China in Transition

The Big Debate over PKO in the Stock Market

Chi Hung KWAN
Consulting Fellow, RIETI

After hitting a record high of 6,092 on October 16, 2007, the Shanghai Composite Index lost more than 50% in the following six months, temporarily dropping below 3,000 on April 22, 2008. With this sudden change, the focal point of debate over the stock market shifted from "whether or not the big surge in share prices is a bubble" to "whether the government should pursue 'price-keeping operations' (PKO) to prop up the stock market." Investors and securities companies, and economists speaking on behalf of their interests, are calling for PKO. However, other economists who take their stand on the principle of market economy are opposing to such operations.

PKO proponents' view

Those who support PKO urge the government to actively intervene in the market, arguing that the Chinese stock market is still immature, and "market failures" abound. Their arguments are as follows.

First, recent sharp falls in Chinese stock prices have been caused by market overreaction to stock price adjustments in the United States and other overseas markets. The current level of stock prices is far below the appropriate level judging from underlying corporate earnings. To correct this situation, the government needs to conduct PKO.

Recent sharp falls have also put the stock market in critical condition. To restore order to the market, the government needs to implement stabilizing measures. Stock prices remaining stagnant for too long may have significant negative impact on the development of the securities market as well as on the economy as a whole.

Furthermore, the government must fulfill its responsibility to investors. To safeguard the interests of investors amid plunging stock prices, particularly small investors who bought their shares when prices were high, the government should employ PKO to bail them out.

In view of these opinions, the Chinese regulatory authority on April 20 announced new guidelines on the sale of non-tradable shares in order to curb deterioration of the supply-demand relationship in the market and reduced the stock trading stamp tax from 0.3% to 0.1% on April 24. However, even now that these measures are implemented, PKO proponents are demanding that the government take further steps, such as imposing restrictions on new initial public offerings (IPOs) and public offerings of new shares, and allowing share buy-backs by companies.

PKO opponents' view

In contrast, those who oppose PKO urge the government to respect the self-adjusting market mechanism and refrain from intervening. Their arguments are as follows.

First, like other market prices determined by supply and demand, stock prices are meant to be signals for guiding effective allocation of resources. PKO constitutes unnecessary market intervention by the government and may distort resource allocation.

Recent stock price adjustments should be viewed as a process in which the stock market returns from a bubble state to a normal state. With the price earnings ratio (PER) hovering around 40, the current stock price level cannot be perceived as substantially undervalued and does not pose the risk of spurring an economic crisis.

Furthermore, it is necessary to ensure that investors strictly base their investment decisions on the principle of self-responsibility in the market economy. Some investors were not aware of the high risks associated with stock investment and the recent plunge of the stock market provided them with a highly effective lesson. Conversely, by embarking on PKO without careful consideration, the government may end up fostering moral hazard among investors.

PKO opponents are thus more concerned about "government failures" than about "market failures." Even if the market does fail, the response should be institutional reform, not government-initiated PKO.

Why economists' opinions are split

PKO proponents are composed of scholars closely associated with the securities industry. The leading figures in this group include: Liu Jipeng, professor, China University of Political Science and Law; Cao Fengqi, director, Research Center for Finance and Securities, Peking University; Wu Xiaoqiu, director, Financial Securities Institute, Renmin University of China; and He Qiang, director, Institute of Securities and Futures, Central University of Finance and Economics. In the debate last year over whether or not the stock price surge was a bubble, these scholars took the view that this was not a bubble but the result of non-tradable share reform.

On the other hand a majority of PKO opponents specialize in macroeconomics. The main figures of this group include: Hu Shuli, editor, Caijing magazine; Andy Xie Guozhong, former chief economist, Morgan Stanley Asia Pacific; Xu Xiaonian, professor, China Europe International Business School; and Yi Xianrong, director, Financial Development Office, Institute of Bank and Finance, Chinese Academy of Social Science. In last year's debate, they warned of the possible bubble forming.

As in the previous debate over the possibility of a bubble, the arguments of the two sides in the latest debate over PKO strongly reflect their stances. PKO proponents say PKO opponents do not understand China's state of affairs and stock market, criticizing them for disregarding the interests of small investors. On the other hand, PKO opponents say that they represent the interests of the entire nation, criticizing PKO proponents for thinking only of securities industry interests. Their divergent views reflect the confrontation of interests between the two sides, rather than stemming from differences in their perceptions about the suitable roles of the government and market.

June 2, 2008
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June 2, 2008