China's stock market stopped crashing on Thursday. After a stunning four-week drop that obliterated a third of its value, the Shanghai Composite Index rose 5.8 percent, its largest one-day gain in six years. This may be a sign that that the Chinese government's extraordinary efforts to calm investors have finally worked.
Or, it might just be a breather before the carnage starts anew.
Since the rout began last month, Communist Party leaders have done everything short of unplugging the computers that run the stock exchanges to stop share prices from falling. The central bank cut interest rates. A state-backed finance company handed out $42 billion to brokers so that they could buy stocks. It let more than half of listed companies halt trading, almost 1,500 total as of today's session. It put a hold on new IPOs. On Wednesday, it banned large shareholders and executives from selling off stock for six months. And that's only about half the list of creative interventions it came up with.
Here's the problem. Sooner or later, trading will have to go back to normal. And when it does, there's a good reason to think the sell-off will start up again, since Beijing hasn't done anything to address the likeliest culprit behind the plunge: Too many mom-and-pop investors borrowed money to buy stock, which they are now being forced to unload in order to cover their losses.
Before Chinese shares started their tumble in June, they had risen an astonishing 150 percent over the year. This unhinged bull market was fueled by an enormous increase in the number of investors buying on margin, which simply means borrowing cash from a broker in order to purchase stock. (As many have noted now, that is exactly what inflated the American stock bubble that burst in 1929.) Officially, margin lending increased five-fold during China's runup, but thanks to the country's massive and poorly regulated financial gray market, it likely grew far more.
That's a big piece of why this recent market correction has been so violent. If you buy stock on margin and prices fall, your broker can demand more collateral to back your loans. If you can't hand over more cash or securities, he'll typically sell off some of your portfolio to cover the difference. This has been happening to millions and millions of Chinese investors. And though these margin calls didn't necessarily start the market downturn, they helped turn it into a self-reinforcing spiral (the more the markets fell, the more stockholders had to sell).
The crash has already wiped out about one third of the borrowed money from China's markets—but that means most of it is still there, and could help kick-start another extreme downturn as soon as investors get a chance to offload shares in the companies they haven't been allowed to trade. “Until the margin buyers are gone, we don’t expect a stabilization or possibility for the market to start heading higher again,” Sean Yokota, head of Asia strategy for SEB Bank, told the Wall Street Journal. “We are only one-third of the way through [deleveraging].”
If that's true, it will be an enormous problem for the Chinese leadership, which has put its reputation for savvy economic management on the line by making such a desperate effort to steady the markets. Already, Chinese citizens feel deeply burned by the crash. While shares are still up enormously for the year, millions of small-time investors jumped on at the tail end of the stock-buying mania, which the government cheered on through state media and helped accommodate through lax monetary policy. As the Economist puts it, “Officials are seen to have promised the population a bull market, only to lure them into a bear trap.”
Should the fall resume in spite of Beijing's dramatic response, it will be bad news for the government. It's one thing to be considered untrustworthy. It's a whole other to be considered inept.