China's Stock market crash , Explained

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  China's stock market Story 

China's stock market has been plunging over the past month, and the Chinese government is panicking. Over the past week it has employed a number of extraordinary measures to try to halt the market's slide, to little effect. On Wednesday, the benchmark Shanghai Composite index fell another 5.9 percent, bringing the market's total losses to 32 percent in less than a month.

Why people are freaking out about the stock market crash?

This do not seem to be just an ordinary correction after a year of big gains however seems as first sign of deeper problems in the chines economy .

The latest boom in China's stock market is different from one that came before it. The earlier boom from 2005 to 2007 coincided with rapid growth of the Chinese economy; when the Chinese economy slowed in 2008, the stock market plunged along with it,Chinese stocks surged last year against the weak  broader economic gains.

 This was  a result of more and more people investing in the stock market with borrowed funds. That has created instability and a danger that many investors will suffer outsize losses as the market falls.Investors used borrowed funds to push up stock prices

In many cases, the risky investments are being made by ordinary Chinese people who use their savings — and in some cases, mortgage their homes — to invest in stocks.

Even worse, the same dodgy financial products that have driven stock market volatility have also been used to make risky bets in other sectors of the economy. Some WMPs have invested money in leveraged stock market investments, but others have poured money into speculative real estate projects or business ventures. In an economic downturn, these investments could fail to pan out, as well, causing even more Chinese investors to take unexpected losses.

China's current predicament bears some resemblance to the situation in the United States in 2007. Risky, poorly regulated financial investments have proliferated in China, creating the danger of a meltdown that spreads beyond the stock market to the broader Chinese economy.

A big reason for the stock market rally was that a lot more people started buying stocks with borrowed money. This practice, known as "trading on margin," used to be strictly regulated by the Chinese government. But as the Financial Times explains, Chinese authorities have gradually relaxed these requirements over the past five years.

So borrowed money flooded into the Chinese stock market between June 2014 and June 2015, helping to push stock prices up 150 percent. During this period, the amount of officially sanctioned margin trading in the Chinese stock market ballooned from 403 billion yuan to 2.2 trillion yuan. And that figure doesn't take into account the vast sums invested through back-door methods.

Why China today is like America in 2008

This practice of making investments with borrowed funds is known as leverage, and it was at the core of the 2008 financial crisis in the United States. For example, large banks made highly leveraged bets on subprime mortgages based on overly optimistic real estate projections. When property values started to fall, the banks with the most leverage — and the least of their own capital at stake — lost money the fastest.

People are also making highly leveraged investments in China ,Chinese banks offer wealth management products (WMPs) that promise the security of a savings account but with higher returns. Some WMPs function like US money market funds, offering modestly higher returns by investing cash in safe assets like high-quality corporate and government bonds. But in other cases, banks invest WMP funds in ways that are a lot riskier than a conventional savings account.

This kind of investment strategy works great as long as stock prices are going up. But once prices start to fall, people who bought the high-risk tranches can quickly get wiped out. And depending on how far the market falls, it could also lead to losses for people who invested in these allegedly low-risk financial products — or for banks that guarantee their customers' investments.

In the US, the risky investments were largely made by large financial institutions, which then became insolvent when the housing boom ended and required a bailout. By contrast, most of the investments in China are made by individual investors who will absorb most of the costs if their bets go bad.


Chinese regulators tried to rein in leveraged stock investments

 
The surge in stock prices alarmed Chinese authorities, and so earlier this year they took steps to rein in margin trading and other forms of leveraged investing. In January, they raised the minimum amount of cash needed to trade on margin, once again restricting the practice to wealthier investors. They also punished a dozen companies for failing to enforce rules on margin trades.

In April, regulators began cracking down on the use of WMPs to fund stock market investments. This included a ban on brokers using a financial vehicle called an umbrella trust to help their customers evade limits on margin trading.

The government's toughest measures came on June 12, when China's securities regulator announced a new limit on the total amount of margin lending stock brokers could do, while also reiterating the ban on illicit margin trading through mechanisms like umbrella trusts.

Chinese stocks have been falling ever since that June 12 announcement.

Now the government is panicking and trying to stop stock price declines

These efforts to slow China's stock market boom seem to be working too well for Chinese officials' tastes. Now that stock prices have plummeted, the government is trying to prop them back up.

Last Thursday, China's securities regulator announced it would once again reduce the amount of money required to open a margin-trading account .

On Saturday, 21 major Chinese brokerages made a coordinated announcement, pledging to purchase $120 billion yuan worth of Chinese stocks to help stabilize the market. Chinese brokers vowed to keep buying stocks until the Shanghai index had risen to 4500. Also, 28 privately held companies canceled plans to hold initial public offerings that could have drained capital away from companies that were already publicly traded. It's widely suspected that these moves were made at the behest of the Chinese government.

On Sunday, China's central bank also announced it would inject cash into the China Securities Finance Corp, a state-owned company that finances margin trading. In other words, the Chinese government is printing money to finance leveraged stock investment. On Monday, the Chinese financial magazine Caijing reported that the government had ordered the nation's social security fund not to sell any stock in Chinese companies.

On Wednesday, the government told state-owned companies and executives to buy stocks. It also authorized insurance companies to buy more equities and offered more credit to help people buy stocks.

But the market has shrugged off these interventions. The Shanghai Composite lost 1.3 percent on Tuesday and an additional 5.9 percent on Wednesday.

What would be the impact on the global and Indian economies? 

Experts say that a spill-over of the stock market crisis into the broader economy is unlikely for now. While stock markets across the globe shivered due to the rout in China, the bigger worry is the slowdown in the Chinese economy.

The Indian financial markets may remain under pressure and the rupee is likely to be volatile given the twin problems of the China stock market meltdown and the crisis in Greece.

Cooling of commodity prices should augur well for the Indian economy but, overall, a Chinese slowdown could be a risk for the global as well the Indian economy. China is the world's second-largest economy and has deep global financial linkages and any spillover effect of the stock market meltdown could hurt the global economy. Any slowdown in the global economy will have repercussions on India's growth prospects.

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