We must learn from great fall of China

CHINA has been a relatively late convert to capitalism and many of the actions of its government in recent weeks indicate that it has not grasped how financial markets work and what they are supposed to do. But as well as expressing dismay at the action of Chinese authorities, we should also note that sometimes even in the West the role of stock markets is too often misunderstood.

China’s market is down 40 per cent since its peak this summer. The fall has wiped roughly £1.6trillion off shares in China’s main market. That is close to the value of the whole FTSE 100. This is despite the Chinese government spending £150billion trying to support share prices. Official reaction has been to point the finger – blaming speculators and pundits for driving share prices lower. The boss of Man Group in China has been questioned by the authorities as part of a probe into the turmoil. What lies at the root of this error is a profound misunderstanding of what a stock market should be doing.

The role of a market, whether it be for apples, oranges or shares, is to help establish a price. By bringing together a wide range of views, often contradictory, a market forms one. If opinion on balance turns negative towards an asset, its price falls. Thus if investors believe Chinese companies are not going to be sufficiently fast-growing or profitable, down come the shares.

Now this is unfortunate, but it is not the root of the problem. The market is just the messenger. Trying to curtail opinion, stopping people selling shares or spending public money buying shares to keep their price up, may keep the market higher in the short term.

But it doesn’t make the economy fundamentally stronger or companies more profitable if you push up their share prices. It just makes the share price wrong.

The West has seen variations on both these themes in recent years. The first was the aggressive low interest rate policy particularly of the United States in the early years of this century. The cuts kept stock markets and housing markets alive in the wake of the dotcom bust and 9/11, but it simply meant markets overpriced everything. As for scapegoating the messenger, we saw a similar attitude here in the financial crisis, when short-sellers (traders gambling on share price falls) became hate figures – as if the fact that Britain’s banks were bust was their fault when they were just calling it as they saw it.

The problem of a slowing Chinese economy, whether shortlived or a serious lasting crisis, cannot be wished away by blaming ‘share speculators’ or artificially pumping up shares. China will hopefully recognise this before it does serious damage to its credibility. We, in the West, also need to be wary of falling into similar errors.