Tuesday, June 21, 2005

The Government Mulls Over Another Bailout to “support the market”

Rumors of an enormous government effort to “support the market” are surfacing again. This time, the government will set up a fund to inject as much as 120 billion RMB into the troubled stock market. The Shanghai Stock Exchange dived below 1000 points for the first time since 1997 last week. Due to this rumor, the depressed market in Shenzhen and Shanghai immediately rallied. We know, however, that this bailout, even if it occurs, will be ineffective in providing long-term buoyancy to the stock market. Past efforts to inject more funds to the stock exchange have failed, and this one will fail also. As long as two fundamental problems—poor regulatory oversight and corporate governance and the giant overhang of legal person shares remain unsolved, the Chinese stock market will continue to stagnate.

We are all familiar with the pervasiveness of inside trading and poor regulation in China. This problem stems from a deeper problem that most of the listed companies are in fact state owned enterprises. By definition, the well-being of these state owned corporations depends on government policies. As a result, those with advanced knowledge of government policies have an enormous advantage in the stock market. Knowing this, would an average investor with no special connection pour his or her savings into this "guanchang" (as in government arena, as opposed to the market)?

Second, over 30% of a typical state owned corporation’s shares are held as legal person shares which are not tradable in the open stock market. Instead, these legal person shares are typically held by state owned corporations or government entities. Because of this over-hang, investors know that at some point in the future, the state might allow legal person shares to float in the market. This way, they expect a large influx of shares into the market in the future, which depresses current stock prices. This is a problem that new liquidity entering the market cannot solve. The only viable solution is “shock therapy” which allows all legal person shares to enter the market all at once. This would of course depress stock prices substantially in the short-run, but would form the foundation of a sustainable rally. Of course, the new bailout package, if true, shows that the leadership is not prepared to make such a politically sensitive step.

The stock markets have plunged continuously since Shang Fulin took office as head of the CSRC, and he is doubtless at his wit’s ends in trying to find a way out. However, injecting more money is definitely not a viable long-term solution. Zhou Xiaochuan’s success had as much to do with his willingness to implement tough regulations and to hire outside help (Laura Cha) as it did with his good political connections. The market involves millions of participants making independent decisions, so the only way forward is more transparent and fair rules, not more dependence on state bailout.

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