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China's Fine, but Beware the Stocks

There were tell-tale signs of China's stock market implosion.

So what else did anyone expect?

The Shanghai stock market blew up today, dropping almost 9%. That was the biggest drop in the Shanghai index in a decade, and it wiped out more than $100 billion in stock market capitalization.

No one should be surprised. And no one should think this has anything to do with a slowdown in China's economy.

The Shanghai market was a stock speculator's wildest dream come true, with that speculator's worst nightmare waiting in the wings. The game was fixed, and everybody knew it. While it lasted, the profits were too good to pass up -- the Shanghai index was up 170% since mid-2005. Every investor hoped to be first out the door when the day of reckoning came -- exactly the kind of rush to the exits that took place on Tuesday.

Tale of Two Markets

Notice I say the Shanghai market and not the Chinese stock market. Not all of China's stock markets panicked. On the same day that the Shanghai Composite Index fell 9%, Hong Kong's blue-chip Hang Seng Stock Index lost just 1.8%.

This isn't a one-time differential, either. On Jan. 12, the Shanghai index fell almost 4% while the Hang Seng actually climbed by more than 1%.

Think the difference might have something to do with the peculiar nature of the Shanghai (and the smaller Shenzhen) stock markets? The Shanghai stock market is essentially a domestic market for the A shares of China's publicly traded companies: Overseas investors are by and large not allowed to buy and sell A shares (although the rules have been relaxed a bit lately).

Who makes up this domestic stock market?

By numbers at least, individual Chinese investors. About 82 million Chinese now have stock trading accounts -- that's about 1 out of every 20 Chinese -- and the numbers of individual traders have been growing at an ever-accelerating rate.

Last year, 2.4 million investors opened new accounts and began trading on the Shanghai stock exchange. In January, 1.3 million Chinese opened new accounts. This influx of new domestic investors -- and new domestic money -- has been key to pushing domestic stock prices higher and higher.

Higher, even, than the share prices of the very same companies on more-international markets such as the Hong Kong exchange. In early February, out of the 37 Chinese companies listed on both the Shanghai and Hong Kong stock exchanges, eight traded in Shanghai at twice the valuation that they had on the Hong Kong exchange, according to a recent study by JPMorgan Chase.

Just Like Capitalism

That's because the true big dog on the Shanghai and Shenzhen stock markets, the Chinese government, has acted to restrict the supply of shares on the domestic stock markets. The Chinese government still owns majority positions in most of the companies that trade on these exchanges. Some figures say the government owns about two-thirds of all the shares of companies that trade on the domestic stock market.

That gives the Beijing government power over any rally. The government could stop any stock market boom dead in its tracks simply by selling its immense shareholdings. That would add enough supply to the market to overwhelm even the fast-growing demand from individual investors.

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Of course, the government has a vested interest in not crushing domestic share prices. The biggest winners in the stock market rally of the past 18 months have been the wealthy elites of the Communist Party and the Beijing government, as well as the entrepreneurs and corporate managers connected to those officials. Fortunes have been made by corporate managers -- who officially receive meager salaries -- from stock options that have soared in value during this market run.

The overnight stock selloff in China is reigniting fears that the country's economy could slow down and, in turn, affect the U.S. economy.

The stock market has become a prime tool for passing a big hunk of the country's growing wealth to the elites whose support the Communist Party needs to maintain its hold on power. (You'll be excused if you think this is strikingly similar to how capitalism works in overtly capitalist countries.)

But the government also doesn't want the stock market boom to get too far out of hand. Too much wealth in too few hands will stoke the resentment that those left behind in China already feel. It also contributes to inflation and could produce exactly the kind of economic bust that the government desperately wants to avoid in the run-up to the 2008 Beijing Olympics.

A Toe on the Brakes

So the government has taken steps to damp the stock market boom. For example, margin lending -- borrowing on stocks in order to buy more shares -- has been restricted. Banks have been required to keep higher reserves, cutting the amount they have to lend.

But the biggest changes have been in regulations that cover all those state-held shares. Under the old rules, the government sold its shares in bulk on the basis of their net asset value instead of the much higher market price. That meant the government could either sell shares below market prices -- in volumes large enough to crush a stock and devastate the portfolios of the economic elite -- or do nothing. Not surprisingly, the government did nothing.

New rules that are being drafted now would require the government to sell its shares at market prices and in smaller lots no larger than 5% of the government's position. (Larger sales would require special permission from the state-owned Assets Supervision and Administration Commission.)

Because the new rules make limited selling less disruptive to the market and to the interests of the country's elite investors, it's logical to see the rules as the first step toward greater government sales of shares and a gradual decline in share prices until they are at par with those on the Hong Kong exchange.

Savvy investors in China -- those who work inside the government and corporate structures -- know how this can work. They've circled next week's National People's Congress on their calendars as the date when the new rules and a policy of greater government sales of shares could be announced. They know that in this meeting in 2005 Premier Wen Jiabao voiced concern about declining share prices, and that a few weeks later the government put into effect new rules on stock ownership that sparked an 18-month rally.

So the elite decided to hit the door first. Other investors, watching them, joined the rush. Soon the market was down 9%. And other markets joined the tumble as hot-money speculators there rushed for the door, just to be safe.

As I said, nobody should be surprised.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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