The measures taken went far beyond just issuing threats to dissuade short-sellers. Intimidating short-sellers is an age-old tactic. Every regulator calls them criminals when conditions turn bearish. (Nobody targets bulls with similar vehemence in bubbly situations).
However, the lock-in that prevents anybody holding a stake of five per cent or more from selling at all, is very unusual. So is a freeze of the primary market along with the cancellation of all pending IPOs. And, it is to my knowledge the first time that the managements of 1,500-odd listed companies "voluntarily" asked for trading in their respective shares to be suspended.
Other pro-liquidity measures were also extraordinary. The central bank not only cut interest rates and reserve ratios; it announced a credit line to traders, in effect investing in shares. This is a tactic last attempted during the Great Depression.
China was already highly-leveraged. The leverage ratio was raised, allowing speculators to use smaller sums. Traders were allowed to offer real estate as collateral. Brokerages were nudged to form a bull consortium that committed to pumping $19.4 bn into Shanghai with a one-year lock-in.
As of now, indices have stabilised. But roughly three-fourth of listed stocks are not being traded. The distortions introduced in the past fortnight will not go away in a hurry. China has done its best to turn the Mainland market into a one-way bet.
The problem is, one-way bets don't work. The trading of risky assets has to be a two-way game. Or else, liquidity disappears as counterparties become reluctant to absorb losses. It doesn't take a background in game theory to understand why.
If you think the market will go up, you will want to buy. But there has to be somebody who thinks the market will go down and therefore, wants to sell. If everybody knows the market will go up, why would anybody sell? Supply dries up.
The current situation in Shanghai-Shenzhen also makes it difficult for somebody to sell, in case they want to. Let us assume a stock trader holds a highly leveraged, profitable long position. He would like to unwind and book profits. Remember there are at the least, opportunity costs involved in sitting with margin blocked in the market.
Right now, positions are hard to liquidate. Many shares are not being traded. Or, if they are, the position has hit the five per cent ownership limit. If a trader tries to offer shares at a lower price than the last quote, he is liable to be arrested as a short-seller in the current atmosphere. Things are even worse for a leveraged trader with a losing position because he will not be allowed to book losses!
The moment it is allowed therefore, leveraged traders will try to unwind positions. That means there is an impending crash waiting to happen if curbs are lifted soon. But if curbs are retained for any serious length of time, desperate traders will negotiate off-market deals offering positions at discounts to free up margin. This will inevitably mean more entanglement with the shadow banking system.
The long-term effect of these measures would be to engender a suspicion of regulatory authorities. There could be far-reaching consequences. As much as 80 per cent of Mainland market capitalisation is owned by households.
Will the average Chinese household remain as enthusiastic about stocks if their savings are locked forcibly into equity? People enter the market because they hope to make profits. But they also hope to be allowed to book those gains. A stock exchange is not supposed to resemble Hotel California. It should not be a place where you can check out anytime but you can never leave.
Twitter: @devangshudatta