China’s authorities are in a near panic trying to manage an equity market bubble. The more pessimistic see this problem as further evidence of a coming financial collapse building on an overextended property market and surging debt levels. Yet the downside risks of the debt and property market problems have been largely contained and the economic consequences of the equity bubble should be minor given its limited role in the economy. The political implications, however, are serious since this bubble was driven by an unwarranted faith in the power of government intentions.
The reputational damage comes from the losses of millions of middle-class investors who are politically important for the Communist party’s base. How did such a widely admired system of economic management allow this to happen? Many observers now worry about the prospects for continued reforms but the more pressing issue is to understand how such reforms should be implemented.
The last time there was a bubble was in 2006-7 when the Shanghai Composite Index soared from 1,000 to 6,000 and then within a year collapsed to 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. But with a president who has staked his reputation on having a firm grip on everything and a premier who has been championing an elevated role for the equity market, 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 holidays 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.
The surge was the result of two well-intentioned but poorly implemented policy decisions, with the consequences exacerbated by the decision to allow excessive risk taking through margin buying and other forms of leveraged financing to continue when risks were already getting out of hand. Policy makers 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 under-developed and lacked credibility after the 2006-7 debacle. Their second objective was to use the equity market to moderate the country’s debt burden by encouraging companies to raise financing through equities rather than borrowing from banks. To make all this work, senior officials and the China Securities Regulatory Commission talked up the gains to be achieved by investing in stocks.
As investors were attracted by the rising stocks, the financial community realised 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 realisation by the more savvy investors that prices had overshot fundamentals, since gross domestic product growth was still declining. Yet equity prices did not fall because less sophisticated investors were still being drawn in by high returns. Gradually, as concern emerged about the power of government intentions to sustain such increases, selling pressures began to build up. 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 stabilised the market, but it is not clear whether further declines are likely without such draconian measures.
When this bubble is finally over and emotions have settled, the lesson should be that a strong and broad-based equity market must be founded on economic and financial forces operating under a regulatory system that is not unduly influenced by political sentiments. Unlike China’s state-dominated bond market and commercial banking system, its equity markets are shaped by private investors and companies that are increasingly private. Thus the role of government as a regulator in protecting standards and mitigating risks should not be compromised by any conflicting pressures to champion rising equity prices, as CSRC frequently seems to be doing. For this to happen, the role and accountability of managers of regulatory agencies such as the commission need to be separated further from China’s party-dominated personnel process to provide assurances that its equity markets are really markets rather than politically motivated institutions.