September 2, 1998

An Investment Opinion
by Louis Corrigan

Short Sellers Make Free Markets

American Depositary Receipts (ADRs) for numerous companies traded on the Hong Kong market enjoyed nice percentage gains today after the blue chip Hang Seng index shot up 293.2 points (or 4.2%) to 7355.67. At their highs, Jilin Chemical (NYSE: JCC) had gained $5/8 to $4 3/8, Shangai Petrochemical (NYSE: SHI) had rocketed $15/16 to $7 1/8, and Beijing Yanhua Petrochemical (NYSE: BYH) had added $1/2 to $3 1/4.

Unless you actively invest in emerging markets, this news probably isn't very exciting. The Dow's rally helped pump up the Hang Seng, allowing some stocks that had been slaughtered to bounce off their lows. Big deal! But the story's a little more interesting and potentially quite troubling for U.S. investors who now understand that the global economy's interconnections run through the even more sensitively intertwined financial markets. That's because today's rally in Hong Kong was partially triggered by new crisis-prevention measures that suggest this once vibrant financial market is becoming increasingly troubled.

To thwart speculators, the Hong Kong exchange today temporarily banned short- selling in three of its largest issues: Hong Kong Telecommunications (NYSE: HKT), China Telecom (NYSE: CHL), and HSBC Holdings PLC (OTC Bulletin Board: HSBHY). Traders hurried to cover their positions, sending these stocks up 8.6%, 11%, and 5%, respectively, in Hong Kong trading. According to news reports, this short-squeeze played a significant role in the Hang Seng's rally.

The crackdown on shorting followed Tuesday's action by the Hong Kong Securities Clearing Co. requiring that trades be settled -- that is, shares actually delivered -- two days after execution. Short-sellers sell borrowed shares hoping the stock will fall so that the shares can be bought back later at a lower price. Most U.S. investors (with the exception of market makers and NYSE specialists) must secure borrowed shares from a broker before a short trade can be executed. That rule apparently doesn't apply in Hong Kong. And given the heavy shorting last week, the change in the settlement date presented a serious burden. Indeed, as of yesterday, there were between 30 million and 110 million shares of each of the three affected stocks that had not been delivered on time.

One could argue that the stock exchange was simply reigning in speculation run wild, but the shorts had entered the market with such conviction partially because the Hong Kong Monetary Authority has over the last two weeks aggressively intervened to support the currency and the stock market. (Indeed, the monetary authority reportedly owns almost 9% of HSBC after the recent purchases.) This artificial stimulus left some potential buyers hesitant to enter the market since they remained uncertain of the "natural" market prices. Put another way, Hong Kong authorities today seem to have cracked down on speculation that their own recent intervention exacerbated by preventing market participants from working out the proper levels for themselves.

The concept of "free markets" is, of course, deceptive. Free markets are constructed through a host of complex rules, some of which allow for various forms of government intervention. The U.S. Federal Reserve, for example, regularly intervenes to adjust the money supply. And for years, Japan's government induced Japanese banks to support stock prices. Moreover, even the esteemed M.I.T. economist Paul Krugman recently suggested in Fortune that some decimated Asian economies would be smart to temporarily adopt currency controls. (Krugman also expressed support for the currency controls instituted today by the Malaysian government.) In other words, even free market advocates can believe that turning away from free market capitalism today may offer the best means for embracing it later.

Nonetheless, free marketers generally believe that the world economy is stronger to the extent that the leading economic powers are willing to answer to the market's discipline. Investors just don't like it when a country veers too far from its own specific commitment to free market capitalism because it suggests a certain amount of desperation. Speculators can smell desperation. And the recent actions by Hong Kong authorities -- especially the crackdown on short selling -- reeks. Shorts ensure a vibrant market that is free to respond honestly to economic realities. Reigning in short-sellers is the best way to foster an unsustainable bubble. That's why investors should worry about even the limited action taken today in Hong Kong.

Consider the NYSE's last major experiment in curbing short selling as a means of turning back a panic. Back on September 21, 1931, prior to the implementation of the securities laws that now structure our markets, the exchange was facing a financial crisis. The British government had abandoned the gold standard the day before and stocks were pummeled on the Paris Bourse, the only European market that had managed to open. The governing committee of the NYSE decided that it needed to provide buying pressure to support the expected sell-off, so short selling was suspended until further notice.

As NYSE president Richard Whitney said a month later, the committee believed that "a sudden ban on short selling would be likely to force covering by those who were short, thus steadying the market temporarily until the immediate shock of the London news could be dissipated." Over the next three days, speculators covered 1.4 million of the over 4 million shares short at the time, and the market stabilized.

Yet shorting was permitted again starting on September 24, and the market steadily declined over the ensuing two weeks. As Whitney put it, the "more cheerful appearance in the market" resulting from the halt in shorting "was not the glow of natural health but the flush of artificial stimulation." Indeed, it's interesting that the number of shares short actually dropped along with the market, standing at 2.6 million by October 5. So the market's decline over this period wasn't due to renewed shorting. Rather, it seemed to be a response to both the actual economic uncertainty and the destabilizing stimulation of the short selling ban itself.

"Within two hours after short selling was forbidden," Whitney said, "the Governing Committee found there was a real danger of technical corners and crazy and dangerous price advances." One stock opened at $48, shot up to $75, and then declined to $62. "Something had to be done immediately or otherwise the buyers would have bid frantically for the stock and a rapid and entirely unwarranted advance would have taken place," Whitney said.

In fact, the market was so volatile that even during the official suspension of short sales, the exchange did in fact permit some on a case-by-case basis simply to ensure liquidity in the market. As Whitney concluded, "These facts prove that a prohibition of short selling could not be enforced for even two hours without creating an unnatural and dangerous market."

Hong Kong today is not New York in 1931. The recent events in Hong Kong may prove nothing more than minor plot points in a continuing saga of global financial uncertainty. But just as miners don't want to see the canary snuffed out, investors should worry when shorts start getting shafted. We need regulators to foster potentially "unnatural and dangerous" markets about as much as a heart patient needs Viagra.