China’s Stock Market Crash: Why It Happened And What’s Next

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Amid all the stories detailing Greece’s slow-motion collapse, you may have caught a stray headline or two about another financial meltdown, this time in China. The two crises are, in some ways, mirror images of each other. While its financial system is tied to the rest of Europe through a common currency (the euro), Greek’s economy relies heavily on imports and so a Grexit (Greece exiting the eurozone) won’t, on its own, cause much heartburn for Europe or the rest of the world. But the financial and political implications could reverberate in ways that aren’t immediately clear.

China, on the other hand, has a financial system that’s largely isolated from the rest of the world. Despite its stocks having increased in value to reach second place in the world earlier this year, only behind the United States, the majority of investors are in China itself. So even though those stocks have lost a third of their value over the past several weeks, that on its own won’t cause much trouble anywhere else. The problems will start when the turmoil in the financial system creeps into the economy. And China’s economy, itself second largest in the world, is far more tightly integrated with the global economy.
How much Greece affects the day-to-day life of someone elsewhere is largely a political question. Politics are clearly central to the troubles in China, too, but the broader consequences will be all about economics.

So it’s a good time to dig into what’s happened so far and what might happen next.

The boom

The Chinese stock markets – the main two are in Shanghai and Shenzhen, with smaller ones like the ChiNext start-up index also in the mix – are essentially seeing their bubble burst. Share prices skyrocketed between last summer and the beginning of this summer, in some instances quadrupling, and the overal stock indexes saw their values double.

That jump was largely due to investors flocking to small and mid-size companies. Many of those investors happened to be working- and middle-class people, including families who borrowed heavily to ride the wave and make their bid at fortune.

All of this, by the way, was happening while the Chinese economy was actually cooling off. Connect some of these dots and you might begin to see a worrisome pattern emerge.

You would not be wrong.

The Crash

The Shanghai and Shenzhen markets each fell by more than 7 percent on June 26, sparking a furious attempt by the government to right the wobbly financial ship. The central bank slashed interest rates the next day. Initial public offerings have been halted. Trading on many stocks stopped altogether to prevent further losses. And last weekend, while Americans were setting off fireworks, big Chinese brokerage firms were announcing a$19.3 billion plan to buy shares of blue chip stocks in a bid to stabilize the markets.

That worked briefly on Monday, by Tuesday things looked worse, and on Wednesday the markets plummeted again. By that point, about a third of the massive gains the markets had made between last summer and early June of this year had been wiped out.

And the temporary reprieves for some stocks, in which trading is stopped when the value drops by 10% on a given stock, might actually be exacerbating the crisis, according to the New York Times:

Those market dynamics can create a chain reaction of selling. China’s major exchanges prevent a stock from falling more than 10 percent on any given day. When that happens, analysts say, many investors opt for selling other shares, broadening the sell-off. Then when the market opens the next day, they continue selling down the stock that was previously halted, effectively prolonging the turmoil.

What happens next?

It’s really hard to tell. On Thursday and Friday, stocks bounced back, but that doesn’t necessarily mean the system is correcting itself. In fact, because of the highly leveraged gains of the past year and the cool economy, a true “correction” would probably see much of those gains reversed. The financial boom just didn’t – and doesn’t – match the economic realities that Chinese companies and consumers are facing.

But while China has opened up economically to a striking degree over the past several decades, it remains guided by a firm hand in Beijing. And even though the Communist Party may not be interested in central planning any more, President Xi Jinping does have a great degree of control – and, more to the point, he has rooted his power in a perception that he is, in fact, in control.

That extends to the economy. Xi and his government had made a point to connect the rising financial tides with his central idea, the “Chinese Dream.” If millions of regular Chinese lose their savings in pursuit of a dream Beijing had encouraged pursuing, the government’s promise might be exposed as a fraud. Xi could see his authority weakened, if not crippled. And, in fact, the famously authoritarian president has already come in for an unusually high level of criticism within China.

So you can probably expect the government to continue doing whatever it can to prop up the stock market despite being as artificially inflated as it already is. The political cost of letting it collapse is just too high. And, in situations like this, government intervention into the economy is not unprecented elsewhere. Recall the fall of 2008 in the U.S., when Washington bailed out the big banks to avoid a financial collapse. That’s just one of the most recent examples.

Former Fortune editor Allan Sloan wrote this week, “the institutions may be publicly shamed and their CEOs pilloried as a sop to the masses.” He also thinks that, similar to the American financial crisis, “the little guy” who was strung along on this mirage of an investment boom will be the one who suffers. But given Chinese politics and particularly Xi’s reputation for aggressively fighting corruption, it wouldn’t be altogether surprising if he used this as an opportunity to go after top financial officials and further consolidate his power by making a populist move to protect those who suffered losses. In other words, he may still be able to make political lemonade out of these financial lemons, even if it requires a bit of finessing the history. After all, Xi probably won’t own up to his or his government’s part in encouraging the bubble.

Will this affect the world economy?

Some are comparing the Chinese crisis to the stock market crash of 1929. That, of course, preceded a global depression. Not everybody sees China’s situation quite so apocalyptically. The Economist writes in its current issue that

Lost in the drama is the fact that the stockmarket still plays a small role in China. The free-float value of Chinese markets—the amount available for trading—is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stockmarket, which is why soaring shares did little to boost consumption and their crash should do little to hurt it. Many stocks were bought with debt, and the unwinding of these loans helps explain why the government has been unable to stop the rout. But such financing is not a systemic risk; the loans are about 1.5% of total assets in the banking system. The economy is solid. Growth, though slowing, has stabilised. The property market, long becalmed, is picking up. Money-market rates are low and steady, suggesting banks are stable.

But what happens if the government’s efforts fail and the markets dive again? Could a Chinese stock market collapse cause the same worldwide ruin as the 1929 crash?

Taken on its own, no. China’s financial system is pretty isolated, with most investment coming from within. So far that’s prevented the turmoil from spilling over into the global economy. But if the government’s attempts to prop up the econoy fail, and consumers are spooked – or impoverished – enough to cut consumption, that could be a different story. As the families and young workers who joined the feeding frenzy by investing borrowed money suffer losses, they’ll be hard-pressed to continue consuming at the rate Beijing would prefer. That, in turn, will likely cause a ripple effect across the Chinese economy, slowing purchases and tightening the flow of money. American companies could also be affected in a big way, especially industrial firms heavily invested in China.

But the biggest – and most obvious – threat is probably to the Chinese political system. And that, like the politics of the Greek crisis and its effect on Europe, could have unpredictable yet potentially devastating consequences.

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