China's stock market fall: Just a correction or indication of an economic meltdown?

Heavy debate is now taking place around the world on whether China's continued falls on its stock market is just a mere correction after sharp rises or an indication of a severe meltdown in the world's second largest economy which could have major global implications.

The Washington Post said the stock market bubble in China has been called the biggest since the dot-com boom and some observers have warned that a fall-out from its collapse could be bigger than the Greek debt crisis.

Observers are now questioning whether the falls in the stock markets in China will affect the Chinese economy or whether the falls are actually an indication of a weakening economy.

One thing they however do agree on: Beijing seems to be powerless to prop up the stock market despite clamping down on short selling and margin trading, including stopping major shareholders of big companies from selling their shares.

Scott Kennedy of the Centre for Strategic and International Studies wrote in a recent research paper: "Over a quarter of China's stock market capitalisation is now supported through margin financing, turning an equity market into a de facto debt market."

Further, in China, retail investors account for about 85% of stock trades in China, which means its stock markets are more volatile, compared to developed markets where institutional investors are the bulk traders.

The Washington Post notes that the two stock markets – the Shanghai stock exchange and the Shenzhen stock market - in China have together seen more than $3tn disappear since the markets started plunging in mid-June, which is more than the value of France's entire stock market.

The latest round of economic data from China has fuelled the drops, further adding concerns that China's economy is on a downward spiral, just like its stockmarkets.

Its industrial profits, which rose on an annual basis in April and May, fell in June, raising concerns that the economy is struggling to regain momentum. Preliminary Caixin's Purchasing Manager's Index came in at 48.2 for July, the weakest reading since 48.1 in April last year.

Qu Hongbin, chief China economist with the Hong Kong and Shanghai Banking Corporation said that the latest figures indicate that the foundation for economic recovery is not stable and that China's manufacturing sector is still in difficulties.

Charlie Awdry, an investment director at Henderson Global Investors in London, told ABC's AM programme that despite the desperate measures to limit the stock market crash, the government seems powerless at the moment.

"This is something they cannot control. I think if they really could control the stock market, it wouldn't have gone up as quickly, and now they're trying to control it on the way down and they're learning that they can't control everything."

Measures to prop up Chinese stock market

So what did the government do to prop up the market? Measures introduced include:

• putting new initial public offerings on hold;
• capping short selling;
• cutting interest rates for the fourth time this year;
• allowing pension funds and social security funds to invest more in stocks;
• banning state-owned companies and controlling shareholders with more than a 5% stake from selling their their shares;
• allowing investors to use their houses as collateral to borrow money to buy shares; and
• through its state-owned securities financing company lent $42bn to 21 brokerages to buy blue-chip stocks, on top of the $20bn that brokerages already said they would use to buy shares.

On 25 July, the China Securities Regulatory Commission said that majorshareholders in five listed companies are under investigation for allegedly selling company shares, in direct violation of a sale ban.

Awdry says that there is "a risk that the turbulence in the equity market will feed through into the overall economy."

He said in his last trip to China where he met a lot of officials from car companies, he was told that people were delaying purchases of automobiles to put their money in the stock market.

"So you could argue that if they don't put the money in the market, maybe they'll go out and buy cars again. You could also argue that actually the fall in the market will wipe out the funds that they had to buy cars."

Biggest risk is to the financial sector in China

Awdry warned that the biggest risk is the financial sector in China, saying that global banks will be monitoring exposure to Beijing banks which have been funding the stock market.

The Washington Post notes that the bigger risk lies in the debt that investors and companies have borrowed, adding that margin debt has more than tripled in the past year. There are fears that some Chinese companies, which have pledged their own shares as collateral for bank loans, may face defaulting on loans and in turn this could threaten the stability of banks and brokerage firms.

"A financial panic ... could potentially plunge the world into recession, particularly if it spread throughout Asia," George Hoguet, a global investment strategist at State Street Global Advisors said, CNN Money reports.

But Hoguet has faith that Beijing will move in before this happens, noting that the Chinese government has a massive cash hoard of $4tn.

"They are a command-control society. If they say this loan is going to survive, then they are going to see that the loan survives," said Mark Luschini, chief investment strategist at Janney Capital Markets.