Don't bet more than you can afford. Don't borrow money to play. Don't chase your losses. Quit while you're ahead.
If only Chinese stock market investors had followed these basic gambling rules. Seduced by dreams of getting rich quick, millions of inexperienced Chinese investors have lately been treating the stock market like a casino. With the help of social media, the optimism spread quickly, pulling more in. The index for the main board of the Shanghai Stock Exchange almost doubled in the past year. The index of small cap stocks has tripled or done even better. It became a classic asset bubble. Then it all came crashing down.
The government-engineered bull market was meant to help resolve China's real estate bubble and over-leveraged local governments, incentivise innovation and facilitate reform of state-owned enterprises. Instead, it was hijacked by highly-leveraged greedy individual investors. As the government became concerned and began to deleverage margin trading, it set off a stampede, with everyone rushing to the blocked exit doors because of the 10 per cent price limit trading rule. Over the past three weeks, the market has fallen by 30 per cent Even after this correction, many small cap stocks remain overvalued.
In an effort to calm the market, the government has taken measures to buoy the prices of blue chip stocks, temporarily halted initial public offerings (IPOs) and lifted insider trading rules to make it easier for company directors to buy back their own shares. It has also imposed a one-year stock sale ban on anyone owning 5 per cent or more of shares in a company. When the government began focusing support on blue chips, at least 1,439 Chinese listed companies - 50 per cent of overall listings - applied for a temporary trading halt in order to protect themselves. This also contributed to the panic.
Even Chinese firms listed on other markets were hit by the crisis.
The hashtag #ChinaMeltdown began to spread on international social media. Investors in the US began selling off stocks in Chinese companies listed in the country even though they are not affected by the liquidity crisis in the Chinese stock market.
Just before the China market plunged, there had been a surge in US-listed Chinese firms planning to go private hoping to chase the higher valuations in China with an eventual IPO in the country. Many will have to delay these plans.
The Chinese market crisis is a reflection of the overvaluation and over-leveraging of small caps, and is not comparable to what happened in the US in 1929, which reflected a fundamental crisis in the economy. The Chinese economy has already moved to a "new normal" stage, in anticipation of a slower rate of growth as it moves from manufacturing to consumption. China's GDP growth rate is still 7 per cent.
Investors in emerging markets tend to overestimate growth, leading to overvaluation. In China, 85 per cent of investors are individuals, unlike in developed markets where they are institutions. The turnover rate of these Chinese investors is more than 900 per cent, the highest in the world. The account balance of 84.1 per cent of these investors is less than 100,000 yuan (S$22,000), and 10.39 per cent of them have an account balance of between 100,000 and 500,000 yuan. Only 6 per cent have a college degree.
Chinese investors also understand that the priority of the government is social stability; the government will step in when anything threatens that objective. This recent bull market can also be seen as a typical example of investors hijacking this sentiment.
The government knows it must rebuild investor confidence or the pessimistic sentiment could spill over into the banking sector. Some insiders believe a significant portion of the capital used for margin trading came from the asset management products that were issued by the banks. If the banking sector is hit, then the negative sentiment could spill over to consumers' willingness to spend, which would then affect the overall economy. There have also been reports of entrepreneurs speculating in the market using their companies' operating capital.
Stock markets are built on confidence and the expected value of future cash flow. The objective of a government should be to mitigate the systemic risk rather than managing the stock index. The function of a capital market is to charge different prices or risk premium on firms relative to their risk levels. Everyone should understand the rule of the market: higher returns mean higher risk.
At the end of last week, as China's market realised how determined the government was to handle the problem, some experienced investors began returning in a hunt for bargains. I expect the market will gradually bounce back, though with some short-term volatility, because small-cap stocks are still mostly overvalued and some investors are still highly leveraged.
The bull market spirit is still here, but hopefully both the government and retail investors will learn a valuable lesson from this crisis. The market is designed for long-term financing, not short-term speculation. Investors should respect the power of the market.
•The writer is professor of finance and accounting at China Europe International Business School.
•This article first appeared in heconversation.com, a website of analysis from academics and researchers.
A version of this article appeared in the print edition of The Straits Times on July 15, 2015, with the headline 'How China's bull market could bleed into its economy'. Print Edition | Subscribe
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