02 January 2008

Why China's Market Must Crash

As Robert Rubin and Larry Summers well know, markets only work when they are allowed to work their way. If you try too hard to manipulate a market, it is the market that will have the last laugh on you. Leaders of the CCP in China have not learned that important lessons about markets yet--but they will.
In a normal stockmarket, speculators can deflate bubbles by shorting shares. That is illegal in China. In a normal stockmarket, investors can reap large rewards by having their investments bought in a heavily fought acquisition. In China, an acquisition must survive central planning (and often doesn’t). Most of all, in normal markets, share prices are based on how a substantial amount of the shares in a company trade. In China, shares in many of the benchmark companies are held by the company or the government and do not trade. Prices are determined by just a few shares being batted back and forth.

If only a few shares are determining the overall valuation, it means only a few people need change their opinions for the market to unwind. Normally, a counter-balancing force for a sudden panic comes from contrarian-minded investors who believe an objective understanding of information provides a reason to buy shares as their prices become more reasonable. Put simply, crashing prices are an opportunity, not just a problem. But finding objectivity in the Chinese market is no easy task because information disclosure is wretched. Companies, and the investment banks that coddle them, distribute information to favoured investors but not to the market at large. For its part, the Chinese government broadly abets this process, granting selective permission to favoured foreigners wanting to invest.

These insiders are comforting friends for China to have, but they are insidious forces for a genuine market. Instead, China needs disinterested outsiders—and insiders—free to do research, free to buy and free to sell. Yet the market in China has become an example of moral hazard gone wild. Historically, this is not uncommon. Markets work in nasty ways and countries frequently try to control them. Critics are faulted for misunderstanding the local “culture” or for missing the crucial fact that this time, really, is different. And then, inevitably, there is a crash.

Before the dot.com crash of the late 1990s, prevalent wisdom declared that the laws of economics had been transcended by the new electronic information media. We know how that turned out.

In China, much of the prevalent economic wisdom parallels that of the early dot.com generation. The market can only rise. But that is not how markets work. When betting on a racehorse or a company, you must look at the fundamentals. The same applies when you bet on a country. China's fundamentals are a bit suspect, given that no one but those occupying the sanctum sanctorum of the CCP has access to the real numbers. And even there--or especially there--the incentive to fudge the numbers is very strongly felt. Almost like a noose around the neck.


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“During times of universal deceit, telling the truth becomes a revolutionary act” _George Orwell

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