WHAT'S BEHIND CHINA'S MARKET COLLAPSE ... IS THIS THEIR MINSKY MOMENT?

According to Bloomberg China has closed 71% of its stock market. It's a real mess. The good people at Naked Capitalism have some interesting observations here. Market Watch has the broader story here. 

While the above links provide solid observations of what's happening in China, the characteristics behind "margin debt" should be one of the places to look if we want to understand what's happening in China. 

As I pointed out two months ago, more and more activity in the world's biggest stock markets is done with borrowed money backed with collateral, or with what's called margin debt. What's been happening in both the New York Stock Exchange (NYSE) and in the Shanghai Stock Exchange (SSE) - the two biggest markets in the world - has been done increasingly with margin debt.

This is where it gets fun for China. 

Shanghai's financial district, Pudon. 

The Shanghai stock market became the largest stock market in the world several months ago when it began trading more dollar volume than the NYSE. It also surged past the NYSE when it came to margin debt purchases. Indeed, margin activity at the Shanghai Stock Exchange came in at a whopping 3.44% of China's total market capitalization several months ago.

This was far superior to the amount of margin debt used in the NYSE (2.65-2.43% range) at the same time.

Making purchases on credit isn't necessarily a negative. However, buying on margin can be a problem when too many market players have negative credit balances. 

As I pointed out in my book, economist Hyman Minsky told us many years ago about the dangers posed to national economies when growth is based on debt. The key is understanding that it's not so much the debt we need to worry about as the economic instability we create for ourselves when troubled borrowers begin to dominate the market (Minsky's financial-instability hypothesis). 

Hyman Minsky (1919-1996), professor of economics at Washington University.

We're all in trouble, according to Minsky, when our economy becomes dominated by speculative market players - who can find money to back their bets in troubled times only by selling stuff - or by Ponzi or Pyramid market players - who are just one step ahead of the next market collapse. We're all on solid ground, however, when hedged investors - market players who can back their bets with their own cash - dominate our market environment.

China is currently in trouble because the collateral of margin debt buyers is collapsing. I think we'll find that it's one of the reasons why China had to close some of their markets. Those who are buried in margin debt are getting hammered, which is leading to panic selling that's collapsing the market further.

Until I'm convinced by a more compelling argument, margin debt is one of the places to start looking if we want to understand what's happening in China today. Zero Hedge has some interesting charts on the issue here.

Stay tuned.

- Mark

UPDATE: I've made several edits to the original post. I'll just say that editing at three in the morning doesn't always work.