Financial stability requires sound money, not artificially low interest rates that encourage risk taking, penalize savers and misallocate capital. Sustainable asset prices rest on long-term economic growth, which is strongly influenced by the choice of economic policies and institutions.
China's financial institutions are still weak: They lack well-defined private property rights and the rule of law; they depend on government manipulation and are divorced from reality. Those weaknesses are evident as we watch the roller-coaster ride that investors are taking on the Shanghai and Shenzhen exchanges.
After more than doubling from a year ago, markets reached a peak on June 12, then lost more than 30 percent of their value in a matter of weeks. That rapid tumble has led to significant government intervention to “stabilize markets”—that is, to place a floor under stock prices.
The People’s Bank of China quickly lowered benchmark interest rates, relaxed the reserve requirement for banks and injected liquidity into the market. Funds were extended to state-owned brokerage firms through the China Securities Finance Corp. in order to mitigate margin selling, and government wealth funds were instructed to enter the market to shore up asset prices.
More recent measures include a six-month ban on stock sales by major shareholders controlling 5 percent or more of a stock, the halting of trading on nearly 50 percent of tradable shares on the two major exchanges, the end of IPOs by private-sector firms and the relaxation of collateral rules for margin lending.
Establishing government-funded “market stabilization funds” and other devices to tame falling markets may be politically popular in the short run but can severely damage China’s future development as a global financial center. What China needs are free private markets based on limited government, responsibility and trust—not more central planning and control.
Open markets require the free flow of information and the rule of law. China lacks both. The latest measures to rig stock prices can only undermine President Xi’s “China Dream” of restructuring the economy away from state-driven investment and toward a more balanced system.
The effect of strictly limiting the right to sell stocks while pumping up demand has temporarily put the brakes on the downturn but has undermined confidence in Beijing’s pledge to liberalize capital markets. The transferability of shares is an important component of stock ownership. If that right is weakened by government intervention, the value of one’s property decreases and the incentive of both domestic and foreign investors to buy shares will weaken.
The attenuation of property rights as a result of stabilization efforts is perhaps the most damaging consequence of the recent interventions. If investors cannot trust the government to abide by the rule of law and protect private property rights, the entire credibility of financial markets will suffer and the reform process will slow. Political forces will enter the vacuum and planning will suffocate competitive markets.
Retail investors have played an important role in driving up stock prices, and they have done so by buying on margin. The announcement of the opening of the Shanghai-Hong Kong mutual trading platform late last year—and the expectation that Beijing was eager to use policy tools to stimulate asset prices in the hope that higher prices would increase consumption and growth—provided a bullish atmosphere.
The People’s Bank of China, like the Federal Reserve, has engaged in financial repression, leading to negative real interest rates. The lack of investment alternatives in China tempts small investors to take on excessive risk. As such, stock markets have become super-casinos. Capital controls mean that only the rich and politically connected can get their money out of China while lower-income families suffer.
China has taken steps to liberalize capital markets, but the markets are heavily constrained, and all major banks and brokerage firms are state-owned. The legacy of central planning resides in the socialist market system that characterizes the allocation of capital, primarily to state-owned enterprises.
If China wants to become a world-class financial center, it needs a rule-based monetary policy designed to safeguard the value of money and a financial system that is grounded in law and liberty—rather than “stabilized” by the heavy hand of the state. Until then, foreign investors will be wary of riding the dragon.