Last month the Chinese government provided a dose of financial morphine for the stock market by halting the placement of a large number of new shares in state-owned enterprises (SOEs).
That announcement came as a relief to anxious investors hoping to gain from official support. China's gambit to appease investors in the short run by trying to support stock prices, however, may come back to haunt them.
What Chinese investors need is not more intervention, but less. The dominance of state-owned enterprises on the exchanges means that there are no real capital markets in China. Government support of the market only compounds the difficulty of trying to evaluate socialist firms. Without real owners with fully transferable shares, there can be no way to know the capitalized values of the listed companies and no way to discipline socialist managers.
A bleak profit picture will reduce the prices of those limited number of shares that can be traded on the exchanges, but most investors have no idea of the future profitability of the listed SOEs. Beijing's attempts to prop up the market will ultimately mean a sharper fall in prices when the bubble breaks. A better strategy for protecting investors is to create real value by getting the government out of the capital markets and by privatizing SOEs.
If SOEs were transformed into private companies in which individuals held saleable shares, the stock market would reflect more accurately the present values of the listed companies, and price-earnings ratios would return to normal levels. Chen Mingxing, senior researcher with the State Information Center, recognizes that fact and has recommended more rapid ownership reform. According to the China Daily's Business Weekly, "Chen said that the government should leave the adjustment of share prices to market forces, but put more effort into establishing a marketplace that is just, fair and transparent, and reforming the ownership systems at the listed companies."
By failing to create real capital markets, Beijing is missing the opportunity to take advantage of the gains to be had from specializing in ownership and risk bearing. The socialization of risk under the current system reduces incentives to innovate and create wealth. The value of firms is below what it could be if capital were free to flow to its highest-valued uses -- and there is no way to discover those uses without competitive markets -- which depend on private property rights.
Privatizing state-owned banks and allowing interest rates to be set in private capital markets would depoliticize the allocation of bank credit and increase invest-ment returns to the private sector. Allowing both Chinese and foreign investors access to China's capital markets would put China's vast pool of private savings to better use than they are now.
The benefits to China and to foreigners from liberalizing the financial sector are great: China would achieve a more efficient use of its capital and attract new investment, its people would have an important part of their human rights -- the right to own property -- protected by law and foreigners would be able to deal with private firms and offer more options to China's savers.
Improving capital freedom by securing property rights and liberalizing capital markets and capital flows will increase wealth and increase the demand for foreign goods, services and investment. As China's internal markets expand, so will its external trade. Increasing economic freedom is a win-win strategy for both China and her trading partners.
Free trade and privatization can help normalize China and transform it into a modern economy and a civil society under the rule of law. China's accession to the WTO will help move it in the right direction. The US, as the world's dominant power, must not lose sight of the long-run benefits of a firm commitment to market liberalism and capital freedom.
James A. Dorn is a China specialist at the Cato Institute.
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