Xuanzong’s Journey to Shu depicts the Tang dynasty Emperor Xuanzong retreating from his capital in Chang’an to Sichuan province during the An Lushan rebellion, ending the golden age of the Tang dynasty’s influence and wealth. The emperor’s train is hard to discern from the rising mountains and is in fact partly hidden as they make their way over hills and around bends. Xuanzong is regarded as responsible for the pinnacle of the dynasty’s power but also responsible for its downfall. The painting, which is an 11th century remake in the style of Tang painter Li Zhaodao currently housed in Taiwan’s National Palace Museum, emphasizes that even emperors cannot outrun some forces.

Yesterday’s Global Market Update remarked that the biggest threat to global markets from China’s recent stock market drop is if those losses affect China’s economic growth. With a slowing economy (in terms of GDP), this is a real concern.

So what has been going on?

Price History of Shanghai Class A Index, Shenzhen Class A Index; Hang Seng Index (Hong Kong)

Beginning in June of 2014, the domestic Chinese stock markets in Shanghai and Shenzhen began a slow rise. By December, prices began rising faster. This spring, the markets kicked into high gear. At their highest point in June of this year, the Shanghai Class A index was up 150% and the Shenzhen Class A index was up a mind boggling 215% from the start of the rise back in 2014. As you can see from the charts, Hong Kong doesn’t move in tandem with mainland stocks, but it too benefited from the rising mainland market.

Was it a bubble? One basic definition of a bubble is when the price of an asset strongly deviates from its intrinsic value. The implication is that when the bubble bursts, everyone in that economic system (be it local, national or global) is hurt. It’s too soon to see how many Chinese investors have been hurt (although one group is obvious: China’s tycoons).

Global investors have less than 3% of domestic Chinese shares and that number is likely even smaller after this sell-off. This is because China’s stock market is still relatively closed. So the idea that the losses in Shanghai and Shenzhen will directly impact global investment flows is minor. What that does mean is that the effects will be indirect and thus harder to predict.

For the size of China’s economy, its stock market is not very robust and had not been considered a conventional investment option. The term for investing in the stock market, 炒股 chaogu, translates literally to speculating in stocks (or even more literally as stir-frying stocks). Yet one reason the stock market had risen so drastically is that the government has been actively promoting stocks in this way. As the market continued to rise, so did margin lending. Once confidence eroded, brokerages began calling in those margin sales and investors were forced to sell, setting off a downward spiral.

It has taken around 8 government interventions to stem this rout which has reminded many international investors that for all its talk of liberalization, the Party is still in charge and very concerned about maintaining economic stability. More importantly, the government has an overinflated sense of its control over the stock market. After the first interest rate cut, prices were still dropping. With no instant positive reaction, the government resorted to ever more heavy-handed measures.

  • June 27: A 25 basis point interest rate cut; bank lending reserve ratios lowered
  • June 29: Pension funds allowed to invest 30% of their net assets (equivalent to more than $100 billion) in equities
  • July 1: Margin financing rules relaxed (after strengthening earlier in the year)
  • July 3: Central bank extends a 250 billion RMB ($40 billion), six-month loan to state owned banks
  • July 4: 21 brokerages say they will invest $19.3 billion in a new blue-chip fund to stabilize the market. Also vow not to sell any of their own proprietary equity holdings.
  • July 5: IPOs frozen
  • July 5: Central bank says it will inject an undisclosed amount into China Securities Finance Corp., a state-owned company that makes margin loans to brokers.
  • July 6: Executives from mutual funds pledge to support the markets with their own capital.
  • July 7: 23% companies halt trading
  • July 8: Over 50% halted
  • July 9: Indexes make largest one-day rise in six years

This meddling with markets, while aimed at protecting its citizens from major losses, runs the risk of filling the crack in the face of a fissure, especially when President Xi Jinping has made reforming the economy as it slows a focal point of his tenure. It will certainly force the IMF to question the validity of the recent efforts to include the Yuan as a reserve currency. An effort that looked very promising just a few weeks ago may be dead in the water.

Still, the relationship between the China’s stock market and economy is not very strong. The top 10 banks, as state-owned enterprises, have fared well. Property prices in the 10 largest cities are rising as well.

Fundamentally, the long term trends in China have not changed. Unless the unwinding of margin lending goes unaided by the government (unlikely), it is hard to say that losses will spread to other markets. Caution is the watchword but don’t discount 1.3 billion people and the world’s second largest economy. How the government reacts to the next dramatic downturn will provide valuable insights into China’s long term trajectory.