Add Bangladesh, January 2011, to the litany of failed government attempts to "stabilize" a falling stock market. The regulator in Dhaka, the Securities and Exchange Commission, has spent the last few months trying to support prices. The predictable result of these efforts has been greater instability and uncertainty for all parties.
Angry investors burned by the mass market selloffs have taken to the streets, most recently in riots last week. And one can hardly blame them, since late last year Dhaka encouraged shareholders to believe that the government would protect them from losses. Instead the carnage has continued. On Jan. 10, the Dhaka stock exchange's index dropped 660 points, or 9%, in an hour.
Bangladesh's stock market started booming in 2009 and rose 80% in 2010, luring even villagers with the promise of making a quick buck. Like other manias, this one had a familiar culprit. Credit was cheap, and with few other avenues of investment open, money flowed into stocks.
Some investors realized last year that the market was overvalued and began to sell, but the SEC had other ideas. To prevent a sharp selloff, the regulator made it cheaper to buy stocks on margin. That worked for a time, but it sowed the seeds of a bigger decline.
That came in December, when the central bank suddenly hiked banks' required reserve ratio in a belated attempt to rein in lending. Encountering higher borrowing costs, companies and investors sold stocks en masse.
That only drove the SEC to more desperate measures. It had to shut down trading four times in 10 days this month, and it closed its exchanges for two whole days. Last Wednesday, it installed circuit breakers to suspend trading if the benchmark index moved more than 225 points. But this worsened the panic; the next day, the market fell 600 points in six minutes. The SEC removed this control yesterday.
Dhaka might have saved itself the trouble by allowing the market to clear and find its natural bottom. As long as the government is artificially supporting prices, those looking for a cheap buy are naturally reluctant to step in. This often causes prices to fall further.
If governments feel compelled to respond to market cycles, their best option is to undertake reforms that help promote future earnings, thus restoring market confidence. Bangladesh's economy has been growing at around 6%, but the government could still disinvest more from state enterprises and increase access to natural resources.
Dhaka could also help stabilize the market by introducing short selling. When investors can bet against a stock, price discovery is more efficient. During a boom, short selling can temper the euphoria. And sudden falls can be softened as the short sellers buy to close out their positions.
But the best way a government can promote a healthy and more stable market is to make clear that it will not socialize the risks of investors. When shareholders know that they alone must take responsibility for their decisions, they are bound to be more prudent about where they direct investment. And that ultimately is what a stock market is supposed to be about.
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