China will struggle with its stock markets until it completes reforms

China’s stock market problems, much in the news lately, are likely to continue, with unfortunate effects beyond share prices. Now that China is the second most important nation in the world on most economic, political and military criteria, problems there are certain to have ripple effects on the rest of the world, including through reduced exports to that nation. The Chinese stock market’s rollercoaster ride is likely to reduce consumer confidence and therefore China’s growth prospects, adding to concerns that led to the recent unusual devaluation of the Yuan. It also adds uncertainty to politics within China, where the rulers are being blamed by investors for their recent losses, and harm the prospects for further moves towards economic liberalization that are necessary in the long-run to avoid an even sharper fall in China’s growth.

Chinese officials have succeeded for now in stabilizing prices in their stock markets in Shanghai and Shenzen after the sharp declines of earlier this summer, which partially reversed the very strong and rapid bull market of earlier in the year. Yet the stability is quite fragile and is almost certain to give way at some unpredictable point in time. China’s stock markets are seriously flawed by problems in the way those markets operate, coupled with weaknesses in corporate governance and the overall structure of Chinese business. Fixing these faults will take years and will require overcoming powerful vested interests, leaving the markets vulnerable in the meantime to excessively sharp rises and falls in value.

It is far too easy to view China’s stock markets as if they were like American markets; they do share some similarities, since they are a venue for the voluntary meeting of buyers and sellers of shares in corporations. However, the differences are stark and important. Chinese stock markets are aptly described as “speculative.” Many Chinese, as well as foreigners, attribute this in part to a long-standing culture of gambling in China. There may be an element of truth to this, but fundamental differences play a larger role.

Stock markets in highly developed economies have their share of speculation as well, but prices are disciplined in the long run by the ability of shareholders to extract value from the companies in which they own shares. They are part owners and share, at least eventually, in the fruits of their firm’s prosperity. They collect their rewards through dividends and the ability to force the sale of the firm. Given these mechanisms, there is a ready market for shares, which allows most investors to sell when they wish, to some new investor who is enticed by future dividends or the proceeds of an eventual sale of the entire firm, or of their shares to another future investor. Shareholders also collectively have the ability to force management teams to take actions, such as paying dividends or selling the firm, or to replace an underperforming management with someone better.

We all know there are problems in the U.S. and other advanced economies that can shield bad management or prevent desirable takeovers, but the ability of shareholders to force changes or sales is strong enough to create a close link between share prices and underlying firm value over time. Warren Buffett famously said, “in the short term, the market is a popularity contest. In the long term, the market is a weighing machine.” The growth of a firm’s net assets will be the biggest determinant of future share price.

China operates under very different conditions. Firms are almost totally shielded by government policy from the possibility of a hostile takeover or a forced change of management, unless there is a dominant shareholder. Similarly, many company heads can determine dividend levels without great concern over shareholder preferences. Further, corporate governance is weak enough that management is often in a position to divert company assets for their own purposes. Widespread corruption makes this even more of a problem, especially for the many firms where a government entity owns a substantial stake.

When shares fail to represent a true ownership stake, then their price will be determined by other factors. In China’s case, this translates into speculation, especially about government policy. The very strong market rally that overshot and produced the subsequent bear market was heavily driven by a growing belief that Beijing would be highly supportive of the stock market. Some of this was the same guessing game that also occurs in Western markets, as observers began to believe that the People’s Bank of China would move to looser monetary policy. On top of this, there were clear signs that many influential officials wanted to see a big move upwards in stock prices, to allow the State to sell shares in the many enterprises in which it owned all or a majority of the shares. Chinese speculators are experts at reading such signs and they correctly concluded that there would be supportive government actions.

However the party came to an end, for a variety of reasons. Some investors, particularly in the West, sold shares as valuations rose to extremes. Alongside this, officials took actions that harmed the market. Some Chinese officials got nervous about the apparent stock bubble and began to rein in the ability of speculators to get margin loans and took other steps that reduced the demand for stocks. In addition, a booming IPO market, often for shares in state-owned companies, was supplying large quantities of new shares to soak up the remaining demand.

Once speculators began to pull back, prices fell quickly and strongly and there came a point at which the official sector pulled together to put a floor under stock prices. China has used extreme measures, including very large stock purchases by government-backed entities, bans on short selling, and even strong hints that there could be criminal penalties for anyone seen as illegitimately pushing the market down. In a nation that has executed people in the past for economic crimes, the latter is a serious signal not to be seen as too aggressive a seller. These extreme measures have worked for now, but there is no guarantee that they will hold forever if economic or political forces create substantial renewed pressure.

I do not know whether Chinese stock prices will go up or down from here. The key point is that China would be well advised to push forward with reforms of corporate governance and of the operations of its stock markets, where too many insiders still manipulate relatively naïve investors. These will be the keys to long-term stability of its markets and to improving the allocation of resources to those firms that will be the winners of the future. In the meantime, investors should exercise great caution, since the markets will remain quite unpredictable.

Editor’s Note: This post originally appeared on Real Clear Markets.