Voice

China’s Stock Market Safety Net Is Too Much, Too Late

With shares down more than 30 percent, Beijing is scrambling to protect investors. But it may end up making things worse.

An investor looks at a board displaying share prices at a security firm in Shanghai on July 1, 2015. Shanghai shares closed down more than five percent on July 1, resuming their downward trajectory a day after recording their biggest gains in more than six years. AFP PHOTO    CHINA OUT        (Photo credit should read STR/AFP/Getty Images)
An investor looks at a board displaying share prices at a security firm in Shanghai on July 1, 2015. Shanghai shares closed down more than five percent on July 1, resuming their downward trajectory a day after recording their biggest gains in more than six years. AFP PHOTO CHINA OUT (Photo credit should read STR/AFP/Getty Images)

China’s stock-market bubble has burst, and Beijing is scrambling to control the chaos. It’s better to stop bubbles from forming in the first place, but Beijing failed to act — perhaps because the rising markets were a rare bright spot in a period of relative economic malaise. Now, with millions of fortunes already destroyed, continuing to do nothing might be the best approach. But that hasn’t stopped the government from diving in.

The crash in Chinese share prices is a symptom of a market that is serving new strata of society as it develops, just like the American bourses during the dotcom boom. I remember one lunchtime about 16 years ago in a small seafood restaurant in Massachusetts, where I overheard two construction workers, hard hats by their sides, talking about stocks. “Yeah, I got some Cisco,” one said to the other as they compared portfolios. My eavesdropping suggested that they hadn’t done a lot of research into the companies or the fairness of the prices. Rather, it was just the done thing; if you had some money in your pocket in 1999, you bought tech stocks. Everyone did it — and the forces of demand and supply, rather than anything to do with the fundamental values of the underlying assets, drove share prices up, up, up.

The same thing has happened in China, even though the last bubble and crash occurred less than a decade ago. In 2008, the Shanghai market plunged spectacularly after increasing its value five times over in the previous two years. Once the global financial crisis subsided, however, it didn’t take long for investors to pour their money back in. And in recent months, they bet that prices in the Shanghai marketand others — would continue to climb indefinitely, borrowing billions to trade on the margin.

One problem is that these are not the same investors as in 2008. For the past several years, China has been the world’s primary growth market for online trading accounts. Tens of millions of people have bought stocks for the first time and discovered the wonders of margin trading. Many are members of China’s burgeoning middle class, but that doesn’t mean they’re sophisticated investors; the majority may not even have finished high school. Now, with the markets down roughly 30 percent, their heavily leveraged positions have started to crumble.

The government is understandably concerned, as more than three trillion dollars in wealth on paper, which didn’t even exist last spring, has already disappeared. But it’s not taking the right steps to salvage the situation — nor does it necessarily have to take any steps at all.

So far, Beijing has placed a moratorium on initial public offerings, apparently in the belief that doing so will discourage churn (and thus more selling) in the markets. In reality, the move just protects existing investors — and the bloated companies they own — at the expense of businesses raising money to expand their operations. The Chinese government is also putting together a stabilization fund, including contributions from 21 brokerage firms, to prop up blue-chip shares.

Though it might seem like the firms are being forced to participate, the fund may not turn out to be a bad deal for them. If Beijing uses it to send a credible signal that the market will drop no further — far from a sure thing, since the fund is fairly small at just under $20 billion — then the fund will essentially be an opportunity for the firms to buy into the market at the bottom. Of course, the investors caught in the selling frenzy will end up with the short end of the stick.

Indeed, it’s not even obvious that the markets are still substantially overvalued, so none of these measures may even be necessary. On the Shanghai market, price-to-earning ratios have come down from a peak in the mid-20s (averaged across the market) to the upper teens, which is somewhat elevated but not crazy for an emerging economy in East Asia. In Shenzhen, the ratio was around 45 at the time of this writing. But given the higher concentration of manufacturers on the southerly exchange, this higher figure could signify lower earnings for exporters — possibly a temporary phenomenon — as well as inflated prices.

If shares are nearing prices that reflect the underlying values of the companies, rather than frothy demand for stocks, then doing something may be more dangerous than doing nothing. Beijing is setting a risky precedent by acting as a backstop not just for financial stability but also for the market capitalization of publicly traded companies. In the future, with no incentive for caution, investors may adopt even riskier behavior than the kind that has landed them in their current multi-trillion-dollar hole.

A better future is coming closer here in the United States, where more construction workers today know to put their money in index funds or other low-fee, buy-and-hold investments that don’t require much information or expertise. They might also even check a price-to-earnings ratio or two before deciding that a market is poised to rise. A similar day will come in China, too. It’s just not today.

Photo credit: STR/AFP/Getty Images

About the Author

Daniel Altman is the owner of North Yard Analytics LLC, a sports data consulting firm, and an adjunct associate professor of economics at New York University’s Stern School of Business.

Trending Now Sponsored Links by Taboola

By Taboola

More from Foreign Policy

By Taboola