Can China Defuse Its Stock Market?

Index futures might create stability, but Beijing fears they could prick the bubble

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Here's a surefire recipe for a stock bubble: Take blistering economic growth, throw in strong corporate earnings, add artificially low interest rates, and stir in a dash of inflation. Then rule out any viable investment opportunities besides equities, and you'll quickly find yourself moving past "pop" and into "kaboom" territory. That pretty much sums up the situation in China, where 250,000 new retail investors are crowding into the market every day. Together, the mainland's 70 million traders have pushed Shanghai's benchmark index up nearly 50% since the beginning of the year, following a 130% gain in 2006.

Beijing is terrified of what might happen when that bubble bursts. Many investors are pensioners and other jobless people who have plowed their savings—and sometimes even funds raised by mortgaging their homes—into stocks. If the market tanks, Beijing fears, it could dent consumer confidence and send disgruntled investors out into the streets. The rest of the world, meanwhile, is worried that any collapse would quickly spread to exchanges across the globe.

Financial experts say there's a way China could create greater stability: stock index futures. Sophisticated traders in developed markets use these wagers on the direction of shares to cushion themselves against massive losses if the market falls. Futures also theoretically dampen volatility as more pricing information is factored into investment decisions. China currently has no equity derivatives such as stock options and futures, and short-selling stocks—betting that the price will go down—is banned. That means people can make money only in a bull market, and have no choice but to cut their losses when prices tumble. And if everyone rushes for the exits, shares go into a tailspin.

DELAYS AND DOUBTS 
Beijing understands this and had originally hoped to introduce index futures this spring. Now the launch has been delayed until at least September. The reason: While futures might eventually create more stability, in the short term investors who don't fully understand the concept might get spooked and start selling their shares. "There is a commonly held belief, which is wrong, that the introduction of futures causes underlying stocks to fall," says Fraser Howie, who manages the China portfolio for CLSA Asia-Pacific Markets. "The authorities are concerned about anything that could pop the bubble."

There's a second fear. To work well, futures markets require transparency, ample safeguards against insider trading, and a sophisticated investor base, all of which are glaringly absent in China. While futures can smooth out the bumps in the market, they also let traders leverage their bets, increasing their potential profits—but also the risk of bigger losses if they get it wrong. "Futures won't achieve what the government is trying to do," says Carl Walter, managing director at JPMorgan in Beijing. "They may even cause more volatility."

Previous Chinese experiments with financial futures haven't been particularly auspicious. In the early 1990s, China introduced bond futures but abruptly halted trading in 1995 after a securities company, acting on bogus insider information, lost billions of dollars on futures, driving itself into bankruptcy and landing its CEO in jail. Since then, trading in most derivatives has been banned, though futures contracts for commodities such as copper, soybeans, and corn are traded on three exchanges.

Lately, the new China Financial Futures Exchange in Shanghai has been experimenting with derivatives again. Last fall the exchange began simulated trading of futures based on an index of 300 companies and has been conducting education seminars around China. While nearly 100,000 people have taken part so far, experts say their behavior doesn't necessarily indicate how investors might actually use futures. In tests, traders "don't seriously look at the profit and loss," says John P. Davidson III, corporate development chief at the Chicago Mercantile Exchange. Putting real money on the line, though, might just be the recipe for reining in China's wild markets.