China's stock market must liberalise to curb volatility

Linda Yueh says the Chinese stock market will begin to stabilise only if it opens up and builds up a good foundation of institutional investors

PUBLISHED : Friday, 31 July, 2015, 10:17am
UPDATED : Friday, 31 July, 2015, 10:17am

China's stock market plunged yet again this week, and the roller-coaster ride is far from over. In fact, China's stock market is more like a casino than an amusement-park attraction. Retail investors account for 85 per cent of the transactions, in contrast with other major markets, where institutional investors - with their relative abundance of information - are the biggest traders.

The result, no surprise, is an extremely volatile market, in which rumour and emotion play an outsize role in driving outcomes. And that volatility is the other reason the casino metaphor applies: China's stock market can rise or fall by double digits without triggering a wider economic crash - at least, so far.

This volatility highlights the challenges of ensuring a smooth process of financial liberalisation in China. After extensive government intervention, prices rebounded. Yet intervention is unlikely to prevent another crash.

The big question now is whether the recent volatility will spill over into other asset markets and the real economy

The reason is that the Chinese stock market is not wholly liquid or globally integrated. Moreover, it is dominated by captive money from Chinese savers - the retail investors. Indeed, it was not until 2009 that most shares on China's stock exchanges were tradable. Until the reforms that began in 2005, two-thirds of shares were non-tradable and held by state-owned enterprises or legal persons, which are typically state-controlled entities.

To be sure, that has led to a huge infusion of liquidity over just the past few years.

Aside from the very wealthy, the hundreds of millions of ordinary Chinese middle-class savers do not have easy access to global markets. Moreover, returns on deposits are low (and had been negative), and the state-dominated financial system offers few diversified products. As a result, housing and domestic equities are the main investments available to them.

But then the housing market stalled, as fears of a property bubble spurred a government clampdown on credit, leaving the stock market the place for middle-class savers to put their money.

The big question now is whether the recent volatility will spill over into other asset markets and the real economy. The double-digit drop in the Shanghai Composite Index since June has not triggered an economic crisis, largely because fewer than 10 per cent of Chinese households participate in the stock market.

But even a small fraction of Chinese households experiencing paper losses still amounts to tens of millions of people. That has caused enough concern for the government to act.

Until China's stock market opens up and its institutional foundation becomes predictable, volatility will be its only guiding rule.

Linda Yueh is a fellow in economics at St Edmund Hall, University of Oxford. Copyright: Project Syndicate