1. Introduction

Once I read an article about China's stock market. I asked myself why the Chinese Communist Party ("CCP") allows the existence of stockmarket in their country ?

The reason I asked that question was not because there is contradiction between communism and stock market. It is very clear to me that the CCP has thrown communism out of the window. The CCP is a staunch believer of capitalism, no matter what they call it. Period.

The reason I asked that question was because I have long noticed that the CCP is a CONTROL FREAK. They operate under a siege mentality. Whenever they look out of their windows, they saw themselves being surrounded by enemies, imaginary or real, waiting to introduce chaos into their system, destablise them, subvert them.

Everything in China exists for a reason, nothing is taken for granted. The Special Economic Zones, the limited convertibility of Renminbi, censorship of internet, etc, all are carefully designed with one thing in mind - how to insulate the system from exogenous shocks and preserve the rule of the CCP. Among all the things, stability is of paramount importance.

Having been through the 1997-1998 Asian Financial Crisis and witnessed the chaos brought about by the collapse of the stockmarket, it is only natural for me to wonder why the CCP is not afraid of the same thing happening to them ?    

I pondered about the question and finally figured out some useful points.

2. What Actually Happens In Stockmarket ?

Have you ever wondered why you can make money from stockmarket ? When the stock market is bullish, EVERYBODY makes money. How can that be possible ? Where does the money come from ?

I can understand if I make money in casino. The guy next to me lose his money to me. I am richer because his money becomes my money.

What actually happens in the stock market ? Whose money makes us richer ? Let me explain.

During normal time, money exists in the form of cash (fixed deposit in banks). Cash is a type of asset that has a tame personality. The ownership of this asset does not make you "high". Many people have it and they barely notice it. Everyday, people are busy with their works, their kid's school results, their health, etc. Nobody will flip open a newspaper after dinner to read about fixed deposit.

However, things get interesting when a country's economy is perceived to be doing well. The feel good factors will induce money to flow from the humble fixed deposits to something called "stocks".

Stocks has a very different personality. It makes you "high", like what illicit drugs do to you. When stocks fly, you feel you are a ten feet tall giant. You grow super confident. You mock and laugh at your fellow members in i3. You pull out your wallets and start spending. You buy new cars. You donate more to charity.

Other than that, NOTHING has changed as far as a country's economy is concerned. There is no addition of wealth even if many people have "become richer". Unlike in a casino, NOBODY lose either. The only thing that has happened is that wealth now exists in the form of stocks instead of cash.

The same is true when a market crashes. There is no destruction of wealth. It is just a matter of money flowing back from stockmarket to fixed deposit. Everybody wakes up with a huge overhang. Other than that, all are very much alive and kicking.

Being a control freak, the CCP probably has gone though the same thought process as me. Once they figure out those points, they realise that IT IS OK TO HAVE A STOCK MARKET. There is no risk that a stockmarket will make a country bankrupt.

But the story does not end there yet. They are still some loose ends to be tied up.

3. Open vs. Closed System

In the section above, it was establish that a stockmarket is a harmless creature. It merely moves wealth around within a system. No matter how bad the market crashes, it will never pose an existential threat to a country.

However, that is only true if it is a closed system - a system without foreign participation. 

In an open system, foreign funds are allowed to particpate in the stock market.

Then it is a slightly different story.

If those funds are good market players, when they exit, they will bring huge amount of profit wih them out of the country. The leakage of such huge wealth will have a tremendous negative impact on the host country's financial well being. It is like your family suddenly lose RM5 mil in a business venture, you will immediately feel the chilling effects of wealth reduction. Many things that you can do previously, you cannot do now. 

India is probably a good example of an open system. I briefly studied the country before. Unlike Malaysia, China and several other East Asian countries, India does not have huge trade surplus. As a result, it relies quite heavily on foreign portfolio inflow to finance its economic activities. Whenever foreign funds leave the country, there will be a noticeable effect on interest rates. This will in turn has a negative impact on many sectors of the economy.

(Malaysia allows foreign funds to invest in Bursa. However, due to our healthy external position, we have abundant liquidity in the system. As such, our financial system rarely feels anything even if there is an exodus of foreign funds, as what happened recently. In a certain sense, our system is not exactly "open", it is quite insulated from external shocks)

4. Concluding Remarks

These few days, the volatlity of Shanghai Composite Index made many equity investors jittery. 

In my opinion, there is no need to be unduly worry about that.

China allows very limited foreign paticipation in its stock market. As such, any crashes will only affect the economy slightly as negative wealth effect dampens consumers' sentiments.

Other than that, there will be no lasting effect on the health of its financial system and economy (which is one of our largest trading partner).

Don't worry, party on. The night is stil young.