Beijing's credibility 'on the line'

By the close of trading on Thursday, July 9, the CSI300 index of the largest listed companies in Shanghai and Shenzhen had climbed 6.4 percent, while the benchmark Shanghai Composite Index (SCI) bounced 5.8 percent for its biggest daily percentage gain in six years. The gains came after regional markets suffered heavy losses a day earlier. The SCI had dropped by nearly 30 percent in three weeks - albeit still up 80 percent year-on-year - including a 12-percent loss last week.

The stock plunges have raised concerns for China's leaders who are already struggling to avert a sharper economic slowdown, and prompted the authorities to take a series of measures to halt the unprecedented slump. In its latest bid to calm the markets, Beijing decided to stop major shareholders - defined as those with stakes of more than five percent - from selling shares and launched a probe into "vicious short-selling" on the country's stock markets, according to state-run news agency Xinhua.

But the situation remains volatile, with some experts arguing that the drastic steps taken by Beijing are not allowing market forces to work. In a DW interview, Dr. Sandra Heep, head of the "Economic Policy and Financial System" program at the Berlin-based Mercator Institute for China Studies (MERICS), says that should markets fail to see any sustainable upward trend, there could be political protests as the Communist Party's credibility is on the line.

DW: How is the ongoing plunge likely going to impact the Party's hold on power, especially if it fails to prevent stocks from further plunging the coming days?

Dr Sandra Heep: If we don't see a sustainable upward trend in the stock markets very soon, there could be political protests. Countless small investors feel let down by the Party and are blaming it responsible for their losses. These infuriated investors could become a challenge for the political system. The credibility of the Party is on the line.

If the Party-state fails to reassure the markets, loss of confidence in its economic competencies will most likely lead to a further decline in growth rates. Private companies in the technology sector that benefitted greatly from the rise in stock prices would once again face major financing difficulties.

Furthermore, the small investors' losses could weaken domestic demand. This crisis would prevent implementation of planned liberalization measures of the financial system.

The urgent need for economic reform in China therefore runs the risk of faltering due to a dramatic stock market crash. A further decline in growth rates could also pose a challenge to the Party, since its legitimacy has long been based on economic performance.

Why have the measures taken so far by the authorities failed to substantially halt the stock slump?

Even though the government has adopted a whole range of drastic measures to stabilize the markets, its interventions have not yet shown the desired effect. The most likely reason for the measures' ineffectiveness is that investors are so heavily leveraged that margin calls are forcing them into sell-offs.

Margin trading - which allows investors to borrow money from their brokerages to invest in the stock markets - has been one of the main drivers behind China's latest stock market rally. In times of falling share prices, this practice can have disastrous effects, with margin calls requiring investors to liquidate their holdings, which in turn triggers a further slump.

Given the markets' hesitant reactions to the authorities' concerted efforts, less leveraged investors have possibly lost faith in the government's ability to steer the markets, which has further exacerbated the situation.

Why is Beijing intervening in the first place, and do you believe the Chinese authorities have the necessary tools to arrest the stock market fall?

The party-state is fully aware of the political, social and economic consequences that a stock market crash could trigger and is thus willing to go to great lengths in its attempt to calm the markets. Given that its measures have so far failed to break the trend, it could theoretically embark on even more drastic interventions, such as ordering the PBOC to provide state actors with sufficient liquidity to corner the markets.

However, such a radical move would completely destroy the notion that China's stock markets are at least partially driven by market economic principles. Since this would jettison the stock market reforms of the last decade in one breath, the authorities probably regard it too costly a measure to be sincerely considered.

Stock markets are worldwide indicators for economic development and confidence. Why are institutional and private investors losing confidence in China's economy?

China's stock markets have always been policy-driven markets whose development has been influenced by political signals rather than national economic fundamentals or the performance of single companies.

For this reason, the current stock market slump should not be considered a verdict on the future trajectory of China's economy, but rather be understood as having been caused by a tightening of restrictions on margin trading.

Given that China's economy has recently displayed growing signs of weakness, it was actually counter-intuitive that stock prices were reaching record levels. If the authorities had not fueled the stock market rally, they now wouldn't find themselves in such a difficult situation.

How did the Communist Party benefit politically from the rising stock market up until just a few weeks ago?

High stock market prices can contribute to improving the precarious situation of state-owned companies that have run up massive debts ever since the outbreak of the global financial crisis. High market prices not only allow them to "polish" their balance sheets, but also facilitate new funding via capital increases.

Also, the stock market hype has improved funding possibilities for smaller companies in the technology sector. They often fail to get loans because the state-owned banks prefer financing state-owned companies. Yet it's the private technology firms that are of great importance for the restructuring of the Chinese growth model because they can contribute to stronger innovation-led growth.

More basically, the state-orchestrated stock market boom can also be understood as a reaction to the increasingly obvious limitations of monetary policy: Over the last months, the central bank has repeatedly lowered the key interest rate as well as the reserve requirement ratio. But these measures have failed to produce the desired results.

Financing costs for companies remain high, and banks are still reluctant to lend money. Trying to stimulate the economy via the stock markets therefore seemed to offer a welcome escape.

Dr. Sandra Heep, head of the "Economic Policy and Financial System" program at the Berlin-based Mercator Institute for China Studies (MERICS).