This is why a ban on short-selling won't help China pick up its stock market

RTR47RZZREUTERS/Jason ReedChina’s Zhou Lulu sets a new world record in the women’s over 75kg clean and jerk weightlifting competition at the Moonlight Festival Garden during the 17th Asian Games in Incheon September 26, 2014.

The first sign of a full blown crisis is a ban on short-selling, and China is no exception.

Short-sellers borrow stocks and sell them off, reasoning they can buy them back at a lower price in the future and pocket the difference.

The US, along with most of the world, tried it in 2008, when the stock market was melting down. Europe followed with a ban on some credit derivatives and bank shares as its sovereign debt crisis exploded in 2010 and 2011.

And now it’s China’s turn to halt short-selling as its share indices plunge. The country unveiled rules that make it harder for speculators to profit from hourly price changes, as some of the nation’s major brokerages suspended their short-selling businesses.

Studies of these bans show that although they can inflate some prices briefly, they can’t hold up the whole market.

Here’s a graph from the New York Fed showing what happened in 2008:

Often policymakers see short-sellers as malicious because they profit from a market downturn while the buy-and-hold crowd lose out, so they get rid of them.

But banning them can severely damage investor confidence in the market, reduce liquidity and push up trading costs, encouraging people to get out while they still can.

Here’s a graph from a 2011 academic paper that shows the difference in bid-offer spreads between Australian stocks that had a short selling ban imposed, and the same stocks in Canada, that didn’t have a ban.

The measure is used to calculate how easy it is for buyers and sellers can interact in a market. The higher it is, the less liquid the market. The blue line represents the stocks with the ban in place, and it stays higher even after the ban is lifted.

A bid-offer spread is the difference in price between what the highest bidder will buy at and what the lowest seller will sell at. If the spread is wide it indicates that the market is illiquid, making it harder for buyers and sellers to find others willing to do a deal at the price they want.

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