How China's Stock Interventions Impact Investors

Potentially Dangerous Impacts of China's Market Interventions

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China’s stock market took a significant turn for the worst in early July of 2015, falling more than 30% over five days amid turmoil in Greece and the Eurozone. While the drop still paled in comparison to the dramatic rise in value over the prior year, regulators took drastic action to try and prop up sinking stock prices by banning listed company shareholders with big stakes from selling shares and using central bank funds to bolster the market.

These moves came shortly after the government began suspending trading in more than half of the country’s stocks, citing the “irrational drop” in share prices. According to a Bloomberg report, more than $2.6 trillion worth of equities were frozen in place, while more than $40 billion has been allocated by the central bank to provide additional liquidity to the market, which has helped temporarily reverse the selling by mid-July.

Moral Hazard

The primary risk with government interventions is so-called moral hazard – or the lack of incentive to guard against risk. In China’s case, the government’s refusal to let share prices decline could prompt investors to put more money into the market. Since the government prevents prices from dropping, investors aren’t incentivized to exercise appropriate caution with risky stocks by considering the company’s fundamentals.

These dynamics cause problems when company fundamentals are in decline.

For instance, China’s sell-off could be due to its significant run-up in the prior months and represent a normalization of stock market values. Without the correction, investors may continue to buy the country’s stocks and permit valuations to expand indefinitely. The policy will ultimately end up in improper capital allocation and perhaps eventually a bursting bubble.

Spill-Over Effects

China’s stock market turmoil caused shares on Hong Kong’s main stock exchange to plummet nearly 10%. While Hong Kong’s stock market operates completely independently of China’s, the two countries’ exchanges host many dual-listed companies. American Depositary Receipts listed on U.S. exchanges could also be negatively affected, while multinational companies operating in China could see some pressure on their share prices, impacting global markets.

Many exchange-traded funds also group Asian equities into the same basket. With Chinese equities falling, investors may be selling Asian ETFs and putting unjustified downward pressure on other companies that happen to be in the same basket. Hong Kong, Japan, and other Asian countries could see downward pressure on their shares, which could end up causing a spill-over effect that has a negative impact on the entire region’s economy.

Political Risks

China’s meddling in the financial markets could introduce a level of political risk to the country and region, since the majority of the market is constituted by individual investors. In effect, subsidizing losses stemming from the market could amount to a form of wealth transfer to these individuals at the expense of the entire tax base.

These dynamics could lead to instability over the long-term if these programs aren’t entirely sustainable.

Of course, the government would likely argue that the total capitulation of the stock market would adversely impact growth and confidence, making it harder to enact reforms, like opening up closed sectors of the economy. These efforts may be true at home, among individual investors, but the danger is that international investors will be scared from participating in the market due to the growing number of restrictions on trading.

Key Takeaway Points

  • China’s stock market interventions have a number of risks associated with them that could impact international investors.
  • The moral hazard created by these actions could lead to the formation of an asset bubble in the stock market and economy.
  • The market’s turmoil could spill over into other regions, if the efforts aren’t successful, and force similar actions onto others.
  • There are some political risks associated with these actions, particularly given the high level of individual ownership in the country’s stocks.a