the international community. This seems strange at first. What one misses out is that the Shanghai Stock Exchange did not allow more than 2% of foreigners to hold shares in the Chinese mainland stock market.
This video summarizes everything you need to know! Just 4 minutes of enlightenment!