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Emerging dangers

Emerging dangers

Bloomberg data from 10 July 2014 to 10 July 2015 show the Shanghai Stock Exchange Composite Index rose by 90.2 per cent and the ChiNext index rose by 85.9 per cent, but these data points hide a very volatile path.

The Shanghai Composite is a widely used index of all companies listed on the Shanghai exchange, while the ChiNext index is an index of fast-growing businesses listed on a NASDAQ-style board in Shenzhen, with weaker listing standards than on the main exchanges.

Following a period of consolidation, July 2014 saw the start of a major bull move in both indices. The Shanghai Composite gained about 150 per cent to its peak in June this year, and the ChiNext index rose by 200 per cent. This was followed three weeks later by a fall of about 30 per cent for the Shanghai Composite, and more than 40 per cent for the ChiNext index – the latter suffering from many stocks not being able to trade at all.

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The Bloomberg data shows that the rise in the Shanghai market was fairly uniform throughout 2014. The ChiNext market had a fairly quiet 2014, before rising by more than 150 per cent in 2015.

In 2014, three things occurred. First, house prices stopped rising and in fact began to fall as it became apparent that supply was running ahead of demand in many cities. Belief in ever-increasing house prices began to evaporate and the savings that would otherwise have funded property purchases moved to other assets.

Second, the People’s Bank of China changed monetary policy as they became confident that inflation was coming back under control and growth began to slip due to poor demand for Chinese exports in Europe and North America. They began to lower interest rates and reduce reserve requirements in the banking system – in western terms, they initiated a new cycle of monetary policy easing.

Third, the Shanghai-Hong Kong Connect investment bridge was launched, which allowed investors in each market to trade shares on the other market using their local brokers and clearing houses. This was announced in April 2014 and went live in November. Many more investors were then able to trade shares on the Shanghai exchange through their Hong Kong brokers.

The rise in the Shanghai market in 2014 was initially ignored by the ChiNext market, a much smaller and less liquid market where trading is dominated by local investors, but at the start of 2015, they too began to bid up share prices.

There are no legal casinos in China, so the sharp rise in share prices in these speculative stocks in Shenzhen sucked in many new investors and finance companies that were prepared to provide capital for speculative investment. Margin debt – debt linked to the purchase of shares – exploded in China in 2015, fuelling demand and pushing up prices at a crazy pace.

At some point in all such market cycles, the confidence in ever-rising prices begins to crack and markets go into reverse. This is what has happened in China – as share prices began to fall, so margin calls were made and forced sellers were created, effectively acting to intensify the downtrend.