Chinese colleagues often complain about China’s stock markets for their immaturity, a view rooted in past decades.
However, the market has progressed since then. While it still faces operational barriers hindering efficiency compared to Western markets, some of these barriers also mitigate manipulation risks.
The idea of a mature market is that it most efficiently works to allocate investment capital. Traders are the lubricant in this investment allocation.
China’s State Council has released new guidelines to enhance market transparency and operation. These carry administrative, criminal, civil and self-disciplinary punishments.
This includes increasing the number of on-site inspections for companies looking to list. The objective is to ensure that illegal activities are discovered before approval.
The guidelines increase penalties for financial fraud and embezzlement of funds. Fraud often involves inflating profits, which can mislead investors about the fundamentals of listed companies.
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Embezzlement typically involves draining funds from listed companies through fraudulent transactions. Neither of these activities is unique to the Chinese market, but it is good to see stronger action being taken to ensure discovery and compliance.
New guidelines
Penalties for market manipulation and insider trading by listed companies are now more severe, with stricter enforcement. Guidelines underscore the need to enhance the monitoring of abnormal transactions and curb market manipulation.
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The new guidelines clarify that if a company is delisted due to major violations, the controlling shareholder, the actual controller, directors and senior managers should be held responsible. This removes management protections that are a feature of US company responsibility.
In Australia, for instance, despite the substantial findings of bank mismanagement and misconduct during the Banking Royal Commission, no charges were laid against any directors.
Most significantly, the new Chinese guidelines say that investors who suffer losses due to a company delisting due to regulatory violations should be compensated. It is unclear how this would work, but it reflects the class action solutions used in similar situations in Western markets.
The State Council said that “the new guidelines for developing the capital markets focus on strong supervision, risk prevention and promoting high-quality development. An environment will be created where all market participants need to be more disciplined and avoid grey areas.”
These are all positive steps in addressing problems that have emerged in the market and been exacerbated during the Covid-19 slowdown. Again, these are not problems unique to China, although the regulatory responses may be more draconian.
Market volatility
Two remaining features of a mature market are lacking. The first is the difficulty of trading short. Not everyone likes short selling, but it plays an important role in managing risk. It also allows for the development of more sophisticated investment products or derivatives. The derivative market carries new risks, but the ability to go short is also used to reduce market risk for longer-term investment activity.
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Chinese stocks can be shorted in a grey market, primarily accessible to larger fund managers. This over-the-counter market operates with limited regulation.
The second feature that is lacking is full freedom of price movement. Daily price moves are limited to 10% up or down. Once the 10% mark is achieved, trading activity is halted. This means the price is locked up or locked down in a falling market.
This policy is designed to reduce market volatility, but in practice, it contributes to the unique extra volatility behaviour of the Chinese market. If the stock you want to buy is locked and limited today, you will bid higher to ensure you get it tomorrow. The result is price rallies that are characterised by rapid multi-day limit-up behaviour.
On the downside, sellers who want to exit cannot trade on a limit-locked-down day, so the next day, they offer at an even lower price to ensure they can exit. The result is a cascade of falling prices, locked limit-down day after day.
Limit-locking price moves are appropriate for leveraged derivative markets like futures but are far less useful in ordinary equity markets.
China’s stock markets are becoming more mature, which provides greater confidence for foreign investors.
The Chinese market closed this week due to the Wu Yi, or Labour Day holiday, so the Shanghai Index has not been updated.
Daryl Guppy is an international financial technical analysis expert. He has provided weekly Shanghai Index analysis for mainland Chinese media for two decades. Guppy appears regularly on CNBC Asia and is known as “The Chart Man”. He is a former national board member of the Australia-China Business Council. The writer owns China stock and index ETFs
