The Chinese Stock Bubble 2007 - Research Paper Example

? Chinese Stock Bubble 2007 Reasons, effects and recommendations Group member Group member 2 Group member 3 Submitted TABLE OF CONTENTS In the past five years, some of the largest stock markets have been subjected to asset pricing bubbles; these have included stock markets in developing markets like Brazil, Russia and India (“How We Explain the Chinese Stock Market Bubble” 1). There is consensus however that China suffered the worst stock bubble in 2007; and this is the stock market crash that this paper will focus on. INTRODUCTION Following a five year period in which China’s Shanghai Stock Exchange (SSE) Composite Index did not do well, the Index saw a dramatic rise - over 130% - in 2006 and 2007 (Tucker & Dyer). This led to the skyrocketing of trading volume, as retail investors sought to reap the benefits of the record-making rise. According to a 2008 report by Yao and Luo, the SSE had hit 6124.04 by October 2007 (10).  That this was a stock bubble, was not lost on analysts - vice chairman of the National People’s Congress in China, Cheng Siwei, was among one of the many analysts to point out that, following a year of volatility, the Chinese stock market was overheating (qtd. in Tucker & Dyer). Even though the government took steps to tackle the dramatic situation, it could not succeed in heading the bubble off. By the end of 2007, the stock bubble had ‘burst’ - the SSE Composite Index began to see a fall right after October 2007 and, by the middle of 2008, had plunged to a shocking 2651.6 1 - less than half of what the index had been at its peak (Yao and Luo 7). This paper looks at this stock market crash - also known as the Chinese Stock Bubble 2007 - in detail, outlining what it was, the reasons because of which it occurred, and its effects on economic conditions within and outside of China. In addition to this, this paper also uses its review of the Chinese Stock Bubble to provide recommendations for avoiding such market crashes, in the future. THE CHINESE STOCK BUBBLE It has been seen that the Chinese stock market was, preceding the crash, characterized by volatility. This is demonstrated in How We Explain the Chinese Stock Market Bubble?, a report that graphs the rise and fall of the SSE Composite Index, from 2005 to 2008 as follows (1). As apparent from the graph, the Chinese stock market saw a boom at the beginning of 2007. This picked up momentum, until the market crashed at the end of the year. According to Yao and Luo (2), prices of stocks shot up after the Industrial and Commercial Bank of China became listed on several Chinese stock exchanges. The authors point out that, by the time the market had begun to heat, the combined market value of the 1500 odd companies listed on the Shanghai and Shenzhen stock exchanges exceeded a massive 32 trillion RMB (2). Following the American economic recession of 2007 and a realization in investors that large Chinese companies had been moving to milk cash from “ignorant, prudent savers,” the bubble began to fizzle off - and fast (Yao and Luo 2). Within months, the market value of listed companies had begun to plummet; by June 2008, the combined market value of listed companies had fallen to less than half of what it had been during the bubble (Yao and Luo 2). Individually, the Shanghai Composite Index fell down by over 60%, while the Shehzen Composite Index saw a 60% plunge (Xinhui). Reasons for the Chinese Stock Market Crash American Sub-Prime Lending. While the official explanation for the Chinese stock market crash centred on the influence of American sub-prime lending on the Chinese economy, analysts have argued that this is a superficial justification that does not delve into the actual reasons underlying the crash (Xinhui). Xinhui points out one valid argument for such criticism - the sub-prime loan crisis resulted in an 11% drop in the S&P Index, whereas the Chinese stock market crash was much more massive. Critically analyzing this chain of thought gives one food for thought - it is hard to believe that the American lending crisis would have a greater impact on the Chinese economy, than it does on the USA’s. Monetary Policy. China attempted to control liquidity and credit growth through a tightening of its monetary policy, in 2007 (Roubini). It also attempted to curb inflation, by raising interest rates. However, because the state did not address its fixed exchange rate, liquidity and credit growth continued. Roubini believes that the combined effect of these factors was to drive savings into the stock market, feeding the stock bubble - and eventually leading to its demise. Investor greed, speculation and inexperience. Yao and Luo believe that investor greed was a major reason in the Chinese stock market crash, because economic reforms after decades of communism incited investors to use the stock market as a quick fix for accumulating wealth (3). The result was that these investors took massive risks, by feeding cash to the market and refusing to sell high-priced stocks to acquire higher returns. When stock prices continued to rise, a large number of people gambled away their savings, withdrawing bank deposits and even pension funds to purchase stocks. The fact that most of these investors were inexperienced blue-collar workers - such as farmers and housemaids - exacerbated the situation, making the market crash worse as these people continued to hold on to their shares, in the hopes that the situation would become better (Yao and Luo 3). Lack of investment capital. As more and more ordinary workers withdrew savings to channel them into the stock market, the finances available to large companies diminished alongside the free capital available to support the stock bubble. Yao and Luo believe that the resultant lack of investment capital, was a major factor in the Chinese stock bubble bursting (3). Overvaluation and loss of investor confidence. Yao and Luo argue that the most important reason the Chinese stock market crashed, was that state-owned companies listed on major Chinese stock exchanges were overvalued (4). Because of government recapitalization, their balance sheets presented rosy financial pictures that investors did not altogether believe them capable of. The result was a loss in investor confidence - by June 2008, the stock price of PetroChina, one of China’s largest state-owned companies, had fallen by an alarming 70% (Yao and Luo 4). Effects of the Stock Market Crash on the Economy The stock market crash of 2007 affected economic conditions around the world in several, significant ways. Losses to companies and financial institutions. According to Yao and Luo, the total market value of the Shanghai and Shenzhen indices fell from 32 trillion to 17 trillion RMB, following the crash (2). This is a massive amount to lose in less than a year. Hong and Xinhua extend this point, showing that major companies and financial institutions lost trillions of yuans to the market crash. Effect on global financial markets. The Chinese stock market crash affected economies around the globe. According to BBC News, the Hong Kong Hang Seng Index fell by 1.8%, while the Japan Nikkei 225 Index saw a 0.5% fall (“Share Sales Knock Chinese Markets”). Hong highlights the global ramifications of the Chinese stock bubble, by addressing the resulting stock market drops in the US, UK and France. This shows how inter-connected economies have become, with repercussions in one having implications for multiple economies the world around. Social impacts. Yao and Luo point out that the biggest losers in the stock market crash were inexperienced, ordinary workers like farmers, cleaners and maids, who had gambled away most of their savings on the stock market (11). From a socioeconomic point of view, then, the stock market crash had implications for more than just corporations and high-profile investors - there was a change in the composition of wealth, in which the poorest became even poorer. Impact on investor confidence. By wiping out trillions of yuan in value across China, the stock market crash raised questions about investor confidence and long-term investments in the Chinese economy. According to BBC News, the crash resulted in leading investors becoming much more cautious about investing in the Chinese economy (“Share Sales Knock Chinese Markets”). Extending this, Hong highlights the thinking that Chinese businesses are not irreplaceable, which means the Chinese government must pay attention to how trading is carried out in the republic, to stop the downward spiral of investor confidence. Market correction. There are analysts who believe the Chinese stock market crash was an economic correction that will, in the long run, benefit the Chinese economy (BBC News, “Share Sales Knock Chinese Market”). These analysts highlight the idea that the stock market crash points out pattern that lead to crashes, as well as flaws in the government’s monetary policy, and can be used to shape a better and less volatile market in the long run. CONCLUSIONS From the above discussion, it is possible to draw several conclusions. To begin with, stock market bubbles are not a new concept. It is possible to gauge when economic conditions are overheating and leading to a bubble - in other words, steps can be taken to address a bubble before it can burst. Given China’s failed attempt at doing so and the resulting socioeconomic consequences, however, it is clear that the Chinese government - though able to predict the bubble - was not able to control it. Secondly, a stock market is no longer bound, in terms of its economic impacts, to one particular country. With globalization having become an integral part of how business is conducted around the world, a stock market crash in a country with multilateral trade linkages, does not just have the potential to but will indeed affect economies all over the world. This holds implication for the fields of politics, economics and foreign policy, and how countries trade with, monitor the progress of and invest in each other. Finally, stock market crashes have affects at both macro and micro levels. At a macro level, they affect corporations and financial institutions; at a micro level, individuals and households. Either way, there are economic, social and political consequences for the entire state. This means monitoring and regulating the impact of its stock markets is essential for the health of any state. RECOMMENDATIONS Based on the above discussion, as well as the conclusions drawn from it, this paper offers recommendations to help the PRC prevent stock market crashes in the future. It is believed that, had these suggestions been in place as policies in 2007, the stock bubble then could also have been prevented. Disclosure policies. There is consensus that one of the major reasons the stock market crash happened, was because of speculation on government policies regarding such variables as taxation and interest rates (BBC News, “China to Allow Yuan to Float”). This points to a need for information that the Chinese government did not address. Based on this, it seems the PRC could can avoid or at least mitigate stock market crashes, if it has a stronger system of disclosure, which eliminates information asymmetry. Free market approach. It has been shown in this report that government intervention in of major companies worsened the stock market crash. The government should seek to privatize companies, eliminating the current system of intervention, to establish a more balanced regulatory regime, where the state only sets the rules of the game - not plays the game itself. Floating the yuan. China has often been accused of refusing to float the yuan, to facilitate its exports surplus (BBC News, “China to Allow Yuan to Float”). Irrespective of the merit in this argument, it has been shown that the fixed-exchange rate worsened the PRC’s stock market bubble. Floating its currency will benefit China in the long run, including mitigating the risk of future stock market bubbles. Using effective monetary policies and prudential regulation. During the 2007 stock bubble, tightening of the monetary policy could not work well, due to the fixed exchange rate (Roubini). It follows that once the yuan is no longer fixed, China can use monetary policy more effectively to mitigate bubbles. During times when stock market prices balloon, it will then have the option of raising capital reserve requirements and interest rates to manage stock bubbles. This also helps fix the problem of inexperienced or lower-middle class workers withdrawing their savings to invest in stock markets. In other words, China can use prudential regulation to help ensure stock bubbles do not lead to stock market crashes. WORKS CITED BBC News. 'Share sale knocks Chinese market.' 27 Feb. 2007. Web. 15 Nov. 2013. BBC News. ‘China to allow the yuan to float more freely.’ 14 March 2007. Web. 15 Nov. 2013. Hong, Cai. ‘Plunge in Chinese Stock Market Leads to Burst in Global Stock Market Bubble.’ Association for Asian Research, 1 April 2007. Web. 15 Nov. 2013. 'How we explain the Chinese stock market bubble?' Cass Business School, 2008. Web. 15 Nov. 2013. Roubini, Nouriel. ‘Why the Chinese Stock Market “Bubble” and “Frenzy” is Partly Due to Its Fixed Exchange Rate Regime.’ EconoMonitor, 31 Jan. 2007. Web. 15 Nov. 2013. Tucker, Sundeep & Dyer, Geoff. ‘Warning on China stock market bubble.’ Financial Times, 31 Jan. 2007. Web. 18 Nov. 2013. Xinhui, Luo. ‘The Root Cause of China’s Recent Stock Market Decline.’ The Epoch Times, 25 August, 2008. Web. 17 Nov. 2013. Yao, Shujie & Luo, Dan. ‘Chinese stock market bubble: Inevitable or Incidental?’ The University of Nottingham. China Policy Institute, August 2008. Web. 15 Nov. 2013. Read More