The East is red.

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China Shows How to Destroy a Market

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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A market, by definition, is a place where buyers and sellers can come together to exchange goods and services. That involves buying and selling those goods. Once you eliminate that free trading, you no longer have a market.

Then there is China, where the authorities have suspended the sale of 72 percent of the A share stocks. “Investors with stakes exceeding 5 percent must maintain their positions,” the China Securities Regulatory Commission said.

Throughout history, rules and regulations have slowly evolved to markets. Indeed, a certain level of regulation is desirable to ensure fair dealings, transparency and efficiency. By removing the ability to freely sell shares, the Shanghai Stock Exchange no longer qualifies as a market. I don’t know what it is, but if forced to come up with a name, the pursuit of accuracy would suggest calling it a government bureaucracy.

Lest you forgot, China remains a centrally planned autocratic regime ruled by the Communist Party. Niceties such as liquidity and free trading are deviant concepts. Pity Xiao Gang, the chairman of head of China Securities Regulatory Commission. The Wall Street Journal said he had “the toughest job in China.”

Let me suggest to Xiao that he might learn from the mistakes the West made in its recent crises.

During the dotcom bubble, Federal Reserve Chairman Alan Greenspan failed to do anything to reduce the speculative excesses. Day trading, excessive leverage, mediocre listing requirements all worked to allow a huge bubble.

After years of gains, the Nasdaq Composite Index doubled in 6 months -- October 1999 to March 2000 -- before its historic collapse of almost 80 percent.

Source: Bloomberg

China's markets YTD, compared with Nasdaq from Oct. 1999 to April 2000.

It may be too late for Xiao to learn much from those errors. He has allowed the use of speculative leverage to run amok in China, leading to the inflation of its historic bubble. Greenspan doubled down on his mistakes, slashing rates after the crash, which contributed to bubbles in real estate, credit and commodities. Perhaps Xiao might find that lesson useful.

During the subsequent financial crisis -- which had many causes -- the Securities and Exchange Commission sided with panicked bankers, implementing bans on short selling. That action subsequently spread around the world.

Ultimately, this kind of action removes a source of buying in a rout. Short sellers are typically the first to buy during a crash. Why? They have no risk in making the buy, as they are closing out an existing position. Thus, they act as a floor under a falling market.

The strongest collapse in U.S. equities took place after the SEC banned short selling in September 2008.

Consider the long buyer in a market selloff: They are catching the falling knife or anvil. They risk being early, and the trade is a money loser. Short sellers suffer no such disadvantage. Indeed, it is not much of a stretch to suggest that every short sale is a future buy.

How ineffective are prohibitions of short-selling? Recall the ban in the 1930s -- despite that, the Dow eventually fell 80 percent from its highs.

If stopping short sales does not prevent the occasional market collapse, consider these actual consequences of stopping sales altogether:

1) Causes markets to suffer a loss of integrity;

2) Selling halts are blatant market manipulations;

3) Are likely to cause a huge increase in volatility;

4) Ultimately creates a huge air pocket, leading to an even bigger crash when trading resumes after the six-month ban ends.

China's state-run Xinhua News reported that "police had visited the China Securities Regulatory Commission to investigate “malicious short selling.” I  thought U.S. and European bans on short-selling were counterproductive and short-sighted, I can’t wait to see the result of these moves. 

When the A-share market reopens in 2016, a bigger question will remain: Why would anyone want to invest in a market where you might not ever be able to sell?

There are many ways to cause a market crash. This should be one of the easiest to avoid.

China, which has made remarkable progress over the past 30 years, may have just set itself back a decade. Or we just found out we have been fooled by the regime's faux gestures toward capitalism. Either way, it will be interesting to watch this insane experiment unfold.

(Updates second paragraph to show that 72 percent of the market is affected by sales ban.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Barry L Ritholtz at britholtz3@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net