Further Decline in the SSE

By Colin (Huaizhi) Chen

For those of us who avoided the excess profiteering of the Shanghai Stock Exchange (SSE), the decline in the composite index earlier this year was a mild sign of vindication. Despite the outrageous price to earnings ratios, the obvious hesitance of China’s ministry of finance in enacting transparency reforms, and the fact that major sources of financial advice come not from company fundamentals but from my neighbor’s cabdriver, the irrationally exuberant investors continued to pile on to the gravy train believing there will be no shortage of liquidity until the 2008 Olympic Games. While the recent declines are a positive correction toward economic efficiency, it is very much a tribute to Keynes’ quip that the market “can remain irrational longer than” one’s solvency that the SSE still maintains a 30% appreciation from the same time last year.

When an equity market is functioning properly, it provides economic efficiency by transparently linking entrepreneurs and companies looking for capital with potential investors. It also provides liquidity and risk reduction to investors by allowing them to trade their equities in an open and relatively transparent market. The SSE, on the other hand, can be seen as the dark back alley of the projects, with its collection of hustlers look for easy marks to buy up shoddy goods in an ever growing pyramid scheme.

From the perspective of Beijing, the still present balloon in the equity market is in fact a large liability. While a sudden crash will have dire repercussions in investor confidence and will spark accusations of government responsibility, a slow and drawn out carefully engineered index deflation blamed on the US financial markets can be seen as the preferable solution. Therefore, Beijing is careful in maintaining a façade of mild financial actions (a cut in the .3% stock stamp tax will not justify a 200% overvaluation), and in secret praying for further index price correction.

More on this later.

-H