China’s stock market dropped 5.42% on March 27 on expected government intervention to fight inflation and lower corporate profits. In the National Business Daily, Ye Tan argues that the government should not put the nation’s stock markets at risk in the hope of saving the economy

The benchmark Shanghai Composite Index dropped below the psychological 3,500 point barrier on March 27, reaching an intra-day low of 3,407 points. It was reminiscent of the tumbling market on May 30 last year when the government hiked the stamp tax on stock trading from 0.1% to 0.3%. Market confidence has collapsed. [The index lost 5.42% on March 27 to close at 3,411.49, which was its lowest close since April 9. On May 30 last year, it lost 6.50% to close at 4,053.09 points – TCP.]

We cannot use as an excuse that it was a natural market correction. The stock market of the world’s largest developing economy is falling at a pace much faster than the speed the US sub-prime crisis wrought havoc across the globe. The collapse came after an intentional effort to suppress the market.

China’s economy needs a stable capital market. It would be a deadly mistake to think reining in the hectic Chinese economy and suppressing its stock market can ease inflationary pressure. On the contrary, the Chinese economy needs a highly efficient capital market to help it ride out the pains triggered by economic transition.

China’s demand-driven inflation cannot be addressed by tight monetary policies; the structural problem will best be addressed through more efficient allocation of resources. China will have to bear unaffordable costs if it mechanically applies western theories.

Chinese firms now face financing and tax pressure, and the evidence of this is clear in the latest economic data. The sharp decline in output from industrial firms announced by the National Bureau of Statistics on March 27 sparked market concern over stagnation. China’s economic expansion is mainly powered by industrial expansion but inefficient allocation of resources has chilled industrial output.

Will the battle against inflation come at the cost of an economic downturn and a widespread reduction in manufacturing efficiency and rising unemployment, given that inflationary pressure is still strong and concerns over economic stagnation are looming? Theory and empirical laws do not apply to China’s economic reforms.

Those who propose bursting the bubble always cite the stagnation that afflicted Japan for a decade from the 1980s. But the difference is, Japan was already a world-class manufacturer by then and the Japanese yen was an international currency, through which Japan was able to mitigate against the impact of any currency war.

Suppose Japan had tried to slow its manufacturing industry by regularly bursting bubbles that formed in the capital market during its booming 1960s and 1970s. It is true that the country would never have overheated, but the Japanese economy would have ceased to innovate and Japan’s modernization would have ground to a halt.

Another major risk of an irrationally plummeting market is that China will lose its price-maker status for foreign capital. This crash was led by the blue chip stocks, such as PetroChina, China Pacific Insurance, and Minsheng Bank, all of which slid more than 5%. Baosteel dropped by the daily 10% maximum due to bad financial figures. Other key players, including China Shenhua Energy, China Life Insurance, and China Coal Energy, all reached record lows since their IPO.

What are blue chips? They are the pivot of the Chinese economy, representing the value of China’s key resources. Now the value of these resources are in a mess. The right of China to value its own resources has now shifted to investors with US dollars.

The slump of the blue chips has been an unspeakable journey of value deception. The blue chips are not a benchmark for investment or a stabilizer of the stock market; they are an instrument to absorb grassroots investors and an instrument for foreign investors to control the Chinese market and make money. The plight of these blue chips is more a crisis of the Chinese economy than a crisis of the Chinese capital market.

A sensible solution when stabilizing overall stock prices is to maintain the price premium of the blue chips, control the inflow and outflow of international hot money, and overhaul internal governance of large listed state-owned companies.

There still are people saying the stock crash is acceptable and the Chinese economy has not collapsed. So to what extent is a crash acceptable and how many bankrupt firms are needed to keep inflation in check?

The government should not use the stock market as a tool to cool the economy when the capital market is in crisis. Rather, it should introduce concrete measures, such as a cut to stamp duties and a more mature financial system, to stabilize the stock market to in turn safeguard the transitional Chinese economy.

This article originally appeared in Chinese in the National Business Daily on March 28, 2008. The China Perspective takes no responsibility for the accuracy of the original article