Americans believe in free markets almost as fervently as they do in God. Faith in Adam Smith cuts across religions and denominations. That is why it is so hard for many of us to accept as reasonable the Chinese government’s massive intervention over the last 10 days to arrest the collapse of its stock markets. The whole endeavor — canceling IPOs, creating a fund to soak up unwanted shares, ordering institutional investors and major shareholders not to sell, suspending trading of some firms, attacking shorting stocks — is utter heresy and couldn’t possibly succeed.
Chapter One of “The Book of Free Markets” states that it is impossible to fight the laws of supply and demand. Chinese stock prices jumped over the last year as a result of repeated stimuli, accelerated by margin trading. Markets must eventually reach equilibrium, meaning the bubble had to burst.
Chapter Two allows for intervention only when the economy’s basic foundations are threatened, and since China’s stock markets account for just 3% of newly raised capital and the economy is still growing at over 6%, this market correction did not qualify.
The concluding chapter tells us that propping up the market may provide temporary paper earnings but reinforces risky behavior by investors, who can expect to get bailed out in the future when their bets go bad.
So on the one hand there’s theory, perhaps best expressed by Jason Zweig of the Wall Street Journal, who declared: “The Chinese government regards markets as clay that can be molded. Instead, markets are like water: They always find their own level, no matter who or what tries to control them.”
But on the other hand there’s reality, which seems to indicate that China’s muscular intervention is working.
The Shanghai Composite Index rose from its low Wednesday of 3,507 to close Monday at 3,970, up 13.2% in just three trading days. The Shenzhen and Hong Kong exchanges gained 12.5% and 10.2%, respectively. Although Chinese markets lost more than 30% of their value during the last month, they are still up 95% from June 2014, when the climb began. Meanwhile, China’s downturn has barely caused a ripple on the New York Stock Exchange. The turmoil in Greece and the recent increase in the price of Starbucks coffee have had a greater effect on American investors.
Recent history is of course not the only evidence that China’s “clay” approach gets results: China has averaged 9% growth for 36 years by combining market-oriented policies with strong doses of protectionism.
Despite what they preach, moreover, individual American officials from the president on down occasionally meddle with the market: They get in front of the camera to jawbone the economy, to reassure investors or try to talk the dollar up or down. And all of us remember where the temporary, if unofficial, CEO of General Motors lived after the global financial crisis broke out — 1600 Pennsylvania Ave.
Although it would be comforting to let laissez-faire dogma guide the way, appropriate policies should always be determined by circumstances, not faith.
That said, it’s just as unwise to revere the visible hand of the state as the invisible hand of the market. Intervention breeds intervention.
In the long run, liberalization and a stronger regulatory framework are more likely to result in economic stability and growth than repeated intrusion. If China’s policymakers want their financial markets to eventually function independently, they’ll have to put forward a new round of reformist policies.
They should begin by removing the series of temporary stimuli to pump up the stock market, including eliminating margin trading, allowing all listed firms to resume trading (1,000 are still suspended) and letting investors large and small buy and sell shares at will.
The next step is to improve the underlying governance of the stock markets by expanding listed firms’ transparency, limiting banks’ involvement and exposure, strengthening the rights of minority shareholders, and making regulators’ overriding task honest market behavior, not growth and profitability.
The final task for policymakers is to further open Chinese stock markets to foreign capital and permit Chinese households and companies to invest abroad. Fully opening China’s capital account would reduce the difference in the stock prices of Chinese companies listed domestically and on foreign bourses and more broadly decrease opportunities for arbitrage, thereby reducing the volatility that China’s regulators so want to avoid.
Anyone who thinks China has broken its intervention habit will certainly be proved wrong before long. But if its leaders move steadily toward liberalization, there should be less need for heresy in the first place.
Scott Kennedy is director of the Project on Chinese Business and Political Economy at the Center for Strategic and International Studies in Washington.