Jul 3, 2015

Why China's Stock Market Crash may be Deadlier than Greek Exit

The China and the Greece drama started almost around the same time. On 26th June 2015 (Friday), the Shanghai stock index fell 7.4% in a single day and investors were relieved that a meaningful correction in the Chinese stock market would lead to a more healthy upwards trend. Things seemed to be going well at the Greece end as investors were positive that the Greek government would be able to come to an agreement with her creditors before the IMF repayment deadline on 30th July.

Things started to unravel over the weekend.


The Chinese government, in an effort to stabilize the stock market fall, announced interest rate cuts and eased banks' reserve requirements. It was the first time since 2008 that the Chinese central bank had to resort to use a double barrel shotgun approach. Meanwhile, over at the Greek front, the Greek government called for a shock national referendum, to be held on 5th July, to let the Greek citizens decide whether they want to accept the austerity measures imposed by the EU creditors.

Analysts generally believed that the China stock market correction will be arrested on Monday, thanks to the strong measures imposed and the global stock market will tank, as a result of the negotiation break down between Greece and her creditors.

Global stock market plummet as a result of the Greece saga and prices of safe havens such as US treasuries and USD shot up. The Chinese stock market rallied 5% on Monday.


Things took a sinister turn for the Chinese stock market on Tuesday and the stock market continued their relentless downtrend. The Chinese government and financial companies came together to try to arrest the relentless bearish onslaught by announcing market supporting measures, relaxing of margin requirements, allowing investors to use their property as collateral for stock investing and starting probes to investigate "market manipulation". None of the measures worked and the Shanghai stock index breach a key technical level at 4000 pts, leading to further panic and sell-down. Chinese investors are screaming on the social media that the Chinese Government is not doing enough to save them.

Over at Greece, the vote for "Yes" (stay in Euro and stomach austerity) and "No" (potentially exit Euro) remains split with both camps exchanging leadership based on polls done on every other day. The global stock market stabilized on Tuesday, despite Greece defaulting on their loan payment to IMF as investors believed that the damage from any Greece fallout will be contained. They were also generally optimistic that Greece will stay in Euro.

The China Contagion

A few months ago, I was chatting with a couple of friends on the brewing China stock market bubble. We agreed that the Chinese stock market are in an irrational exuberant stage but we disagree on the ability of the government to manage the stock market.

I believe that no organization or government in the world, is powerful enough to fight against market forces.

My friends believed that the Chinese government is so rich and powerful, that they will be able to stop any market crashes and prevent any economic depression.

What has happen so far prove that the Mr Market is greater than any government.

The Chinese government made efforts to redirect their citizens wealth to the stock exchange, to help to deflate the triple bubbles of property, corporate debt and trust products. By redirecting the funds to the stock exchange, the citizens will direct their wealth towards the stock market and rather than property, corporate companies can raise funds using equity, rather than debt and also help to divert funds from the less transparent shadow banking trust funds to the more transparent stock market. The stock market seems like the perfect solution to their problems. The quiet China stock market suddenly soared to life, thanks to the successful propaganda initiated by the Chinese government and the stock market tripled in a couple of months time. The average return of IPO stock is around 40-90% and the stock trading suddenly became the day job of many Chinese.

It seems like their effort to stop the stock market crash is not as successful as their ability to ignite a stock market rally.

What I am worried right now is the potential contagion effect of the stock market crash as the retail investors, which constitute 80% of the market value, rushed to get out of the stock market and liquidating their properties and trust fund products in order to meet their margin calls. The pullout from these two products will inversely impact the finances of property and industrial companies leading to their collapse. Should this contagion and panic spread to other markets, China may face their first serious recession since the 1980s. We have an entire generation of Chinese who have not ever experience an economic recession and their blind optimism and faith towards the ability of the Chinese Government to rescue them may plunge them into deeper waters.

On the other hand, the EU had a few years to manage the Greece crisis and most of the contagion has been limited as the risk has been transferred from banks and private companies to the EU government. There can be a chance that the Greek crisis can unfold into something more serious, but the EU central bank and governments have ample of time to prepare for such an eventuality, unlike the Chinese government, whom seems to have been caught off-guard by the irrational exuberant and panic selling of the China equities.

Asia, which has been able to prosper despite a crippling recession in US and EU is thanks to the growth and hot money from China. Should that disappear, Asia will suffer more as compared to the 2008 US Financial Crisis. 

Our Portfolio Strategy

Our portfolio has been positioned perfectly for this twin crisis with 80% of the portfolio in short term bonds and USD money market funds. Thanks to the Euro crisis, the USD shot up netting us a nice profit in that position. The Euros and European equities have fallen sufficiently to make me interested in getting back into it again. However, I want to observe how the Greek drama will progress, before I make a decision whether to take a position into Europe. I do not wish to buy into a correction, only for the market to turn into a crash. Right now, the global market is a bit too optimistic on how the Greece crisis will unfold and this optimism may lead to a drastic correction in the future should the Greek drama play out unfavorably. I will not recommend taking a position in the China stock market now as the crash may just be the beginning of something bigger. Other Asian economies and commodity prices will definitely be affected should the Chinese economy falls into a recession. This will be an opportunity of a lifetime should that happen.

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