Chinese Stock Bubble Hits Retail Investors Hard

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.

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.