What Can We Learn From the Chinese Stock Market Crash?
The recent debacle is a good reminder that China still needs more reforms.
Few people who give international markets even a cursory glance can have missed the recent meltdown in China’s stock market. Between June 12 and July 8, the Shanghai and Shenzhen indices were down 32 percent and 40 percent, respectively, generating headlines around the world. After the authorities took dramatic steps to halt the plunge, the markets stabilized, but then dropped a record 8.5 percent last Monday. It is not too early to start extracting some lessons from this meltdown -- lessons that could serve China well going forward. If the country is still committed to making the stock market one of the important components of its new, more market-based capital allocation model, then the recent collapse, while painful, could yet prove extremely useful.
Few people who give international markets even a cursory glance can have missed the recent meltdown in China’s stock market. Between June 12 and July 8, the Shanghai and Shenzhen indices were down 32 percent and 40 percent, respectively, generating headlines around the world. After the authorities took dramatic steps to halt the plunge, the markets stabilized, but then dropped a record 8.5 percent last Monday. It is not too early to start extracting some lessons from this meltdown — lessons that could serve China well going forward. If the country is still committed to making the stock market one of the important components of its new, more market-based capital allocation model, then the recent collapse, while painful, could yet prove extremely useful.
The well-worn saw that those who forget history are doomed to repeat it applies to stock market bubbles and crashes, too. China desperately needs to avoid a repeat of the past few months. Of equal or even greater importance, the heavy-handed government intervention in the market has generated widespread concerns about China’s commitment to financial reform more generally. To both allay these concerns and prevent another similar episode, Chinese regulators will have to make an even greater commitment to reforms and capital account liberalization.
To understand the need for this commitment, we need to appreciate the causes of the run-up and subsequent meltdown. In hindsight, there were two key issues: a narrow investor base subject to dramatic swings in sentiment and set of market regulations and structures that exacerbated the worst tendencies of these investors.
We know from research on the U.S. technology bubble and crash in the late 1990s and early 2000s that over-optimistic investors combined with a limited supply of securities and the inability of other investors to express negative views via short selling can facilitate the creation of bubbles, which will inevitably crash. What are the right corrective measures?
First, expand the investor base beyond the approximately 80 percent retail market that characterizes China. This goal can be achieved both by promoting the development of the institutional asset management industry in China, which will place less sentiment-driven institutional investors between retail investors and the stock market, and by further opening up the capital account to increase the participation of a diverse set of international investors. China’s tremendously high stock-return volatility — over 30 percent even at the market level — is partly rational and inherent to the high-growth, high-risk structure of its economy. However, it is amplified by policies that concentrate the ownership of this market in such a small fraction of the global investor base. China’s stock market now represents over 10 percent of the world’s equity portfolio by market capitalization, but is held almost entirely by Chinese households. This makes pricing highly sensitive to swings in their sentiment. Moreover, the concentration of China’s equity risk in this narrow investor base depresses equity prices, because these undiversified investors discount this risk more heavily than if it were shared broadly across the global investor base. Our research shows that China’s stocks have been priced to deliver extremely high average monthly returns over the last two decades. Opening China’s equity market to allow foreign capital in and domestic capital out could both reduce stock return volatility and boost stock prices.
Second, increase the supply of tradable securities by floating more of the shares in state-owned enterprises held by the government, reopening the market to new IPOs, and, more generally, streamlining and rationalizing the IPO process.
Third, set up the institutional structure necessary to increase the ease with which investors can short sell stocks. Short sales may exacerbate market crashes, but they may also prevent the growth of the bubbles that lead to those crashes in the first place.
Moreover, there are features unique to China’s stock market that are proving problematic. One is the 10 percent daily price limit on both upward and downward moves of individual stocks. This was introduced in 1996 to prevent market manipulation, but it is now counterproductive. In both rapidly rising and falling markets, these price move limits significantly curtail market liquidity — once stocks hit these limits they effectively stop trading. Consequently, traders are induced to accelerate their transactions, whether buys or sells, to exploit whatever limited liquidity might exist.
The other problem is the ability of individual firms to apply for trading halts in their equity, and the willingness to grant these halts. This also reduces liquidity and introduces liquidity risk, again altering trading behavior for the worse. Except under extraordinary circumstances, all stocks should trade when the market is open.
Finally, regulators do not seem to have a good handle on appropriate margin restrictions. It makes perfect sense, especially in a market with arguably less sophisticated retail investors, to limit both the extent of margin trading and the set of traders who can access margin loans. As the United States learned from the 2008 crisis, sometimes consumers need to be protected from themselves. In the long term, better financial education may be the answer, but in the shorter term, restrictions may be necessary. Moreover, margin limits should be negatively related to volatility. China’s market is extremely volatile, and margin limits should be commensurately tight.
Now is not the time to panic. Both the Shanghai and Shenzhen indices are still up significantly on the year. China’s economy is humming along. A continued commitment to the right set of reforms can put China firmly on the track to more efficient capital allocation through the stock market and sustainable growth.
Photo credit: FRED DUFOUR/AFP/Getty Images
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