China’s Finances: From Sound Bull Market to Mad Cow

The tumult in China’s equity market appears to have come to an end. But considerable uncertainty remains, not only about what caused the recent plunge in the Shanghai and Shenzhen stock exchanges, but also about what the episode will mean for China’s financial reform efforts.

China’s stock market crash has been attributed to a variety of factors. Official media initially attributed the disaster largely to the “malicious” short-selling of Chinese shares by foreign banks and traders. Later, domestic investors were added to the list of suspects, and the Chinese authorities announced a rigorous investigation into the source of short-selling.

More recently, the discussion has shifted toward a seemingly more credible cause: the proliferation of margin financing since 2010. With retail investors borrowing large amounts to finance share purchases, participation in the stock market surged, effectively turning a sound bull market into a “mad cow.”

But while margin financing, enabled by online platforms, amplified the risks of volatility, it alone could not cause such a crash. The real culprit is the government, which first fanned the flames of excessive investment, then suddenly tried to cut off the fire’s oxygen supply. China’s fragmented regulatory system – composed of the People’s Bank of China (PBOC), the China Securities Regulatory Commission (CSRC), the China Banking Regulatory Commission (CBRC), and the China Insurance Regulatory Commission (CIRC) – exacerbated the situation considerably.

Last December, after two years of a “slow bull” market, People’s Daily, the mouthpiece of the Chinese Communist Party, announced the arrival of a so-called “reform bull” market that would push the Shanghai Composite Index far above 4,000. This convinced practically everyone that a “big bull” market, possibly lasting a decade, had begun and spurred investors to buy stocks at already-high prices. In other words, the authorities fueled a bubble.

The CSRC was pursuing an excessively narrow objective, focusing only on getting the bull market going by delivering policies and speeches aimed at boosting investor confidence and spurring participation. After this crisis, it became clear that this incentive was both toxic and precarious. The CSRC, as China’s capital-market regulator, together with other regulators, neglected to fulfill their proper mission: to create a robust institutional framework capable of sustaining strong investment.

Once the market took off, euphoria took over. Even as stock-market indices moved well beyond reasonable bounds, regulators failed to predict the boom’s speed and scale. Not surprisingly, they lacked any plan for stabilising the market in its wake.

To be sure, as the A-market headed toward 5,000, regulators finally realised that the risk of a sharp correction was rising, too. But, instead of working incrementally to create strong, targeted regulations, they performed an abrupt about-face, warning investors about risky bubbles and declaring war on margin finance.

With that, the soaring index started to plummet – and the CSRC fell into chaos. Beyond issuing a flurry of administrative orders, it did little to interact with investors and the market, lacking the means to solicit public opinion and advice. It was only when the rout was in full swing that the PBOC recognised what was happening – the CSRC had been unable to turn the tide alone – and declared that it would step in to capitalise the market.

The conclusion is clear: the current regulatory system, characterised by a clear and rigid division of responsibility among its constituent bodies, is completely out of sync with China’s rapidly growing, and increasingly integrated, capital markets. Yet, according to China’s recently announced draft Internet finance regulations, the country’s “1+3” regulatory model is to be retained.

It is time for China’s leaders to recognise that its regulatory framework – and, in particular, its approach to regulating the capital market – is no longer tenable, and to pursue a major regulatory restructuring. One option that has been proposed would be to create a single super-regulator, like the Financial Supervisory Committee that was established in South Korea after the 1990s Asian financial crisis. With or without such a body, improved channels for cooperation among ministries will be vital.

Such cooperation is not unprecedented in China. Indeed, although ministries, seeking to protect their own turf, undoubtedly impede one another on major issues, they have been collaborating wholeheartedly in China’s effort to reshape the world economic order. Former Deputy Finance Minister Jin Liqun, whom the government has nominated to be the first president of the Asian Infrastructure Investment Bank (AIIB), has indicated that the AIIB’s successful launch was driven by such ministerial cooperation.

In order to protect the interests of investors better, China now must find ways to ensure such cooperation among its existing financial regulators, including by revamping the relevant institutions. As it pursues far-reaching financial-sector reform, now is the time to do so. The market plunge should provide added impetus.

The fear is that the recent stock-market crash may have spooked the government, causing it to slow the pace of reform, including efforts to open up China’s capital account. Whether reform momentum is maintained will depend largely on whether the government recognises that the crash was the result of a regulatory failure, or remains adamant that it was the work of some nefarious foreign force, determined to destroy the Chinese economy.

While the latter scenario is possible, it seems unlikely. Judging by China’s reform progress in recent years, and the current government’s repeated promises to deepen those efforts, I am confident that the country’s leaders will respond to the recent crash by reaffirming the financial-reform agenda. Ignoring the lessons of the recent crash would be a serious mistake – one that China’s pragmatic and tenacious authorities will be determined to avoid.



By Zhang Jun
Zhang Jun is professor of economics and director of the China Centre for Economic Studies at Fudan University, China.

Published on Aug 10,2015 [ Vol 16 ,No 797]



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