The Chinese stock markets plummeted Monday in the biggest one-day drop since 2007. The Shanghai Composite Index fell 8.5 percent, weighing on Japanese, Hong Kong and U.S. markets. The trend is raising doubts about the effectiveness of Beijing’s recent efforts to prop up the market, as well as the health and direction of the world's second-largest economy.

The Chinese government has gone to huge lengths to support its volatile stock markets in Shanghai and Shenzhen, which climbed to dizzying heights in mid-June and then shed about a third of their value over the following month.



By early July, the Chinese government seemed to have halted the carnage by announcing a truly massive array of measures to support the market. It encouraged banks and other financial institutions to increase lending to investors, froze initial public offerings, cut interest rates, forced state-owned companies and funds to buy shares, and threatened to prosecute short-sellers. At one point, over half of the listed companies on the exchanges had suspended trading in their shares to stem further losses. The state-owned China Securities Finance Corp pledged to loan 21 securities firms about $42 billion to purchase shares.

The reaction has left the Chinese government heavily invested in its own stock market. The China Securities Finance Corp had borrowed a stunning 1.22 trillion renminbi from commercial banks to buy stocks as of July 13, according to financial media Caixin, and is now one of the top 10 shareholders of many listed firms, Chinese media reported last week.

But Monday’s precipitous drop shows that even these extreme measures haven’t been successful in restoring investor confidence. “The lesson from China’s last equity bubble is that, once sentiment has soured, policy interventions aimed at shoring up prices have only a short-lived effect,” a report from analysts at Capital Economics said.

Nick Lardy, a senior fellow at the Peterson Institute for International Economics who studies China, says a correction has been inevitable. Price-to-earnings ratios in China -- a measure that indicates whether a company is fairly valued -- have been well over 100 this year, in the neighborhood of values on the Nasdaq when the U.S. dot-com bubble burst, Lardy says. “As in all corrections, it’s a matter of not if but when.”

The trend shouldn’t come as a surprise. China experienced a similar stock market boom and bust in 2007 and 2008. In 2007, as the stock market climbed to dizzying heights, analysts claimed that Beijing wouldn’t allow the stock market to crash before the 2008 Olympics, which was widely seen as China’s coming out party. But despite government efforts to support stocks, about two-thirds of the market’s wealth was wiped out between Oct. 2007 and Oct. 2008.


The Opening Ceremony for the Beijing 2008 Olympic Games on August 8, 2008 in Beijing, China. (Photo by China Photos/Getty Images)

This time around, the impact of Chinese stock market volatility on the broader economy is fairly limited, said Lardy. Chinese stock markets aren’t nearly as developed as Western ones. Lardy says that only about 10 percent or slightly less of Chinese households have direct exposure to the Chinese market. That compares to about half of Americans.

But the Chinese government's response to the stock market is evidence of a more worrying trend, according to many analysts. In a market economy, financial markets are supposed to play an essential role of distributing financing to the worthiest companies and risk to those investors who are willing to bear it. As its latest response suggests, Beijing appears to have little interest in letting Chinese stock markets play this role.

Scott Kennedy, a China expert at the Center for Strategic & International Studies, says the government's efforts are not primarily directed at small, individual investors. The government wants to prop up the market for two reasons, he says: to protect the banks, which have extended hefty loans to investors, and to support state-owned companies, which get financing through the stock markets.

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Kennedy says Chinese leaders have had difficulty reconciling the logic of the market – that “when the market goes up you win and when the market goes down you lose,” he says – with “the basic logic of Chinese regulatory style.” Chinese officials are used to turning the taps on and off for certain parts of the economy -- those that are strategically or politically important. “Securities markets are really tough for them, because you’re supposed to treat all investors the same,” he says.

Barry Naughton, a professor of international relations at the University of California, San Diego, suggests the response is also partially an effort to save the government's credibility. China's state media and propaganda department painted the stock market increase as evidence of the success of China’s new administration, Naughton says. That left the regime on the hook when the market started to fall.

“When things started to correct, there was a sense among the political leaders that this is really bad, not just for the pure economic reasons, but because it presented a challenge to the official narrative of Xi Jinping’s being the face of a new, more successful and more confident China," says Naughton.


Chinese Vice President Xi Jinping and U.S. counterpart Joe Biden, not in the picture, attend a meeting with U.S. and Chinese business leaders at the Beijing Hotel in Beijing, China Friday, Aug. 19, 2011. (AP Photo/Lintao Zhang, Pool)

Despite the government's heavy-handed response to the stock markets, China continues to carry out important economic reforms that will allow its economy to grow, experts say. Lardy points out that China has taken steps in recent months to open up the state-dominated oil sector to private companies and internationalize its currency.

Economists widely believe that reforms are necessary to encourage the growth of China’s economy, which has been slowing in recent years.

But the government's outsize efforts to prop up the financial markets point to lingering issues with China's attitude toward markets. As Citi analyst Mark Schofield pointed out in a note on Monday, the government's response may promote moral hazard -- encouraging investors to take more risks in the future because they know the Chinese government will jump in and save them -- as well as the misallocation of resources.

Free markets are supposed to be designed to direct financing to the worthiest companies. If the government messes too much with this mechanism, the thinking goes, funds tend to end up where the government wants them, rather than where they're most profitable. And that drags on economic growth.

“[I]t would not be surprising to conclude that these folks are addicted to intervention,” says Kennedy.

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