By Dr Rakesh Gupta, Department of Accounting, Finance and Economics
Memories of the Asian financial crisis and global financial crisis are still fresh.
In 1997 the Thai government tried to support the Thai Baht in an attempt to stop the devaluation of the currency. However, it didn’t work and a widespread economic crisis in five Asian countries followed soon after. Efforts by the US to support some of its troubled banks during the global financial crisis also failed.
The only solution is to allow unprofitable businesses to succumb to their losses, along with reallocation of resources to more productive investments.
China’s stock exchanges in Shanghai and Shenzhen commenced operations in their current form in December 1990. With the two combined, China’s stock market is the third-largest in the world with a capitalization of $5.5 trillion. China now is the second-largest economy in the world and has been growing rapidly. This period of fast economic growth coincides with the opening up of the Chinese economy and rapid development toward a market economy from a centrally controlled economy.
China’s stock market since its start has increased strongly in value. However, amid the recent drop in prices, market participants became concerned about stability in the stock market and hoped the government would save them.
The government has indeed stepped in, using measures such as restrictions on short selling, suspension of trading and lending $209 billion to the State margin lending agency to inject money into the stock market to support prices. It appears policymakers are frantically doing things to restore confidence in the market.
I do not discount the value of confidence in the market. However, policymakers ought to consider that a forced confidence in the market, which is based on government intervention, may not sustain the stock market for a long period of time. I am not arguing against all kinds of interventions in the market, but the interventions should be focused and should aim to achieve a specific objective, such as preventing panic selling.
China’s capital market is significantly different from other major markets.
First, it is a young market and has grown rapidly in a very short period of time. With the country’s high economic growth and a high savings rate, opportunities for investors have been limited. This has given rise to the rapid appreciation in the real estate and equity markets in China. But bull runs boost the value of all assets, not only the good ones. After a major rally, market corrections can be sharp and swift, which appears to have been the case this time.
Second, China’s stock market is dominated by individual investors. Institutional investors form a much smaller proportion of the market than in most other developed markets around the world, and even a developing market such as India’s. This has implications for market efficiency, which refers to how well assets are priced in the market, and how effectively new information is reflected in stock prices.
Savvy investors can assess and incorporate new information in their trading much faster than less sophisticated investors. As such, the presence of large institutional investors may mean that the new information is quickly and accurately assessed amid trading of shares in the market place, thus bringing the prices of a stock closer to its fundamental value. Without investors such as these, prices of the assets may significantly deviate from their real value. When a correction occurs, over-priced assets may fall in value significantly, thereby giving an impression of a crash and leading to panic selling. Recent evidence about China’s stock market suggests investors can use simple strategies like buying stocks two days prior to holidays and selling after the holiday to make abnormal profits.
Third, higher volatility is a characteristic of all emerging markets, such as China, India and Malaysia. Higher volatility in these markets is also associated with higher returns. China is no different from any other emerging market in that sense and has higher volatility. What may be needed for the market is for the overpriced assets to decline to their fundamental value. I do understand that in the process, the hard-earned savings of some investors will be eroded. But that is the nature of an equity market that has higher potential returns and also higher risks.
At this stage, what policymakers ought to do is to strengthen the institutional framework in China and ease back on market intervention as much as possible. Excessive intervention in the market probably works against market confidence. Confidence gained from intervention can be short-lived.
This article was originally published by Global Times.