Commentary on Political Economy

Thursday 4 February 2021


China’s struggle to control stock bubble offers lessons in investor mania

China’s experience is a reminder: when the herd is unleashed, it is difficult to control © Reuters

What happens when millions of individuals suddenly decide to dabble in a frothy stock market?

It is not a new question, but a timely one, as US regulators weigh the implications of a sudden burst of retail trading that has caused stock prices to pop like solar flares. Is it something to worry about, should something be done? And if so, what?

China found itself in a similar position in 2015, when an army of novice investors flooded into equities, fuelled by cheap credit and cheered on by the central government. 

Beijing wanted its people to share in the country’s economic growth, give its companies access to a new source of capital and take some heat out of the property market. 

There was a neat structural argument too — worthy of any sell-side analyst. The doors to China’s long-guarded capital markets were finally opening to international investors, so get in quick. And the economy was about to pivot away from heavy industry for the first time in 30 years. A gold rush was easy to justify. 

China’s market then was not as accessible as the US market is in 2021, where fee-free trading and complex investments are just a thumb-tap away. But it was getting much easier for the average person to get involved. Smartphones offered a slick channel for stock tips and share prices, while young, hungry brokerages were eager to extend margin loans to millions of have-a-go investors.

In many ways, it worked. Chinese stocks roared, shaking off years of underperformance and bringing valuations more in line with other emerging markets. A long pipeline of initial public offerings filled up, and “new economy” stocks — healthcare, technology, consumer goods — saw the funds flow in. Many people got very rich, very quick. 

But soon came the mania. Individual companies began to see sudden bursts — sometimes sparked by something as small as adding the word “fintech” to a company’s name. Billionaires emerged from nowhere in the space of an afternoon, while hundreds of obscure small-cap stocks rose to nosebleed valuations. 

Line chart of Shanghai Shenzhen CSI 300 showing China's 2015 stock market bubble

Grannies lined up to bet their pensions on the trading floor, while their children and grandchildren took out mortgages to up their bids. Trading ideas flowed via WeChat messages, with nothing more than a stock code and good feeling to go on. 

Of greater concern to the authorities was that those new investors had borrowed hundreds of billions of dollars to trade stocks, leaving banks and brokers with huge potential problems. 

China’s experience is a reminder: when the herd is unleashed, it is difficult to control. It moves fast and in numbers. Professionals can dismiss it as dumb money, but retail punters can simply overwhelm. 

In the end, the only regulatory tool that eventually worked was a squeeze on finance provided by brokerages for investors to buy stocks. After multiple crackdowns, this began to starve the market of new money. 

Sapped of forward momentum, China’s market turned hard. Months of gains were erased in a few short days as everyone raced to lock in gains, minimise losses or pay back debts. Trillions of dollars of paper value, gone. Those newly minted billionaires unmade in hours.

In a panic, Beijing then tried almost everything to prop up the market. It banned short-sellers, cut interest rates, cancelled IPOs and directed state funds to buy. At one point, hundreds of listed companies simply suspended their shares when things got too choppy. 

China’s heavy-handed interventions were driven by a fear of social unrest if too many people got burnt, and the potential for a Lehman-style blow-up causing the financial system to seize up. Both David and Goliath were at risk.

This experience offers a cautionary tale for global policymakers, who have — for more than a decade — propped up markets with a flood of liquidity support.

Single stock flare-ups, like those seen recently in companies such as GameStop and BlackBerry, were a feature of the China rally too, and were a telling sign of how overheated the market had become. Late arrivals can often make for overeager buyers. 

The Reddit army’s war on hedge funds may not in itself pose any serious systemic risk to the financial system. The moves have generally been confined to esoteric backwaters of the market. 

But its advent could still be a new symptom of a deeper, festering malaise. History tells us that years of cheap credit can cause a dangerous misallocation of capital.

In 2015, Beijing saw the problem, and decided to act with force. Yet even then it struggled to get a grip. That underlines just how difficult it will be for western central banks to rein in current frothy markets — and the risk of a painful denouement for investors as the largesse of monetary support is withdrawn.

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