Here's a simple explanation of why Chinese stock markets are in free fall right now

Qin Kai of China competes in the men's 3m springboard preliminary diving competition at the Beijing 2008 Olympic Games August 18, 2008. (CHINA)REUTERS/Laszlo BaloghQin Kai of China competes in the men’s 3m springboard preliminary diving competition at the Beijing 2008 Olympic Games August 18, 2008.

Chinese stock markets are in complete collapse right now, with the main Shanghai Composite index losing 30% of its value in just the last three weeks. The turmoil is now starting to spread to other Asian markets and global commodities markets.

The reason behind the crash is this: millions of ordinary Chinese citizens sunk borrowed cash into shares, which inflated prices to unsustainable levels.

When prices began to dip, these investors were forcing to sell shares to pay back the borrowed money and cover losses. That vicious circle of selling is going on right now and it’s creating “panic” and pushing down prices.

A huge amount of money has been put into Chinese stock markets over the past year or so by regular Chinese people, something the government has encouraged. There are now 90 million “retail” investors — ordinary people who own stocks — in China, making up 80% of all shareholders. That means there are more stock market investors in China than there are Communist Party members, Bloomberg noted recently.

The rush of money into Chinese stocks coincided with a surge in the benchmark Shanghai Composite, which had risen over 150% since the start of the year when it peaked in June.

Shanghai boomInvesting.comThe main Shanghai Composite index has exploded since the start of the year.

But the companies whose share prices were rising weren’t actually getting any better — the prices were going up simply because there was so much demand and people were bidding prices up.

The cracks began to show when shares in a few notable Chinese companies, such as Hanergy, went into free fall earlier this year.

That unleashed the biggest problem of all — margin calls. Most of the retail investors who put money into shares weren’t using their own cash, but using their money as collateral to borrow way more money than they had to invest. This is known as “leveraged investing.”

Chinese brokerages went all-in on this — Credit Suisse estimated that the figure for borrowed funds invested in the stock exchange reached between 4.4 trillion yuan (£460.1 billion, $US708.3 billion) to 5.9 trillion yuan (£617 billion, $US949.8 billion) before the pop, according to the South China Morning Post. At the top end that’s 9% of the exchange’s entire worth.

But when prices went down, the brokerages that had advanced all this money asked investors to put up more cash to cover the fall in value. Sophisticated investors would have the resources to do this and the understanding to calculate whether it was worth the risk.

But most retail shareholders just sold the stock they’d already bought, using this cash to meet the fees. That’s now creating the opposite problem to the one that inflated the market — a wealth of sellers, pushing down prices.

Despite the fact that the Shanghai Composite has fallen off a cliff in recent weeks, it looks like the fall will continue. Repeated efforts by the Chinese government to stem the losses have failed and Citi calculates that just 1/4 of leveraged investors have been driven out of the market. Plenty more will be flushed out.

The panic is now starting to spread to other markets that haven’t been hit by the same problem. It doesn’t look like this isn’t going to end well.

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