My Blog

April 25, 2008

FRI 25 APR

Stock market is down today By Michael Pettis

This is exactly what I was worried about.  After a strong start this morning on the back or yesterday’s furious rally the Shanghai and Shenzhen stock markets suddenly turned negative and ended the day lower, with the SCI dropping by 0.71%.  It is widely known among financial market experts that governments can have powerful impacts on the market by signaling their intentions, but the more often they do it by pure signaling (i.e. with measures that have no fundamental impact) the less credible their signaling becomes over time.  In other words the more you intervene to control the market the more empty your intervention becomes – this is a weapon whose greatest power lies in the rarity with which it is used. 

 

I suspect we may be about to prove this yet again.  For the past year we have seen a whole series of interventions designed explicitly to manage market prices – and although they have worked well, they have done so with decreasing success.  The market surged 9.3% yesterday when the tax authorities announced that they were cutting the stamp tax, but everybody bought just because they expected everyone else to buy.  There was no real conviction.  

 

And since the announcement provided no real change in the earning prospects for Chinese companies, savvy investors seem to have taken advantage of the event to shift their shares into the hands of the more gullible.  China Daily today quotes a man who trades stock at a Shanghai broker saying, in the midst of yesterday’s rally “I bet the market would undergo a strong rebound before the Olympics, and I will exit the stock market forever if I can make any gains then.  It is just too risky for ordinary people like me.”  He is probably unhappier than ever today.  If this kind of opinion is widespread, and I think it is, it bodes badly for the longer-term development of the stock markets.

 

How aware are the authorities of the risks of this kind of intervention?  The always astute Li Xinxin at Observatory Group wrote yesterday about the reasons for the stamp tax cut – a decision that he worries about no less than I do.

 

The new cabinet, especially Vice‐Premier Wang, once intended to reinstitute the non-intervention principle for China’s capital market, but their effort failed.  In recent weeks, there was an intense debate among both policymakers and scholars about whether the government should rescue the stock market.  Wang preferred not to use the trading tax rate to micromanage equity prices, but his opponents used the social stability argument as a major reason for such a decision.  This is a critically strong argument in an Olympic year, and particularly when top leaders already are stretched by challenging issues such as Tibet and inflation.  

 

The government has performed particularly poorly in public communications. Vice Premier Wang and his team had a good chance to establish new criteria for government intervention by expressing their views and guiding market expectations. But no government officials dared say anything on this issue, reflecting a very rigid political system.  That silence gave the impression that the government made a major concession to market pressures in return for nothing. 

 

With this tax rate cut, the government reversed an 11-month-old tax increase and reinforced the policy-driven feature of China’s stock markets.  Certainly, the constant change of market rules does not help build a well-functioning market which could efficiently distribute financial resources in the long run.  In this sense, the new cabinet is not different from its predecessor.  

 

It will be interesting to see what happens to prices next week.  My assistant Shang Ning tells me that there are rumors that the big buyers who pushed prices up prior to the announcement of the cut in stamp tax were the local pension funds.  I have no idea if this is true, but they do tend to have better access to information than the rest of us do, and clearly someone either very lucky or with very good information sources was buying the market if it traded up 4.2% after so many weeks of decline.  

 

If many small investors really do expect a pre-Olympic rally that lets them out of their losing positions, I am afraid this is going to result in another disappointment.  Still, maybe the government has a few more tricks up its sleeves.  I think 3000 is widely considered to be the minimum level below which the government acts.  Call it the “3000 put”?

 

In June 1999 I remember that Paul Krugman wrote a note on the implicit euro “put” that existed because for purely symbolic reasons European authorities were loathe to let the euro trade below $1 (how long ago that seems!).  His conclusion, reached by an elegant application of option theory (you can find the note at http://web.mit.edu/krugman/www/hershey.html), was that when the euro finally broke $1, it would break big.  It did.  Perhaps this has nothing to do with the Shanghai markets, but if the “3000 put” really does exist, it might have.