Coddling markets won't lift their game

PUBLISHED : Tuesday, 12 July, 2005, 12:00am
UPDATED : Tuesday, 12 July, 2005, 12:00am

Mainland authorities are resorting to increasingly drastic measures to prop up domestic stock prices. Instead, they should be trying to build a better market.

Yesterday, as the Shanghai A-Share Index slumped to a fresh eight-year low at 1,062.45, news emerged of measures aimed at supporting the market above the psychologically critical 1,000 barrier.

Some of the moves make good sense. Giving China's social security fund and insurance companies more freedom to invest in equities will - over the long run - allow them to improve their risk-reward balance and help to develop a much-needed domestic institutional investor base.

Some, like increasing foreign investment quotas in yuan-denominated securities from US$4 billion to US$10 billion, are unlikely to have much immediate impact.

Others, like giving state-owned enterprises free rein to play the markets, allowing fund management companies to borrow against their stockholdings and setting up a government fund to prop up the market, sound downright dangerous.

They may help to support the market in the short term, saving Beijing further political embarrassment, but they scream 'moral hazard'. In the long run, they are likely to undermine, rather than advance, the development of China's capital markets.

Do not expect foreign investors to complain. The 27 international financial institutions granted qualified foreign institutional investor (QFII) status have been lobbying for expanded quotas since last year.

But much of the existing QFII money has been invested in domestic bonds rather than stocks as a relatively cheap and risk-free bet on a possible revaluation of the yuan. If market moves are anything to go by - bonds rallied yesterday on the news of the higher quotas, while stocks fell - then much of the new money is also destined for the bond market, not A shares.

China's social security fund, insurance companies and state-owned enterprises may prove more willing than foreigners to invest their assets in A shares, especially given the added comfort of a stabilisation fund to step in and buy if the market threatens to head south.

Although their presence for the time being will help put a floor under prices, it will do little to strengthen the market's structure. The A-share market needs better companies.

But to restrict the supply of new equity while non-tradable shares are sold off, listed companies have been forbidden to raise new capital. That means companies have no incentive to raise their game.

Until the A-share market is allowed to act as a real capital market where enterprises raise long-term funds from shareholders, it will be little better than a casino.

In the long run, it may be better to allow the market to find its own bottom and accept the balance sheet weaknesses - and red faces - that it exposes.