My Blog

January 2, 2008

Two weeks ago when I was being interviewed for Dialogue, a local current events show on CCTV 9, I was asked about the sophistication of Chinese investors, and I responded that China does not have a real investor base.  The whole market here is speculative, I argued, not because Chinese investors are naturally speculative but rather because the structure of the market does not permit any other form of investing.

The other guest on the show, the chief economist of a major Shanghai fund, disagreed, saying that Chinese investors are not speculators but are simply investing based on their perception of what the government is going to do.  In China, he explained, the only important question for an investor is “What will the government do tomorrow?”

He is right of course in his description of the motives of Chinese investors, but he is wrong in saying that this isn’t speculative.  In fact investing based on perceptions of government behavior is a classic speculative strategy, and it explains why Chinese markets are so inefficient at allocating capital and why, for all the attempts by financial authorities to make local markets more “sophisticated”, nothing is likely to improve in the near and medium term.

Basically speaking most investment strategies can be fit within a triangle whose three corners represent the purest form of the three main investment strategies.  In one corner, value investment or fundamental investment involves buying assets in order to earn the long-term economic value generated over the life of the investment.  In the second corner arbitrage or relative value trading involves exploiting short-term pricing inefficiencies to make low-risk profits.  In the third corner speculation takes advantage of “technical” information that will have an immediate effect on prices by affecting short-term demand or supply. 

Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently to its more productive use.  Fundamental or value investing allocates capital to its most productive use.  Speculation, because it involves frequent trading, provides the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply.  It also ensures that information is disseminated quickly.  Arbitrage or relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence.  It also increases market liquidity by combining several different, related assets into a single market.  When buying of one asset forces its price to rise, for example, relative value traders will sell that asset and buy related assets, thus spreading the buying.

China does not have a well-balanced investor base.  There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, neither of which is available in China.  There are also very few value investors because the quality of financial and macroeconomic information is poor and corporate governance and regulatory frameworks are weak and inconsistent.  If we broadly divide information into “fundamental” information, which is useful for making long-term value decisions, and “technical” information, which refers to short-term supply and demand factors, it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former.  The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behavior, but in China there is little such confidence.  Furthermore, regulated interest rates and pricing inefficiencies makes it nearly impossible to develop good discount rates.

On the other hand there is plenty of technical information, and as a consequence the vast majority of investors in China must be speculators.  Insider activity is very common in China, even when it is illegal.  Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate behavior.  Markets are illiquid and fragmented, so large price movements can easily be caused by determined traders.  In addition, the single most important player in the market, the government, is able and very likely to behave in ways that are not subject to economic or value analysis.  One consequence of this is that local markets do a poor job of rewarding companies for decisions that add economic value over the medium or long term.  Another consequence is that Chinese markets are very volatile, and this raises the cost of capital for business.

All investors in Chinese markets must be speculators if they expect to be profitable, and if Warren Buffet moved to China he, too, would be forced to become a speculator.  As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism in the markets.  In order to change this, Chinese authorities must reduce the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders.  They must also improve corporate transparency.  They must continue efforts to improve the quality of both corporate reporting and national economic data.  Finally they must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.

Unfortunately, Chinese financial authorities are not reducing, but are in fact increasing, the importance of technical information related to government activity.  In recent months the importance for investors of predicting government attitudes to the markets has actually increased.  The authorities are caught in a tough position, because they are worried about a bubble in the stock and real estate markets, but their inability to keep their hands off the market is actually seriously undermining the development of a balanced investor base by reinforcing the perception that only the government matters.  This will continue to be a largely speculative market for many more years.

Comments (7) for "The government condemns Chin...

Mike this is a really powerful essay -- thank you. Extremely incisive. 2 questions. first, a variable I often see added to market driver matrices but which is not discussed above is "psychologicals". Is that just a special case of speculation? And second, is there a natural sequence for what msut come first, good relative price investing or good fundamentals investing? Best, Dan R By DHR - 1/2/2008 11:19 PM

The problem with increasing "corporate transparency" is a trust and credibility issue. Suppose I put together an annual report and balance sheet that looks good. How do you know that it is actually good? One way that the Chinese government has dealt with this issue is overseas listings. The main reason Chinese companies list in NYC or Hong Kong is that the securities regulations, accounting firms, and analysts have credibility, and by getting the stamp of approval from the SEC and the NYSE, a Chinese company gets a credibility. Other mechanisms include having credible outside directors and minority shareholders which is one reason Chinese governments are looking for overseas dance partners. The problem with this is that this means that the best Chinese securities are off-limits to PRC investors. The two mechanisms to deal with that are dual listing on both Shanghai and HK and also a QDII program that PRC investors can use to buy PRC companies listed in HK and NYC. I think that those mechanism will probably be effective over the next three to five years. Two other mechanisms to make the stock market more rational are institutional investors, and exchange traded index futures. If you have index futures then you can subtract the effects of government policy on the overall markets if you are interested in the performance of a single company. Finally the market becomes less speculative if it becomes really big, since it means fewer swings in response to government policy. The next big challenge is not so much the stock market since there is a plan. The next big challenge is the corporate bond market. One other historical note. Just as it helps to think of bank loans in the 1990's as a method of social welfare spending, it helps to think of the stock market in the 1990's as something like the state lotteries that US states use to raise money for education. In this case you bought a lottery ticket (a share of stock) that could pay off, but probably wouldn't, and the proceeds went to pay for unemployment benefits. Also as with a lot of things, there are timing issues. For example allowing shorting is a good thing to do in general, but if you allow shorting and don't have good securities regulation, this opens the door to a lot of bad things happening. By Twofish - 1/3/2008 1:25 AM

The mention of Warren Buffett is interesting since one of Buffett's big profitable plays was buying PetroChina circa 2000 and selling it recently. The reason Buffett could do this is that PetroChina was an SEC approved, NYSE listed stock. The other problem with emerging stock markets is the liar effect. In a badly run stock market, investors will basically run to the company that is best at lying about themselves. Suppose a company on Shanghai *did* disclose all of the bad things about it, and honestly said that there is no way in hell that your money would double in one year, it would get fewer investors than a company that was good at lying through its teeth. By Twofish - 1/3/2008 1:31 AM

If the chief economist of a major fund don't think that trading according to speculation on government action is speculative, the market is purely speculative. This also underlines the maturity of Chinese investors. Sounds like Warren Buffett is a very good speculative trader, as well as a value investor, a turn-around magician. By Bill - 1/3/2008 4:00 AM

think market "psychologicals" are conditioned responses which are developed through frequent, consistent and long-term interactions among market actors that Mike ID'd. it seems to me that it is most pronounced in a mature, efficient market which each market actor has access to largely similar and accurate information e.g. default of certain SIVs, CP market contracts overall, CP rate jumps significantly. None of the reaction is due to governing body's decree. However, this is not to say that there are no market psychology invovled in China's financial market. I suppose the difference is that the effects of "psychologicals" in the US market (or other mature market) can self-correct as they are driven by economic forces mostly, but that of China cannot as they are in connection with non-economic factors... By zh - 1/3/2008 4:27 AM

Dan, I would argue that “psychological” trading occurs a lot less than people think. For me the two most famous psychological factors, fear and greed, generally don’t explain much except in a very circular way. At any rate “greedy” behavior – pouring into a market long after it has surpassed its fundamental valuations – and “fearful” behavior – panic selling even after prices have gone down substantially – are usually, in my opinion, caused by technical factors such as the existence of margin, derivative hedging, program trading, or redemptions, that increases buying power in a rising market and forces selling in a declining market. To the extent that there is psychological trading, however, I would definitely qualify that as speculative. As for sequence, all I can suggest is that historically most markets start out as extremely speculative but as enforcement mechanism are put into place to ensure good corporate governance and accurate financial reporting, investors discover that they can make money based on fundamental analysis and so their trading strategies shift. This is where Twofish’s comments come in. As he points out (if I am reading him correctly), there is a sort of game theory problem here where it doesn’t benefit individual companies or corporate officers to be the first ones to tell the truth and give up the ability to obtain various forms of rent. This is why enforcement mechanisms are important – investors must be able to force management to do their bidding and punish management for lying. Like democracy in general, these are not a panacea that automatically creates well-functioning markets, but they do address various forms of the agency problem by forcing insiders to align their incentives with investors. Twofish, I am actually very skeptical about the introduction of futures and derivatives in China and think they should go slow until after they have a more balanced investor base. I am afraid that derivatives don’t change investor behavior but can be used to magnify certain types of strategies, including speculative strategies. In a well functioning market, they increase efficiency, especially for relative value traders and arbitrageurs, but in a highly speculative market they may exacerbate volatility by increasing the power of insiders and large traders. ZH I think your comment is a very interesting one. A well-functioning market needs some sort of systematic self-correction mechanism so that we can learn from our mistakes. Here in China there is only sort of a mechanism that really does this – don’t bet against the government. By Michael Pettis - 1/3/2008 2:35 PM

The Buffet-Petrochina deal is very interesting but it is a good example of a smart fundamental investment. I didn’t have time to explain in the original posting, but the reason fundamental investors are not involved in the market is that they are essentially priced out of the market. Every additional uncertainty that hampers the development of a fundamental investor base (poor disclosure, government interference, weak governance) does so by requiring fundamental investors to increase their discount rate, so they often find it difficult to find assets that are “cheap”. However that doesn’t mean that they can do nothing. In some cases, where a company is easier to value (oil companies, for example), it is still possible to make a fundamental investment decision even when there are valuation problems, as long as the company is so cheap relative to its fundamentals that a high discount rate is not an impediment. By Michael Pettis - 1/3/2008 2:36 PM