Research Affiliates: The China Syndrome: Lessons From The A-Shares Bubble

September 21, 2015

To Intervene Or Not?

Should the government intervene in response to a bubble or not? The answer is not black and white. Government intervention was widely adopted in the developed countries during the global financial crisis of 2008 and the European sovereign debt crisis of 2010. Enthusiasts for a muscular government role claim that governmental actions may have headed off a global systemic breakdown in market and macroeconomic function; others argue that interventions did far more harm than good. Both are untestable hypotheses.

What is a systemic crisis? It is a liquidity crunch that erupts and spreads when very large negative shocks hit the economic grid, throwing normally well-functioning enterprises into distress. In the event of a systemic crisis, governmental intervention chiefly aims to buffer these "good" firms from the full brunt of the shock with loans and direct equity investments. Oftentimes these short-term liquidity provisions result in very positive investment gains for the government and, indirectly, the taxpayers. Viewed from this perspective, successful intervention can thus be seen as a wise investment at a time of low prices and high prospective returns.

The problem is that the government may, and often does, intervene ineffectively or even harmfully. For example, due to inexperience or regulatory capture, the government might misidentify the firms to support. If the government regularly provides financing to bad firms in crisis situations, the intervention would be counterproductive. The investment would likely be lost, resulting in nothing more than a transfer of wealth from taxpayers to politically well-connected business owners. Another unintended consequence is that Schumpeter's "creative destruction," clearing bad businesses from the world stage, is blocked.

It is not uncommon for Asian governments to mobilize state-controlled capital pools to intervene in the stock market by buying equity shares. The goal is usually to prevent a crisis in investor confidence which could lead to a panicky sell-off with worse effects than the irrational run-up. In a precipitous price decline, good firms with great investment opportunities could fail due to insufficient capital. This problem can be particularly severe with banks and insurance companies whose assets often include stock shares.

But direct intervention in the stock market rarely accomplishes its goals. First, the government cannot assess fair value. No government can know if the market has actually entered an irrational sell-off in which good firms trade at unreasonably low prices and cannot raise capital at a fair cost. The government may fail to recognize that the market decline actually reflects a return to rational pricing and a fair cost of capital.

Second, the government often justifies a direct stock market intervention in the name of helping retail investors who have lost money in the crash. This motive, if true,3 communicates a policy that unintentionally supports overpricing by removing the economic penalty for poor judgment. Ironically, price support programs launched under this pretext would actually erode market confidence on the part of institutional investors, both foreign and domestic. Bans on selling are even more pernicious: If I might be prevented from selling, why should I buy in the first place? In the long run, regular intervention discourages institutions, including the much-sought foreign pension funds, from investing in the stock market because it reduces the quality of the market and increases regulatory risk, such as arbitrary market closures or pressures to limit selling.

 

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