Following The Herd In China

For all its communist trappings, China is one of the few countries in the world where the public obsession with the stock market routinely spills out onto the streets. Every weekend, the sidewalks of Guangdong Road, near Shanghai's People's Square, are thronged with hundreds of investors who come to exchange tips and opinions on the market. Some talk conspiratorially in small groups, while others express their views loudly and animatedly, attracting crowds of onlookers. Many participants are retired or laid off, others are menial workers, but some regulars here have sizeable investments. "I've put tens of thousands of dollars of my family's savings into the market," says a middle-aged man in a scruffy T shirt and trousers.

The mood on Guangdong Road has been glum lately, as it has in New York, London, São Paulo, Istanbul and pretty much every other world market. But the Chinese downturn is unique in terms of its sheer size and scope. Since late last year, the Shanghai composite index has plunged by more than 50 percent, from a high of more than 6,000 points—making the Chinese domestic exchanges the second largest in the world by market capitalization—to a low of just over 2,800 in June (by contrast, the New York Stock Exchange has fallen just under 20 percent over the past year). Now, many retail investors (which account for 60 percent of the market) have bailed; the rest are chewing their fingernails.

How China handles the fallout from this megabubble could have consequences which reach far beyond its retail investment community. Most of the people buying these shares are the middle class and wealthier consumers that China—and the rest of the world—was counting on to boost domestic consumption and rebalance the world economy. Now, with some households seeing as much as 50 percent of their wealth destroyed via market losses, and retail prices rising, there are early signs that they're being more cautious about spending. Meanwhile, market turbulence continues to be stoked by the fact that investors can't really get a clear grip on corporate fundamentals, in large part because the level of government control and meddling in the market makes true transparency impossible. This opacity—and the fact that many investors have always believed that Beijing will simply buoy the market by fiat at some point—makes the Chinese situation particularly volatile, even by emerging market standards.

You'd think China's investors might have learned from the past. In the late '90s, a dramatic plunge in Shanghai was followed by a sharp rise in 2001, and then a rapid fall. For the next four years, the market stagnated. Yet that just made the Shanghai index's recent explosion—it shot up some 500 percent between late 2005 and October 2007, thanks in part to a rash of government-stoked IPOs—all the more thrilling for investors.

What's ironic about this is that more government involvement in markets is generally seen in the West as having a tempering effect. Yet in China, public officials and the media they control are just as prone to hype as the bankers they're supposed to regulate. China's equity markets were initially set up to help raise funds for reforming the country's state-owned enterprises in the 1990s. Even today, the government not only approves all IPOs, it even sets IPO prices, says Andy Xie, an influential Shanghai-based economist. This is an old pattern, Xie notes; the authorities, he says, "always expressed views on the market; they used the official media to encourage people to buy stocks." Stories of fund managers and even state firms being instructed to buy particular stocks have been commonplace—as have cases of insider trading and other types of market manipulation.

The fact that China's stock market has continued to lure domestic investors despite these flaws has been in large part due to the relative backwardness and isolation of the country's financial system. Bank interest rates have been low for years, financial products have been limited, and citizens have had few channels to invest abroad. Real estate and the local stock market have been the two major outlets for investing savings.