China’s stock market bubble, explained in one chart

If you want a single chart that summarizes what caused the past year’s 150 percent stock market rise, and the subsequent 32 percent decline over the past month, this chart based on data from Macquarie Research is a good choice:

“Margin debt” means money people have used to buy stock “on margin” — that is, with borrowed money. “Free float” refers to shares that are available for public trading — as opposed to stock that’s locked up by corporate executives, the government, or others. The ratio of the two provides an indication of how much the stock market’s moves are being driven by people gambling with other people’s money.

Until 2010, China had strict regulations of this kind of margin trading. But over the past five years, China has relaxed those rules. As a result, margin trading — and margin debt — has skyrocketed. China used to have less margin debt than the US stock market. By mid-2014, it had a lot more.

Margin trading introduces instability into the market. If the stock market starts to fall, mortgage brokers will ask investors to put up more collateral, something called a “margin call.” If the investor can’t provide more cash, then the broker will sell some of the shares to make sure the borrower doesn’t get under water. But those sell-offs can trigger further declines in the market, which can trigger more margin calls and more sell-offs. This vicious cycle likely contributed to the past month’s rapid decline in Chinese stock prices.