China's Correction

August 26, 2015 09:00 AM

The sheer size and importance of China’s equity markets cannot be overstated. Second in size only to the New York Stock Exchange, the combined value of the Asian country’s stock markets is $14 trillion and change. Or at least it was, before it fell 30%, wiping away nearly $2 trillion in value (see “China in three charts”). To put this in perspective, the gross domestic product (GDP) of debt-troubled Greece is around $200 billion.

So how did this happen? The answer has a lot to do with the quantity and quality of investors.

In most major economies, stock market trading is dominated by professional money managers. But in China, between 80% and 90% of the domestic A-share market is made up of retail investors, many of them novices who sought to participate in the year-long bull market. An eye-popping 40 million new brokerage accounts were created in the one-year period ending in May. The Communist Party, by comparison, gained only a little more than one million new members in the same period. At the peak, accounts were being added at a rate of over three million per week (see the second chart).

For many of these first-time or relatively inexperienced investors, the price of entry was margin lending. Cosmic amounts of it. Near the end of June, 2.08 trillion yuan ($335 billion) worth of borrowed funds flooded the Shanghai and Shenzhen markets. Margin lending as a percentage of total market cap rose to as high as 20%. In the United States, it’s about 2.5%.

This combination—millions of new accounts mixed with unprecedented leverage—greatly contributed to the selloff. As you can see in the third chart, this leverage is now unraveling as investors are forced to sell to meet margin calls.

Beijing has responded with a host of measures to prevent the market from sliding any further, one of the most significant being a ban on large institutional shareholders from selling until the Shanghai Composite rises above 4500. As of this writing, it’s just above 3800 after breaking a three-day rally. 

The good news is that some analysts say the worst might be behind us. Financial services firm UBS takes the position that, as massive as the correction was, it shouldn’t have a “major” economic impact.

In the meantime, it is wise to move your Chinese market investments into cash and be ready to deploy it when the right opportunity arises.

About the Author

Frank Holmes is CEO and chief investment officer of US Global Investors. This first appeared in his Frank Talk blog. For more updates on global investing from Frank and the rest of the U.S. Global Investors team, follow on Twitter at www.twitter.com/USFunds or like on Facebook at www.facebook.com/USFunds.