Is the Chinese Stock Market Rigged?
Skip to content
Introducing Insight Unpacked, Season 2 - American Healthcare and Its Web of Misaligned Incentives | Listen Now
Aug 27, 2015

Is the Chinese Stock Market Rigged?

By Kellogg Insight | Based on the insights of Torben G. Anderson and Philip Levy

It has been a tumultuous summer for the Chinese stock market. After a months-long boom, share prices tumbled in late June, causing the leadership in Beijing to take action. In addition to new regulations—such as a ban on short selling—and an investigation into one of the country’s largest brokerage firms, the government has used emergency funds worth hundreds of billions of dollars to prop up the market through stock purchases.

The immediate goal is to restore public confidence, but experts in global finance worry that the government’s response is a sign that the Chinese stock market is not yet fully mature. “When you start buying stocks on the whim of the government, it’s a recipe for disaster, because it gives the impression that the system is rigged,” says Torben G. Andersen, a professor of finance at the Kellogg School and current department chair.

For stock markets to function effectively, they need institutions that enforce regulations and disclosure rules (in the United States, that role is played by the Securities and Exchange Commission; its Chinese counterpart, the China Securities and Regulatory Commission, is currently under investigation) as well as professional intermediaries such as rating agencies and stock analysts who ensure that investors have full access to accurate market information. The presence of both helps guarantee that the stock market remains transparent and free from bias or political manipulation.

“People need to have the sense that this is not just a casino,” Andersen says, “but rather a self-regulated organization where the rules are set independently of politicians.” It is one thing to establish policies that will keep investors in check; it is another thing to inject billions directly into the market. “This kind of intervention should only happen in extreme emergencies.”

The Dangers of a Hybrid System

But given how much is at stake for the Chinese government, whose mandate over the past three decades has been linked to rapid economic growth, a response to plunging stock prices was always a possibility. Compared to the leadership of Western democracies, the Communist Party has little tolerance for stock market volatility, which it views as a threat to social order.

“What we’re seeing is a sign of the tension that exists between China’s economic liberalization and its lack of political liberalization,” says Phil Levy, a clinical professor of strategy at the Kellogg School and a fellow at the Chicago Council on Global Affairs. “They are trying to run a hybrid system—it’s not fully under state control, but it’s certainly not a full market economy, either. Economists have long pointed out the dangers of this kind of system. One is the perception that the government makes everything right.”

That perception might explain the investment behavior of the middle class, many of whom borrowed heavily in order to buy shares of companies listed on the Shanghai and Shenzhen composites, in part as a result of a government push to increase domestic investment. Now, there is a risk that those investors are losing faith in the system.

“At least in the initial decline,” Levy says, “the stock market really just fell to where it was six months ago. The problem is that if someone took a leveraged position on the way up and bet their life savings, that person is not where they started.”

Warning Signs

Ironically, China’s reluctance to let its stock market operate freely and transparently may be contributing to the volatility. Without disclosures, ratings, analysis, and clear signals about future earnings expectations, investors can never be fully confident in the value of their information, boosting the potential for crisis. “In China today, it is not always clear that you’re getting the right numbers, and it’s not clear that analysts have real access,” says Andersen. “When the market is unable to send clear signals, there’s a risk of serious distortion.”

And while the U.S. has had its own experience with real estate and stock market bubbles, Levy points out that it may actually be harder to perceive the threat of a bubble from Beijing or Shanghai, because the economy has grown so rapidly for so long. “When you’re used to incredible growth, it makes it that much more difficult to tell when you’ve moved into bubble territory,” he says.

The stock market turmoil comes at an especially awkward time for China, as it attempts to play a bigger role in global financial matters while at the same time adjusting to slower growth. The tumble is not likely to sink the global economy—though China’s recent slowdown (and the move to devalue its currency) has certainly rattled overseas markets. But it is a signal that the government may not have the economy under control, which could make investors think twice about buying shares on the Chinese stock market—even beyond this turbulent period. Given that China now appears to have hit the limits of its export-driven growth model and is more reliant on capital markets and domestic consumption to drive its economy, that is a troubling prospect.

“It’s certainly a blow to the government’s credibility,” Levy says. “And it sends a bad message both domestically and internationally. A dependable stock market is an essential part of China’s long-term liberalization, so it’s important that they get this right.”

Photo credit belongs to myheimu. Published under a Creative Commons license.