Source: Caixin Online

Eventually the current equity bubble will evaporate and given the relatively minor role equities play in China's financial system, its economic impact will be limited. The more important issue is whether China's leadership has learned the right lessons.

China's economy is becoming more normal in the sense that market forces now have a greater impact in shaping trends and its financial system is increasingly linked with global markets. But while market driven economic systems have the potential to generate more efficiency than centrally-controlled systems, they are inherently more unstable. The lesson from this equity bubble is that markets cannot be based on the unwarranted faith in the power of government intentions. If they are to become credible they need appropriate regulatory agencies to protect the public.

The last time there was a bubble was from 2006 to 2008 when the Shanghai Composite Index (SCI) soared from 1,000 to 6,000 and then within a year collapsed to around 2,000, where it remained until June last year. That bubble was also grounded in excessive speculation and greed, but memories are short lived. With economic growth slackening, why did the equity market suddenly become so attractive again?

This surge was unrelated to fundamentals given the protracted economic slowdown. It was the result of two well-intentioned but poorly implemented state-driven policy decisions. Policymakers rightly felt that savers needed a broader array of investment options beyond just parking their money with banks or buying property. Compared with other countries, China's equity market was underdeveloped and lacked credibility after the 2006 to 2008 bubble. Their second objective was to use the equity market to moderate the country's debt burden by encouraging companies to secure financing through equities rather than borrowing through banks. To make all this work, the China Securities Regulatory Commission (CSRC) and senior leaders talked up the gains to be achieved by investing in stocks.

Since the leadership was championing an elevated role for equity markets, the average citizen was persuaded that here was an opportunity for enrichment. After watching others making a small fortune as the SCI increased from 2,000 a year ago to 3,500 by the time of the Spring Festival Holiday, which is also known as Chinese New Year, in February, betting on continued rising levels seemed a sure thing for untested investors who piled in and were rewarded as the index rose to 5,000 within a few months.

Part of this enthusiasm came from the realization within the financial community that if China's request to be included in the MSCI Emerging Market Index was approved, it would trigger additional global demand and even higher prices. The market euphoria was also boosted as countless retail investors carried on buying stocks on margin with borrowed money. Within a few months, margin trading pushed prices beyond any reasonable relationship to fundamentals. Yet while the CSRC expressed caution at times, it continued to talk up prospects and was not firm enough in reining in excessive leveraged buying.

Months before the crash began, sentiments were beginning to shift. First was a gradual realization by the more savvy investors that prices had overshot fundamentals, since GDP growth was still declining. Yet equity prices did not fall because less sophisticated investors were still being drawn in by high returns. Gradually, as concerns emerged about the power of government intentions to sustain such increases, selling pressures began to build. When the decision to include China in the MSCI global stock index was shelved in early June, sentiments totally changed. The slide was now in full force but any possibility of moderating it was negated by the margin calls, which triggered even more selling with the SCI falling to 3,500.

The same forces that exacerbated the market's rise made it inevitable that the decline would be amplified. Recent stopgap measures to prevent selling and encourage buying may have temporarily stabilized the market. But statements that the authorities would not be satisfied until the index rose back to at least 4,500 is a repeat of previous mistakes in trying to promote higher prices and specifying specific levels rather than trying to cushion the downturn and build a floor for falling prices. The government intervened to moderate panic trading and to instill a degree of confidence. This seems less of a problem compared with its attempt to prop up the market beyond what is warranted.

When emotions have settled down, the lesson from this bubble should be that equity markets must be driven by market forces and economic fundamentals – not by government sentiments. Thus the role of the state is to be a credible regulator in protecting standards and mitigating risks. This should not be compromised by any conflicting pressures to champion rising equity prices, as CSRC seemed to be doing. For this to happen, the role and accountability of regulatory agencies such as CSRC need to be clearly separated from China's party-dominated personnel process. Only by doing so can we ensure that the equity markets are really driven by the market.

This article was originally published on Caixin Online.