In an experimental move to reform the domestic stock market, China's regulators said last week that it will soon allow investors to short sell stocks and buy on margin, following a recent decision by financial authorities to charge taxes on income from transactions on nontradable shares.

For the past four years, China has been considering margin trading, in which people borrow money from brokerage firms to invest in stocks, and short selling, in which investors borrow stocks from brokers and then sell them with the assumption the stock can be bought back at a lower cost than the price at which they sold short.

These changes, which have been approved by the State Council, will be made on a trial basis by a small number of brokerage firms. The investment moves will be gradually expanded to other securities companies, the China Securities Regulatory Commission said.

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The securities watchdog also said stock market index futures - contracts to buy or sell at a future date a stock that copies the performance of a stock market index - would be launched at an appropriate time.

Despite receiving varied market responses, the two moves are expected to tremendously influence the Chinese stock market, which has drastically fluctuated over the past two years. Launching the two moves also shows that the domestic securities market is taking a big mature step forward.

The two moves and the multitude of other stock market policies and regulations adopted by the Chinese government since the start of the year show that authorities are aspiring to develop an upward market.

The drastic drop in shares on the market in 2008 has not only caused the value of assets to depreciate by a large margin. Authorities are also now aware that a lingering stock market slump will negatively affect the entire national economy.

The downturn of the Chinese economy in the latter half of 2008 was partly blamed on the global economic recession that was ignited by the United States' financial meltdown. But to a large extent, it was also pinned on the drastic decline in the country's exports because of the continuous renminbi appreciation and in the investors' drop in confidence in the stock market.

It is particularly important and necessary for the government, under these circumstances, to jolt the fluctuating stock market because it will help restore the market's finance functions that were neglected. It will also restore the public's confidence that the national economy can grow in a sustainable and stable fashion.

When share prices skyrocketed last year, they helped stimulate the nation's robust economic growth. Now the nation has the daunting task of figuring out how to carry that momentum forward to maintain economic growth this year.

It is increasingly obvious that innovating a well-developed network of systems and regulations for the stock market would be greatly helpful to a stable market. And authorities are keenly aware of this: It explains why they have employed a string of policies and measures within a short period to boost the bullish stock market.

Margin trading and short selling can produce more positive than negative effects, as experiences around the world have shown. While signifying a big step toward a matured stock market, the introduction of these financial transactions, along with the expected launch of index futures, meanwhile is expected to fundamentally alter how investors view the country's stock market and its methods of operation.

As opposed to other countries around the world, China's stock market in the past stopped short of the role of leverage. Investors mainly used their own money for investments and lacked the opportunities to tap into various financial channels. This model seriously hampered the formation of an active stock market and its expansion. Investors simply cared about gaining access to inside information in this model, rather than analyzing market conditions and how listed companies perform.

With margin trading and short selling in place, investors can borrow money from brokerage firm to buy stock and possibly reap a profit if they are optimistic about market conditions. Investors can borrow stocks from brokers and sell them when the risks are right, hoping to buy them back at a lower price.

But these investment moves can also add problems to some investors and speculators who try to manipulate the stock market.

The moves should spur the domestic stock market and help investors shun market risks. As expansive credit tools, these investment moves must be effectively implemented. Authorities also certainly need to forcefully monitor and supervise how investors use these moves to prevent them from being abused, which can fuel risks in the national economy.

To ensure that these investment strategies are smoothly advanced, the country should put in place a sound system as well as regulations that can be effective supervisory tools.

The experiences China has learned from tackling the global financial crisis has laid a solid foundation for the nation to practice margin trading, short selling and stock market index futures. The moves could have a positive effect on the domestic stock market and promote its development in a more stable and healthy manner.

The author is a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences.

(China Daily 01/14/2010 page8)