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Global Economics

China Stocks Tumble Back Toward Earth

Share prices take a beating as Beijing continues to tighten the tourniquet on the explosive stock market rally in Shanghai and Shenzhen

Everyone from Hong Kong billionaire deal maker Li Ka-shing to former Fed chairman Alan Greenspan and People's Bank of China Governor Zhou Xiaochuan have been warning for weeks that the levitation act at China's domestic bourses in Shanghai and Shenzhen wouldn't last forever. Beijing financial mandarins have also sounded the alarm and followed up with interest rate moves and other tightening measures.

Nobody knows for sure, but the mother of all stock rallies in China that has seen the benchmark CSI 300 Index nearly double this year and inspired millions of new investors to open up trading accounts may finally be reaching a turning point. On May 30, the CSI 300 Index which tracks the most important "A shares" traded on the Shanghai and Shenzhen markets tumbled 6.8%. That's the most precipitous fall since a 9%-plus blowout on Feb.26 that rattled markets worldwide.

The trigger for the sell-off was a move by the Chinese government to triple the stamp tax—a fee on trades—from 0.1% to 0.3%. Although the absolute impact of the increase alone is hardly enough to dampen investor enthusiasm for markets that have been on a tear for the past two years, the move could signal that the government is deadly serious about guiding the market down with even stronger measures if need be.

Herald of Tougher Measures?

"This is very symbolic and a signal that the government is using targeted means to dampen irrational exuberance in the A-share markets," says Jing Ulrich, chairman of China equities at JP Morgan Chase (JPM). Ulrich points out that while the latest stamp duty adjustment in itself will have "a very limited impact," it's important to view it historically. Since the Shanghai market opened in 1991 the government has cut the stamp duty six times from an initial 0.6% rate, each time in an attempt to shore up sagging prices.

This small tax increase could herald a more profound move, such as the creation of a capital gains levy on stock transactions. Market rumors that Beijing was considering such a levy helped touch off the fall back in February.

This latest development also follows moves by China's central bank to steadily tighten credit conditions on the mainland, though they remain lax for an economy that grew 11.1% during the first quarter. The People's Bank of China has steadily hiked the reserve requirements for cash the banks must maintain at the central bank, and on May 18 hiked the interest rate on one-year loans to 6.57% from 6.39%, the fourth such increase since the spring of 2006 (see, 5/18/07, "China Tries to Turn Down the Heat").

Market Sentiment Shifting

Chinese financial authorities have also slowly twisted the tourniquet on liquidity and tried to dampen the speculative fever at domestic bourses in other areas. Beijing this year has introduced limits on allowing mutual fund companies to raise money from investors by launching new funds; has stepped up probes into insider trading and stock market manipulation; and has urged brokerages to make better attempts to educate retail investors about the risks of investing.

Only two trading days ago, on May 28, the CSI 300 Index touched a record high, but now market sentiment may be shifting as evidence grows that the government will keep up its "death by a thousands cuts" strategy to bring stock prices to more reasonable levels.

"The thousand cuts sound like they are now biting," says Stephen Green, the Shanghai-based senior economist for Standard Chartered.

The big question is whether this administrative measure portends something more Draconian in the future. It didn't take long for the Shanghai and Shenzhen markets to recoup declines in February and resume their moon-shot trajectory. And even with May 30's haircut, the Shanghai Stock Exchange Composite Index is up 51% on the year and shares traded on the smaller Shenzhen bourse have delivered returns of 117%.

Balfour is Asia Correspondent for BusinessWeek based in Hong Kong.

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