Cooling Down China's Stock Market

Just over a week ago--on May 29th, the Chinese government tripled the "stamp duty" on stock purchases--from .01% to .03%. The move was, in essence, a direct attempt by the Chinese government to let some steam out of its domestic stock markets. Up until the announcement last week, the Shanghai Stock Exchange (SSE) had grown approx. 50% since the beginning of 2007, and approx. 225% since December 2005. The day following the announcement, the Shanghai Composite Index (SCI) posted a 6.5% loss, and by the end of the following Monday the SCI had lost another 8.3%--resulting in a 15% overall consolidation. In the days following, the SSE has posted only marginal gains.

While the reaction of Chinese investors to the announcement was obviously quite strong, the government had been trying to reign in the market through less aggressive measures (mainly interest rate hikes and reserve requirements) for several months. Both The Economist and the WSJ were running articles on the Chinese stock market 'bubble'--chalking the continued expansion up to growing exuberance rather than investment value. Just last month, Former Federal Reserve Chairman Alan Greenspan foretold of a "dramatic contraction" of the Chinese markets. And, even as the SSE tanked (its sister market--the Shenzhen Stock Exchange--also took a dive), the Hong Kong and Nikkei exchanges barely shrugged.

But, all of this begs the question--if everyone knew this was coming, then why did it still happen? The WSJ points out that the Price/Earnings ratios of most stocks on the SSE have been extremely high, with the average ratio at around 50. By contrast, the average Price/Earnings ratio for stocks in the S&P 500 is 18. For one thing, China's stock markets are still somewhat isolated; the average US investor cannot trade on either of the mainland exchanges--and the share prices on other Asian exchanges aren't nearly as inflated.  Second, China's growing middle class are investing more and more in stocks instead of traditional savings accounts--over 20 million new investment accounts (20% of China's total) have been created since January, alone. And, widespread use of laptops and cellphones to buy and sell stock has created greater potential for violatile daytrading.

But, as The Economist argues, perhaps primary reason that the Chinese keep pouring their money into the market is the sheer lack of investment alternatives. It may be that simple. If the only viable alternative is a low-yield savings account, then investing in higher-risk stock makes economic sense--though overinvesting would not. The problem is the lack of certainty in determining where that line is. However, if the Chinese government relaxed some of its investment regulations, Chinese citizens could more easily diversify their investments (allowing for ranges of risk, instead of extremes), and the market would presumably equalize and simmer down on its own.