Bloomberg/Qilai Shen

When Hollywood finally films China’s version of “The Big Short,” it’ll begin like all the best dramas – somewhere near the last act. It’ll begin when all hell broke loose, when confusion and paranoia reigned. It’ll begin in late August.
That’s when authorities trotted financial journalist Wang Xiaolu onto national television to apologize for writing that regulators might allow brokerages to sell stocks they bought as part of a state-sponsored bailout that summer. Wang’s confession was part of a dragnet by the Ministry of Public Security and regulators that scooped up brokers, investors and eventually regulators themselves in an attempt to find scapegoats for the market’s breathtaking, 38% plunge from mid-June to Aug. 31.
It’s an important story to tell -- and not just because the crash wiped $5 trillion of value off what had been the world’s second best-performing market. China’s stock market crash woke global investors up to just how fragile China’s economy has become and how big an impact it’s having on global growth. Beijing’s ham-fisted response also shattered what remaining faith investors had in the infallibility of China’s Communist Party to manage it. And while the rescue has crippled the ability of China’s stock market to efficiently allocate capital and price risk, investors have little to grumble about: though it’s 29% below its peak, the market is still on track to finish the year as Asia’s top performer, up 13%.
To really tell the story of China’s stock market in 2015, though, you have to go back to the fall of 2014…
The Bottom, Sept. 22, 2014. Shanghai Composite: 2,290.
With the housing market softening and billions of yuan seeping out of China each month in search of safer investments overseas, authorities launch a campaign to promote stocks. Excitement is already brewing about opening Shanghai’s stock market to investors from Hong Kong, and state-owned media is publishing articles urging citizens to buy stocks. Beijing eases restrictions on using borrowed money to buy shares and later relaxes rules on opening brokerage accounts.
Dec. 8, 2014. Shanghai Composite: 3,020, up 32%.
Beijing’s efforts have worked only too well. Margin buying has jumped 54% to more than 900 billion yuan. Nervous authorities try to let some air out of the balloon, raising requirements for collateral investors must post against margin trades. Stocks fall 5.4% the next day.
Jan. 16, 2015. Shanghai Composite: 3,376, up 47%. Margin buying: 1.1 trillion yuan.
China’s economy looks ever-shakier, but desperate savers keep pumping money into stocks, pushing prices to 16 times earnings, a 20% premium to their five-year average. Accusing brokerages of bending rules on margin trading, China’s securities regulator bans them from opening new retail accounts for three months. China’s banking regulator, meanwhile, cracks down on lending money to buy stocks. Stocks fall 7.7% the next day.
March 20. Shanghai Composite: 3,617, up 58%. Margin buying: 1.4 trillion yuan. P/E premium: 32%.
Stocks are rising not because investors think corporate profits will improve, but on hopes for government stimulus like lower interest rates and fiscal spending. And while Beijing is preaching reforms to wring out waste and corruption, investors are confident it won’t do anything to upset bloated state-owned enterprises.
As a result, the China Securities Index Co.’s gauge of state-owned stocks has outperformed its index of privately owned enterprises, rising nearly 60% since Sept. 22 against the private index’s 45% -- a trend that will continue for another two months.
April 29. Shanghai Composite: 4,477, up 96%. Margin buying: 1.8 trillion yuan. P/E premium: 65%.
China’s deepening slowdown has prompted the central bank to devise new ways to inject liquidity into the economy. One big beneficiary: China’s banks. Even though profits are sinking as growth slows and bad loans rise, investors realize that banks – like state-owned firms -- can count on breaks from Beijing. Rising stock prices, moreover, have enabled corporate borrowers to raise $82 billion so far in 2015 selling new shares, thereby lowering the risk they default on loans. Beijing is thus using the stock market to bail out banks and their heavily indebted borrowers.
May 27. Shanghai Composite: 4,942, up 116%. Margin buying: 2.1 trillion yuan. P/E premium: 81%.
Stocks are soaring even as analysts warn that prices are dangerously divorced from reality. But with Beijing still eager to bail out debtors and make consumers feel wealthier, investors dare not bet against the market.
Besides, greater fools are on the way: index-maker MSCI is considering adding China’s stocks to its widely used benchmarks. Beijing takes another stab at releasing the pressure, ordering brokerages to raise collateral from margined investors. That, and a raft of initial public offerings, triggers a 6.5% correction.
The Top, June 12. Shanghai Composite: 5,166, up 126%, 60% year-to-date. Margin buying: 2.2 trillion yuan. P/E premium = 91%.
MSCI dashes hopes for a deluge of foreign buying, saying June 9 that it won’t include China in its benchmarks just yet. The company cites restrictions on the ability of foreign investors to buy and sell Chinese stocks, repatriate their profits or vote the shares they hold. Despite the disappointment, the market rises for the rest of the week.
The Bailout, July 3. Shanghai Composite: 3,687, down 29% from the Top, 61% from the Bottom, 14% year-to-date. Margin buying: 1.9 trillion yuan. P/E premium: 35%.
With stocks in a free-fall, Beijing steps in to rescue the stock market’s heavily leveraged investors with taxpayer money. The central bank says it will lend money to the China Securities Finance Corp., or CSFC, to buy stocks. China’s sovereign wealth fund and 21 brokerages promise to buy, too.
Beijing’s fear is that falling stocks will trigger a wave of defaults. Margin purchases turn out to be just part of the leverage that’s been inflating China’s stock market. HSBC estimates that there’s another CNY1.4 trillion in stock loans issued by the same shadow-banking sector that helped inflate China’s property bubble.
Even more has been borrowed by big shareholders in China’s listed companies using their now-plummeting stock as collateral.
But as prices dive, there are fewer and fewer shares available to liquidate. Thanks to circuit breakers designed to calm the market by suspending trade in a stock once it rises or falls by 10%, many stocks are pulled minutes after the opening bell. And Bloomberg calculates that at least 1,331 companies have voluntarily suspended trading in their shares altogether. Combined, these suspensions have eliminated more than 70% of the market’s capitalization from trading.
Beijing’s rescue succeeds in setting a floor under stock prices at 3,500. But a promise by brokerages not to sell anywhere below 4,500 establishes a ceiling. Stocks fall into a corridor between 3,500 and 4,000.
July 15. Shanghai Composite: 3,806, down 26% from the Top, up 66% from the Bottom, 18% year-to-date. Margin buying: 1.4 trillion yuan. P/E premium: 40%.
Media reports on staggering losses faced by taxi drivers, villagers and grandmothers feeds concerns that the lost wealth might kill the only healthy part of China’s economy: the Chinese consumer.

Fueling this misperception is the fact that up to 90% of trading in China’s markets is by retail investors. But the reality is that those retail investors are relatively affluent citizens who leveraged up to ride the rally. And the only wealth they’ve lost is wealth they made in just four months.
Of China’s roughly 260 million brokerage accounts, nearly a third were opened since the Bottom last September, and each holds about $16,000 on average. Many investors opened several -- they’re allowed to open 20. Only about 9% of Chinese households invest in stocks and they spend only about 10% of their wealth. China’s quarter of a billion brokerage accounts are thus controlled by only 89 million individual investors, only about 50 million of whom trade actively.
July 22. Shanghai Composite: 4,026, down 22% from the Top, up 76% from the Bottom, 25% year-to-date. Margin buying: 1.4 trillion yuan. P/E premium = 48%.
Wang Xiaolu’s article is already published in Caijing business magazine, reporting that the CSFC is considering ways it can begin selling the estimated 1 trillion yuan in shares it bought to prop up prices.
The bailout is showing signs of having run its course. Margin purchases have stopped declining and trading is recovering, suggesting that investors who needed to liquidate to repay loans have done so.
The Witch-Hunt, Aug. 5. Shanghai Composite: 3,695, down 29% from the Top, up 61% from the Bottom, 14% year-to-date. P/E premium: 36%.
The search begins for scapegoats. China’s futures exchange, the securities regulator and the police promise to investigate “malicious” short selling of stocks and futures during the summer rout.
Investigators also crack down on automated trading, freezing dozens of brokerage accounts, including one belonging to Chicago-based Citadel Securities.
Authorities raise margin requirements in the futures market and restrict short selling. Brokerages respond by temporarily banning short sales altogether. Yet data show short-selling was never much of a threat: even at their peak in April, short sales amounted to just 10.3 million yuan, an amount short sellers could have covered in less than a day.
“Victory,” Aug. 31. Shanghai Composite: 3,206, down 38% from the Top, 1% year-to-date, but still up 40% from the Bottom.
Wang has made his TV appearance and the witch-hunt is yielding results: the Ministry of Public Security has rounded up a range of suspects including a dozen employees from Citic Securities and a senior official from the China Securities Regulatory Commission, or CSRC.
The CSFC, however, has declared victory and retreated, announcing in mid-August that it will no longer intervene in the market. It turns over the shares it bought to Central Huijin Investment, an arm of China’s sovereign wealth fund.
Its purchases have effectively nationalized a significant portion of the private sector in an economy where the largest companies were already government-controlled. Trading in China’s equity futures market, once the world’s most active, is at record lows. Investors have fled the stock market in favor of bonds. And money continues to pour out of China into investments overseas.
Epilogue, Dec. 23. Shanghai Composite: 3,654, down 29% from the Top, up 59% from the Bottom and 13% year-to-date.
China’s central bank began allowing the nation’s currency to weaken on Aug. 11, a move that defends export earnings against falling currencies in Europe, Japan and elsewhere. But it stands to make outflows worse.
The witch-hunt isn’t over, either. In September, police began investigating another Citic Securities’ executive for alleged insider trading. The CSRC’s assistant chairman, who led the market bailout, was fired.
In mid-November, China’s anti-corruption agency said it was investigating CSRC vice-chairman Yao Gang.
Stocks, however, are rising again. They’ve gained 14% since the end of August to finish the year as Asia’s best-performing market. With the economy showing little sign of improvement, what’s driving the rally?
Hopes for further stimulus: after China’s leaders emerged this week from a year-end planning meeting, they promised a more flexible monetary policy and more forceful fiscal policy…