China stock market: Five facts that show how the bubble arose - and why it might be bursting

The value of Chinese equities had grown at a phenomenal rate over the past year. But with some fearing the only way was down, Friday's crash will come as no surprise

Shanghai Duolun Industry, a Chinese real estate company, managed to win over investors with a little re-branding in May.

In the midst of a boom for technology stocks, the company changed its name to “P2P Financial Information Service Co”. The company hasn’t actually developed a peer-to-peer lending business – it just bought the domain name www.p2p.com – but its shares jumped 10 per cent anyway.

P2P Financial Information Service wasn’t alone in this strategy. One Chinese floorboard company doubled its share price by shifting to online gaming. A hotel group became a high-speed rail company and a ceramics specialist re-branded itself as a clean-energy group. Investors rewarded these decisions.

China’s domestic stock markets have climbed to near-historic heights this year. The bigger of China’s two main stock exchanges, in Shanghai, is up 40 per cent since the start of the year, while the other one, in the southern city of Shenzhen, has risen by more than 90 per cent. But those figures are off from a 12 June peak, raising concerns that the great Chinese stock bubble of 2015 is heading for a dangerous end.

No one knows for sure what will happen next. It’s possible that Chinese stocks are undergoing a slight correction, which will calm everyone down and lead to more sustainable growth, rather than a crash. But it’s also possible that a correction will trigger a stampede for the exits. That could weigh on China’s broader economy, with negative consequences for the rest of the world.

Here are five facts about China’s stock market bubble that help explain why it arose and what might happen.

1. In just 12 months, Chinese markets have created enough value to give every person on Earth almost $900

This is a bubble of epic proportions. In 12 months, Chinese stock markets rose enough to create $6.5trn (£4.1trn) of value. That’s the equivalent of around 70 per cent of China’s GDP in 2013, or about 40 per cent of the total value of the New York Stock Exchange – or enough to pay off Greece’s debt 20 times over.

No other stock market has ever grown this much in dollar terms over a 12-month period. Some, however, argue that Chinese stocks have a lot of catching up to do. While the broader Chinese economy has recorded impressive growth rates for years, its stock market had languished since an abrupt crash in 2008, before starting to climb again in 2015.

But others see a more ominous future. A survey by Bank of America Merrill Lynch revealed that seven out of 10 global investors agree that China’s equity market is in a bubble.

2. Most Chinese investors do not have a high-school degree

People often say that markets follow the “greater fool” theory – even if a stock is irrationally overvalued, it still might be worth purchasing if there is another fool out there willing to pay a higher price.

That may be the calculus now. As high as valuations are, novice investors keep rushing into the market. Just last week, 1.41 million new investors opened stock accounts, according to the news agency Reuters – a similar number to each of the two weeks before.

The make-up of these new entrants isn’t encouraging. A survey last year showed that two-thirds of Chinese investors haven’t completed high school. Even Chinese farmers are giving up tending their fields in order to tend their stocks.

3. China now has the world’s most volatile stock market outside Greece

After climbing for months, mainland exchanges took investors on a scary dip, falling by more last week than they had since 2008. And the ride for investors in general is getting bumpier. According to Bloomberg data, the market has experienced bigger swings over the past 30 days than any other market except Greece.

4. There’s a disconnect between Chinese stocks and the real economy

The stock bubble may seem all the more strange given that the Chinese economy is not doing that well any more. In the first quarter of 2015, GDP grew at its slowest pace since 2009. Imports, retail sales and investment have also dropped off.

The slowing economy and a supply glut in some cities have also caused prices to slump in the property market, which has long been considered the safe and reliable way for Chinese households to invest. As a result, according to Patrick Chovanec of Silvercrest Asset Management, people have started shifting their money out of property and into the equity market.

5. The bubble is fuelled by borrowing

The other reason for the stock market boom is China’s huge expansion in lending in recent years. As the American Enterprise Institute’s Derek Scissors writes, China’s M2 – a measure of the amount of money sloshing around the economy – was $20trn at the end of 2014, an incredible 70 per cent larger than in the US.

In China, as in the US and UK, monetary expansion was intended to stoke the economy but often instead ended up in the stock market.

The other trend fuelling the Chinese stock market has been a huge increase in the use of margin debt. This has more than tripled in the past year, raising the risk of a stock market crash. In a margin trade, an investor uses some borrowed money from a broker to buy stocks. If the value of a share falls below a certain level, investors will get a margin call to stump up more money. This dynamic means that a dip in prices in China could quickly spark an even bigger sell-off, as investors sell stock to pay their brokers.

Despite these troubling trends, the market could continue to climb in China. As the adage goes, markets can stay irrational longer than investors can stay solvent.

© Washington Post