In Mainland China, Shanghai and Shenzhen are the main financial hubs. The two stock exchanges have followed a similar trajectory since the beginning of 2015 (observable in the graph below). Although we refer to the Shanghai Stock Exchange Composite Index for descriptions of current events, the causes of the recent bubble deflation are common to both stock markets.

The Shanghai Stock Exchange Composite Index has lost about 30% of its value since its peak on June 12, representing the worst selloff in two decades. When a stock market goes through such a big collapse, there is a combination of factors that need to be investigated.

Before attempting to explain the major factors that led to the recent jolt, I would remind readers of the concept of “animal spirits” proposed by John Maynard Keynes in his 1936 book, The General Theory of Employment, Interest and Money. In light of the huge number of private investors (roughly estimated at 90 million), who account for over three quarters of trading volume in the world’s second largest equity market, an introduction on human beings is fundamental.

Keynes used the term animal spirit to interpret human behaviors; in economics, it is mostly related to trust. Animal spirits are included in or produce trust, which offers a first explanation for why the stock exchange has suffered a crushing blow.

The stock exchange in China has grown rapidly, particularly in the last year. Stock prices increased sharply, and everyone was confident about the never-ending growing trend. In his discussions regarding animal spirits, Keynes sought to convey the idea that swings in confidence are not always logical. There are good times when people have substantial trust and associated feelings that contribute to an environment of confidence. They make decisions spontaneously; they believe in their success instinctively, and suspend their doubt. This explains part of the mental mechanism that has led to the current situation of extreme stock volatility. Recently in China, public authorities have promoted trust in both institutional and private investors. The flow of confidence injected by public authorities is one of the major causes of the proliferation of private investors. The huge number of private investors possessing very limited knowledge of financial markets amplified the overconfidence. A high degree of “mom and pop” investors, inexperienced investors playing the market casually, can easily cause either massive sell-offs or buy-ins, similar to what occurred in the last month.

An additional cause of the extraordinary increase in investors is the deficiency of investment opportunities. The lack of investment opportunities, especially for private investors, creates difficulties in obtaining satisfying returns on private savings. Private savings are very high in China: most Chinese have to save for retirement and health care because the country’s social welfare system is still in development. Indeed, after the slowdown of the real-estate boom, the stock market remained the main vehicle for investment and speculation. Thus, the amount of invested money increased and trading volume on the Chinese market is now bigger than on the NYSE.

There is another major reason that has lead to a remarkable rise of funds injected in the stock market: the new regulations on margin loan availability. China officially launched margin trading by securities brokerages as a pilot project in 2010. Then, it expanded the program in 2012 with the creation of the China Securities Finance Corp, established by the state-backed stock exchanges specifically to provide funds for brokerages to lend to clients. The government, hoping to get the market going, opened the lending spigots for individual investors. Excessive overconfidence combined with margin loan availability created the conditions to enter into a boom period in which stock values no longer reflected their fair value. In any boom there is the chance that the betting will get out of hand.

However, tightly regulated and relatively transparent official margin lending is only the tip of the iceberg for Chinese leveraged stock investing. The shadow banking system presents a related and greater dimension to margin loans.

After the real estate market crunch, China’s shadow banks, increasingly wary of lending into a slowing economy, have turned to the stock market, thus fuelling a surge in unregulated margin lending. Only investors with cash and stocks worth Rmb500,000 in their securities accounts may participate in standardized margin lending by brokerages. Leverage is capped at Rmb2 in loans for every Rmb1 of the investor’s own funds, and only certain stocks are eligible for margin trading. In contrast, however, few rules apply in the murky world of grey-market margin lending. Leverage can reach 5:1 or higher, and there are no limits on which shares investors can bet. With such an unregulated credit system, the consequences could be dramatic. Whenever an individual wants to obtain loans by a Chinese brokerage house, he has to own, as aforementioned, a stock of capital or cash of at least Rmb500,000. In the case that he doesn’t have this availability, he could decide to obtain such an amount from the unofficial credit system. The result is a multiplication of leverages that becomes uncontrollable at a certain point.

Given that the brokerage houses receive money directly from Chinese banks, there are huge potential consequences for the overall economy in the case of turbulence. After Lehman Brothers’ default, everyone is aware that banks are financial institution capable of dismantling the worldwide financial equilibrium. This explains the strict measures adopted by the government to limit the damages.

This shadow-system has a complex and articulated structure. It is composed of several tiers, each one offering specific interest rates commensurate to the amount controlled by the tier itself. Another level of this peer-to-peer credit system is the entirely online lending mechanism. More technologies are available to shadow-banking system players. Using new technologies, clients can be controlled by software that follows their accounts, and shadow lenders are in this way somewhat protected. When the market is bearish, they can decide to sell the stocks if the margin calls are not met.

Over the past years, the number of “fund matching” companies (known in Chinese as peizi) has increased. These companies used to provide margin funding to virtually anyone who asked. After opening securities accounts at brokerages, fund-matching companies use a software program to divide the account into multiple sub-accounts that enable peizi clients to trade independently. The peizi company, as the official account holder, maintains ultimate control and can liquidate any sub-account if the investor racks up heavy losses. Chinese securities regulators have tried in the last months to close these funds’ spigots. The turning point was on June 13, when the agency responded with rules explicitly forbidding brokerages to co-operate with fund-matching companies by offering them direct access to their electronic trading systems. The country’s stock markets began their tumble the following Monday.

After the Shanghai Stock Exchange Composite Index’s skyrocketing performance (150 percent in 12 months) reached a peak on June 12, stock market capitalization started to decline sharply, burning about one third of the whole value in just one month. From June 12th to July 8th, the Shanghai Stock Exchange Composite Index declined from 5166 to 3234 basis points.

As soon as the market slowdown started, Beijing actively intervened. On Saturday, June 27th June, The People’s Bank of China (PBOC) cut official interest rates and reduced the required reserve ratio (RRR) for banks that met certain criteria. It appeared as though these cuts were aimed at stopping a stampede in the domestic stock market. However, it didn’t prevent the progressive decline of stock exchange values.

In the first week of July, the government decided to suspend initial public offerings (IPOs). The IPO suspension affects nearly 30 companies that hoped to raise more than 9 billion RMB ($1.45 billion). On July 1, the China Securities Regulatory Commission (CSRC) stepped in to prevent further declines by letting securities firms roll over margin trading contracts and loosening collateral requirements. By giving securities firms access to more money to lend to stock investors, the regulator made a U-turn on margin trading policy. Nevertheless, the Shanghai index continued to fall.

Financial authorities adopted new measures regarding the stock exchange by the end of the first week of July. Over a tense weekend, the government oversaw several steps to stem the selling fury. At a July 4 meeting, securities firms were enlisted to support the market intervention strategy. In a joint statement, the firms announced that they would spend at least 120 billion Yuan to buy exchange-traded funds linked to blue-chip stocks listed on the Shenzhen and Shanghai bourses in order to stabilize the stock market. Moreover, the firms pledged to hold all stocks that had been bought with their own money until the index reached at least 4,500 points.

New share offerings were suspended, quotas for foreigners to buy stocks were increased and the PBOC provided liquidity to China Securities Finance Corporation (CSFC) in order to make loans to qualified securities firms for margin on-lending to stabilize the market. The abundant injection of liquidity was aimed at increasing the market’s limited liquidity. The maximum 10% daily volatility limit for stock price variation is an important rule that helps the market control unpredictability, but it becomes a major cause of scarce liquidity in a background of massive sell-offs. Moreover, the China Securities Regulatory Commission banned major shareholders, corporate executives, and directors from selling stakes in listed companies for six months. Investors with stakes exceeding 5% must maintain their positions in order to preserve capital market stability, and speculative short-selling (meaning short selling without hedging purpose) has been largely halted. The Shanghai Composite Index opened 7.8% higher Monday, July 6th, making it look as if the all-out government mobilization would decisively lift stocks. But the index quickly pared those gains, spending part of the day in negative territory. It ended only 2.4% higher. Investors and analysts said heavy buying of blue-chip stocks like state-owned banks and energy firms late in the session appeared to be the work of state-backed funds. The Shanghai Stock Exchange Composite Index reached the bottom value on July 8th, at 3234 basis points. Meanwhile, 1,442 companies had exercised their right to suspend trading of their own stock on the Shanghai and Shenzhen exchanges as of July 9.

A sense of urgency prevailed. Never before had the country’s stock markets taken such a wild ride.

Beijing’s all-out campaign to avoid an equity market collapse finally showed signs of bearing fruit on Thursday. On Thursday, the Shanghai Composite Index rallied 5.8 percent, notching its best session since 2009. The Shanghai Composite finished up 4.5 percent on Friday, marking its biggest two-day gain (10.6%) since 2008.
Only seven Chinese stocks fell during these two days of escalation, while more than 1,000 companies hit their daily upward limit of 10 percent as investors rushed to buy whatever was still trading. But doubts remain about the rebound’s sustainability as trading of more than 1,400 remains suspended — about half of all listed companies. However, more and more stocks have been resuming every day. The suspensions have frustrated investors and increased market volatility by limiting the transfer of stocks that traders need to sell in order to raise cash. Analysts said the number of suspended shares distorted the market by forcing investors to sell stocks they might have preferred to hold.

On July 13, The Shanghai Composite Index rose 2.4% to 3,970.39 at close. The number of halted companies fell by 408 from Friday. On July 14, China’s benchmark stock index fell for the first time in four days of volatile trading amid concerns that recent gains were excessive. The Shanghai Composite Index slid 1.2% to 3,924.49 at close, halting a three-day 13% rally. About 27% of companies listed on the mainland stock exchanges were still suspended, according to data compiled by Bloomberg. On July 16th, Chinese stocks rose for the first time in three days of erratic trading as smaller companies advanced and almost a quarter of the market remained frozen. Overall, it seems that the market is on a new, stable path after the recent collapse. Analysts have different estimates regarding the level the stock market will reach in its stabilization phase, in terms of basis points.

However, the public authorities’ actions also have intrinsic drawbacks. Going back to Keynes’ animal spirits, moral hazard could drive a potential backlash. Retail investors’ faith in policy makers illustrates the growing risk of moral hazard, an unintended side effect of government efforts to halt the $3.9 trillion selloff. While the support measures have helped stocks rebound, the risk is that investors come to view the market as a one-way bet, fueling bubbles that authorities may struggle to control.

The extreme and uncontrollable volatility of the Chinese stock market has damaged most of the financial authorities’ certainties. The Chinese government’s questionable trust of the stock exchange’s advantages has been threatened. The government couldn’t control such a gigantic shock to the market, and this inability is a clear sign of financial markets’ often uncontrollable complexity. The stock market will no longer be seen as a riskless source of funds. The Chinese dream to finance high tech companies and fast-growing enterprises via stock markets should be reshaped. The ChiNext index, as well as others, has suffered the most in recent events.

Despite the complex structure forming a stock market, its backbone is basically related to the relationship between demand and supply, perhaps one of the most fundamental concepts in economics. The government has to rebalance the equilibrium between the two dimensions, not only acting on the supply side as it has recently done, but even cheerleading on the demand side. Nowadays, China is definitely too big to fail.