China’s Misguided Ban on Short Selling

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Commentary

China’s financial regulators are panicking. They banned short selling and suspended the sale of restricted shares (owned by employees and “strategic” investors) starting Jan. 29.

Beijing promises more such regulations in March. In what sounds not a little oxymoronic, regulators now say they may start evaluating the chiefs of state-owned enterprises by their market capitalization.

These interventions would be laughable were they not so tragic for real people and families in China who lost their savings. The country’s stock market lost $6 trillion since 2021. The MSCI China Index lost 60 percent of its market cap over the same period.
Other dirigiste measures meant by Beijing to boost Chinese equities include a planned infusion of regime money of up to $488 billion, demands on institutional investors to increase their investment, capital controls that limit offshore investing, a ban on crypto, and a requirement that major investors maintain positive net stock purchases. In other words, they cannot sell more than they buy.
On Jan. 24, the governor of the Bank of China said the regime would decrease reserve requirements for banks. While this would free another $141 billion to lubricate the economy, including through a boost to stocks and lending, it also increases systemic risk in the already troubled Chinese financial sector.

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The Chinese Communist Party’s (CCP) latest move against short selling has not impressed investors, given the party’s track record in managing its bourses. In October, for example, the CCP established limits on strategic investor short selling, but the measure failed to stop the indexes from falling further.

The United States had no better luck with its last short ban during the 2008 financial crisis, according to Jim Overdahl, former chief economist of the U.S. Securities and Exchange Commission (SEC). The ban was imposed when Mr. Overdahl had his SEC position. It lasted three weeks and ultimately applied to 900 mostly financial stocks as part of former Treasury Secretary Hank Paulson’s “shock and awe” strategy.

Mr. Overdahl warned against another U.S. short ban in the Financial Times in May in response to an increase in Wall Street sentiment against short sellers. He pointedly noted that studies showed that the 2008 ban was a counterproductive mistake and departure from the SEC’s longstanding view that short selling “plays an important role in promoting market quality and helping investors by contributing to price discovery, liquidity, risk management and by lowering the overall cost of trading and raising capital.”

Studies showed, according to Mr. Overdahl, that the 2008 ban failed to boost financial stocks and, on balance, harmed many market participants. The ban’s premise, “that short sales were more aggressive than the sales made by those holding shares and wishing to dispose of them—was mistaken,” he wrote. The studies “also showed that short selling of financial shares was more intense in rising markets, not falling ones.”

Mr. Overdahl observed that the studies found “a severe degradation in market quality by increasing intraday stock price volatility, reducing market liquidity, increasing bid-ask spreads and price impacts, reducing pricing efficiency and increasing trading costs.” He said it led traders to substitute “other instruments to gain short exposure, such as equity swaps or credit default swaps.”

Hedging, arbitrage, and ETF creation of new shares were impaired, causing additional downward pressure on financial stocks. “The result was many ETFs trading at a premium to their net asset value since there were no new shares created to meet demand,” he wrote.

U.S. and Japanese ETFs recently sold in China at a 5 percent premium to their underlying assets, suggesting that Chinese investors are willing to pay 5 percent more for foreign than local equities.

Other than a likely short-term boost from one of the regime’s interventions—the inadvisable $488 billion—the latest CCP moves will likely put further downward pressure on Chinese equities. All of the measures are anti-market and will erode investor confidence in the long run.

The regime is like a fish caught in a communist trap of its own making—the more it wriggles and adds to the trap, the further it goes in. The latest economic data from China is not encouraging. Manufacturing contracted for the fourth month in a row in January, according to the latest purchasing manager’s index (PMI), released on Jan. 31.
Confidence in the future of China’s economic growth and liberalization will be key to freeing China’s economy and putting its equity markets back on track to positive growth. The return of such confidence is unlikely as long as communist ideology increasingly biases the most important military and economic decisions made in Beijing, not least of which is the threat of war with Taiwan and all the economic dislocation that would follow.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.

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