LexisNexis(TM) Academic - Document

Financial Times (London, England)

July 14, 2005 Thursday
Europe Edition 1

SECTION: COMMENT; Pg. 15

LENGTH: 755 words

HEADLINE: A bail-out will worsen the plight of China's investors MICHAEL PETTIS

BYLINE: By MICHAEL PETTIS

BODY:


China's State Council is considering whether to set up a Dollars 12bn (Euros 9.9bn) stabilisation fund to support the mainland stock markets, which are now 50 per cent lower than their highs in 2001. Although the fund is to be modelled on Hong Kong's 1998 bail-out of its stock market, conditions are too dissimilar for the new fund to succeed. Its only effect will be to set back the development of mainland stock markets.

Although some economists argue that all government bail-outs distort the market's long-term ability to ­allocate capital efficiently, interventions can at times be useful and even necessary.

A stable market is one in which investors buy and sell assets based on their perceptions of value, which automatically counteracts random price movements. "Buy low, sell high" is a stabilising investor strategy.

There are times, however, when trading strategies do the opposite. When investors are highly leveraged, rising prices increase the ability of investors to borrow more, and so increase their purchasing power. Not all investors use this purchasing power but some do, and the net effect is that rising prices can lead to further buying, which will cause prices to rise further.

In a declining market, these investors suffer from margin calls as the value of their assets fall. In such cases, they may be unable to meet margin calls and the banks holding their assets are forced to sell part of the position. Falling markets, in this case, unleash selling, which causes markets to decline even further. In extreme cases, excess leverage can create bubbles on the way up and financial collapses on the way down.

Derivative instruments also implicitly involve leverage and so can also create the same destabilising trading strategies. In addition, those who hedge their positions engage in similar self-reinforcing behaviour. Their hedging strategies require them to sell when prices decline and buy when prices rise.

When markets are so heavily leveraged and derivative positions are so high that falling prices and forced ­selling are heavily intertwined, a ­market fall can quickly lead to a collapse, in which case it may make sense for financial authorities to intervene. ­Government intervention acts as a floor that stops the price decline and allows traders to adjust without more forced selling.

Hong Kong in 1998 was suffering from such a condition. There was a real risk that if new buyers did not quickly emerge to purchase undervalued assets, falling prices could feed on themselves into a market collapse. By creating a buy-out fund as the investor of last resort, the Hong Kong authorities broke the mechanism that forced price declines and, in a short time, after traders and investors finally adjusted to the new price levels, the normal stabilising investor behaviour drove prices back up to more reasonable levels, allowing the government to exit with a handy profit.

These are not the conditions that characterise the mainland markets today. In China, prices have been falling for four years largely because excessive liquidity and weak policies drove markets to unsustainably high levels in the late 1990s. Even after four years of decline, average price-to-earning ratios of around 18 - compared with 15 in Hong Kong and 8 in South Korea - make it hard to argue that mainland markets are seriously undervalued. Furthermore, there is no evidence that highly leveraged investors and large derivative positions have trapped investors into self-reinforced selling to the point where they need a buyer of last resort. Prices are falling simply because they are not justified by the expected profits and high governance risks associated with listed companies.

A buy-out fund would make matters worse. The beneficiaries of the fund would not be the thousands of efficient and productive companies in China that desperately need a well-functioning capital market to grow. On the contrary, they would have to wait longer for help. The real beneficiaries would be inefficient and, at times, foolish investors and securities firms that have found themselves caught with overvalued stocks and are desperate to find an even more foolish buyer to take them out.

This is not the role the government should play, and it will not be profitable for China. The bail-out fund would only postpone the necessary price adjustments and ensure that China, like Japan in the 1990s, will draw out its agony over an even longer period.

The writer is professor of finance at the Guanghua School of Management, Peking University

LOAD-DATE: July 14, 2005