China's reminder that markets are never risk-free: Don Pittis

Like all booms, at its peak, investors seemed to think it would go on forever.

It wasn't just investors. When China's leaders and officials saw the Shanghai Stock Exchange lose 30 per cent of its valuelast month, with plenty more room to fall, they were mortified. Beijing stepped in tostemthe decline.

But yesterday, theroutresumed. In the last few hours of the trading day, the market plunged sharply, closing morethan eightper cent lower, followed by a further fall today of 1.7 per cent today, while offeringa useful reminder about what markets are for.

• Chinese stock seebiggest one-day drop since 2007, despite Beijing's intervention
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In a replay of last month's tumble, much of the blame has been put on inexperienced Chinese investors. The government itself faced criticismfor encouragingthose inexperienced investors to gambletheir life savings inthe market just as the Chinese economy was slowing.

'Not really markets'

"The markets in China now are not really markets," China market watcher DonaldStraszheimtoldBloombergnews before the latest meltdown."They are government operations."

In the1990s,when I lived and worked in Hong Kong as a business reporter, I watched asChinaexperimentedwith the institutions of capitalism, recognizing their value in creating a powerful modern economy. But the recognition was uneasy.

I remembera Chinese friend's graduate thesis thatrepeatedly used the phrase "breaking through demand" every time he referred to "market forces." WhileI helped him make English-language corrections, he hesitantly explained that the euphemismwas necessary so as not to offend whatever party official might be looking over his shoulder.

Twenty years later,you would think that the Chinese leadership would have come to terms with market forces.

Not a one-way bet

They have something very close to a free floating currency that trades on foreign markets. Despite growing pains, they have largely acceptedHong Kong's frenzied form of free market capitalism.

• The astounding rise of China's currency
• Why China might be willing to sacrifice Hong Kong's economy

But what China is only now facing is that putting your faith in markets is not a one-way bet, thoughyou can see why recent events may have given them that false impression.

Since the 2007 collapse, every time the Chinese economy weakened, the government was there. With almost no debt and a huge trade surplus, global observers didn'tblinkwhen China poured more public money into the economy, sending it from strength to strength.

To Chinese officials, there was no reason that the stock market should not follow the same model.

The Shanghai stock market officiallyrestarted in1990 under some very restrictive rules. Since that date, the market's rise has been anything but continuous, with sharp declines in the early 2000s and during the global credit crunch that began in 2007.

Margin selling

China-watchers have saidthe market surge that led to the recent sharpdeclines was orchestrated by the government itself. It was allpart of an effort to create a culture of shareholdingamongst ordinary Chinese people with money to invest.And for the first time,fuellingthe stratospheric stockboom earlier this year,ordinary Chinese investors were allowed to buy on margin.

That is the process notorious in the New York crash of 1929when people used borrowed money to bid stocks higher and higher. And just as in 1929, margin sellingwhen investors must unloadplungingstock to come up with the money to cover those loans was a big part of yesterday's eight per cent decline.

As I write, debates over how or why the Chinese government allowed the latest crash to happen are not yet resolved.

Some say,guided by advice from the International Monetary Fund, Beijing withdrew so market forces could prevail. Some speculateit was a warning toillicitmargin traders.Others say the pressure to sell overwhelmed the government resources propping it up.

Inherent risk

Either way, it was a painfullesson for neophyteChinese investors. It remindedthem that even with the backing of a 1,000-pound gorilla like the Chinese government,in freely trading marketsthere is no such thing as a safebet. While it may scare them off for a while, those who come back will be wiser.

The purpose of markets, especially in the short term,is not merely to make people ever richer. It is to find the true current value of the thing being traded. While there are alwaysperiods when popular enthusiasm pushes markets to new irrational heights, eventually prices alwaysreturn to reality.

Despite the latest round of cash infusions andinterest rate cuts, theChinese economy is coming down to earth. Canada is already feeling the effect as shrinking Chinese demand takes its toll onour own commodities-based economy.

In the case of China, investor inexperience and new rules may have made the stock market rise and fallquickly.But as we look at our own stock and property markets, Canadians would be wise to take thelesson that whether here or in China,markets are never without risk.

Follow Don on Twitter @don_pittis

More analysisby Don Pittis