China stocks crash

China's Shanghai Stock Exchange (SSE) Composite Index, one of the leading stock indices in China, exemplifies well the wild ride the Chinese stock market has been on over the past year.

The index tracks the performance of all A and B shares listed on the Shanghai exchange, using a composite number weighted by the market capitalization of the portfolio of stocks included in it.

The SSE Index had a unit value of about 2,000 renminbi (CNY) in June 2014 - a level at which it ended up after a gradual decline from the post-financial crisis high of around 3,400 it reached in the second half of 2009.

But a year ago, the index suddenly shop up like a rocket. In June 2015, it surpassed the 5,100 mark - two and a half times what it had been a year ago. Three weeks ago, the market peaked, and now the rocket is pointing downward rather than up.

But why did the rocket go up in the first place? And why is the Chinese government now doing whatever it can to stop the market from crashing back down to more reasonable valuation levels?

Why not let the bubble deflate?

There was nothing in the real economy that justified the latest massive run-up. The Chinese economy didn't suddenly become 2.5 times more valuable in early 2015 than it was a few months earlier.

The cause of the most recent bubble was a speculative mania, one very similar in scale and speed to a previous stock market bubble that began in mid-2006 and ended in October 2007, knee-capped by the outbreak of the global financial crisis.

During that previous bubble, the SEE Composite hit a peak of 6,092 at the apex of a two-year bull run. In mid-2005, before the run began, it had been hovering between 1,000 and 1,200. By late 2008, it had dropped back down to around 1,700, a 70 percent decline from its peak value. Clearly the Chinese market had seen its first major bubble.

The 2014 bubble is following a very similar trajectory. It seems to have been generated by a rather sudden discovery of the joys of stock market investing by very large numbers of additional Chinese retail investors - people new to investing.

Some 80 percent of trading in China is done by small investors. The newcomers had perhaps bought into their government's hype about building a new Silk Road on land and by sea, promising to increase China's trade links to the world. And they were excited by the promise of their strong-willed new president, Xi Jinping, to increase the role of markets in the economy.

From real estate boom to stocks bubble

Most importantly, there was a widespread understanding in China that the real estate market's long boom had topped out. The property bubble had gone to such excess that whole new cities were built with apartments for millions of people for which no buyers could be found. It began to deflate in 2011, after average housing prices had tripled between 2005 and 2009.

Chinese people's savings had to go somewhere. Money that previously had gone to real estate investments now went to the stock market. Around a year ago, the stock market started rising ever more quickly, as ever more retail investors piled in, hoping to make a fast buck in a rising market. Many of them felt so euphoric that they borrowed money to invest. The bubble's collapse is a result of those retail investors abandoning the market.

When the bubble starts to deflate, margin investors are caught with their trousers around their ankles, owing money they cannot repay. If the value of their stockholdings at the time they get back out of the market is less than what they paid, they stand to lose a lot of money, as do their lenders.

If the total amounts of money involved are very large, as in the present case, the deflation of a debt-fuelled bubble can have serious repercussions for the real economy. People who have lost much or all of their life's savings, or who now find themselves in debt and unable to pay, don't make good consumers or investors.

The government doesn't want a crash

A sharp correction would come with costs and consequences the Chinese government would dearly love to prevent. That's why it is intervening in the stock market, using every trick it can think of.

It has pulled hundreds of firms out of active trading to prevent their shares from tanking further. It has ordered the Chinese central bank to provide liquidity to China Securities Finance, a state-owned company that provides margin financing to stockbrokers. Official state-owned media ceaselessly talk up the markets, trying to persuade retail investors to pile back in.

Beijing has even begun to invest in the market directly, buying up blue-chip stocks and units in exchange-traded blue-chip funds to support equity indices like the SSE Composite.

None of this is likely to achieve a lasting reflation of the stock market bubble in the medium run since the market's recent peak was at levels that do not reflect real-economy performance. But it appears the government hopes that it may be possible to slow the market's slide sufficiently so that it will bottom out at a higher index value than would have occurred had there been no government intervention.

Why is the Chinese government trying to stop the correction?

Beijing doesn't want a disorderly, panic-driven unwinding of the bubble. It's trying to manage the markets to achieve a soft landing.

The risk to China's leaders is political as well as economic. Millions of small investors who came into the market at or near its frothy top could lose their life savings as a result of the ongoing correction.

The Chinese leadership is well aware that it lacks a democratic mandate and that its popular support is based largely on having delivered rising living standards and prosperity to hundreds of millions of citizens. A rising economy is crucial to the Chinese Communist Party's political calculus.

That's one of the reasons the government is so determined to throw the kitchen sink at the perhaps impossible goal of stopping an over-inflated, over-leveraged stock market from dropping back to saner valuations.