Trees don’t grow to the sky. After surging over 150 per cent over the past year, the Shanghai Stock Exchange Composite Index forest has been cut down. The recent breathtaking destruction of capital seen in China has sucked a huge amount of oxygen out of this market.

At one point the rout in Chinese shares was over $3 trillion, which is equivalent to the size of India’s entire stock market. Near the peak the ChiNext (Chinese Technology Index) price-to-earnings ratio exceeded 140 times, eerily familiar to that of the Nasdaq dotcom era.

Many Chinese technology stocks had price-earnings ratios 41 per cent HIGHER than that of peers in the US circa 2000. Peak margin financing stood at about $355 billion or 12 per cent of all freely traded shares on the market and about 3.5 per cent of China’s GDP. According to Goldman Sachs this was “easily the highest in the history of global equity markets”.

The gambling mentality in China seems to shift from various assets classes over time.

Gambling at Macau constrained? No problem: shift to real estate. Real estate prices falling? No problem: just shift to stocks. Need to stop stocks from selling off? No problem. Here is a list of recent regulatory actions, courtesy of the Peoples Republic of China:

1. Suspend selling in 90 per cent of the 2,774 stocks listed on Chinese exchanges.

2. Forbid investors with stakes exceeding 5 per cent in companies from selling for a period of six months.

3. Halt supply. China has suspended initial public offerings (IPO).

4 Increase demand. A multibillion-dollar fund was set up by Chinese brokerages at the governments “behest” to buy blue chip stocks.

5. Hold a gun to people’s heads. The China Securities Regulatory Commission issued “administrative orders” with measures that ask companies to do the following: coerce major shareholders to buy more shares; buy back stock; call on directors, managers and senior executives to buy stock and introduce stock buying incentives for employees. Employee stock ownership should be initiated. 6. Put people in jail. The police are rounding up people that have “maliciously sold stocks”.

Over the last few days, the market has bounced higher. Is the rout over? Maybe. History, however, would suggest things may get worse. In the late 1980s and early 1990s, when Taiwan stocks witnessed this sort of frenzy, they fell over 80 per cent in just eight months. Back in 2008, the largest collapse in US equities occurred after the Securities and Exchange Commission (SEC) banned short selling. Short sellers are, after all, future buyers.

At some point they actually help the market stabilise as they come in to cover. If you can’t sell period, I’m not sure what’ll happen when free trading begins. I would suspect a lack of confidence could actually hurt the market further.

Here are some points to consider and the ugly unintended consequences that market manipulation entails:

1. After having your money frozen, would you ever invest in the Chinese market again? If you can’t take your money out, are you really likely to put any more in? Trust is a difficult factor to regain once lost. International investors now have to consider if recent legislation in China is a new mandate to override the move to open-market principals when real or imagined dangers develop that threaten the Communist Party.

2. Will Chinese shares deserve to trade at a substantial discount to similar countries in the world due to “political risk” and liquidity restrictions?

3. The Communist Party’s pledge to let market forces play a decisive role in allocating resources is in doubt. How far back will liberation of markets be set back? Has China now halted its progress in becoming a more free market?

At some point the liquidity musical chairs stops after the destruction of wealth and there are fewer options. Markets are arenas where people gather for the purchase and SALE of goods. All developed and sophisticated economies need healthy equity markets. They offer, in theory at least, higher returns over time for pension funds and savers. Equity markets also offer financing for new companies that need to diversify financing away from bank loans or other forms of leverage. With rules and regulations that prevent the free flow of capital and price discovery, you don’t have a market. It’s an abomination and a perversion. A hideous sight to witness. An autonomous communist government is not omnipotent when it comes to market forces. It is not capable of defying human nature. In China, we now know, markets aren’t really markets.

Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and can be reached at nkowalski@anchor.bm

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