Free-falling Chinese Stocks:Are measures to bolster the stock market necessary?

The Shanghai Stock Exchange (SSE) Composite Index, which hitherto had been rising sharply, plunged from a peak of 5,166.35 on June 12, 2015 to 3,687.92 on July 3, 2015 (a cumulative drop of 28.6%) (Figure). In response, the Chinese government has taken a series of measures to bolster the market.

On June 27, 2015, the People's Bank of China announced that it would cut key interest rates by 0.25 percentage point--the one-year base lending rate from 5.10% to 4.85% and the one-year base deposit rate from 2.25% to 2.00%. In concert with this, the central bank also announced the reduction of some reserve requirements. All of these measures were implemented on the following day, June 28, 2015.

On July 1, 2015, the Shanghai Stock Exchange and the Shenzhen Stock Exchange announced that they would lower commissions on securities transactions by 30% on August 1, 2015. On the evening of the same day, the China Securities Regulatory Commission (CSRC) announced that it would ease the requirements for collateral for margin trading.

On July 3, 2015, the CSRC presented a policy of limiting the number of initial public offerings (IPOs) and fundraising through issuing new shares. To stabilize stock prices, the CSRC would also support long-term investments by pension funds, insurance companies, and qualified foreign institutional investors (QFII). Specifically, the CSRC indicated its plan to raise the investment quota of the QFII from $80 billion to $150 billion. In addition, the CSRC announced it would raise the capital of the state-owned China Securities Finance Corporation Limited (CSF), which provides loans for margin trading, from 24 billion yuan to 100 billion yuan.

On July 4, 2015, 21 leading securities companies announced that they would invest in exchange traded funds (ETF) comprising blue chip companies, providing 120 billion yuan in total. The State Council also announced that it would cease the approval of IPOs for the time being; following this announcement, 28 companies that had planned an IPO on the Shanghai and the Shenzhen markets announced late that night that they would postpone their listings. In addition, executives at 25 investment funds promised to purchase stocks actively and hold them for at least a year.

On July 5, 2015, Central Huijin Investment Company Limited, a government-affiliated investment fund, announced that it had already injected funds in the stock market by purchasing ETFs and would continue to inject funds. The People's Bank of China's policy of providing the CSF with liquidity support was announced by the CSRC.

Despite all of these efforts, stock prices did not stop falling, and many listed companies had to suspend trading in their shares.

A major factor behind the series of measures to bolster the stock market was the deterioration of the economic situation in China and overseas. First, the Chinese government expected an improvement in the economy driven by rising stock prices, but this strategy failed due to the steep declines. On top of that, Chinese market chaos amid the Greek crisis would be a major concern for the global economy.

However, some may charge that the government-led measures to bolster the stock market run counter to the rules of the market, which China aims to achieve. While the principle that investment should be made at the investor's own risk has to be fully enforced in the market economy, some investors in China lack the awareness that investing in stocks carries risk. This could in turn foster moral hazard, with investors believing that the government will always step into to bolster the market.

Following a series of measures launched in rapid succession during the period from the close of trading on Friday, July 3, 2015 to Sunday, July 5, 2015, the Shanghai market (A-shares) recovered its composure to some extent on the following Monday as the Shanghai SE Composite Index rose 2.41% from the end of the previous week. In contrast, H-shares continued to fall in the Hong Kong market. The asymmetric reactions in the two markets suggest that investors in China (particularly individual investors) and investors overseas (particularly institutional investors) have different perspectives about the measures taken by the government.

Even though stock prices fell sharply in China, the closing price on July 9, 2015 has only returned to the level of late March, and is still about 80% higher than the level of a year ago. Given that most investors hold unrealized gains, the sharp fall in stock prices this time is unlikely to have a major negative asset effect on consumption.

Meanwhile, there are concerns that measures such as the suspension of IPOs will prevent companies from raising funds in the securities market, thereby reducing their investment. However, given that financing (of non-financial companies) through stocks accounts for only 3.1% (as of the end of 2014) of "total social financing (TSF)" (on a stock basis), that impact should also be limited.

In China, housing prices have a much stronger impact on macroeconomic performance than stock prices, and tend to correlate negatively with stock prices, reflecting the limited availability of investment tools. This time, too, falling stock prices have been accompanied by a rebound in housing prices. Whether this trend continues or not will have an important bearing on forecasts of the future course of the Chinese economy.

Economists have long viewed the stock market in China as being something like a casino, with a highly speculative characteristic that does not reflect the fundamentals. The sharp falls in stock prices this time after the strong rally support this perspective. The highly speculative characteristic of the stock market reflects the following facts: Individual rather than institutional investors play the major role; most of the listed companies are state-owned enterprises; and more than half of shares outstanding do not circulate in the market as they are owned by the government or cross-held by state-owned enterprises.

To create a more mature securities market, the following reforms are required.

First, it is already an established policy that the system for the new listing of companies will change from the present approval system to a registration one, but a specific schedule has yet to be presented. If this is implemented, a kind of automatic stabilization mechanism is expected to be put in place, with IPOs increasing when stock prices rise, and decreasing when stock prices are depressed. The listing of private enterprises will also increase.

Nurturing institutional investors is also an urgent task. In fact, the volatility of H-shares on the Hong Kong market where transactions are conducted mainly by foreign institutional investors is much lower than that of A-shares in the Shanghai market.

In addition, the investment quota for inward and outward investments in securities, including those for the QFII, the qualified domestic institutional investors (QDII), and the Shanghai-Hong Kong Stock Connect, needs to be increased. This will broaden choices for investors in China, and the participation of more foreign investors (particularly institutional investors) will also help reduce the volatility of the domestic stock market.

I hope that China will accelerate these reforms, learning from the recent market turbulence.

The original text in Japanese was posted on July 17, 2015.