Written by David Dickinson.

The economic progress of China over the past 40 years or so has been remarkable. Part of that success has been due to the role that the state has played in creating a stable, long-run environment for business to grow and flourish, able to take advantage of the globalisation of economic activity.

The Chinese government has just seen confirmation that it is far harder to marshal the competing forces in financial markets.

Simply put, the sector suffers from inefficiency and distortions built in to its current structure. The stock market – which has suffered such a jolt in recent weeks – is a relatively small part of the picture. Banks are still the predominant source of finance and can be asked to act as policy mechanisms to fund the state’s favoured projects.

Restrictions on the official banking sector, meanwhile, have led to a rise of an unregulated shadow banking system. There remains limited access to household finance and a lack of short and longer-term corporate debt markets. Add to this mix the absence of full capital account convertibility, which would allow limit-free conversion of yuan holdings into foreign currency for investment. The continued restrictions might offer some protection from events such as the global financial crisis, but they still isolate China from financial globalisation.

Taking stock

The Chinese stock market has provided a good example of how markets can deviate significantly from rational valuation. If we go back 10 years, we see an overheated market between 2005 and 2007. After the bubble burst, the market drifted as Chinese investors looked to real estate as a way of making good investment returns – and indeed it was a highly successful strategy. The 150% rise in the Shanghai stock index during 2014-2015, which preceded the recent collapse, was a result of the cooling of the real estate market and consequent re-emergence of share buying, assisted by an increase in lending.

Now, investors are looking to sell stock as the market tumbles, with the losses experienced in 2007 at the forefront of their attention. So two bubbles and, in between, a market in the doldrums is the experience from which investors are making their decisions. Participants in the Chinese stock market are used to volatility and level of prices which in no way reflect the true value of the stocks they hold. Short-term profit-taking and loss-minimisation is the focus for buying and selling activity.

Value judgments

This is the environment into which China’s policymakers have stepped in recent weeks. They have found, as King Canute attempted to show his obsequious courtiers, that the sea will not obey. It should by now be clear that trying to influence the waves of selling created by highly disturbed financial markets is a task beyond even the most powerful.

Chinese investors reacted to various policy measures and exhortations with further unloading of stocks and even the injection of huge support has only served to leave traders skittish and susceptible to rumour.

Rational investors regard buying stocks now as highly risky given the sentiment of small investors and the desire to cash in on some profits while they still exist. Yet, why would policymakers expect anything less when the market, for a long time, has been driven by anything but a rational assessment of the long-term value of holding stocks.

There have been some attempts to explain what has happened. One tactic has been to blame professional fund managers who are using the recently introduced capability to short-sell – essentially betting on stocks to fall. But, in truth, fund managers have followed policy strictures not to abuse this new market mechanism – and my contacts in China have said there has been little evidence of the use of short-selling since the measure was introduced. Another approach has been to blame foreign investors, but again this lacks credibility given the small amount of such investment allowed and the strict controls on it.

The past few weeks have taught policymakers that they can create as well as reduce volatility. By intervening, cajoling and blaming international investors and fund managers, the rational element of financial markets have priced in additional risks. In other words, the market is betting that if policies to stabilise the market eventually fail, then the result will be more draconian measures which will have negative consequences for the markets and financial institutions.

And they are right to do so. One response from policymakers was the introduction of restrictions to stop major investors selling stocks altogether. That does appear to have prevented market meltdown for now, but the problem with returning to this solution is that the state is not in charge of what happens once trading is allowed again, or crucially, how such intervention affects the longer-term view of investors.

Norse play

Policy makers in China, as they have done previously, will learn from the experience. They may think they understood what has driven economic development, but doing the same for the financial markets is a much more difficult task. It has been an awareness of this, coupled with fear of exposing the economy to unshackled markets, which has delayed liberalisation efforts. It will be a pity if recent events encourage policy-makers to postpone reforms necessary to bring China’s financial system into the 21st Century, to join the country’s real economy.

China’s recent roleplay as a beach-bound Norse king should push policy-makers to create financial markets that take the long view. The key is to encourage investors to build portfolios that deliver long-run risk management, rather than portfolios which attempt to second guess how Beijing will next interfere. This means some serious institution building and financial market reforms. It won’t exempt China from volatile financial markets and short-term decision-making but it would deliver a more predictable environment that allows angry small investors to take less risky positions to avoid the vagaries of short-term financial market behavior.

Choice and freedom to make mistakes is as important in financial markets as it is in any part of the economy; China should recall that even Canute got his feet wet in the end. The difference is that he knew he would.

David Dickinson is a Professor of Economics at University of Birmingham. Image credit: CC by Bon Adrien. This article first appeared on The Conversation and is available here.