China stock market intervention a setback for reform

Aggressive intervention on China's stock exchanges by the Communist government, to try to arrest a dramatic rout, has raised questions over its reform agenda and pledges to let the market play a bigger role.

With the benchmark Shanghai stock index falling more than 30 percent in less than a month, wiping out around $3.2 trillion of value, government officials have cobbled together rescue measures aimed at propping up the market.

But analysts say that much more fundamental reforms are required to develop financial markets that are currently highly volatile and flooded with "mom and pop" investors now learning a painful lesson in economics.

The bailout runs contrary to a 2013 commitment pledged at a key Communist Party meeting, known as the Third Plenum, which promised to allow the market to play a greater role in the economy to ensure long-term growth.

With the world's second-largest economy in the grips of a slowdown as it shifts to a more sustainable consumer-led model, the leadership had hoped that more efficient markets would give firms access to capital and lessen the need for bank loans.

But a wave of liquidity unleashed by government stimulus measures, accelerated by a wall of borrowed money, created a bubble that is now fast deflating with uncertain consequences for a leadership whose legitimacy rests on its economic stewardship.

"There is a pretty high degree of inconsistency of what we've seen over the last, say, 10 days and of what the reform programme is, which essentially is that they would like to increase the influence of market," said Brian Jackson, senior economist at IHS China.

"This is a very clear counter to that," he told AFP.

On Wednesday, the government said it will allow insurance companies to invest more assets in stocks and launch a programme to buy shares of smaller companies.

Earlier measures included halting initial public offerings (IPOs) which under China's current system are set by the government and add to volatility, as their near-guaranteed profits cause funds to be sucked from elsewhere in the market.

The central bank also pledged liquidity for margin trading, already blamed for a heady rise that saw the Shanghai market spiral more than 150 percent in the 12 months to its peak last month.

Margin trading allows investors to use borrowed funds to trade stocks with only a small portion of money put down as deposit, magnifying both profits and losses.

- Needed reforms -

"This is a deviation from the broad reform principle set in the CPC's (Communist Party of China) Third Plenum reform document, which strives to allow the markets to play a decisive role in allocating resources," said Li-Gang Liu, chief economist for Greater China at ANZ Banking Group.

"The main aim is to stabilise the market so that the regulators and investors can have some breathing space."

But in the longer term China will have to improve the quality of listed companies, Liu said, and build up institutional investors in a market dominated by retail players making speculative bets.

The stock market should be opened wider to the outside world, by allowing foreign financial firms to play a bigger role and allowing overseas companies to list.

"Without such necessary reforms, it is difficult to see how the A-share market can be a value investment place in the future," Liu said, referring to the domestic market.

One possible consequence of the market rout could see China slowing moves to make its yuan currency freely convertible, on worries that could make it easier for funds to flee the country.

- Credibility on the line -

China will still pursue step-by-step moves to transform its economy from a state-planned one, a process which began when it launched economic reforms in 1978, analysts say.

"The leadership messed up in cheerleading the equity boom and now feels that its credibility has been put on the line by the market collapse. That’s why it has overreacted," said chief Asia economist for Capital Economics Mark Williams, who has labelled the package as "market meddling".

"But there’s no reason to believe that the leadership’s broader analysis of why wholesale economic reform is needed has changed," he told AFP.

Economic reforms have helped raised the living standards of ordinary Chinese, which the ruling party uses as a key plank of its claim to legitimacy, and maintaining future growth relies on the process continuing.

A slowdown in reform also would reinforce China’s partial separation from the world’s financial system. While it is a major trading power, its currency is not freely convertible and access to its financial markets is tightly controlled.

The administration of Chinese President Xi Jinping can however point to some achievements, unlike his predecessor Hu Jintao under whom economic reforms largely froze.

In May, China launched deposit insurance to help protect bank customers, a key to eventually freeing interest rates. In 2013, the country launched its first free-trade zone, promising a range of reforms, although foreign firms have been disappointed by the progress.

Even so, in an unusually critical article, China's Caixin magazine said the government lacked a good reason to intervene in the stock market.

"The securities regulator has again given in to pressure and taken measures that do not suit its role," it said on its website Tuesday. "These are clearly not market-driven decisions."