Money shouldn't be used to inflate asset bubbles

An investor looks at an electronic trading screen at a brokerage in Nanjing, Jiangsu province. [Asinewsphoto by Su Yang]

China's stock market has been in the news since the summer, when a rapid rise gave way to a major plunge, triggering a global equities sell-off. The question now is what can be done to prevent further volatility.

In mid-June, the prolonged surge in stock prices finally drove an unnerved China Securities Regulatory Commission to impose restrictions on offline private fund matching. The decision immediately triggered a sell-off, with the Shanghai Composite Index falling 2 percent in just one day.

Initially, this looked like a natural correction. But the prevalence of margin trading caused the decline to turn quickly into a rout. First, as plummeting stock prices caused the equity in investors' accounts to fall below the maintenance margin, brokers began issuing margin calls, forcing investors to offload more assets to come up with the needed cash. When they failed to pay margin calls on time, their shares were sold by brokers, pushing stock prices down further.

The authorities scrambled to stanch the bleeding. On June 27, the People's Bank of China lowered the reserve requirement ratio and the benchmark interest rate. But the Shanghai Composite Index kept falling, reaching 4,200 on July 1.

At that point, the CSRC launched a succession of desperate measures: it suspended initial public offerings, allowed companies to stop trading, and limited short selling. It even organized a "national team" of 21 large securities companies to purchase shares to buttress the Shanghai Composite Index.

In doing so, China's regulatory authorities changed many well-established rules of the game virtually overnight. While massive official intervention may have halted the rout, it could have permanently damaged regulators' credibility. And it was not even merited; the banks were not overly exposed, so there were no systemic risks.