Two weeks ago when I was being interviewed for Dialogue, a local current events show on CCTV 9, I was asked about the sophistication of Chinese investors, and I responded that China does not have a real investor base. The whole market here is speculative, I argued, not because Chinese investors are naturally speculative but rather because the structure of the market does not permit any other form of investing.
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The other guest on the show, the chief economist of a major Shanghai fund, disagreed, saying that Chinese investors are not speculators but are simply investing based on their perception of what the government is going to do. In China, he explained, the only important question for an investor is \’93What will the government do tomorrow?\’94
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He is right of course in his description of the motives of Chinese investors, but he is wrong in saying that this isn\’92t speculative. In fact investing based on perceptions of government behavior is a classic speculative strategy, and it explains why Chinese markets are so inefficient at allocating capital and why, for all the attempts by financial authorities to make local markets more \’93sophisticated\’94, nothing is likely to improve in the near and medium term.
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Basically speaking most investment strategies can be fit within a triangle whose three corners represent the purest form of the three main investment strategies. In one corner, value investment or fundamental investment involves buying assets in order to earn the long-term economic value generated over the life of the investment. In the second corner arbitrage or relative value trading involves exploiting short-term pricing inefficiencies to make low-risk profits. In the third corner speculation takes advantage of \’93technical\’94 information that will have an immediate effect on prices by affecting short-term demand or supply.
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Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently to its more productive use. Fundamental or value investing allocates capital to its most productive use. Speculation, because it involves frequent trading, provides the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply. It also ensures that information is disseminated quickly. Arbitrage or relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence. It also increases market liquidity by combining several different, related assets into a single market. When buying of one asset forces its price to rise, for example, relative value traders will sell that asset and buy related assets, thus spreading the buying.
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China does not have a well-balanced investor base. There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, neither of which is available in China. There are also very few value investors because the quality of financial and macroeconomic information is poor and corporate governance and regulatory frameworks are weak and inconsistent. If we broadly divide information into \’93fundamental\’94 information, which is useful for making long-term value decisions, and \’93technical\’94 information, which refers to short-term supply and demand factors, it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behavior, but in China there is little such confidence. Furthermore, regulated interest rates and pricing inefficiencies makes it nearly impossible to develop good discount rates.
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On the other hand there is plenty of technical information, and as a consequence the vast majority of investors in China must be speculators. Insider activity is very common in China, even when it is illegal. Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate behavior. Markets are illiquid and fragmented, so large price movements can easily be caused by determined traders. In addition, the single most important player in the market, the government, is able and very likely to behave in ways that are not subject to economic or value analysis. One consequence of this is that local markets do a poor job of rewarding companies for decisions that add economic value over the medium or long term. Another consequence is that Chinese markets are very volatile, and this raises the cost of capital for business.
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All investors in Chinese markets must be speculators if they expect to be profitable, and if Warren Buffet moved to China he, too, would be forced to become a speculator. As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism in the markets. In order to change this, Chinese authorities must reduce the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders. They must also improve corporate transparency. They must continue efforts to improve the quality of both corporate reporting and national economic data. Finally they must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.
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Unfortunately, Chinese financial authorities are not reducing, but are in fact increasing, the importance of technical information related to government activity. In recent months the importance for investors of predicting government attitudes to the markets has actually increased. The authorities are caught in a tough position, because they are worried about a bubble in the stock and real estate markets, but their inability to keep their hands off the market is actually seriously undermining the development of a balanced investor base by reinforcing the perception that only the government matters. This will continue to be a largely speculative market for many more years.
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