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'Animal spirits' driving stocks

By Sun Lijian (China Daily)
Updated: 2009-08-26 14:40

The momentum of continuous rise in China's stock market over the past few months recently suffered a heavy setback.

After reaching a peak of 3,478 on Aug 4 since it launched an accelerated recovery offensive from the lowest level of 1,664 in late October, the Shanghai Composite Index rapidly reversed downward. On Aug 19, the benchmark index slid below 2,800, declining 677 points, or a drastic 20 percent drop in only 13 trading days. The index went up this week, but closed at 2,915 yesterday, down 2.59 percent from the previous close. The Shenzhen Component Index closed at 11,688 yesterday, down 3.21 percent.

Stock markets have been likened to an economic barometer. But China's and the world's economy have not undergone the same drastic changes over the past few days as that in the country's capital market. On the contrary, data released indicates that China's real economy so far this year has obviously turned for the better than last year when the worst effect of a global financial crisis took its bite. And, continuing deterioration of some economic factors, if there is any, is the unavoidable after-effect of the crisis.

For a fluctuated capital market, it seems to show a permanent law that favorable factors always follow on the heels of unfavorable ones. Given that stock investment is an investment in the future's economic tendency, people should have enhanced confidence in China's stock market because the country's economy has shown signs of better development. Thus, any attempt to link the recent steep decline in its stock market to the deterioration of its basic economic landscape seems unreasonable and groundless.

It is true that there is an increasingly pessimistic atmosphere in today's Chinese stock market, which has gained much since it began to rebound from the 1,664-point low level. Quite a few investment agencies and funds have reduced their holdings by a large margin, and many individual investors and international "hot money" have also chosen to exit from the country's market. Also, a sizable number of large and small-sized non-tradable shares have been sold.

Related readings:  Stocks fall as Wen says economy faces uncertainties  World stocks slide amid caution, China off 2.6%  Stocks slump, oil continues decline as recovery hopes dim  Mainland stocks headed for 'sizable correction'

However, the concern over the country's fluidity contraction after the government tightens bank loans should not be blamed for the runaway large-scale funds. Otherwise, how can we explain the flood of liquidity in the country's stock and real estate markets in the first half of 2007 when the central government showed a growing determination to strengthen its macroeconomic regulation, but the stock and real estate markets still both witnessed steady surges? It may be more reasonable to attribute the recent drastic fluctuations in China's stock market to its normal market technical adjustment, that is, a lot of funds choose to flee after gaining certain returns. If the process carries on, the stock market is expected to hit a new low.

In fact, what China's stock market has long lacked desperately is not liquidity, or the good economic landscape that bolsters the rising share prices, but confidence. Most investors, individual ones in particular, choose to rush into the stock market after the government took a series of economic stimulus plans to rescue the faltering market amid deepening economic recession. Due to the lack of explicit market recognition or investment targets, investors cared more about other people's judgment than about the market trend. Under the circumstances, any misinterpretations of government policies or misjudgment about market tendencies will inevitably add to worries about security of their assets, and prompt their exit from the market.

For the recent drastic fluctuations in China's stock market, the fundamental cause is not the worsening of its basic economic conditions, or the bubbles in its share prices and the possible reversal of its macro-economic policies, but the lack of necessary market confidence.

The country's bullish stock market in the first half of this year has been mainly propped up by "inspiring" market news, instead of being driven by a new round of tangible development of its and the world's economy.

Despite signs of a substantial recovery emerging in the world economy after a volley of favorable policies, people are well aware that this economic rebound is not solidly founded; and, they have good reasons to worry whether it can continue to steer well without follow-up policies and measures.

When investors' judgment grows that the speculative stock market would be deserted by bank loans, they are alerted that the rapid rise in stock prices over the past months should be largely attributed to their primitive "animal spirits" - a particular sort of confidence based on herd mentality. Thus, when the government shows increased determination to prevent the country's much-needed industrial structure adjustment from being interrupted by the excessively prosperous capital market and began to funnel a flood of bank loans into the real economic projects, the previously stimulated "animal spirit" among investors has been finally overwhelmed by their pessimism. However, any loosening of monitoring of bank lending will once again inflame the irrational animal spirits in the stock market. That would be extremely unfavorable to the healthy development of the stock market.

For a rational and healthy development of the country's capital market, the increase in share prices should be mainly based on people's confidence in the country's new economic growth model.

The author is a vice-president of the School of Economics under the Shanghai-based Fudan University.