China's reminder that markets are never risk-free: Don Pittis

China's latest staggering stock decline may be a signal that the Chinese government is not as powerful as it thinks it is. But yesterday's 8.5 per cent decline in Shanghai provides a more important reminder that real markets always involve risk and booms don't go on forever, Don Pittis writes.

Investors learn that even with government support markets don't just keep going up

Chinese investors watch stocks fall yesterday in Qingdao. Despite efforts by the Chinese government to stop the decline last month, the Shanghai market saw its biggest plunge since the global meltdown in 2007. As Don Pittis explains, it's a useful reminder that free markets can never be free of risk. (Associated Press)

Like all booms, at its peak, investors seemed to think it would go on forever.

It wasn't just investors. When China's leaders and officials saw the Shanghai Stock Exchange lose 30 per cent of its value last month, with plenty more room to fall, they were mortified. Beijing stepped in to stem the decline.

But yesterday, the rout resumed. In the last few hours of the trading day, the market plunged sharply, closing more than eight per cent lower, followed by a further fall today of 1.7 per cent today, while offering a useful reminder about what markets are for.

In a replay of last month's tumble, much of the blame has been put on inexperienced Chinese investors. The government itself faced criticism for encouraging those inexperienced investors to gamble their life savings in the market just as the Chinese economy was slowing.

'Not really markets'

"The markets in China now are not really markets," China market watcher Donald Straszheim told Bloomberg news before the latest meltdown. "They are government operations."

In the 1990s, when I lived and worked in Hong Kong as a business reporter, I watched as China experimented with the institutions of capitalism, recognizing their value in creating a powerful modern economy. But the recognition was uneasy.

I remember a Chinese friend's graduate thesis that repeatedly used the phrase "breaking through demand" every time he referred to "market forces." While I helped him make English-language corrections, he hesitantly explained that the euphemism was necessary so as not to offend whatever party official might be looking over his shoulder.

Twenty years later, you would think that the Chinese leadership would have come to terms with market forces.

Not a one-way bet

They have something very close to a free floating currency that trades on foreign markets. Despite growing pains, they have largely accepted Hong Kong's frenzied form of free market capitalism. 

But what China is only now facing is that putting your faith in markets is not a one-way bet, though you can see why recent events may have given them that false impression. 

An investor finds no joy in the electronic board showing stock information at a brokerage house in China's Anhui province on July 27, 2015. (Reuters)

Since the 2007 collapse, every time the Chinese economy weakened, the government was there. With almost no debt and a huge trade surplus, global observers didn't blink when China poured more public money into the economy, sending it from strength to strength.

To Chinese officials, there was no reason that the stock market should not follow the same model.

The Shanghai stock market officially restarted in 1990 under some very restrictive rules. Since that date, the market's rise has been anything but continuous, with sharp declines in the early 2000s and during the global credit crunch that began in 2007.

Margin selling

China-watchers have said the market surge that led to the recent sharp declines was orchestrated by the government itself. It was all part of an effort to create a culture of shareholding amongst ordinary Chinese people with money to invest. And for the first time, fuelling the stratospheric stock boom earlier this year, ordinary Chinese investors were allowed to buy on margin. 

That is the process notorious in the New York crash of 1929 when people used borrowed money to bid stocks higher and higher. And just as in 1929, margin selling — when investors must unload plunging stock to come up with the money to cover those loans — was a big part of yesterday's eight per cent decline.

As I write, debates over how or why the Chinese government allowed the latest crash to happen are not yet resolved.

Some say, guided by advice from the International Monetary Fund, Beijing withdrew so market forces could prevail. Some speculate it was a warning to illicit margin traders. Others say the pressure to sell overwhelmed the government resources propping it up. 

Inherent risk

Either way, it was a painful lesson for neophyte Chinese investors. It reminded them that even with the backing of a 1,000-pound gorilla like the Chinese government, in freely trading markets there is no such thing as a safe bet. While it may scare them off for a while, those who come back will be wiser.

The purpose of markets, especially in the short term, is not merely to make people ever richer. It is to find the true current value of the thing being traded. While there are always periods when popular enthusiasm pushes markets to new irrational heights, eventually prices always return to reality. 

Despite the latest round of cash infusions and interest rate cuts, the Chinese economy is coming down to earth. Canada is already feeling the effect as shrinking Chinese demand takes its toll on our own commodities-based economy.

In the case of China, investor inexperience and new rules may have made the stock market rise and fall quickly. But as we look at our own stock and property markets, Canadians would be wise to take the lesson that whether here or in China, markets are never without risk.

Follow Don on Twitter @don_pittis

​More analysis by Don Pittis


Don Pittis

Business columnist

Based in Toronto, Don Pittis is a business columnist and senior producer for CBC News. Previously, he was a forest firefighter, and a ranger in Canada's High Arctic islands. After moving into journalism, he was principal business reporter for Radio Television Hong Kong before the handover to China. He has produced and reported for the CBC in Saskatchewan and Toronto and the BBC in London.


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