October 27, 2015 7:00 pm JST
Jennifer Huang

Market forces could help with China's stock woes

Panic has subsided in China's stock markets in recent weeks, but it is far too early to celebrate; the question of what to do next remains.

     The principal of risk-diversification suggests regulators should drop their "national team" approach of shoring up prices through coordinated share purchases by large shareholders, state-owned enterprises and brokerages. Instead, they should encourage small investors to pool into the market to share its risks and rewards.

     The move to rally the "national team" to bail out the market when stock prices in Shanghai and Shenzhen first started to plunge in June simply added to team members' heavy market exposure. While the rescue favored highly leveraged investors by offering them a chance to gamble their way out, the results may have only made things worse.

No time for teamwork

Fair prices have to be determined by the market itself. While individual investors may not be as accurate in their price assessments as the national team and do not have the might to force a rebound in prices, they can offer the market long-term support.

     If the government props up the market too much, investors will not dare enter at all, and the government will have to ride the tiger alone, using more and more favorable policies to encourage investors' participation. This would be the seed of bad consequences.

     The markets' initial rebound saw more money coming in than was leaving, but regulators then began new investigations into capital movements. Yet a crusade against investor greed should not be conducted without reflection on whether or not the policies themselves acted as catalysts for a gambling spirit in the stock market.

     For investors already bound up in the unraveling of the market, this means having to accept losses as they stand and the unlikeliness of a rebound in terms of capital or opportunities. Extending investments or purchasing more shares at this stage are desperate options. Those with leveraged positions could yet ride any upside if the market turns. Otherwise, their losses will be further felt by their lenders and the wider market.

     Another issue is that the share purchases by state-owned enterprises, insurers and pension funds contradict ongoing ownership reforms with effective renationalization.

     All in all, the bailout was a serious setback for China's capital market reforms. It showed the government's lack of confidence in the free market that policymakers considered abandoning the dividends of 20 years of reforms by not respecting the basic essence of the market at the first sign of crisis.

     Repeated official statements show that the core purpose of the bailouts was to ensure the systemic soundness of the financial sector. So on the one hand, the government had to appease market sentiment, while on the other hand it brought out a series of measures to improve supply and demand and bring liquidity into investment portfolios, aiming to use executive power to calm the market and avoid future stampedes.

Doing the right thing

In working to save the market, the government should have at least respected its principles. The government eventually realized it could not continue to prop up the market regardless of the cost, as this would only turn value investors away.

     One thing the government can do at this point is to directly subsidize share purchases. At the current juncture, the principle of risk-diversification would suggest that investors currently with low or zero exposure to the market should be encouraged to increase their holdings. Most investors do not have large enough risk tolerance to take on leveraged positions and they should not be encouraged to do so.

     Share-purchase subsidies could be recouped later, when the stocks are sold via levies on capital gains. Done this way, the net costs of a bailout would be quite moderate and investors would be encouraged by the reduction in risk. This could give investors waiting on the sidelines the right kind of push to dip their toes back in the water. In broader terms, risk-sharing will reinvigorate the overall economy in the long run.

     While there are no direct precedents for such a subsidized-purchase approach in other capital markets, it would not be the first time China has gone its own way. In essence, a subsidy for share purchases would be equivalent to a negative stamp duty. Looking at it this way, the subsidy approach actually appears highly conventional. Most importantly, it could allow the market to adjust by itself.

     Some people have begun to question the efficient-market hypothesis. Indeed, the market is not always right, but no individual or institutional investor can know more than the market as a whole. The market will eventually correct the irrational behavior it attracts, but in its own way: slowly and inevitably. The global history of capital markets has repeatedly confirmed that this will happen.

     In capital markets around the world, there has never been a situation where a government endorsed specific price levels, or where regulators were responsible for individual returns on investments. There never has been and never will be.

     China can be no exception. While the government can prop up the market temporarily, in the end only the market -- and its investors -- can bail themselves out.

Jennifer Huang is a professor of finance at the Cheung Kong Graduate School of Business in Beijing.

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