Chinese regulator must heed signals from stock market rout to determine timing - and scale - of intervention

The two events that shook the world last month and early this month were the Greek crisis and China's stock market gyrations. Both events were about getting prices right - the Greek negotiations on whether Greece can sustain such high debt without some debt write-offs and the mainland stock markets finding their own price equilibrium.

After nearly seven years of stagnation of drifting around the 2,000 level, the Shanghai composite rose sharply to 5,166 on June 12 and then fell in a 30 per cent correction, ending up with an unprecedented intervention by authorities. The index seemed to have stabilised between 4,000 and 4,200 this week.

There was no doubt that the Shanghai and Shenzhen markets demonstrated considerable "irrational exuberance" in the run-up to the 5,166, and that the expected correction turned out to be a classic crowded exit, as drops in price removed market liquidity and the illiquidity forced more price drops. Margin finance played a considerable role in creating market fragility, as stop losses and liquidation reinforced the downward spiral.

As the dust settles, it is useful to review the purpose of stock markets and how the next phase of reforms may make another intervention unnecessary. Hong Kong did a major review after the stock market intervention of 1998, resulting in a new Securities and Futures Ordinance, the merger and demutualisation of the stock exchange and also a revamp of the financial technology infrastructure.

Stock markets basically fulfil four key functions: resource allocation, price discovery, risk management and corporate governance.

The stock market allocates resources primarily through initial public offerings, whereby companies can raise capital directly from investors, who can then trade the shares on the secondary market - namely, the price discovery process. Stock markets also fulfil a risk management and hedging function, since investors can buy, sell or short (hedge) their holdings. Finally, the stock market imposes corporate governance discipline by enforcing the listed companies to disclose their activities that affect their shareholders, such as prospectuses and annual reports.