More pain now or later?

Photographer: Greg Baker/AFP/Getty Images

China's Tamed Stock Market Might Bite Its Economy

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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China pulled out all the stops last week to end the plunge in its stock markets. After markets slid about 30 percent, erasing more than $3 trillion of notional wealth, the mighty Chinese government engaged in perhaps the most spectacular act of market manipulation of all time.

First it dramatically loosened curbs on margin buying, banned new initial public offerings and enacted a raft of other measures to encourage buying. When that didn’t work, it halted trading on a majority of stocks, and banned all major shareholders from selling shares for six months. In a final, desperate, panicky moment, the government threatened to arrest short sellers (those who profit when shares decline) and throw them in prison, and -- in a comically totalitarian flourish -- ordered elite college graduates to chant “Revive the A shares, benefit the people!” at a commencement ceremony. 

The chant may not have done much, but the selling bans did the trick. When shareholders are not allowed to sell and are encouraged to buy, pretty much only one thing can happen, which is that stocks go up. And go up they have, by as much as 10 percent from their lows. 

So the question of whether the Chinese government is powerful enough to control the stock market has been answered with a resounding “yes.” As for why it’s doing it, there are many theories. But the really important issue -- for China and perhaps for the global economy -- is what happens next. 

The optimistic case for China is that the government’s action helped arrest an irrational panic. Stocks tend to overshoot on the downside in busts -- you can verify this statistically just by watching how stock prices tend to bounce around more than corporate fundamentals such as sales and profits. Those overreactions might be caused by so-called extrapolative expectations -- the tendency of investors to think that a big crash will continue longer than it will. If China’s intervention short-circuited that panic, then it might have averted a bigger collapse of share prices that could trigger more damaging margin calls, injuring the financial system. 

The pessimistic case for China is that stocks may still be overvalued. Chinese share prices rose about 150 percent from July 2014 through June, when they began to tumble. The fact that share prices went up and then rapidly fell implies that the big runup was a bubble, not justified by fundamentals. If that’s the case, share prices may still be too high. That would mean that expected returns on Chinese stocks are still negative -- in other words, the market has more to fall. In this pessimistic scenario, selling pressure hasn’t been eliminated, just frozen. It is still pent up, waiting to be released. 

This is what usually happens when people try to prop up share prices. Economist Owen Lamont has studied episodes in which companies resort to various legal actions and market manipulations to keep short sellers from driving down their stock prices. Even when the companies succeed, their share prices usually continue to drift lower. If this is true for a company, it should be similarly true for the Chinese government. 

Many analysts say they think China’s stocks still are overvalued. BlackRock’s global chief investment strategist Russ Koesterich was quoted as saying: “Given the magnitude of the run-up [in Chinese share prices], it is possible that even after a 30 percent correction, we haven’t gotten back to something approaching fair value.” Whether he’s right, he’s certainly expressing a widely held view, and that means that pent-up selling pressure might remain. 

So China may have succeeded in turning a short, sharp crash into a long, dreary bear market. That could actually be worse for China’s economy than if the government had allowed the crash to take its natural course. Negative expected returns make stocks a bad bet.  Financial institutions, saddled with stock portfolios that they expect to fall in value in the long term, may cut lending. Additionally, a seemingly endless parade of negative returns might create economic pessimism in China, replacing the heady optimism of the long boom with a sense that things will get worse and worse. 

Finally, the nationalization of the stock market will surely have a chilling effect on foreign investment. The ban on selling stock held by large investors has trapped a number of foreign companies, which are unable to liquidate the investments they made in Chinese corporations. These global companies are now waking up to the reality that although China has liberalized its economy a great deal, the government retains the ability and the willingness to retake control at any moment. 

Already, there is speculation that China’s economy is slowing. China’s government may have proven that it is more powerful than the stock market. But the forces of the economy are a different animal entirely. 

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

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Noah Smith at

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James Greiff at