Normally, stocks go up during economic booms and fall during recessions. But the huge rise in China's stock market that began in mid-2014 didn't reflect a booming Chinese economy — which was actually slowing at the time. Rather, it reflected ordinary Chinese people making stock investments with borrowed money.
This practice, known as margin trading, used to be tightly restricted in China. But a couple of years ago, hoping to promote more stock market investment, the government relaxed these rules.
Ordinary Chinese people entered the stock market in droves. More than 40 million new stock accounts were opened between June 2014 and May 2015. Many of these new investors had less than a high school education. Their money pushed the stock market up by 150 percent in less than a year.
By early 2015, Chinese authorities feared that stock prices were rising too fast, so they started trying to tap the brakes. A series of new restrictions on margin trading in the first half of 2015 culminated in a June 12 announcement of a new limit on the total amount of margin lending stock brokers could do. The stock market has been falling ever since.
Soon, Chinese officials started worrying that stocks were falling too quickly. In the last week, they've announced increasingly desperate measures to prop up Chinese stock prices. Margin trading rules were relaxed once more. China's central bank provided more cash to the state-owned company that finances margin trading.
This week, a majority of Chinese companies suspended trading altogether. And on Wednesday, Chinese regulators announced that large shareholders and corporate executives of Chinese companies would be banned from selling shares for six months.
This week, the stock market has been volatile. After modest gains on Monday, the Shanghai Composite index lost 1.3 percent on Tuesday and another 5.9 percent on Wednesday. Then it gained 5.7 percent on Wednesday. It's still 28 percent below June's high.
The fact that so much of the stock market's rise was financed with borrowed money poses two threats for the government.
One danger is political. Over the past year, tens of millions of ordinary people have invested in the stock market with the encouragement of the government. If they lose their money, many will blame the government. And tens of millions of angry investors — and their family, friends, and neighbors — could pose a serious threat to the government's legitimacy.
The other danger is that a falling stock market could trigger a financial crisis like the one the United States experienced in 2008. Just as ordinary Chinese investors used stocks as collateral to borrow money and buy more stocks, so Chinese companies themselves have used their own stock as collateral for loans. Other financial institutions called trusts have also made risky stock investments with borrowed funds. If stock prices fall, creditors might start to call in these loans, triggering the same kind of domino effect that did so much damage to the US economy seven years ago.