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China Stock Market Fall

11 October 2015 |

Monday 24th August 2015 has been dubbed 'Black Monday' after economic concerns, mainly in China, led to a sharp fall in stock markets around the world. The Shanghai Composite, a central stock exchange in China, fell by 8.5% during the day. Other areas of the world were affected too. In the UK, the FTSE 100 fell by 4.5%, the Dow Jones in the US fell by 1000 points, and in Europe the German DAX and French CAC exchanges both fell by around 5%.

Stock Markets

Before we address the 'Black Monday' incident, it is important to understand stock markets. In a market for fruit, one can buy apples, oranges or other fruit. In a market for clothing, one can buy suits, trainers, or maybe a coat. In a stock market, one buys shares in a company. A share is essentially a piece of that company. The value of it will increase if the value of the entire company of which it is a part increases. This can be thought of in terms of an apple pie. If you own a 6th of the pie, and the pie subsequently grows to twice the size, your 6th will be much bigger than when you bought it, so if you sell it you will make a profit. This is why people buy shares in the stock market. They hope their investment will grow, so they can make a profit when they sell it later on.

Nobody can predict the future, so when people buy shares thinking the company will grow and increase in value, they are speculating. People speculate based on all sorts of things, usually news. For instance, if people hear a company is set to enter a new market where it will gain lots of new customers, people will think the company is going to do well and so they might invest. Many people simply invest because others invest. They think a company must be doing well otherwise others would not be buying shares in it. Of course, if people invest in a company but the pie subsequently shrinks, they will have lost money.

Stock markets are huge drivers in the economy for a very simple reason. When you invest in a company, you are purchasing a share from them. The money they get for that share can be used to grow their business, for instance by building new factories or hiring higher quality executives. It is a huge source of capital all around the world, which when put to use, begets economic growth. The stock exchanges, on which shares are issued, are simply lists of companies and the aggregate value of all their stock. For instance, the FTSE 100 is a list of the largest UK-based companies and their aggregated stock value. So when the FTSE 100 goes up or down, it is a reflection of how well these huge companies are doing, and in turn how well the economy they are in is doing.

What caused stock markets to fall?

A year ago, China encouraged its citizens to invest in its stock markets as a means of boosting the economy. They did this because growth in the Chinese economy, which proliferated at an extraordinary pace over the last couple of decades, has slowed down. This change of pace is the backdrop to why investors have been investing less in the stock market and selling their shares. The Chinese economy abounded after the financial crisis in 2009 largely because of lending to property companies. However, lending comes with debt. As a result, China has been concerned with what might happen if house prices form a bubble (reach a point where house prices cannot get any higher because there is no demand for more housing, spurring the beginning of a fall in prices). Falling house prices would reap fewer revenues for property companies causing them to default on their debt, and the growth would collapse. This is why they encouraged citizens to invest in the stock market, so that the economy would grow that way instead.

As a result, around 80% of the Chinese stock owners are ordinary citizens who are uneducated in stock market technicalities. This is unlike in the west where the vast majority of stock owners are big companies, funds and trained analysts. This means that Chinese investors are more likely to panic and move their money in herd mentality, rather than basing their decisions on technical knowledge. When the Chinese economy continued to slow down, investors began selling their shares in the stock markets. And, as a result of seeing fellow investors leaving the markets, the selling of shares snowballed and stock prices plunged further. This has exacerbated economic woes because as investment in stocks decline, companies are losing money they would have got from selling shares to expand and grow.

What sparked 'Black Monday'?

This explains why there has been a gradual decline in investment in the Chinese stock markets, but it does not explain why there has been a sudden drop on Monday. Investment in the stock markets is hugely dependent on whether people think it will be good to invest or not. New information, which influences these decisions, has caused the number of people selling their shares to accumulate more and more rapidly, until news over the weekend caused panic to gather apace resulting in huge waves of share-selling on Monday.

First, the impending and inevitable decision by the US Federal Reserve to raise interest rates have fuelled worries. This is because raising interest rates makes borrowing money more expensive, because the interest you have to pay back on it is higher. This tends to cause people to spend less and save more, resulting in less demand for products around the world. Chinese investors have found this worrying because America is home to many of the huge companies that operate in the Chinese market. These companies will decrease in value if a raise in interest rates causes a decrease in demand for their products. In addition the companies themselves will be borrowing less to spend on growth because it is more expensive.

More saliently perhaps, the Chinese government's attempts to arrest the stock market decline and allay fears of further losses failed, sparking more panic in the weeks and days leading to 'Black Monday'. Two weeks ago, China devalued its currency, the Yuan. Devaluing the currency (making the currency worth less so that it is cheaper to purchase with other currencies) means it is cheaper to buy Yuan in other countries. People may not directly go into a shop to buy Yuan, but they buy it indirectly when they buy Chinese goods. So, by devaluing the Yuan, Chinese exports will tend to increase as other nations capitalise on how much cheaper it is to buy the Yuan to buy Chinese goods. This would see more money coming into the Chinese economy from the increase in exports, which could be spent on stock markets and other means of recovering economic growth.

However, this tactic was counter-productive. Investors saw the depreciation of the Yuan as a reflection of the Chinese government's fear of something more sinister - perhaps that the economy was going to tumble dramatically again soon, so investors started selling their shares. People began posting on social media, pleading the Chinese government to do something over the weekend to restore the stock market. They didn't. So when the markets opened on Monday, investors began selling their shares in droves, fleeing as fast as they could. 'Black Monday'.

What impact does this have?

This affects the rest of the world because many of the big companies around the globe listed on European, British and American stock exchanges, are multinational companies with business in China. The huge decline in investment in China means that these companies lose money and have to tighten their belts around the globe. Glencore, a huge mining and commodity company which relies heavily on Chinese investment and demand, fell in value by 11%, as did Apple, the innovative technology brand. Another reason this is significant is because pension funds are huge investors in stock exchanges in the West, and the falling stock market values have meant that people's pensions are falling in value too.

China has responded by allowing pension funds to invest up 30% of their assets into stocks in an attempt to haul the stock market back up onto its feet. They have also cut interest rates, making borrowing cheaper, to encourage companies and individuals to spend money in the economy and the stock markets. However, as the stock markets look destined for more trouble in the near future, one upshot is that the plunge in share prices may provide savvy traders with an opportunity to make money in a period of unusually low stock prices.