Share prices falling.

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The Good News in China's Stock Plunge

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Panic is in the air as China suffers its biggest one-day stock plunge since 2007. It shouldn't be. The 8.5 percent slide in the Shanghai Composite Index is actually a development that could leave China better off eight years from now.

I'm focusing on eight both because it's an auspicious number in Chinese folklore (the Beijing Olympics didn't begin on 8/8/08 by accident) and Beijing's idea of nirvana. Growth returning to 8 percent (relative to this year's 7 percent target) would buttress President Xi Jinping's reformist bona fides. Instead, stocks fell by that much Monday as Xi's magic has lost potency. Why is that a good thing? It's at once a reminder that rationality is returning to mainland markets and a message to Xi to stop putting the financial cart before the proverbial horse.

Since mid-June, when shares began sliding, Xi's market-rescue squad has tried everything imaginable: interest-rate cuts, margin-lending increases, bans on short selling, a moratorium on initial public offerings, hauling supposedly rogue traders in for a talking to, ordering state-run institutions to buy shares, halting trading in at least half of listed companies, you name it. What Xi hasn't tried is upgrading the economy and financial system in such a way as to help the stock market thrive.

To find out what he should do next, Xi could do worse than to check in with Henry Paulson. Even though Paulson might regard with scorn China's love of the number eight, it was on his watch as Treasury secretary in 2008 that the U.S. had its own brush with financial collapse.

Paulson has been merciless in his all-hype-and-no-fundamentals critique of Xi's government. "China is especially vulnerable at this point because while its economy has grown and matured, its capital markets have lagged behind," he wrote in the Financial Times. "It is no surprise that those ideologically opposed to markets would use recent events to make the opposite argument -- that to prevent market instability, Beijing should slow the pace of financial liberalisation or perhaps even abandon market-based reforms altogether." Yet, he argued, "while Beijing’s instinct to protect investors is understandable, the best way of doing so is to create a modern capital market."

That's why ambivalence toward Xi's titanically large market interventions could be a positive. It refocuses Beijing on what's needed to re-create the vibrant markets that prevail in New York and Hong Kong. Xi's Communist Party has tried and failed to stabilize things by edict. In fact, heavy-handed manipulation has set back Beijing's designs on making the yuan a global reserve currency and getting Shanghai shares included in MSCI's indexes.

As Paulson points out, no nation has ever achieved high-income status with a closed market system that misprices risk. The longer Xi's men delay adopting international standards of capital allocation, transparency and basic trust in markets, the bigger the odds China will experience a Japan-like crash, circa 1990.

In recent days, the International Monetary Fund has, according to Bloomberg News, urged China to unwind measures taken to stem the stock sell-off. This week, Vice Finance Minister Zhu Guangyao said the real challenge is how regulators exit without incident. But after Monday, the odds favor Beijing getting even more deeply involved in markets that are proving less docile than its 1.3 billion-person-strong population.

With Shanghai shares now below the psychologically important 3,800 level (there it is again -- the number eight), the question isn't investor confidence but Xi's. Any government might step in with "circuit breakers" as market losses outpace economic logic. At some point, though, Xi must realize he's losing perspective as well as control. Isn't it odd, for example, that trading has become more volatile even as half of listed companies are shut off? Talk about the laws of unintended consequences! Really, if this isn't a good argument for letting markets work as they're supposed to, what is?

Xi's legacy was supposed to be recalibrating China's economy and opening the financial system. Turns out, it's battling stock short-sellers. That leaves China's leader with a choice: Either create the fundamentals needed to support rich stock valuations or keep putting the entire weight of the government against hedge funds. The longer China does the latter at the expense of the former, the 8 percent figures in its future will be for stock losses, not economic growth.

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

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Mary Duenwald at mduenwald@bloomberg.net