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7 big questions about China’s astonishing stock market crash and what happens next

Stock investors check computers under an announcement that reads 'the stock market has risk' at a brokerage house in Shanghai on July 6, 2015. AFP PHOTO / JOHANNES EISELEJOHANNES EISELE/AFP/Getty Images

There's a huge drama unfolding in China. Local stock markets, which rose to dizzying heights over the past year, are rapidly falling back to Earth. And the Chinese government is trying to restore investors' faith in the markets with a truly mind-boggling package of counter-measures.

It has been called the biggest stock market bubble since the dot-com boom, and some say its effects could be bigger than the crisis in Greece. China represents more than 16 percent of the global economy, after all, while Greece is merely 0.38 percent. Here are the seven biggest questions and answers about what's happening right now, and what could come if the boom goes bust.

(1) What's happening now?

China’s stock markets took another dive on Wednesday, with the Shanghai market falling 5.9 percent. [On Thursday, the Shanghai rebounded 5.8 percent.]

China has two main stock exchanges that have been around since the 1990s: One in Shanghai, and the other in the southern city of Shenzhen, on the mainland across from Hong Kong. Both have both fallen sharply since hitting a peak on June 12. The Shanghai Composite Index has lost 32 percent of its value in less than a month, while the Shenzhen Composite Index has dropped 40 percent.

Here's a look at the two exchanges as of Wednesday.

Altogether, more than $3 trillion in share value has evaporated since mid-June – more than the value of France’s entire stock market.

The drop hasn't erased all of the gains markets have made in the last year. Both markets are still up more than 70 percent from mid-2014. But it was enough to spook investors, companies and the government alike.

The drop spurred 500 listed companies to halt trading on Wednesday to stem further losses. In total, at least 1,300 companies have suspended trading – over half the listed companies in China. The suspensions caused the stock sell-off to spill over to blue chips -- investors couldn’t sell off small cap stocks, so they had to sell blue chips to meet margin calls and limit their exposure.

All of these suspensions are slowing the market crash, at least for now. But once these stocks resume trading, the market could drop further.

(2) How has the government responded?

The Chinese government denounced the market movement as panic selling, and responded to the drop in a way that many analysts saw as a huge overreaction.

Working through various agencies, the government cut interest rates for the fourth time this year, paused new initial public offerings, capped short selling, changed the rules to allow pension funds and the social security fund to invest more in stocks, and ordered state-owned companies and controlling shareholders not to sell their shares. It changed the rules so that investors can, for the first time, use their houses as collateral to borrow money to buy stocks.

Most significantly, it used a state-owned securities financing company to lend $42 billion to 21 brokerages so they could purchase blue-chip stocks – on top of $20 billion that brokerages said they would buy over the weekend. As Gwynn Guilford of Quartz notes, taken together China’s response was bigger than TARP, one of the U.S. government’s prime responses to the financial crisis.

And of course, it sent out many cheerful messages about the stock market through the state-owned media.

(3) How did we get here?

China’s stock markets have had an incredible run. In just 12 months, they rose enough to create $6.5 trillion in value – enough to pay off Greece’s debt 20 times over. No other stock market has ever grown that much in dollar terms.

The boom has been fueled by novice investors rushing into the market. The number of newly opened trading accounts surged to a new record earlier this year. Many of these new investors are uneducated and inexperienced. A survey last year showed that that two-thirds of Chinese investors haven’t completed high school. Even Chinese farmers are giving up tending their fields in order to tend their stocks.

The real mystery of the Chinese stock market boom is its disconnect with the real economy. While the stock market has surged, the Chinese economy has finally begun to slump after decades of strong growth. The Chinese economy grew 7 percent year-over-year in the first quarter, its slowest pace since 2009. Imports plummeted 18.1 percent in May, and analysts expected them to contact further in June. In recent years the government has boosted growth by encouraging heavy investment in infrastructure and property. But as those projects are completed, the same investments are doing less to drive economic growth.

The Chinese stock market bubble has been driven by a few factors -- including an expansion in lending and poor prospects in alternative investments, like the property market.

(4) What role does lending play?

One way money has flowed into the stock market is through margin lending, or allowing brokers to lend their clients money to buy stocks. China has relaxed its regulations on margin financing over the last five years, and it now plays a bigger role in the Chinese market than it has in perhaps in any other market in history.

The rise in margin lending has deeper roots: the huge expansion in money in China after years of interest rate cuts and easy monetary policy. Even after the U.S. government has been printing money for years, China's money supply is still significantly larger than America's -- even though the U.S. has a larger economy. All that money has to go somewhere, and much has poured into the stock markets.

As Scott Kennedy of the Center for Strategic and International Studies wrote in a recent note, “Over a quarter of China's stock market capitalization is now supported through margin financing, turning an equity market into a de facto debt market.”

(5) What about the property market?

There’s another clear reason that the stock market began rising in late 2014. The price of property, the traditional way for many Chinese households to invest, started to slump, due to a slowing economy and excess inventory.

China's property market slump may seem far away now, but not so long ago it was a huge deal. Property has long been a primary store and generator of wealth for the Chinese middle and upper classes, since the country’s underdeveloped financial sector offers few other investment opportunities. Selling land to property developers has also been a primary source of funding for most city and village governments, which mostly don't have the authority to levy their own taxes or issue bonds. McKinsey has estimated that, excluding the financial sector, almost half of China’s debt is directly or indirectly related to real estate, about $9 trillion.

When the property market started to slump, it put much of the country's wealth at risk. In 2014, Morgan Stanley Economist Andy Xie compared the Chinese stock and property markets to a horror movie. “People like to watch, but don’t want to be in it,” he said.

The Chinese housing market has been undergoing its sharpest correction in a decade, as Kent Troutman of the Peterson Institute of International Economics shows in the chart below.

The property market has actually showed signed of reviving in recent months (which may be pulling some money out of stock markets) but investors still don’t see property as a good financial investment. When people don't want to invest in housing, some naturally turn to equities. “You squeeze one side of the balloon and the air goes to the other side of the balloon,” Chovanec says.

(6) How do Chinese stock markets differ from the U.S.?

China's recent history as a capitalist economy is pretty short -- it really only started opening up to trade and investment in the 1980s, and its stock markets started in the 1990s.

Its financial markets are much less developed than those in the U.S., and involve fewer people and a smaller percentage of total assets (that's one reason why the property market has historically been so important). China’s free-float, the amount of value available for trading on stock markets, is about one-third of its gross domestic product, compared to more than 100 percent of GDP in most developed economies. More than half of Americans have some investment in stocks, whereas the figure in China is only about 6 percent.

China's financial markets are also mostly closed off to those outside the country: Foreigners own only about 1.5 percent of all Chinese shares, according to Capital Economics.

Finally, professional money managers play a more prominent role in the U.S. than they do in China. Unlike developed stock markets, where institutional investors account for the bulk of trades, retail investors (a.k.a. average people) account for about 85 percent of stock trades in China. Since retail investors typically have shallower pockets than professional money managers, China's stock market ends up being a lot more volatile.

(7) What are the risks?

It's not clear what will happen next. The Chinese government has put a huge amount of money and energy into turning the market around. The drop in the market so far this week shows that investors don't believe the government yet, but perhaps they can be convinced in the future.

There are a few other interesting, potential casualties of the latest market drop. Some analysts say that the Chinese government's repeated pledges to boost the market and subsequent failures to do so could damage its credibility and lead to a crisis of confidence. Even if that doesn't happen, the government's latest measures are definitely calling into question its 2013 pledge to let the market play a "decisive" role in governance -- the central promise of its economic reform agenda.

A dip in the market could slow specific reforms. Joyce Poon of GaveKal Dragonomics said in an interview that one of the Chinese government's goals in stoking the stock market boom is to create an environment where certain companies – specifically, big state-owned companies in non-essential sectors like health care, retail, hotels and low-end technology -- can restructure, carry out mergers and acquisitions, and sell stakes to private shareholders. In order to privatize state assets, people must want to buy them, says Poon.

 If the market continues to decline, some individual investors will lose their savings. But since average Chinese people aren't that exposed to stocks, the wealth effect from a stock market crash would be somewhat limited.

Since foreigners own such a small percentage of stocks, the possibility of contagion outside the market is low. But a stock market bubble could threaten the Chinese economy in other ways.

The bigger risk lies in the debt that investors and companies have borrowed. Margin debt, which has more than tripled in the past year, in particular greatly increases the pressure to sell in a slump. If the value of a share falls below a certain level, investors will get a margin call, meaning they need to either deposit more money in their account, or sell shares to make up the difference.

This dynamic means that a dip in prices in China could quickly spark an even bigger sell-off, as investors sell stock to pay their brokers. Some Chinese companies have even pledged their own shares as collateral for bank loans -- meaning that, if their share price falls enough, they may default on their loans. This leverage could threaten the stability of banks and brokerage firms.

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