China's Government Proves it Cannot Defy Market Forces

The economic progress of The far east over the past 40 years or so continues to be remarkable. Part of that achievement has been due to the role the state has played in creating a stable, long run environment with regard to business to grow and prosper, able to take advantage of the globalisation of economic activity.

The Chinese government just seen confirmation that it is much harder to marshal the competing forces in financial markets.

Simply put, the sector suffers from ineffectiveness and distortions built in to its current structure. The stock market – which has suffered such a jolt in recent weeks – is a relatively small part of the picture. Banks are still the predominant source of finance and can act as policy systems to fund the state’s favoured projects.

Restrictions on the official banking sector, meanwhile, have resulted in a rise of an unregulated shadow banking system. There continues to be limited access to household finance and a lack of short as well as longer-term corporate debt markets. Add to this mix the absence of full funds account convertibility, which would allow limit-free transformation of yuan holdings into foreign currency for investment. The continued restrictions might offer some defense against events such as the global financial crisis, however they still isolate China from financial globalisation.

Taking stock

The Chinese stock market provides a good example of how markets can deviate significantly from logical valuation. If we go back 10 years, we see an overheated marketplace between 2005 and 2007. After the bubble burst, the market drifted as Chinese investors appeared to real estate as a way of creating good investment returns – and indeed, it was a highly successful strategy. The 150% rise in the Shanghai stock index during 2014-2015, which beat the recent collapse, was a result of the cooling of the real estate market and consequent re-emergence of reveal buying, assisted by an increase in lending.

Now, investors are looking to sell stock as the market tumbles, using the losses experienced in 2007 at the forefront of their attention. So two bubbles and, in between, an industry in the doldrums is the experience that investors are making their choices. Participants in the Chinese stock exchange are used to volatility and degree of prices, which in no way reflect the true value of the shares they hold. Short-term profit taking and loss-minimisation is the focus for buying and selling activity.

Value judgments

This may be the environment into which China’s policymakers have stepped in recent weeks. They have discovered, as King Canute attempted to show his obsequious courtiers, that the sea wouldn’t obey. It should be clear which trying to influence the surf of selling created by highly disturbed financial markets is a task beyond even the most powerful.

Chinese investors reacted to various policy measures and exhortations with further unloading of stocks and even the injection of huge support has only served to depart traders skittish and susceptible to rumour.

Rational investors regard buying stocks now as highly risky given the sentiment of small investors and the desire to profit from some profits while they still exist. Yet, why would policymakers expect anything less once the market, for a long time, has been driven by anything but a logical assessment of the long-term value of holding stocks.

There have been some tries to explain what has happened. One strategy has been to blame professional fund managers who are using the recently introduced capability to short-sell – essentially wagering on stocks to fall. However, in truth, fund supervisors have followed policy strictures not to abuse this new marketplace mechanism – and my connections in China have said there has been little evidence of the use of short selling since presenting the measure. Another approach has been to blame foreign traders, but again this lacks credibility given the small amount of such investment allowed and the strict regulates on it.

The past few weeks have taught policymakers that they can produce as well as reduce volatility. By intervening, cajoling and blaming worldwide investors and fund managers, the rational element of markets have priced in additional risks. In other words, the market is betting that if policies to stabilise the market eventually fail, then the result will be more draconian measures, which will have negative consequences for the markets and financial institutions.

In addition, they are right to do so. 1 response from policymakers had been the introduction of restrictions to stop major investors selling stocks altogether. That does appear to have prevented market meltdown for now, the main problem with returning to this solution is that the state is not responsible for what happens once allowing buying and selling again, or crucially, exactly how such intervention affects the longer-term view of investors.

Norse play

Policy makers in China, as they have done formerly, will learn from the experience. They might think they understood what has driven economic development, however doing the same for the financial markets is a much more difficult task. It has been an awareness of this, coupled with fear of exposing the economy to unshackled markets, which has delayed liberalisation efforts. It will be a pity if recent events encourage policy-makers in order to postpone reforms necessary to provide China’s financial system into the 21st Century, to join the country’s real economy.

China’s recent role-play like a beach-bound Norse king should push policy-makers to produce financial markets that take the lengthy view. The key is to encourage investors to build portfolios that deliver long-run risk management, rather than investment portfolios, which attempt to second-guess how Beijing will next interfere. What this means is some serious institution building and financial market reforms. It will not exempt China through volatile financial markets and short-term decision-making but it would deliver a more foreseeable environment that allows angry small investors to take less risky positions to avoid the vagaries of short-term financial market behaviour.

Choice and freedom to make mistakes is as important in financial markets as it is in any part of the economy; China should recall that even Canute obtained his feet wet ultimately. The difference is that he knew he would.

China’s attempt to control hot markets only fans the flames is republished with permission from The Conversation