As a retired teacher of history, I sometimes wonder if my former students remember some of the lessons I taught and their relevance to crisis in the world today. When 98% of my fellow students were taking political science courses in college, I opted to take economic courses to further my knowledge. It paid off. I understand why Greece, Venezuela and now China are experiencing financial failures of the first magnitude. The old cliché that “History repeats itself” is true; however, there are always some new twists in the circumstances with the fundamentals remaining the same.
Today, June 8, 2015, the Chinese stock market is experiencing a crash of sorts. Chinese stocks are tumbling down with massive selling of stock. Prices are dropping precipitously. As a result, the Chinese Government issued emergency orders for its state-dominated corporations to buy stocks to prevent a major crash. In addition, hundreds of Chinese companies have halted trading company shares to prevent a major sell off by investors.
Why did this happen?
There is a parallel in our own financial history. The 1920’s was a period of tremendous economic growth in the United States. Under President Coolidge the government lowered taxes and scaled back interest rates which stimulated consumer spending. People used their money to buy a variety of goods that were more affordable such as cars, radios, telephones, refrigerators, etc. This resulted in a manufacturing boom. To finance expansion to meet the consumer demand for goods, companies sold stock to finance expansion. People who invested in the stock got an extra income through the dividends. When a company made money, investors received part of the profits through their dividends.
There was also the buying and selling of stock. There was a scheme called buying on margin. A person, Mr. Investor, who bought and sold stock by the hundreds of shares would only put a little money down. Keeping it simple here is an example. A person who purchased 100 shares of XYZ Company worth $50 a share would not pay the total of $5,000. Instead, lending firms would allow him to just put a small portion down on the stock like 10%. Ten percent of $5,000 is $500. The other 90% of $5,000 would be $4,500 which would come in the form of a credit. Now there were fees and interests that would be on the $4,500 because the credit was basically a loan. Credit cards today are loans from banks.
XYZ products sell so well that a lot of people want to share in its prosperity and earn more money. So their demand drives stock prices up to $75 a share. Mr. Investor decides to sell his 100 shares at $75 for a total of $7,500. But Mr. Investor still owes the lending firm the $4,500 plus fees and interest. So let’s say he pays the lending firm who sold him the stock and gave him credit for the $4,500 a total of $5,000. He has paid off his debt but he also has the remaining money from the profit he made. $7500 minus $5,000 yields him a profit of $2,500. A good chunk of change!
People who buy on margin are basically borrowing money through credit. The borrowed money is a debt. They need to have a continuous rise in prices for a profit. If the stock comes down in price then they face the possibility of a loss and a debt they may not be able to pay off. This would be especially true if thousands of stockholders in the same corporation decide to sell their stock at the same time. This is what is happening in China today.
For example, like our own stock market crash in 1929, many Chinese investors borrowed money to pay for stock using the buying on margin method. Using dollars as our currency example, Mr. Wong, an investor decided to buy stock in the China Petrol Company. China Petrol stock is worth $50 per share when he buys it. He purchases 100 shares for a total of $5,000. Like Americans in the 1920’s, he buys on margin and only pays $500 as a down payment. He still owes $4,500 which is a credit (borrowed money). Everything looks good! But for a variety of reasons the China Petrol stock value declines and the price starts to drop. Investors don’t like to lose money and so thousands of people start to sell their stock in the company at the same time. (This is what happened in the US in 1929.)
China Petrol stock falls to a low of $30 a share by the time Mr. Wong can sell it. $30 times 100 shares equals $3,000. Oops! Remember Mr. Wong borrowed $4,500 on credit so he needs to pay it back plus fees and interest. To minimize his debt, he pays the lending firm the $3,000 which leaves him with $1,500 that he still owes not counting fees and interest. With fees and interest, maybe his total debt comes to $2,000. He now has a major debt.
Now my examples are simplified to illustrate what happened in the US in 1929 and what is happening in China today. I am leaving out a lot of variables also. My point is that the Chinese stock market has taken a major hit. The ramifications still need to appear in the future. But consider this, people who make money spend it. 15% of Apple products are sold in China. Chinese who lose money will curtail their purchases in the future and Apple Corporation faces a decline in profits in the future if sales fall off in China. Apple will likely lay off workers off who specialize in the Chinese market.
Apple Corporation is just one example of what could happen with hundreds of American companies that sell products in China. The Chinese crisis would affect other global corporations around the world and perhaps trigger a major global recession.
One major difference from our 1929 crash is that the Chinese government is buying up the stock declining in value to stabilize the Chinese market and prevent a crash. But it is creating a significant debt for the government that will go into the billions and possibly trillions. This could impact our own financial security. People forget that President Obama outspent all of the previous presidents combined. He amassed the greatest debt in American history. The $18 trillion debt for our nation was partly produced by his borrowing from nations like China. Our economic growth has been anemic for years because he failed to create jobs and has driven corporations out of the US through one of the highest corporate tax rates in the world. (Sounds like Greece.) What if China says to the US Government, pay us now?