China's stock market experiment goes badly awry

Frantic efforts by the Chinese government to halt a plunge in stock prices are paying off -- for now. A day after suffering another sharp drop, equities listed on Shanghai's stock market rose 5.8 percent Thursday, and Hong Kong's Hang Sen gained 3.8 percent. Financial markets in Japan and South Korea also rebounded.

But the $3 trillion loss in market value in China in recent weeks -- more than 10 times the gross domestic product of Greece -- amounts to a foghorn-like warning for the People's Republic. The message: Building a modern economy with functional capital markets, especially at China's usual double-quick tempo, is a massively risky exercise. Or, to cite a popular Chinese proverb, be careful what you wish for.

What's at stake in China is not just its experiment in equity markets as the country gradually drifts away away from a command-and-control economy, but the credibility of its robust growth model and political leadership. And that credibility has not been helped by the role China's state-controlled media has played in blowing up the bubble in stocks, which have risen more than 150 percent in the last year even as economic growth was slowing.

What China is doing to curb its market crisis

Encouraged by The People's Daily, Xinhua and other government-controlled media outlets, 4 million Chinese per day were piling into stocks in June alone -- just in time for the markets to lose almost a third of their value.

Between April and July, the number of mostly urban households in China that bought stocks shot up to 8.8 percent, up sharply from 6.1 percent in the previous three months, research firm IHS notes, citing data from the Southwestern University of Finance and Economics in Chengdu China. Many investors borrowed heavily to fund the stock purchases.

The fervor made Shanghai's stock market the world's leading destination for initial public offerings in the first half of the year, with Hong Kong racking up the second-most IPOs, according to accounting firm EY.

Although the share of mainland Chinese who own shares is lower than in developed economies around the world, the rush for a piece of the action is evidence of the speculative fever that the government has helped foster.

Indeed, even as the government was pulling out the stops to prevent an all-out crash, state-run media proclaimed that China's economic fundamentals were strong. It remains to be seen if a $19 billion bailout fund, mandatory buybacks and suspending a third of the countries 2,800 publicly traded companies from active trading will put Chinese stocks on a glide path to that "soft landing" the central government has wagered so much on.

If Chinese investors feel burned, the government could feel the wrath.

"It's a double blow to their credibility," said Michael Santoro, professor of management and global business at Rutgers Business School. "First they were so vigorous in promoting stock ownership, and now they had to intervene. Now there's not much more they can do, but in the process they set off a second wave of panic."

For perspective, China's stock exchanges are nowhere near the size of the U.S. markets. But Santoro explains that the experiment in using stocks to raise capital was an effort "to try and bring some kind of market discipline to the banking system." The goal is to substitute the relative discipline of the market for the kind of government-guaranteed lending that favors the politically connected in China.

But the government's stock-touting has drawn enough people in to prompt plenty of unhappy investors.

"A lot of people will be screaming bloody murder about the market," said Peter Kwong, distinguished professor at Hunter College specializing in Asian-American and immigration Studies. "You see that small investors, cab drivers and the working class have gotten into it."

China builds wine country in its own desert

If many average investors have lost their shirts, China's latest stock crash is unlikely on its own to take the broader economy down with it. China's huge state corporations, which continue to dominate the economy even as Beijing moves to unleash the private sector, can raise capital outside the stock market.

"But now the bigger problem is a global slowdown and the realization the Chinese economy can't continue to be built on exports," Kwong noted. "Now the pressure mounts internally for China to make that switch to a slower growth rate, but with higher household incomes that could drive domestic demand."