Folks, China is about to play one of the most dangerous games in finance…
Its government is planning to restrict capital markets in an unusual way. The idea is that this will slow the terrible stock market declines taking place there.
But it’s a fool’s errand. And history makes that clear.
In fact, countries like Spain, France, Italy, and South Korea have tried this before. Crazier still, even the U.S. has tried it… and it didn’t work.
The reason is simple. What China is trying to do here is really about restricting speech… or the freedom to communicate how investors feel about particular stocks.
If that sounds a little strange, don’t worry. I’ll explain the details today…
Right now, China’s stock market is in the midst of a massive $6 trillion rout that began back in 2021. And this past weekend, to try to prop up the market, the Chinese government announced restrictive measures on short selling.
As you probably know, short selling is betting against a stock in the market.
To do it, investors borrow shares of a stock and plan to sell those shares later with the hope that the price will fall. Then investors will repurchase the shares at the new lower price.
The difference between the initial sale price and the repurchase price creates the gain or loss, depending on how the trade works out.
Now, some folks argue that the borrowing and subsequent selling of shares creates artificial downward pressure. To a small extent, that’s true. After all, share prices tend to move lower when investors sell.
But fundamentally, we’re talking about an expression of opinion here.
Short sellers believe so strongly that a stock is heading down that they’re willing to take out a loan by borrowing shares… just to bet against it.
If anything, that’s some of the most valuable information a freely trading market can get. And that’s why short interest is one of the 20 factors we use in the Power Gauge.
But most important, China should know this won’t work. That’s because other countries have tried it before… and it didn’t work for them.
In September 2008 amid the financial crisis, the U.S. banned short selling. The government hoped that this would stop the market’s collapse.
As we all know, the ban didn’t stop the market slide. Stocks didn’t bottom until the next year.
After all, short sellers didn’t cause the financial crisis. It was the housing and debt crisis and the bad assets it created. Short sellers were simply expressing their opinion about certain stocks and the broad market.
The U.S. plan worked so poorly that the government lifted the ban early…
Now, you would think China would know better. After all, do you think Chinese stocks are in freefall because of short sellers… or because something is wrong in the markets over there?
Well, as I said earlier, the Chinese stock market is in trouble. And with the short-selling restrictions, the government is trying to stop the bleeding. It’s a big mistake.
The government doesn’t have a real solution. But, instead, it can punish those folks betting that Chinese stocks aren’t done falling.
I’m sure economists have told the Chinese government that this won’t work. But the idea of “betting against your country’s stocks” just infuriates some people.
That’s where China’s market is at now. It’s doing so poorly that the government says it’s illegal to bet against it.
This isn’t a good sign. I would steer clear of Chinese stocks while this plays out.
Good investing,
Vic Lederman
