Can the World Handle Another China Stock Market Crash in 2016?

china stock market crashThe Odds of a China Stock Market Crash in 2016

I find it amazing that Wall Street is getting amnesia about the China stock market crash last summer. Everyone in my office stopped what they were doing that day to watch as the Shanghai Composite Index began bleeding 30% of its value. Now, just months after the China stock market crash, we’re seeing that contagion spread to other parts of the Chinese economy.

It should be noted that Chinese stocks gained more than 150% between the summers of 2014 and 2015. The stock market growth is still a net positive, but that is the part that worries me. It means there is room for a further decline, and possibly, a second full-blown stock market crash.

The stock market boom that began in June 2014 was not matched by equal gains in the Chinese economy, a fact many analysts were eager to note in the immediate aftermath of the decline. Since then, a lot of other headlines have taken precedence in financial news.

However, the China stock market should not be forgotten so easily. It exposed a vulnerability in China that no one had previously considered. After all, the Chinese economy is nearly nine times larger than it was in the year 2000—a feat that stretches the limits of imagination. The total wealth of the country grew by a factor of NINE!

During that period, China has had two stock market booms. The first, between 2005 and 2007, corresponded to an acceleration in China’s growth rate. Not only was Gross Domestic Product, or GDP, getting larger every year, but the size of the gains were also getting bigger. All that ended in 2008. (Source: “China’s stock market crash, explained,” Vox.com, July 8, 2015.)

The first China stock market crash was understandable. A subprime mortgage-led financial crisis in the United States ricocheted around global markets, wreaking havoc on every corner of the planet. The Shanghai Composite Index crashed from above the 6,000 level to nearly 1,500.

It was not a pretty sight. But at least the first China stock market crash didn’t suggest deeper issues with the underlying Chinese economy. The China stock market crash in 2015 is a whole different ball game. This one was built on leverage.

Origins of the China Stock Market Crash in 2015

Lending too much money to financial speculators became the rule, rather than the exception, in modern markets. The 2008 stock market crash in the United States was proof enough. How else could a relatively small amount of bad mortgages upend the entire global financial system? Leverage was the problem.

Mortgage lenders pooled all their loans into a financial asset and sold it to banks, which in turn made more complex products, and sold those to institutional investors. The trail of dominoes grew longer and longer. By the end of it, a heck of a lot of money was resting on relatively little in real assets. There was no real value being created.

It seems obvious in hindsight. A stock market crash was the only eventuality for such a precarious scenario. Unfortunately, there’s symmetry between the run up to the 2008 stock market crash and last year’s growth on the Shanghai Composite Index.

What we saw on the Shanghai Composite Index is a clear example of leverage run amok. China has historically used state-sponsored banks as the funding apparatus for business development, but it was (and is) under pressure to open its economy. With greater influence over the world economy comes greater responsibility.

So Chinese regulators have started adopting some international norms. Among these norms is something called margin trading. Margin trading a common feature of stock markets in the United States and Europe. Here’s how it works.

First, open a margin account with an investment broker. There is usually a minimum amount you’ll have to put in and then the broker will lend you money to invest in stocks. In China, regulators began to allow a 2-to-1 margin ratio, meaning you could effectively double your investment with borrowed funds.

Although margin trading can greatly increase your profits if the investment appreciates, it can also magnify losses. This is at the core of understanding the possibility of a China stock market crash in 2016. As soon as Chinese investors realized they could borrow money to invest, the stock market bubble started taking shape.

Growth in the Chinese economy was slowing down, highlighting the absurdity of a ballooning stock market. Regulators started to worry. They tried to curb the speculation, but it just didn’t work. So on June 12, 2015, Chinese regulators banned all margin trading on the country’s stock market. Chaos followed.

Like I said earlier, my coworkers and I sat in horror as we watched the China stock market crash unfold. The government responded with extreme measures like jailing short-sellers and halting trading on over half the firms listed. Over the next two months the Shanghai Composite Index would crash more than 43.33% to a low of 2,927.29 before recovering slightly to its current level of 3,429.58.

Another China Stock Market Crash in 2016?

The prospect of another China stock market crash seems almost inevitable. If you think that prediction is too bold, let me explain. I haven’t yet explained how the Chinese government stabilized the initial stock market crash. How did the Shanghai Composite Index rebound?

It’s simple: Chinese regulators re-allowed margin trading on the stock exchange. Never mind if that credit gave birth to the China stock market crash this past summer. Investors were all too willing to bottle up their panic and carry on once margin trading was back on the table. The stock market bubble generator was back on.

The mainstream media has a notoriously short attention span. All it took for them to forget the China stock market crash was a minor period of calm. After a cursory round of follow up articles, the media was eager to declare the storm over and move on. But after following the story for several more months, I think we may have to face a darker truth.

The storm hasn’t passed; we’re just in the eye of the hurricane.

Since the bubble inflated by nearly 150% year-over-year, and we’re down only 33.62% since the China stock market crash in the summer, I’d say there’s plenty of room for further declines. What worries me is how far the international damage will extend.

I mentioned earlier that China is under pressure to integrate with the global economy. In effect, that means China must bring shadowy areas of the Chinese economy into the light. Greater transparency is a must.

In return for greater transparency, China hopes to secure reserve currency status for the yuan. The country has strategically targeted deeper integration into the global financial system to helps its bid with the International Monetary Fund (IMF).

Getting the yuan classified as a reserve currency is central to their integration plan. It will bolster trade and financial activity denominated in yuan, which would help raise the purchasing power of China’s citizens. And that is probably the most important thing the Chinese economy needs—for its citizens to consume more. (Source: “China’s stock market crash, explained in charts,” Vox.com, August 26, 2015.)

China Stock Market Forecast for 2016

The Chinese economy can no longer run on growing exports and investment. The living standards of Chinese citizens must rise and that means they need to buy more things. It’s as simple as that. But how can they buy more things if their wealth gets decimated in a stock market crash?

Think about it: China’s economic performance is lagging, and it must turn to consumer spending to fuel future economic growth. But the wealth of consumers is tied up in a stock market bubble that is propped up by credit. The credit was extended because Chinese growth was thought to be invulnerable.

The entire house of cards is built on the premise that the Chinese economy will stay strong. As the economic numbers continue to fall, pessimism will set in and no amount of credit will prevent the fall. Another stock market crash in 2016 is all but guaranteed.

On the whole, China’s attempt to open markets and liberalize has been successful. But introducing and legitimizing leverage in the Chinese stock market paved the way for disaster. The China stock market crash was collateral damage from that outward pivot.

Luckily for China, only a small portion of the Chinese economy was exposed to the stock market crash. The country’s ham-fisted response to the crisis was enough to pacify markets and keep the country out of the media eye. But it is by no means over.

The stock market crash was like a tiny pebble let loose on a highway, smacking into the windshield of a car and leaving a tiny crack. Overnight, the tiny crack spread across the glass, forcing you to replace the entire windshield.

That’s the effect I see from the China stock market crash. What we saw this past summer was only the first hit. The crack has slowly spread across the Chinese economy, revealing a vulnerability no one expected. Soon enough, we may see yet another China stock market crash.