In the 12 months through the market peak on June 12, the Shanghai index was up 152 percent, with the more tech and small stock heavy Shenzhen index climbing 195 percent over the same period. In the subsequent 15 trading days, these two indices lost 29 percent and 33 percent of their value, respectively. These stock market moves in both directions have been extreme, but while they are not exactly reassuring from an investor's, or even an economist's, perspective, they are understandable. Here's why.
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The initial run-up was driven by good news about the pace of and commitment to economic reform in China, including the all-important announcement and implementation of deposit insurance. We then saw a subsequent bout of what might be termed "rational momentum," as investors woke up to the possibilities for the equity market. This awakening of interest, both domestic and foreign, is illustrated by the surge in Chinese stock trading accounts and the notable rush of firms, such as MSCI and FTSE, to include more Chinese stock exposure in their indexes.
Yes, this stock-market rally got out of hand, driven in part by an explosion of margin trading, with the lack of easy ways for negative views to be incorporated into prices via short selling also contributing to the run-up. As a result, a correction, even one as sharp as we are currently witnessing, is not totally surprising. However, it is critical to keep some perspective. Shanghai and Shenzhen are still up 74 percent and 99 percent since the beginning of 2014, and, despite some headwinds, the new normal of lower but sustainable growth is still arguably on track. This growth is still very high by the standards of developed economies.
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But what is both surprising and troubling is the response we have seen from the Chinese authorities. First, there were attempts to cool down the fast rising markets with limits on margin trading. More recently, we have seen a set of panicked reactions as the market has plummeted, ranging from dramatic reversals of these margin trading limits, to interest rate cuts, halts on new IPOs, and direct and indirect cash infusions into the market. The instinct to protect investors and maintain stability is laudable, but that does not make these measures any less worrisome.
Why are these actions such bad news? The role of the stock market is to generate and aggregate information, allocate capital efficiently, and provide a vehicle for savings and investment. Attempts to manipulate the level of prices by the authorities undermine all of these important roles, regardless of the perhaps worthy motivations behind them.
Right now the stock market no longer reflects economic fundamentals, but rather beliefs about current and future government action. As we learned in the U.S. from the era of the "Greenspan put" in the 1990s, when investors took on excessive risk believing that they would effectively be bailed out by the Federal Reserve if things went sour, the resulting behavior can have serious negative consequences. Moreover, the interference in the IPO market, control of which was to have been turned over to the stock exchanges, may again create havoc in the channeling of capital to the small and medium enterprises that will fuel China's growth engine going forward. These actions send negative signals to both domestic investors and institutions, and their foreign counterparts, about the prospects for liberalization of interest rates, development of the bond market, and the floating of the Chinese currency.
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All is not yet lost. But the authorities should step back and take a deep breath. Short-term market gyrations can be frightening, but China should be playing a long-term game. There has to be an understanding that giving up some control is the only way to foster the economic future that the country deserves and the world needs.
Commentary by Jennifer Carpenter and Robert Whitelaw, professors of finance at NYU Stern School of Business.
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