As the Chinese stock market unravels, liberal economists are eating their words on the supposed benefits of heavy government intervention in the financial sector.
On Monday, the Shanghai stock index declined by 8.5 percent, the largest single-day drop in 8 years. Before this point, the government had already taken extraordinary steps to further preserve the stability of the financial sector. After the first major stock market slide at the end of June, the central bank slashed interest rates to spur greater investment.
This is the fourth major rate cut in the past year. Additionally, the government has legally prohibited major stakeholders from selling shares, equipped the public China Securities Finance Corporation with $500 billion to prop up prices, and promised to protect the troubled state-run financial enterprises.
Despite these shielding measures, markets are nonetheless performing poorly.
The market breakdown, much like the remarkable growth in stock prices earlier in the year, is a product of investor confidence rather than economic output. The market value of all Chinese equities doubled from June 2014 to June 2015, even though GDP growth was actually slowing over this period of time.
The trigger for the upshot in stock prices was the influx of new investors into the market: middle-class Chinese citizens.
With real estate in decline and nearly exclusive state control over banks, citizens have had little choice but to store their savings in the stock market.
China is attempting to solve this crisis by restoring confidence among nervous stockholders. But ultimately, it is the government’s strict financial regulations that have brought the market to this point.
By giving preference to state-run banks over private institutions, the government prompted massive infusions of cash in the few sectors open for investment. China also has relied excessively on margin lending to encourage stock purchases.
To top it off, the government has covered up details of corporate governance for large Chinese firms.
Many large Chinese companies are being poorly managed, but stockholders have little information and therefore little understanding of the weakness of their investments.
Stock prices in China remain overinflated, which means state interventions are only prolonging the ultimate adjustment.
Foreign investors are wary of Beijing’s promises of market stability, and their levels of investment in recent weeks have been low. The government promises that more interventions will be the antidote to the market contraction.
Unfortunately, public recognition that control by the government has been the primary cause of the problems has eroded confidence that even more government might be the solution.
The Chinese government has repeatedly repudiated a free-market approach to stock trading. Opening markets to private investment, reining in state spending on stock ownership, and requiring accurate financial information disclosure for publicly traded companies could establish a Chinese stock market with the steady long-term growth necessary for lasting stability.
But the Heritage Foundation’s 2015 Index of Economic Freedom has ranked China only 158th out of 186 countries in terms of investment freedom, and a lowly 131st in financial freedom.
Investors are now suffering the consequences.