Three years after Chinese stocks dropped precipitously by 50% in less than two months, regulators are increasingly stepping in to police individual trades that the Chinese government deems would have a destabilizing effect on the markets. The ostensible political goal is to make China’s markets appear less volatile — particularly during high-profile political events such as the National Congress of the Communist Party, which occurs every five years.
The government uses its far-reaching surveillance capabilities to monitor individual trades it deems disruptive and then expresses its disapprobation to the appropriate brokerage firms, who then contact the offending customer. The larger the dollar amount of the trade, the more likely it will draw scrutiny from authorities. Monitoring activities include warnings to brokerage firms to police trading activity that is not in accord with government wishes.
Some Chinese day traders who engage in rapid buy-sell transactions, which can impact the price of certain securities, receive warnings from their brokerage firms at politically sensitive times such as during meetings of the National People’s Congress.
The timing of such interventions is clearly inauspicious. Last Friday, 200 listed stocks of Chinese companies were included in the MSCI index for the first time. Previously, equities in Chinese companies were only available on the Hong Kong exchange through a program called stock connect.
The new and, at times, strident interventions are becoming more frequent. The potential problem for the MSCI is the index no longer can be said to be representative of individual companies’ earnings capabilities. Due to uncertainty about the scope and timing of regulatory intervention, the pricing of stocks can become wholly arbitrary, as the laws of supply and demand have been rendered inoperative.
If investors can’t buy and sell when they want, transactions on the exchanges no longer reflect the necessary attributes of a well-functioning, fair and transparent market. What is the intrinsic value of a particular stock if supply and demand are no longer related? Such intrusion will inevitably lead to pricing disparities in asset classes.
How does one know when to sell? When to buy? Should astute investors time these decisions in concert with official party functions? Perhaps enterprising investors will be able to time trades to coincide with meetings of the Chinese Communist Party. Such an environment, rife with uncertainty, makes value investing particularly difficult.
Some investors who have wanted to participate in China’s rapid growth, imperfectly manifested in its initially marginally regulated securities markets, have been handsomely rewarded. The market has returned 24% annually since the opening of the Shanghai exchange in 1990 through last year. However, calamity can also strike unannounced. When the Chinese markets move, they tend to move in extremes, with investors trying to beat the next seller to the exit or get ahead of the next buyer in a rapidly rising market.
After a rally strongly encouraged by the government, share prices plunged in 2015 with panic selling the order of the day. At the height of the selloff, more than 50% of listed Chinese companies halted trading of their shares. The government subsequently imposed a ban on major shareholders from selling their stocks for six months.
According to the Wall Street Journal, China’s actions to stem the precipitous drop raised too many red flags for MSCI, sufficient for it to keep those shares out of the index. The excessive restrictions imposed by the government, including Chinese police investigating instances of “malicious short selling,” was viewed by MSCI unfavorably as unwarranted government tampering in the market.
Removing restrictions on direct foreign investment in Chinese companies could attract hundreds of billions of dollars from index-tracking funds. But, as long as market mechanisms are artificial, investors would continually be at risk for unannounced and potentially dramatic interventions.
Ever since the Communist Party under then-chairman Deng Xiaopin allowed the Shanghai exchange to trade stocks, the government’s disposition toward free and unfettered securities markets has seemed to be one foot in, one foot out.
Perhaps it has to do with ideological antipathy on the part of older communist party officials for unrestrained free market capitalism. Or perhaps it represents the last vestiges or gasps from older party leaders to maintain at least some semblance or pretense of ideological purity.
Even though today's China is not that of Mao Zedong or Zhou Enlai, if unbridled capitalism makes the state look bad, then to members of the Chinese Communist Party, intervention is warranted at times and, indeed, should be expected. These are not the attributes of a free market.
Investors should be mindful of the new risks.
Disclosure: I have no positions in any of the securities referenced in this article.
