Friday, May 25, 2007

How to Pop a Stock Market Bubble...

Continuing with my recent theme, today I will suggest ways for the Mainland authorities to pop the equities bubble. Fundamentally, too high a share price implies too much demand or too little supply of shares. Ultimately any meaningful solution must address at least one side of the market. So what can be done?

1) increase transaction fees. Many recent participants are flipping shares with high frequency. Tax them for their troubles, and some participants will cool their activities. Note that transaction fees would have little effect on long-term investors, but only those "frequent flippers."

2) Tax capital gains to reduce the benefits from short-term speculation.

3) encourarge foreign firms to list in Mainland China. Yesterday I mentioned that A-shares in Shanghai trade at approximately 3 times the price of the equivalent H-shares in Hong Kong, even though they are effectively the same shares. This is as a direct result of capital controls preventing investors from arbitraging between the different markets. Capital controls segment the market, limiting the potential investments that Mainland savers can access. as a result, asset prices in the Mainland trade at a premium over equivalent assets elsewhere.

If capital controls cannot be dismantled in the near term, then why not try to encourage foreign firms to list in Mainland China? Given the huge savings rates and high price-earnings ratios, this must be an appealing prospect to some firms, as it implies that it would be a relatively cheap way to raise capital. In addition, there may be a political pay-off for such firms in the future as China continues to develop.

If foreign firms list in the Mainland, the total supply of available shares increases, effectively putting downward pressure on share prices.

4) Reduce Government share holdings. In general, only a small portion of the total number of available shares are actually traded; the rest are held by the Government. If the Government reduced its holdings, the supply of shares would increase, reducing prices.

5) Do nothing. In the short term, this is the path of least resistance. But the longer the Government follows this route, the larger the bubble may get. Then one day, when the taxi drivers / university students / pensioners wake up and all realise collectively that their life savings / tuition fees / retirement savings are all built on a house of cards, they'll try to sell their investments. But selling shares requires a buyer, and they're likely to be in short supply! So prices will come crashing down.

Even if the mainland market is not a bubble, some of these steps are desirable in their own right- e.g. 3) and 4).

What other solutions have I missed?

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