Rescue Measures Not Applicable for Stock Market

From cover, issue no. 385, Sept 15, 2008
Translated by Zuo Maohong, Liu Peng, Ren Yujie
Original article: [Chinese]

On September 7, the US federal government announced it would take over the two mortgage giants Fannie Mae and Freddie Mac to prevent a broader financial crisis.

Upon learning the news, many Chinese market watchers remarked that even the biggest advocate of free market economy had begun to intervene in the market, thus the Chinese government should also take action to save its tumbling stock market.

We are of the opinion that the Fannie-Freddie bailout should not be used as an excuse for the Chinese government to intervene the stock market, as the two scenarios are not of parallel comparison.

Why did the US government step in to take control of the two agencies? It is an example where the forces at play would not let such gigantic financial institutions to collapse.

Fannie Mae and Freddie Mac own and guarantee a total of five trillion dollars worth of mortgages, almost half of the country's total mortgage volume. The two firms sell securities backed by their loans' income stream, and these securities are owned by investment institutions from around the world.

If the two agencies went bankrupt, it would hurt not only the companies and the US economy, but trigger a global chain reaction affecting the financial systems in terms of liquidity, stability and credibility. Facing such a broad fallout, any government would have intervened.

Similar to the Fannie-Freddie takeover, the Chinese government's capital infusion and disposal of non-performing assets in state-owned banks between 1998 and 2005 also demonstrated state effort in preventing gigantic financial institutions from going under.

At the core of the Chinese financial system, state-owned banks directly impacted the financial system and even the whole economy. The government therefore was resolute in aiding them with trillions of yuan and restructuring them into market-oriented ones. As a result, these state banks have today become some of the world's most profitable and biggest by market value, and thereby maintaining China's financial stability.

However, the problem-riddled stock market is a different issue entirely.

Judging from history - be it 10 years ago when the US Federal Reserve (FED) requested the Wall Street financial giants to jointly rescue failed hedge fund Long Term Capital Management Corporation, or today's government taking over the two home mortgage agencies - the logic applied during government intervention was the same.

That is, when the collapse of an individual gigantic financial institution would likely threaten or destabilize the entire financial system, the government must lend a hand to prevent a systemic crisis.

Neither the US FED nor its government ever step in to rescue an ill-performing stock market. Not when the NASDAQ index crashed to 1,200 points from 5,000 points as a result of high-tech industry bubble burst in 2000; and also not when the recent sub-prime crisis led to sharp drops in the Dow Jones index.

In the past year, the FED and European Central Bank have carried out a series of moves aimed at ensuring liquidity in the global financial market. The moves prevented financial institutions without credit risks but faced with tight liquidity from collapsing.

None of the moves were aimed at propping up the stock markets, or based on consideration to minimize losses for investors. When the share prices of Citibank or Merril Lych tumbled, it only reflected that the market economy was at work, and that price tumbles were the result of investors' judgement. That does not warrant a rescue package.

The Chinese A-share stock market index has declined from its highest 6,100 points last October to around 2,000 points today. It is a stock market disaster, but also a market economy norm.

First, the decline is a result of the inflated stock market bubble bursting. Even at 2,000 points, the average price to earnings ratio for listed companies stands around 20; from an international point of view, this ratio may not be considered undervalued.

Second, when the A-share index rose to over 6,000 points last year from 998 points back in May 2005, and more recently dropped to 2,000, it was merely a redistribution of interests among investors and listed companies; and all those involved knew well the risks facing stock markets and that they should have invested cautiously.

In other words, the performance of the current Chinese stock market, and the risks attached to it, do not provide a strong enough reason for the government to intervene.

Having said that, it does not mean that the economic risks arising from the stock market are not worrying; or that the government should not improve the condition through other means.

If the current tight credit control measures persisted,  the volume of investment, export, consumption and production would slump further. The government should review past policies from time to time - be it fiscal or monetary measures - and inject new vitality into the economy when needed.

We believe by applying the right macroeconomic control tools timely  is more effective than direct rescue package, and the former is more befitting of a government's duty in the market economy.