Milton Friedman was thought to have said, “The stock market and economy are two different things.” Looking at the recent actions of the China Securities Regulatory Commision and Chinese leadership, the two appear increasingly intertwined. This is setting a dangerous precedent for Chinese government intervention in the stock markets: Last year by increasing the stamp duty to cool the market’s irrational exuberance, this year by goosing it to prevent market losses from spilling over into the general economy.

In the long-term this will inevitably create more instability in the system for several reasons. While some regulation is good - corporate reporting standards, for example - micro-management of the stock markets to cool the economy or appease the public should not be the role of a regulator. Friedman, who implictly blamed government mismanagement for causing the Great Depression, abhored government interference in the markets except for defending against a systemic collapse. If he saw what was going on in China’s stock exchanges, he would be rolling in his grave.

In late April the CSRC announced a pair of regulatory actions designed to stimulate the market after its free-fall in March, which saw Shanghai’s Composite Index decrease by 20 percent, its biggest one month loss ever. The first, a block trading system for sales of more than one percent of outstanding shares, was announced on April 20th. In the next trading days the reponse was lukewarm, the index went up only six percent. Clearly more investor relief was needed and, on April 24th, the Commission delivered a cut to the stamp duty, the tax on transfer of stocks, from 0.3 percent to 0.1 percent. The next day, Shanghai’s index increased by 9.29 percent and, for the week, up 14.96 percent, the biggest one week gain on the index, ever.

Whenever I want to know how the stock markets in China are performing, I can ask several of my Shanghainese friends whose sole occupation is chao gupiao - stir-frying stocks. If they say they’re in a bad mood that day, I know the market is down, if they’re in a good mood, the Shanghai Composite must be up.

Thinking back to March, my friends were in a very bad mood. The Shanghai index had its largest monthly drop in the last ten years, just over 20 percent, and this made for some bubble-popping pessimism. Then in late April, the emergency regulatory moves to stem the bleeding were like a one-two blow to the pessimists: A block-trading system was unveiled to stop quanties of shares from flooding the market, and, most importantly, the stamp duty was reduced from 0.3 RMB per share to 0.1 RMB per share. That day, my stir-frying friends cooked up an extra-large serving, so overjoyed were they. But in a nation with a 5000 year historical memory, didn’t they remember the last time the regulator lowered the stamp tax, then raised it again, then lowered it again, or raised it once again? The public have started to buy and sell based on the actions of the China Securities Regulatory Commission, not on the fundamentals of the stocks themselves.

From the best major-index performer globally in 2006 and 2007 to one of the world’s worst performers in 2008, is there anything wrong with the Shanghai stock market then? According to one local investor, “Too much government interference, that’s what’s wrong with these markets…Things won’t improve until the government leaves these companies alone to get on with their business.” That’s good advice, perhaps from last month when the market was in freefall? No, it quoted in an article from the May 29 1996 International Herald Tribune. Clearly, when it comes to government participation in the markets, old habits die hard.

It occurs to me then that these techniques, for questionable short-term benefit, only serve to further destabilize the fragile market equilibrium by increasing moral hazard. This term, when applied to investing, means taking too much risk in the belief that one will be bailed out if things go wrong. In early April trading volumes were way down: Clearly Chinese investors were expecting the government to do something, waiting for it in fact, to bail them out after the worst trading month on record. Now that the Commission delivered, the expectation will be increased the next time around. Any recovery will be short-term at best, and we are likely to see more Dead Cat Bounces.

As I disucssed in the innaugral post of this blog, the idea of a dead cat bounce is a temporary reprieve from a downward trend, due to some optimistic investors or positive news coming out, but lacking a fundamental change in the factors driving the bear market sentiment.

April 30’s Shanghai Daily reported that 1574 listed firms had combined 2007 profits of more than 136 billion US dollars. Meanwhile, a commonly reported statistic is that 15% of corproate profits, or about 20 billion US dollars, were from stock market speculation in 2007. You may want to reread that sentence if the implications aren’t clear: A major source of profit for Chinese firms, not including invesment banks or insurance companies which have to invest, is buying and selling stocks retail. Nor is this is not some kind of strategic, pre-merger or cross-shareholding action as Japanese companies are apt to do (and lost more than US$3.2 billion on in 2007, incidentally). It is plain speculation.

A year ago, the Commission had to prohibit Chinese firms from using thier IPO funds for speculation on the stock markets, so widespread was the practice of many companies to invest their working capital into stocks, bonds, and derivatives. You might be thinking it is all insurance companies and investment banks when you should be thinking Zhengzhou Yutong Bus Company, one of China’s top makers of buses, investing part of its IPO funds into other companies’ IPOs. It was not alone. The lure of easy money was too great.

In 2007 you may recall that Shanghai’s market was the best performing major index in the world, gaining 97 percent after a 127 percent increase in 2006. This year, with the index dropping sigifantly off its 2007 highs, one might wonder how many companies are sitting on losses right now. Bounce.

The new block-trading system recently announced, whereby amounts of shares over one percent of the total outstanding had to be sold in a block trade, seems like a good way to prevent shares from flooding the market. In the days following the announcement, numerous companies were found to be selling 0.99 percent of their holdings at a time. Bounce.

Of the last four times the stamp duty was modified, the three times it was decreased were in flat or declining markets with no appreciable long-term stimulus, and the one time it was increased, May 2007, the market continued its great bull run. Now tell me again the logic that decreasing the stamp tax will push the market back into bull territory? Bounce.

The big question on Chinese investors’ minds is, how low will it go? I’m reminded of some other stock market investment experience that I wish I could share with Chinese inv estors. This situation in China’s stock markets seems eerily similar to teh Dot-Com NASDAQ bubble around 2000 (the equavalent of 2007 in China) and 2001 (how China’s marketrs are right now). From the classic “Buy the Dips” investment stategy to “Sell the Peaks” all in the course of about a half year. The Shanghai Composite index is close to having lost 50 percet of its value from the 6000+ point high which occured … about six months ago. My bet then is that we have not seen the last of the declines in 2008, though we might see a few dead cat bounces before the end of the year. Meow.

Categories: Affluencing