The Right Way to Buoy China’s Stock Markets

As margin calls and panic selling spread, China’s stock markets continue to plunge. So far, the government in Beijing has compelled a variety of companies to bolster the markets, from insurers to brokerage firms, as well as promising to provide liquidity itself. But there’s a much better strategy that could also help China to grow in the long term.

At this point, some amount of the selling is simply mechanical. Investors who are facing margin calls have to unload their assets to cover their losses as much as they can. Another portion of the selling is probably hysteria — mob psychology taking over with no regard to the fundamental value of assets.

In the world’s major markets, hedge funds exist for these moments. When the combination of mechanical and hysterical selling artificially depresses prices for specific shares, they swarm in to buy. But China has strict rules on how much, how quickly, and who can trade shares on markets like the Shanghai and Shenzhen stock exchanges. And right now, these rules may be keeping out the very traders that China needs most.

To be sure, the rules are looser than they were just two years ago. First, Beijing raised the limits on portfolio investment by foreigners. Then it lifted the maximum holding in a single company from 20 percent to 30 percent. And finally, in November, it launched a system allowing reciprocal investments between Hong Kong and Shanghai, which allowed foreigners much greater access to the latter market.

But plenty of restrictions remain. There are still caps on total investment in the mainland markets, as well as constraints on the timing of trades. The sort of high-frequency, highly leveraged moves favored by hedge funds and other active traders are practically impossible for foreigners. And of course, a single foreigner investor still can’t buy enough shares for the outright takeover of a publicly traded Chinese firm.

These restrictions are designed to keep the control of Chinese companies in Chinese hands. They’re also supposed to stop foreign speculators from playing havoc with Chinese markets. It’s hard to imagine, though, that even a dozen George Soroses could create as much chaos in the Chinese markets as they’re experiencing right now.

To stave off the panic, China needs new cash to flow into its stock markets. Foreign investors could provide this cash. This is the case even if, according to some observers, the markets are still overvalued.

This is because foreign investment depends both on valuations and on China’s rules for investors. At any given level of valuations, changing the rules will shift foreigners’ demand for Chinese shares. Right now, there are still foreigners invested in China’s markets. Loosen the restrictions, and more will join them.

This would be a healthy move for China’s financial development, too, by adding heterogeneity to the investor base, reducing the likelihood of herd behavior in the future. It would also enhance demand for the renminbi, which China hopes to transform into a popular reserve currency and a linchpin of global trade. And greater foreign ownership of Chinese firms would bring with it new management expertise and, to the extent that foreign owners faced reporting requirements back home, enhanced transparency.

But perhaps most importantly for China’s government, an increase in foreign investment would tie more portfolios around the world to the Chinese economy, thus expanding Beijing’s soft power. The United States, the United Kingdom, Germany, and others are already careful not to let concerns about human rights, territorial disputes, and cybersecurity get in the way of their commercial relationships. With more foreign investors, foreign governments will step even more gingerly.

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