China's Harshad Mehta moment
Take a large saucepan of weak macros, pour a lot of easy money and let it heat on the stock market. Sprinkle small investors in the pan and let them soak boiling money beyond their means. Now add government funds to thicken the gravy and simmer it over low regulations for couple of months. Voila! The Chinese recipe for stock market disaster is ready.
The Chinese formula of stock market debacle may sound obnoxious to the western world, but China is enduring a Harshad Mehta moment, created in its own peculiar style. Unabated flow of easy money, skyrocketing stocks beyond fundamentals, gamblers' frenzy among grandmas, animal spirits among cab drivers and college kids and finally a big collapse: the Chinese stocks mayhem carries a host of parallels to the 1992 stocks scam in India. In the early 1990’s, Mehta triggered the biggest bull run in the Indian stock market followed by a massive debacle causing a loss of more than Rs 4,000 crore to various entities.
Small investors in big soup
The Chinese benchmark Shanghai Composite peaked to 150 per cent in June since the start of the year. While the juggernaut of the world’s second largest economy was coming to a creaking halt, the unprecedented spurt in stock prices came as a classic warning sign of a bubble.
The cracks appeared when shares of a few notable Chinese companies went for a free fall earlier this year followed by a rout starting earlier last month. This unleashed the nasty problem of margin calls. Retail investors weren't using their own cash, but their money as collateral to borrow way more funds than they owned to invest.
There are now 90 million "retail" investors - ordinary people who own stocks - in China, making up 80 per cent of all shareholders. This means that there are more stock market investors in China than there are Communist Party members, at least according to Bloomberg. Last year, the Chinese central bank slashed bank rates to make available cheap loans for investors in the market. While other countries invest cheap loans in the bond market to bail out their ailing economy, China invested in its equity market. As a result the Chinese stock market rose to new highs.
The Chinese economy provides only two major options for investment. One is real estate and other, the share market. The Chinese real estate sector is already in deep trouble, which leaves only the option of share market for the common investors.
In the last one year, hordes of new investors have hit the stock market with their borrowed money. During this period more than ten crore demat accounts were opened. Several companies with weak fundamentals were re-listed with new names, and as a result, their shares multiplied several times.
The market regulator diluted the trading margin which promoted excessive activities by bull managers. However, this exodus converted the growing market into a bubble and now when it has burst and the market has crashed, these new retail investors are at the receiving end.
A leaf out of Harshad Mehta’s cookbook
Mehta manipulated loopholes in the Indian banking system. He hobnobbed with corrupt bank officials and offered them returns up to 15 per cent and used bank deposits to invest in select stocks in the share market. As a result, several companies' shares skyrocketed, for example, a Rs 200-worth share of ACC climbed to Rs 9,000. This attracted lakhs of petty investors to enter the market with all their saved capital.
However, after the expose, alarmed authorities speeded up reforms in the share market. That was the first time the Indian stock market endured lower circuit, which is applied to guard a free fall. A regulatory crackdown forced Mehta to pull his money out of the market. Soon the markets crashed and the crisis reached the doors of banks that began demanding their money back from Mehta. Many big-time investors went bankrupt and quite a few small investors who entered the market with borrowed money committed suicide across the country.
It was then that the government realised the need for a strong market regulator and a transparent mechanism to operate the stock exchanges. Learning from the mistake, a National Stock Exchange (NSE) was founded in 1992 and the market regulator Securities and Exchange Board of India (SEBI), in existence since 1988, was vested with fresh powers to ensure transparency and security in the stock market.
By now, China's stock market crash has stretched into its third week as stock market losses are crossing over the $3 trillion mark. As more than 1,000 companies have suspended trading, global investors are realising that this is a classic tragedy of millions of common Chinese citizens, who have sunk borrowed cash into shares, driven by greed.
China has its stock market regulator in the form of the China Securities Regulatory Commission (CESC), but it needs to toughen it. The Chinese stock market is in dire need of stronger and transparent regulation to keep a check on “shadow” activities. China is an integral part of the global financial setup and its stock market bust has sent shivers down the spine of global investors.