Investors upbeat, but it's still a roller coaster ride

Investors in China are frequent roller coaster riders. The Shanghai Composite soared 130 percent in 2006 and 97 percent in 2007, but plummeted back to late-2006 levels at the end of last year.

Thus far in 2009, the Shanghai bourse has risen by about 80 percent, while the Shenzhen Composite has more than doubled. Despite the robust upward momentum, investors still face wild swings in stock prices.

The Shanghai Composite slipped 5 percent on July 29, down by as much as 7 percent at one stage, spreading panic to its Asian neighbors. Nevertheless, the strong response to initial public offerings (IPOs) this month indicates that investor sentiment is still upbeat on the mainland.

The July 29 sell-off

Market watchers attribute July 29's sell-off to two key factors: an IPO and speculation on lending curbs.

The IPO released on July 29 was the world's largest in 16 months, so one explanation for the plunge is that investors left blue chips to purchase the debutante.

However, the Shanghai Composite experienced its sudden plunge in the afternoon, rather than the morning when the IPO hit the market, weakening the weight of this argument.

A second explanation sounds more convincing. Speculation emerged that some large State-owned banks would slow lending for the rest of 2009, prompting profit taking.

If true, the move should be favorable for the economy and the banking sector's medium-term outlook, as it eases the risk of bad loans.

However, as it sparked a mass sell-off in equities, investors clearly took a short-term view of the move. Possibly they were worried by the fact that it meant the end of the recent surge in liquidity that was supposedly for stimulus projects but has instead leaked into stock and real estate markets.

China likely has a large pool of speculators in the stock markets. Fund managers have indicated that low interest rates allow, and even encourage, borrowing for short-term stock market investment.

The China Securities Regulatory Commission admitted shortcomings in the current lending regulations. Institutional investors, having already exhausted their quotas, are increasingly applying for IPO allotments using the accounts of retail investors. Stockbrokers, driven by commissions, lack the incentive to report suspicious activity.

Subsequently, institutional and retail investors together fuel the stock market frenzy. As the objective is to pocket short-term gains, any market-sensitive news can trigger a mass sell-off or buying spree, thereby amplifying the ups and downs of the stock markets.

Government's response

The authorities were quick in trying to restore market confidence. However, some steps are perhaps far from beneficial for the economy in the medium term. Central bank officials reassured the public that fiscal and monetary policy will remain accommodative.

As investors in China often base their decisions on government policy directions, the pledge has certainly revived market optimism.

However, the authorities may have gone a little too far by stating that more lending will go to infrastructure and technological innovation.

The Chinese government's repeated act in picking winners will continue to fuel stock market speculation in such industries.

The government needs to fine-tune policies now; otherwise, downside risks will grow.

For instance, bad loans were costly to the fiscal budget several years ago, when the government had to bail out major State-owned banks.

A return of the bad loan problem would not only weigh on fiscal balance, but also threaten financial system stability and broader economic growth.

However, current and proposed policies aiming to curb stock market volatility may do little to improve the situation.

Measures such as suspending trade amid volatility could only slow the bubble, but not prevent it from growing. Meanwhile, allowing underwriters and companies to decide on their own IPO prices, in a bid to limit first day gains, would also do little to cool broader stock market momentum.

One area that clearly requires attention is financial education.

The authorities need to raise retail investors' awareness of the risks involved in stock market investments and perhaps introduce them to other financial instruments that better cater to their risk profiles.

Helping investors make informed decisions is important. For instance, risk adverse investors may find bonds, a safe haven asset, more appropriate. The authorities might also enjoy the benefit of expanding different financial markets.

The author is an economist in the Sydney office of Moody's Economy.com. She is responsible for analyzing the economies of China, India and Vietnam.

(China Daily 08/17/2009 page4)