Mini-Bond Protests in Hong Kong: A Wake-up Call for Securities Law Enforcement in China

Last week, the Congressional-Executive Commission on China held a hearing on whether China is stable. I raised the following question:

“In Hong Kong, there has been real anger about the Lehman mini-bond fraud. These instruments were sold to investors in Hong Kong as secure, low-risk investments, but they were actually risky derivatives, and people lost a lot of money. This has led to popular protests in Hong Kong and demands for compensation through the political rather than the legal process. I'm wondering whether this could happen in China. With the fall of the stock market in Shanghai and some of the other financial issues -- money flowing out of China in record numbers -- if investors in the middle to upper middle class have lost a lot of money, will they be a source of instability, especially as there are many of them in Shanghai or Beijing? If they cannot pursue their claims in court but rather take them to the political process, will that be a problem?”

While fraud, especially insider trading, is widely believed to be rampant on the Shanghai and Shenzhen exchanges, I suspect the answer is, in general, "no". (I wouldn't be surprised to see an occasional organized protest, similar to the mag-lev protest in Shanghai, if an entire issuer goes under.)

Nevertheless, the PRC securities regulators should take the market drop and the implications thereof in Hong Kong as a wake-up call to vigorously enforce China’s nascent securities law regime. When markets are booming and everyone is making money, enforcement is easily overlooked. We saw this in the U.S. But now that the markets have dropped, enforcement is key to making sure that the markets will function properly when the money starts returning. Failing to do so could jeopardize the economic growth effects of the securities exchanges, which, in turn, would harm the ability of Chinese companies to raise capital and create jobs.

Moreover, justice is an important release valve for social pressure. Given that corruption and the popular sentiment against it are the gravest threats to stability in China (they serve as lighter fluid on the firewood of unemployment and/or inflation), breaking the corrupt practices in Chinese stock markets -- assuming rumors to be correct -- would be an important step towards further stabilizing the economic and political Chinese system. Given China's important role in the interconnected global economy, this is critical, for China and for the U.S.