China's stock market plunged yet again last week, this time by 8.5 per cent - its second-largest fall in a single day, and the largest since the global financial crisis. The roller-coaster ride is far from over.
In fact, China's stock market is more like a casino than an amusement park attraction. Retail investors account for 85 per cent of trades, in contrast to other major markets, where institutional investors - with their relative abundance of information - are the biggest traders.
The result, no surprise, is an extremely volatile market, in which rumour and emotion play an outsize role in driving outcomes. And that volatility is the other reason why the casino metaphor applies: China's stock market can rise or fall by double digits without triggering a wider economic crash - at least so far. For example, China's GDP growth was unaffected (in fact, the economy was growing at nearly 10 per cent) when the stock market lost half of its value between 2001 and 2005 - or, for that matter, when the market then recovered (only to fall dramatically again after the 2008 financial crisis).
Since then, China's stock market has been a global laggard - that is, until the past year, when it became the best performing in the world, rising by more than 150 per cent. And yet the roller-coaster pattern continues: The 8.5 per cent plunge came when the market re-opened on a Monday that followed the largest two-day rise since 2008. That rise had been preceded by a loss of nearly one-third of the market's value from the middle of June to early July.
This volatility highlights the challenges of ensuring a smooth process of financial liberalisation in China. After extensive government intervention prohibited some selling of shares and froze trading for the bulk of the market, prices rebounded. Yet intervention is unlikely to prevent another crash.
The reason is that the Chinese stock market is not wholly liquid or globally integrated. Moreover, it is dominated by captive money from Chinese savers - the retail investors. Indeed, it was not until 2009 that most shares on China's stock exchanges were tradable. Until the reforms that began in 2005, two-thirds of shares were non-tradable and held by state-owned enterprises or legal persons, which are typically state-controlled entities.
Indeed, private firms still comprise a minority of China's listed companies, though today fewer than 30 per cent of shares cannot be traded.
To be sure, that has led to a huge infusion of liquidity over just the past few years. But China also imposes capital account restrictions on portfolio investment flows, which means that its stock markets remain relatively closed. Until the recent launch of the Shanghai-Hong Kong Connect corridor, which links the two markets, international investors could not directly buy A-shares on the mainland exchanges. Direct purchases remain subject to a quota, in the form of a limited number of so-called Qualified Foreign Institutional Investor licences.
By the same token, aside from the very wealthy, who benefit from personal connections and other devices, the hundreds of millions of ordinary Chinese savers who have achieved middle-class status do not have easy access to global markets. Moreover, returns on deposits are low (and had been negative), and the state-dominated financial system offers few diversified products. As a result, housing and domestic equities are the main investments available to them.
But then the housing market stalled, as fears of a property bubble spurred a government clampdown on credit, leaving the stock market the place for middle-class savers to put their money. The ensuing boom was a mirror image of the pattern between 1998 and 2001, when the housing market was liberalised and the stock market fell.
The big question now is whether the recent volatility will spill over into other asset markets and the real economy. The double-digit drop in the Shanghai Composite Index since June has not triggered an economic crisis largely because fewer than 10 per cent of Chinese households participate in the stock market, and equities comprise less than 15 per cent of household assets.
But even a small fraction of Chinese households experiencing paper losses still amounts to tens of millions of people. That has caused enough concern for the government to act, including by relaxing collateral requirements to permit real-estate assets to be used to cover margin calls.
It was, in fact, the authorities' clampdown on margin borrowing, together with a loss in confidence as global markets declined, that is thought to have triggered the market meltdown. And that, too, is a feature of a market dominated by small traders: The "herding" behaviour that fuels major booms and busts becomes more prevalent, because individuals assume that others have better information.
The result, as we are now witnessing, is that a moderate sell-off can easily turn into a stampede. And government intervention to block the exits is inadequate. On the contrary, until China's stock market opens up and its institutional foundation becomes predictable, volatility will be its only guiding rule.
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• The writer, author of China's Growth: The Making Of An Economic Superpower, is fellow in economics at St Edmund Hall, University of Oxford.
