Sometimes, The Market Just Wants To Go Down (Part II)
With prices in China’s A share market falling precipitously from their October 2007 peak, and many in China calling for the government to do something, anything, to stop the stock market’s slide. I wrote a post on April 29, Sometimes, the Market Just Wants to go Down, where I argued that further intervention by the Chinese government would be the worst thing it could do. The duty of any government is to implement sound economic policies, and to ensure transparency and fairness in its capital markets — not to guarantee that its citizens and investors earn positive returns through the stock market.
Sometimes, despite any government’s best efforts, stock markets react to global events or trends that are outside the government’s control. In these cases, the market just wants to go down, and the government should let it. This is how vibrant, well-functioning capital markets that efficiently allocate capital in any country’s economy are built.
Anxious to ease the pain of investors, the government nonetheless continued to intervene. Despite these efforts, China’s stock markets have continued to slide, with the Shanghai Composite Index dropping below 3,000 last week. On Tuesday, June 17, the Index plunged another 2.76 percent to close at 2794.75, a 15-month low. The Shenzhen Component Index tumbled 4 percent on the same day.
Commenting on the market, a recent Wall Street Journal editorial summed up the futility of government intervention in the country’s stock markets, and the distortions it causes in capital allocation:
There are good economic explanations for this week’s bear run. As the U.S. and European economies slow, there are worries about China’s export growth. Domestic consumer price inflation hit 7.7% last month. Beijing is trying to slow the economy in response – most recently by increasing banks’ capital reserve requirements Saturday. In any normal market, investors would be worried about corporate earnings right about now.
But China’s stock market isn’t normal; underlying economic growth is less important than government meddling. In the past few months, regulators have reduced the stamp tax on stock transactions, imposed new regulations to limit large block sales, and even told mutual fund managers not to sell their holdings too quickly.
As a result, investors are punting on what the next new regulation will be, rather than on the economic fundamentals of listed companies. This leads to inefficient capital allocation, herd behavior and boom-and-bust cycles. It may also prove self-defeating. Now that Beijing has shown it can’t hold the market above 3,000, the danger is that investors lose faith completely and a sharper plunge might ensue.
In “Managing the Dragon,” I argue that one of China’s biggest problems is the current state of the country’s capital markets. There is plenty of capital in China — it’s just not distributed efficiently. In the book’s final chapter, where I review the bumps ahead for China’s economy, I wrote:
Inefficient use of capital, as I’ve discussed on a couple of occasions, is another big problem. The amount of capital required to generate an additional 1 percent growth in the country’s GDP’s increases each year. Unless China develops a better way to channel capital to the individuals and companies that can use it best, the country won’t be able to achieve its full economic potential.
Despite their current shortcomings, the development of efficient capital markets represents one of China’s biggest opportunities going forward. If you think that the country’s growth over the past 30 years has been something, wait until China develops deep, diverse and independent thinking pools of capital — “cold-nosed capital” that seeks only the highest returns as Charlie Williams, one of my Harvard Business School professors, used to say. The economic growth caused by the eruption of entrepreneurial activity that will occur as a result will be nothing short of spectacular.
As a first step towards that goal, the editors at The Wall Street Journal said it best:
If Beijing wants to create conditions for a healthier market in coming months, it will let this slide run its course.
