What Today's Drop in the China Market Could Mean

China's stock market is down today. This is exactly what I was worried about. After a strong start this morning on the back or yesterday’s furious rally, the Shanghai and Shenzhen stock markets suddenly turned negative and ended the day lower, with the SCI dropping by 0.71%.

It is widely known among financial market experts that governments can have powerful impacts on the market by signaling their intentions, but the more often they do it by pure signaling (i.e. with measures that have no fundamental impact), the less credible their signaling becomes over time. In other words, the more you intervene to control the market, the more empty your intervention becomes – this is a weapon whose greatest power lies in the rarity with which it is used.

I suspect we may be about to prove this yet again. For the past year we have seen a whole series of interventions designed explicitly to manage market prices – and although they have worked well, they have done so with decreasing success. The market surged 9.3% yesterday when the tax authorities announced that they were cutting the stamp tax, but everybody bought just because they expected everyone else to buy. There was no real conviction.

And since the announcement provided no real change in the earning prospects for Chinese companies, savvy investors seem to have taken advantage of the event to shift their shares into the hands of the more gullible. China Daily today quotes a man who trades stock at a Shanghai broker saying, in the midst of yesterday’s rally, “I bet the market would undergo a strong rebound before the Olympics, and I will exit the stock market forever if I can make any gains then. It is just too risky for ordinary people like me.” He is probably unhappier than ever today. If this kind of opinion is widespread, and I think it is, it bodes badly for the longer-term development of the stock markets.

How aware are the authorities of the risks of this kind of intervention? Th always astute Li Xinxin at Observatory Group wrote yesterday about the reasons for the stamp tax cut – a decision that he worries about no less than I do.

p>The new cabinet, especially Vice‐Premier Wang, once intended to reinstitute the non-intervention principle for China’s capital market, but their effort failed. In recent weeks, there was an intense debate among both policymakers and scholars about whether the government should rescue the stock market. Wang preferred not to use the trading tax rate to micromanage equity prices, but his opponents used the social stability argument as a major reason for such a decision. This is a critically strong argument in an Olympic year, and particularly when top leaders already are stretched by challenging issues such as Tibet and inflation.

The government has performed particularly poorly in public communications. Vice Premier Wang and his team had a good chance to establish new criteria for government intervention by expressing their views and guiding market expectations. But no government officials dared say anything on this issue, reflecting a very rigid political system. That silence gave the impression that the government made a major concession to market pressures in return for nothing.

With this tax rate cut, the government reversed an 11-month-old tax increase and reinforced the policy-driven feature of China’s stock markets. Certainly, the constant change of market rules does not help build a well-functioning market which could efficiently distribute financial resources in the long run. In this sense, the new cabinet is not different from its predecessor.

It will be interesting to see what happens to prices next week. My assistant Shang Ning tells me that there are rumors that the big buyers who pushed prices up prior to the announcement of the cut in stamp tax were the local pension funds. I have no idea if this is true, but they do tend to have better access to information than the rest of us do, and clearly someone either very lucky or with very good information sources was buying the market if it traded up 4.2% after so many weeks of decline.

If many small investors really do expect a pre-Olympic rally that lets them out of their losing positions, I am afraid this is going to result in another disappointment. Still, maybe the government has a few more tricks up its sleeves. I think 3000 is widely considered to be the minimum level below which the government acts. Call it the “3000 put”?

In June 1999 I remember that Paul Krugman wrote a note on the implicit euro “put” that existed because for purely symbolic reasons European authorities were loathe to let the euro trade below $1 (how long ago that seems!). His conclusion, reached by an elegant application of option theory (you can find the note here), was that when the euro finally broke $1, it would break big. It did. Perhaps this has nothing to do with the Shanghai markets, but if the “3000 put” really does exist, it might have.

Comments

[odin]

In a market like China's, govt manipulation (regulation, micromanagement etc) is a given. With the assumption that investors are not throwing up their hands and getting out of the business of china entirely, I think the more interesting question here the goals behind the regulation and secondarily, the short-term and more long-term effect of these policies bring.

There is some consensus that the political appartus in China is obsessed with stability and its own survival. Issues surrounding Tibet, inflation, market drops, yuan valuation and the official responses to them all stem from the same worry. Even the Olympics, for all the hoopla as a coming out event, is about bread and circuses.

The concern here is that the responses to the stock market decline -- even with all the technocratic prowess touted in Beijing -- have been rather short-sighted. Perhaps there was undue influence and self-serving advice from the middle layers of governance, since essentially there has been a transfer of wealth here to the insiders. But I would tend to venture that the government will be even more willing to support the market in the future because the ones who have bought into this retail frenzy are the so-called middle classes. The educated--perhaps not financially but still educated and world-aware--masses. I believe the government is most wary of this group. (though to me, its a group that most desires stability and is unlikely to protest too heavily). So much so that it appears the government has pushed forward these rules before the SMS-aided "protest" against market decline materialized. It leads me to believe that the government will further provide a cushion against major declines to prevent major dissatisfaction amongst the millions of investors here.

However, the establishment doesnt just face a single challenge. From a ocean away, the rural population I feel is the biggest unknown in the government policy response. How will inflationary pressures, pollution, loss-of-land affect this population? How will they respond? If faced with greivances from this segment and a major backlash, how will the government respond? Will it still prioritize the urban investing population? Will it continue to encourage the stock market lottery? I think the government is most at risk from getting blindsided by the problems and actions of the rural population and so is the market.

[city]

What would you call what Fed Ben did last 4 months ? Free market adjustment instead of panic intervention?

Come on guys; Why everything Chinese government did is always considered second rated?

What a pity you guys do not have the guts and insight to see this on going Credit crisis is the the direct result of your governemnt's policies during the last 15 years!!!

[city]

I like to remind readers here; Mr Petti worked for Bear Stearns and also he is working in a State Chinese Communist run school at the moment. Details please visit seekingalpha.com/autho...

China has many problems on its own; but it's very ironic the red communists do not mind Mr Petti (who is paid salary by the Chinese communist run school) being so critical of everything in China even the air he breathes every day.

[city]

All Mr Petti's pupils and seeking alpha readers here; the story about Mr Petti just does not add up! According to Mr Petti's views (you can read all his articles about China on this site ; strangely he only wrote about China), everything in China is in crisis even the air is filthy so why he is making a living there; getting paid from the red Communist school; why not go back to Wall street to work for Bear Stearns ? Bear Stearns is not dead yet.

It is time for Mr Petti and his loyal pupils to disclose his relationship with the red Chinese government now!!! And all readers on this site should also make such a demand; otherwise it's an insult to the intelligence of all seekingalpha readers!

[city]

Mr Petti; everyone here knows you worked for Failed Bear Stean and you are working in a Red Communist Run School in China Now.

Are you a bit embarrased to talk about creditability then? Are you insulting the intelligence of Alphaseeking readrs?

[city]

Mr Petti; everyone here knows you worked for Failed Bear Stean and you are working in a Red Communist Run School in China Now.

Are you a bit embarrased to talk about creditability then? Are you insulting the intelligence of Alphaseeking readers?

[akhait]

The author provides an interesting insight into how individual investor's psychology interplays with the government's policy, and is nuanced enough to give a good first-cut view of the current pulse of the market.
The author's current and past affiliation's bearing on his views may be a factor affecting his views, but is likely the reason why he can write with some authority on the subject. city made his point reminding us of this affiliation, but once is enough. There is no good reason for dwelling on this issue every time the author publishes some information. After all, we would rather read comments of someone with practical knowledge and exposure of the Chinese market, as opposed to an analyst who is ideologically pure but with no connection to China.
Instead of the multitude of cut-and-past comments, city could focus his energy on addressing any of the points raised in the actual articles.

[huangthomas]

China is preparing to install certain "market mechanisms" to her stock market and hopefully to lesson the necessity of government intervention. Margin account and short sell on up-tick will be allowed, possibly in June, before Olympic game, of course. For example, margin accounts are allowed to borrow only 10% of the market value of the security. After that, Shanghai stock exchange index future will follow. The new policy will be "spot tested" (limited to certain well established brokerage houses) before finalized and generalized. The government is a control freak. We have to wait and see if they can really give up market manipulation and micro-management.

[huangthomas]

The news of lowering the stamp tax was announce in the evening news broadcast. Prior to the announcement, who are the major buyers of the stocks? Government agency retirement funds and QFII.
QFII? Mmmmm.....

[huangthomas]

Today's slight drop follows market's 3 day rule. It is a very common technical phenomenon following two days of 4 and 9% rise.

[jegan ;-)]

I guess I'm the only one that reads this column that is tired of hearing that Mr. Pettis worked for BS and is employed somehow by the Chinese Government.... I'd like to see the posting party explain clearly what he is trying to say about Mr. Pettis and I'd like to see Mr. Pettis answer those charges.... In fact, I'm asking Mr. Pettis to devote one column to this issue alone. Then maybe we can eradicate these posts and focus on the issues that Mr. Pettis raises.

So: Mr. Pettis... Please post your background and ties with Bear Sterns and the Chinese Government and your personal slant on China.

And, ask these posters to: Post what their company background and ties to either mainland China, Taiwan or whatever. They can then provide a detailed response to Mr. Pettis..

Thanks jegan ;-)

As a disclosure: I am a homeowner in Northern California, a landlord, and aside from a 1 1/2 year stint working in a County Child Support office and 21 years as a claims adjuster, I have no bias one way or the other towards China. It would be nice to make a few $bucks$ off the China story, but that is no different than my approach to any other sector, company or news story.

[paultaut]

I have a bias...I want my Chinese stocks to go up....

Having said that, when a stock moves up 30% in a week, from intraday low to intraday high, some selling may occur. Gee Whiz

While China's market might go down more next week...it does not really matter...this is the Year of the Rat...The Chinese market will be at new highs, probably coinciding with the olympics. The Chinese gov. will see to it.

As far as Mr. Pettis is concerned: he was cleared to post this opinion...why...

[city]

Again, I am not telling you anything except all the published information disclosed by Mr Petti himself on this web site !!!
Details please visit seekingalpha.com/autho...

[city]

One thing you guys all must know before you even just like to start looking into Chinese Market is YOU ARE NOT ALLOWED TO SHORT THE MARKET. So when Mr Petti and all his loyal pupils on this board are trying to tell you everything in China is in crisis; they want you to short the Chinese Market but HOW HOW HOW????? This is another example how Mr Petti is insulting the intelligence of alphaseeking readers; of course if you do not have any intelligence then be Mr Pettis's pupils!!!

[jegan ;-)]

Well, one way of shorting the market is the ETF 'FXP"... Which you should be aware of if you are involved at all in the China market.

And, yes, I already did read his bio, and he does declare everything you said... I'd just like to see and end to your constant silly, over-posting spam.

Thx jegan

[city]

John why it's silly; I am just disclosing what Mr Petti disclosed.

[Itsjustal]

City, you personify an internet stalker. Go get therapy.

[odin]

citi, chinesepetti et al.: if you find fault with the article, criticise the message with hard facts...or better yet, given your location, comment on local opinion and sentiment, but there is no reason to say bad things about the messenger personally.

as you can see from these comments, your message makes people assume you have nothing useful to say. you lose face everytime you post these empty messages. people may assume that you know nothing and lie about everything (even some that might be true).

readers:
its possible that some people undoubtedly have been at the wrong end of the 2008 selloff and it gets personal....but whats curious based on some of many comments i've seen about china and the immediate rebuttals dragging in the us or iraq or at one point nazism (in retaliation against a german poster) that this has taken a nationalist tinge for many chinese citizens. imagine putting up a spirited defense of value in the s&p500 just because you are american or the ftse because you are british!

[M. Pettis]

Odin, yes, stability is a big issue. My understanding of the debate in Zhong Nan Hai is that the growth guys insist that anything that harms employment growth hurts stability, and the monetary guys argue that monetary excess will lead to a sharp and destabilizing adjustment. They are both right, but who is more right? I hear that V. Premier Wang Qishan is tending toward the monetary camp.

Huangthomas, you are right and on this topic too there is a big debate. The PBoC and CSRC seem to be advocating less interference, and the rumors are that Wang Qishan is also opposed to intervention, but he was convinced to permit the stamp tax change because of worries about destabilizing effect of the sudden convergence of all the recent financial and political problems.

John Egan, sorry, but my blog is carried by Seeking Alpha and a lot of other sites and it doesn't make sense to respond to each of the stalkers and loonies who populates the blogospehere. Basically for those who care, I worked fifteen years on Wall Street for various banks where I ran fixed income trading and capital markets desks for emerging markets. I've written a bunch of books and journal pieces and taught nine years at Columbia and six years at Tsinghua and Peking University, the top two schools in China. I am sure there is enough info here to tantalize any hard-core conspiracy theorist, but no, I am not part of the secret elite that rules the world. I applied for membership but they turned me down, basically because I admitted that I opposed obliterating small countries for less that $2 million in personal profits. I have since changed my mind and plan to apply again next year after the standard four-year waiting period.