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China Becomes More Free-Market Than Europe, Sort Of

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I guess it's time for me to stop being amused when China does not-especially-Communist things, but still, I giggled a bit when I saw that China is liberalizing its short-selling rules at around the time that Western Europe is tightening its rules. Because freedom on the march, or whatever, though as David Keohane at FT Alphaville points out, China's short-selling thingie is pretty solidly in the state-sponsored capitalism camp.

It's not entirely clear to me why China is liberalizing its rules; the answer seems to be "so that financial institutions can make more money charging hedge funds for stock borrow," which I guess. Another possible answer could be loosely of the form "China is tired of Americans and Australians making all the money shorting Chinese fraud companies and wants domestic investors to get a crack at that action." More generally, if you have capital markets beset with fraud, you want to provide incentives to catch that fraud. And if you're looking to get foreign capital and are worried about embarrassing incidents, it's nice to have at least some of those incidents taken care of within the family - by Chinese speculators catching Chinese frauds - rather than being exposed to the wider world.

Of course the same incentives exist in Europe, where companies with pretty opaque balance sheets bounce around not telling you whether their balance sheets are filled with fake trees, in the form of Greek bonds, or real trees, in the form of, I don't know, Swiss francs. Which is why lots of people aren't that keen on short selling bans on financial stocks in Europe. And yet European regulators seem to disagree. Let's strain ourselves to justify that a bit shall we?

NBER recently put up this paper by Philip Bond of Minnesota and Alex Edmans and Itay Goldstein at Wharton and Minnesota about "the real effects of financial markets." The organizing idea here is that secondary financial markets (that is, markets for the trading of existing financial claims, not the new issuance of stocks and bonds) have an effect on the real economy because they send price signals to "real decision makers" that encourage them to do or not do things with their companies, and those decisions have an effect on the values of the companies. Much of the paper is literature review; here is a thing they say about short selling:

Goldstein and Guembel (2008) consider a model where the manager of the firm learns from the stock price about the profitability of an investment project. Due to this feedback effect, manipulation arises as an equilibrium phenomenon. A speculator realizes that if she drives the stock price down, even when she has no information, the manager might cancel the investment since he thinks that the price decrease may have been due to negative information. Since the cancelation is based on no actual information, it reduces firm value, allowing the speculator to profit from her short position. Interestingly, the effect cannot work in the opposite direction. If the speculator buys without information, she causes overinvestment, which is also bad for firm value, and so she loses from her long position.

For those keeping score, two of the three authors of this paper also wrote another paper that we mentioned a while back that sort of argues the contrapositive: if you do have information, and managers listen to secondary prices, you can make money long but not short - because if you send an informed signal saying "don't do that merger" by shorting the buyers' stock, its managers will listen to you and not do the merger and their stock will recover and then where will you be? Nowhere, that's where.

Anyway this is all sort of interesting stuff and useful to have in your mental toolkit when you think about efficient markets and whatnot. But it's also worth recognizing that it's all just a little bit fake and airy-theory-y. Do managers care about their stock price, particularly when much of their net worth is in options and RSUs? Sure. Do they regularly abandon projects because of stock price reaction? Seems less likely. What that means in practice is that short selling is unlikely to have real-economy effects negative (uninformed manipulation!) or positive (informed price signal!); the big real effects are likely to come instead, if at all, when short sellers go public to talk about fraudulent or otherwise crap companies so that their prices fall and they make money. And in fact there's not a lot of reason to believe that robust short selling leads to lots of manipulation.

But that breaks down maybe just a bit if you're in an industry where it's hard to separate "real business" from "secondary market." Say a business where your funding comes mostly not from long-term instruments that are sent out into the world to eventually find their way into the arms of loving investors who will hold them and love them forever and aye, but from instruments that investors can DK at any time, or at least once a day. That's - hey, that's kind of the financial industry! That's an industry where you actually can manipulate the real world through secondary markets, because driving down a bank's stock price or driving up its CDS sends a signal, not to its managers but to its investors, that shit ain't right. And since its investors are creatures of the market, they do things like, y'know, drive up the cost of a bank's credit just because of little things like its CDS spreads going up or its stock going down. Or something. And, while a forestry company more or less stands or falls on the number and quality of its trees, a bank is pretty much its cost of credit - so the shorts don't have to be "right" in the beginning to be right in the end.

Maybe. You can definitely argue with the causation there, and there's not much more evidence that short selling manipulation is prevalent in financials than there is in non-financials. But, y'know, tell that to Dick Fuld. Or George Papandreou or the late lamented Silvio Berlusconi.

If China is liberalizing its secondary market in order to improve efficiency by shining a light on fraud, that seems like a straightforwardly good thing, because people seem to be looking for frauds in forest and software and other industries not so much susceptible to runs on the bank. If Europe were into shining more light on its capital markets - well, we certainly wouldn't object. But since everyone's looking for shadiness in one place in Europe, and since that place is one place where noise in short selling could at least theoretically swamp information, you can understand why the Europeans are being just a bit more anti-capitalist than the Chinese.