What Will the Chinese Share Market Crash Mean for Australia?

The Chinese share market is in a free-fall. On June 13, 2014, the Shanghai Stock Exchange Composite Index was valued at just under 2050. Within twelve months, the same shares were trading at 5166. That’s an increase of 152 percent in one year. If the value of your investment property grew that much in one year, what would you do?

Chinese shares were clearly in bubble territory, as is evident from the graph below. What inevitably happens to every bubble? It bursts.

Within another two weeks, on June 26, shares had dramatically dropped, taking out their 50-day moving average, indicated by the blue line below. This blue line had been providing support for the last year. Each time previously that shares hit that line, they bounced back up, but not this time.

Breaking through this support was a clear signal that a sell-off had begun and that the market was in danger of collapsing. The smart money began heading for the hills.

By last week, the Shanghai index had lost 32 percent from its high just one month ago. The bubble has now burst. But how low will it go? It seems the 200-day moving average, shown by the red line below, has provided at least some temporary support for the market.

As you can see, since last week, we’ve seen a bounce. The Shanghai soared 11 percent on Thursday and Friday, which was its biggest two-day rally since September 2008, during the global financial crisis.

This is not unusual. Most markets coming off a bubble experience a “dead cat bounce,” an initial spike back up, followed soon by a continued retreat downward.

One thing is clear at this point. Chinese investors have little remaining to trust in but government intervention and the hope of resolve in Greece.

Some are already comparing Chinese shares today to the great stock market crash of 1929, the one that led the United States into the Great Depression. If we see the Shanghai index fall below the 200-day moving average and then continue dropping with authority below 3250, it’s anyone’s guess when the carnage will end. At that point, 2250 could be the next stop.

What Caused The Bubble In Chinese Shares?

Market bubbles, whether in shares, real estate or something more bizarre, all tend to happen for similar reasons. The Chinese share market has been no different. The following are the three primary reasons Chinese shares were so inflated. Perhaps you’ll notice some similarities to other markets around the world, or perhaps even closer to home.

1. Government Intervention

Being a communist nation, the Chinese government certainly has no philosophical qualms about getting involved in the nation’s economic affairs. Not that their communism was necessarily a contributing factor.

As we’ve seen around the world since 2008, even democratic governments in so-called free market economies have no reservations about manipulating markets.

But, China has taken intervention to new extremes. For the last 15 years, China has printed money faster than any other nation and has subsequently amassed the largest money supply in the world. All of this “wealth” has to flow somewhere, and that “somewhere” has primarily been real estate and shares.

Chinese real estate is now ridiculously expensive relative to incomes. The median house price to income ratio in Beijing is about 36 to 1. Shanghai is closer to 30 to 1. In contrast, “unaffordable” Sydney is about 12 to 1. Most regional centres around Australia are under 5 to 1. It doesn’t take an economic genius to predict that the next bubble to burst in China will be real estate.

To take intervention to yet an even greater extreme, China’s securities regulator announced a six-month ban on share sales last week. Company executives, senior management and investors who own a greater than a five-percent stake in a company are prohibited from selling their shares. Under fear of arrest, or worse, the government’s hope is that this forced illiquidity will patch the hole in the bubble.

Wait, there’s more: Brokerage firms have been forced to buy tens of billions of dollars of shares to halt the decline, and then the public security ministry declared that anyone caught selling short by betting on market declines would go to jail. And, just when you thought it couldn’t get more ridiculous, brokers and investors are now prohibited from saying negative words and phrases, like “bear market.”

The Chinese government has now effectively halted trading on 49 percent of all mainland Chinese stocks. Any rally where investors can’t sell half of the shares in the market is pretty much meaningless.

For years, Chinese officials have been pumping up the share market through their rhetoric, as well.

They’ve been major cheerleaders for the equities markets, insisting that retirees and young people alike pour savings into shares, but now that the economic tide has turned, people are losing their life fortunes.

Once the Chinese people lose faith in the government’s authoritarian underpinning of the economy, we could see significant civil unrest. In a country where nearly 40 percent of the people live on less than a few dollars a day, and the average university graduate makes about $3,000 per year, it won’t take much to upset the apple cart.

2. Speculation By Inexperienced Investors

China has over 90 million retail share traders. They are ordinary citizens who have very little financial expertise, but high hopes for wealth creation. People who lack investing skills tend to buy assets at any price, assuming they always go up in value.

As “the greater fool” theory goes, unskilled investors presume that they can always make money buying assets, whether they are overvalued or not, by selling them later for a profit, because there will always be someone willing to pay a higher price.

As the herd mentality kicks in, more and more new investors will rush to the party. This adds more fuel to the fire as this new investor demand sends prices even higher. The greatest fool is the one caught holding the assets when the bubble bursts. We’re seeing who the “greatest fools” are now in the Chinese share market.

3. Investing With Borrowed Money

Financial bubbles often have at their centre a plentiful supply of borrowed funds. This has certainly been the case for Chinese shares.

Brokerage firms allow investors to buy “on margin.” This means that they can finance a portion of their purchases with borrowed funds. Rather than being limited to their own money, traders can gain leverage by using other people’s money.

Up until 2010, Chinese regulators strictly controlled margin lending, but since that time, they have greatly relaxed those restrictions. So much so, that at the market’s peak, 8.5 percent of Chinese shares were owned with borrowed money.

In contrast, on the New York Stock Exchange, the figure is closer to three percent. China’s extreme level of margin lending is a clear signal of rampant speculation.

Once a highly leveraged market starts to fall, trouble ensues in the form of “margin calls.” This is when brokers force leveraged investors to pony up more collateral, similar to a bank asking a property investor to lower their LVR. If the investor is out of cash, the brokerage firm forces the sale of some shares, which further exacerbates the downward spiral and the bursting of the bubble.

Since the recent margin calls in China, these over-leveraged investors have been forced to reign in their borrowing. Recent stats show the total margin lending in Chinese shares has dropped by a third. But the levels are still high, relative to other markets around the world.

Another way that investors can meet their margin calls is to sell other assets, like commodities or real estate. This is why we’ve seen such volatility in commodities like iron ore, because investors were selling futures contracts to meet margin calls.

What Will China’s Woes Mean For Australian Property Values?

While the blow to our iron ore industry has been more evident, the jury is still out on the impact on our real estate market. This is because there will be somewhat of a time lag until the supply of money from China into Australia either speeds up or slows down. Here are the two basic opinions on how the Chinese share meltdown will impact Australia property:

Some Say It’s Good News

The optimists make their case that plunging Chinese equity values will lead to a flight of capital to the “safety” of Australian real estate. They say this will be further fueled by a weaker Australian dollar, making investment here more attractive.

The proponents of this theory claim that a percentage of the recent growth in Aussie real estate values has been due to Chinese investors pulling money out of an overheated Chinese stock market. In other words, this has already been happening, and it will speed up due to an even greater loss of faith in shares.

Others Say It’s Bad News

The pessimists claim that the drop in value of Chinese shares will mean that there is less money available in the future to flow into Australia. They fear that Chinese investors who have already purchased off the plan will no longer have the funds to settle these recent Aussie real estate purchases. In part, this theory presumes that Chinese investors have been keeping their funds in shares until it’s time to settle.

I’d Say the Optimists Are a Little Late to the Party

In reality, the situation is a little more complex. I agree with the optimists that much of our recent growth has been due to the smart money pulling equity out of shares and moving it into the supposed safe haven of Aussie property.

But, now that the share market has taken a 30 percent hit, I’m inclined to believe that the party will be coming to an end soon. As the bubble deflates, so will the flow of investment funds into Australia.

But that said, there is still plenty of wealth tied up in Chinese real estate. Until that bubble bursts, we’ll continue to see the smart money sell those assets to buy in overseas markets that they perceive to be safer. There may not be much time remaining however. When one domino falls, meaning shares, the next one, real estate, is destined to fall, as well.

While developers here in Australia will certainly feel the pinch of a decline in Chinese wealth, I’m not so sure the problem will be the settlement on previous contracts.

The challenge will lie with the developers who have purchased land and are preparing to come to market with off-the-plan apartments. They may find that the overseas investor market is no where to be found.

Conclusion

Time will tell just how smart the Chinese “smart money” is. If our property market takes a subsequent hit, those investors may find that Australia wasn’t quite the safe haven they were hoping for after all.

If your property investing strategy is dependent on a continual inflow of Renminbi, it may be time to think outside the tangram.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.