Following The Herd In China

Now, as China plays a bigger and bigger role on the world stage, a properly functioning stock market is becoming increasingly important—to it and the world. China hopes to attract international funds through a scheme launched a few years ago in which overseas fund-management companies are given qualified foreign institutional investor (or QFII) status. Such funds, which today account for only about 4 percent of China's market capitalization, had some $30 billion invested by 2007. Equally important, the authorities have announced grand plans to make Shanghai a major international financial center for the Asia-Pacific region, with talk of capital markets, financial futures and derivatives trading. An independent stock market is seen as a prerequisite for all of this.

What happens next may also be an object lesson—or a warning—for other developing countries. Certainly the frenzy of last year, when the Shanghai index doubled in value in just six months, seemed like a textbook case of the dangers of an immature market. New investors swarmed in to snatch a piece of the fast-growing pie: "the number of trading accounts in China went up by 40 million in May-June last year, from 60 million at the end of April to around 100 million at the end of June," says Victor Yuan, chairman of the Chinese market research firm Horizon. The authorities, fearful of the social unrest that might be caused if the bubble burst, even began reminding punters that share values could go down as well as up. In Fujian province, the local government reportedly sent out a special warning aimed at high-school students, urging them not to get involved in the market.

These precautions were somewhat rich given Beijing's own role in fueling the most recent boom-bust cycle by hyping IPOs of some of the country's biggest financial companies. Even as the global economy became more volatile in the last 18 months, China's government relaxed market rules, allowing for the trading of previously non-tradable shares (many held by the government) in listed companies.

The hugely aspirational psychology of Chinese retail investors, who are notoriously willing to gamble, added fuel to the fire. "Because Chinese people have such a strong desire for wealth, the bubbles in China can also mushroom quickly and deflate quickly, probably quicker than what other countries have experienced during their development process," says Xie.

The fact that China has not experienced the sort of protests that hit other countries after major market meltdowns—as in India, where investors took to the streets of Mumbai earlier this year—is partly down to the fact that Chinese banks are not allowed to support margin trading (that is, lend people money to invest in stocks). That has limited the absolute size of losses, says Stephen Green, Chief China Economist of Standard Chartered Bank. At the height of the boom last year, China's tradable market cap was equal to around 36 percent of GDP, compared with 109 percent in Japan and 142 percent in the United States.

That said, the effects of market losses are beginning to translate into more tight-fisted spending patterns. For example, car sales—which were boosted by proceeds from last year's stock-market boom—have fallen notably recently. In an effort to head off major discontent, the Chinese government did cut stamp duties on new share transactions and promised to improve the transparency of listed companies. Though interventionist, the moves are a far cry from old-fashioned market manipulation. Paul French of Access Asia believes the Chinese authorities have recently made a conscious decision to reduce the level of political control over the market. "Previously, they would have insured that every listing was oversubscribed, but they've not done that, if you look at some of the Chinese listings this year a lot have been undersubscribed." French says the aim is to show foreign investors that the exchanges are now guided more by market forces—even at the expense of wiping trillions off the paper value of the state holding in listed companies.

If it comes off, that's good news for market capitalism in the Middle Kingdom. But for Chinese investors brought up in a system where state control was the norm for so long, the shift might take some time to sink in. "The market will definitely go up for the Olympics—the government will make sure of it," says one investor on Guangdong Road excitedly. The bubble mentality, like bubbles, dies hard.

© 2008