Read more: Will the next financial crisis be made in China?
In February, China will celebrate its New Year. It’ll be the Year of the Monkey, which, according to tradition, is supposed to be unlucky for those born in it. For China, misfortune has already marked the year since financial markets opened on 2nd January. Today, so-called circuit-breakers were used for the second time to shut down the market and halt a precipitous fall. All of a sudden, a pervasive sense of deja-vu has spread as people recall the brutal stock market decline of last summer, and the curious mini-devaluation of the Renminbi (RMB). Bearing in mind China’s global significance, what is China’s financial flop all about, and how long could it last?
Let’s start with a bit of backdrop. The Shanghai Composite Index began its upward “bull” run in 2014 at around the 3,000 mark, and soared to 5,178 last June. It then dropped like a stone to 2,850 in September, before a barrage of support measures finally stopped the decline, pushing it back to just over 3,500 for much of the end of 2015. When the circuit breakers halted trading earlier today, it stood at 3,125.
Circuit breakers kick in if the market falls by 5 per cent from the previous close. It is closed for 15 minutes, and then re-opened. If it subsequently records a loss of 7 per cent from the prior close, it is shut for the rest of the day. And that’s what happened today. After 13 minutes of trading, the first closure kicked in. About a minute after re-opening, the fall in prices lead to the market being shut down for the day.
A lot of people will be wondering how to make the circuit-breaking mechanism more effective at curbing volatility, which is what it is designed to do. For example, in the US, the Securities and Exchange Commission has thresholds for the S&P 500 Index, which kicks in at losses of 7, 13 and 20 per cent—in other words unusually large movements. China’s problem by comparison is that daily movements of 5 per cent or 7 per cent aren’t unusual at all, and it is possible that traders, fearful of being caught on the hop by the imposition of the circuit breaker, accelerate their sales of stock.
Whatever the faults with the Chinese regulatory system though, four fundamental things stand out starkly.
First, while the US embraces market mechanisms (mostly) and really believes that they tend to work (mostly), China really doesn’t like or trust them. The result, as in the wider economy, is festering instability.
Second, China’s equity market woes aren’t about technicalities, but reflect an array of underlying problems, which have undermined confidence. Stock prices are probably still expensive, both on conventional measures and more specifically because most listed companies, including banks, are vulnerable to the lingering and worsening problems of over-capacity, indebtedness, and slowing growth. Successful global Chinese companies such as Alibaba are listed in Hong Kong, not the mainland.
Read more on China:
Can Uber crack China?
Is everything going wrong for China?
Finding God in China
Third, China’s reform agenda, the backbone of what the government has trumpeted as economic transformation to a new economic development model, is stuck in the mud. Many reforms have succumbed to pushback or inertia, and even the political top brass appear to be downplaying reform now in favour of keeping the economy running at an unsustainably high rate.
The Chinese expression, “loud thunder, small raindrops,” describes perfectly the progress of these reforms, since they was launched with great fanfare in 2013. Many useful and necessary things have been done, notably in the finance sector, but in incremental steps that don’t really alter the institutional ways in which the economy works. For example, there is some reform of state enterprises, but not in ways that alter ownership structures or the pervasive nature of state monopolies. There is judicial reform going on, but it’s not possible to have an independent judiciary and the rule of law. More advanced reforms in finance, without parallel changes in the real economy, have exposed the economy to greater capital flight and financial instability.
Fourth, the volatility in China’s stock market cannot be divorced from what’s going on with the its currency, the renminbi. Last year’s mini-devaluation of 2 per cent was followed by about $250bn of market intervention to push the currency back up again, and for a while it stabilised at around RMB6.40 to the US dollar. Stability was certainly essential to strengthen the government’s successful case to get the renminbi admitted to the IMF’s Special Drawing Right late last year (an accounting unit, comprising the US dollar, Yen, Euro and Pound and now the renminbi, but one that carries status). But the authorities also introduced a series of restrictions on the ability of Chinese residents, companies and banks to export capital, and then launched a new currency index, comprising 13 currencies, as a reference rather than a target. The not so veiled implication was that the renminbi would be allowed to drop against a higher US dollar, if that should happen.
And that’s how it has turned out. The renminbi rate per US dollar (the onshore rate known as CNY) is now 6.59, while the rate for the renminbi traded outside the mainland (known as CNH) is at 6.70, the lowest ever since it was introduced in 2003. The latter is widely regarded as a signal of where the former is heading. Uncertainty and often confusion in currency policy is also undermining financial confidence generally and adding to capital flight. China says it wants a stable currency, but is adding liquidity at home to keep interest rates repressed and allowing excessive credit creation to continue. These goals are incompatible.
The bottom line then is how long will this volatility in China’s markets continue and does it matter?
It’s hard to see an immediate end to turbulent market conditions, or the attainment of lasting stability while many of the uncertainties I’ve alluded to persist. And persist they will. The stock market shenanigans in China are symptomatic of problems both for China and the rest of the world. Western stock markets and economies will be more sensitive to what happens to China’s economy and to its banks, than to the gyrations in the Shanghai Composite. It would be another matter if the Chinese authorities either lost control of the currency because of capital flight, or embraced a formal and large devaluation of the renminbi.
Failing that, I suspect periodic and rising levels of economic tension will endure. Ironically, even though the immediate effects of a sharp drop in the renminbi would be to add to global economic pessimism, it could prove to be the ultimate successful circuit-breaker, at least for global markets.
In February, China will celebrate its New Year. It’ll be the Year of the Monkey, which, according to tradition, is supposed to be unlucky for those born in it. For China, misfortune has already marked the year since financial markets opened on 2nd January. Today, so-called circuit-breakers were used for the second time to shut down the market and halt a precipitous fall. All of a sudden, a pervasive sense of deja-vu has spread as people recall the brutal stock market decline of last summer, and the curious mini-devaluation of the Renminbi (RMB). Bearing in mind China’s global significance, what is China’s financial flop all about, and how long could it last?
Let’s start with a bit of backdrop. The Shanghai Composite Index began its upward “bull” run in 2014 at around the 3,000 mark, and soared to 5,178 last June. It then dropped like a stone to 2,850 in September, before a barrage of support measures finally stopped the decline, pushing it back to just over 3,500 for much of the end of 2015. When the circuit breakers halted trading earlier today, it stood at 3,125.
Circuit breakers kick in if the market falls by 5 per cent from the previous close. It is closed for 15 minutes, and then re-opened. If it subsequently records a loss of 7 per cent from the prior close, it is shut for the rest of the day. And that’s what happened today. After 13 minutes of trading, the first closure kicked in. About a minute after re-opening, the fall in prices lead to the market being shut down for the day.
A lot of people will be wondering how to make the circuit-breaking mechanism more effective at curbing volatility, which is what it is designed to do. For example, in the US, the Securities and Exchange Commission has thresholds for the S&P 500 Index, which kicks in at losses of 7, 13 and 20 per cent—in other words unusually large movements. China’s problem by comparison is that daily movements of 5 per cent or 7 per cent aren’t unusual at all, and it is possible that traders, fearful of being caught on the hop by the imposition of the circuit breaker, accelerate their sales of stock.
Whatever the faults with the Chinese regulatory system though, four fundamental things stand out starkly.
First, while the US embraces market mechanisms (mostly) and really believes that they tend to work (mostly), China really doesn’t like or trust them. The result, as in the wider economy, is festering instability.
Second, China’s equity market woes aren’t about technicalities, but reflect an array of underlying problems, which have undermined confidence. Stock prices are probably still expensive, both on conventional measures and more specifically because most listed companies, including banks, are vulnerable to the lingering and worsening problems of over-capacity, indebtedness, and slowing growth. Successful global Chinese companies such as Alibaba are listed in Hong Kong, not the mainland.
Read more on China:
Can Uber crack China?
Is everything going wrong for China?
Finding God in China
Third, China’s reform agenda, the backbone of what the government has trumpeted as economic transformation to a new economic development model, is stuck in the mud. Many reforms have succumbed to pushback or inertia, and even the political top brass appear to be downplaying reform now in favour of keeping the economy running at an unsustainably high rate.
The Chinese expression, “loud thunder, small raindrops,” describes perfectly the progress of these reforms, since they was launched with great fanfare in 2013. Many useful and necessary things have been done, notably in the finance sector, but in incremental steps that don’t really alter the institutional ways in which the economy works. For example, there is some reform of state enterprises, but not in ways that alter ownership structures or the pervasive nature of state monopolies. There is judicial reform going on, but it’s not possible to have an independent judiciary and the rule of law. More advanced reforms in finance, without parallel changes in the real economy, have exposed the economy to greater capital flight and financial instability.
Fourth, the volatility in China’s stock market cannot be divorced from what’s going on with the its currency, the renminbi. Last year’s mini-devaluation of 2 per cent was followed by about $250bn of market intervention to push the currency back up again, and for a while it stabilised at around RMB6.40 to the US dollar. Stability was certainly essential to strengthen the government’s successful case to get the renminbi admitted to the IMF’s Special Drawing Right late last year (an accounting unit, comprising the US dollar, Yen, Euro and Pound and now the renminbi, but one that carries status). But the authorities also introduced a series of restrictions on the ability of Chinese residents, companies and banks to export capital, and then launched a new currency index, comprising 13 currencies, as a reference rather than a target. The not so veiled implication was that the renminbi would be allowed to drop against a higher US dollar, if that should happen.
And that’s how it has turned out. The renminbi rate per US dollar (the onshore rate known as CNY) is now 6.59, while the rate for the renminbi traded outside the mainland (known as CNH) is at 6.70, the lowest ever since it was introduced in 2003. The latter is widely regarded as a signal of where the former is heading. Uncertainty and often confusion in currency policy is also undermining financial confidence generally and adding to capital flight. China says it wants a stable currency, but is adding liquidity at home to keep interest rates repressed and allowing excessive credit creation to continue. These goals are incompatible.
The bottom line then is how long will this volatility in China’s markets continue and does it matter?
It’s hard to see an immediate end to turbulent market conditions, or the attainment of lasting stability while many of the uncertainties I’ve alluded to persist. And persist they will. The stock market shenanigans in China are symptomatic of problems both for China and the rest of the world. Western stock markets and economies will be more sensitive to what happens to China’s economy and to its banks, than to the gyrations in the Shanghai Composite. It would be another matter if the Chinese authorities either lost control of the currency because of capital flight, or embraced a formal and large devaluation of the renminbi.
Failing that, I suspect periodic and rising levels of economic tension will endure. Ironically, even though the immediate effects of a sharp drop in the renminbi would be to add to global economic pessimism, it could prove to be the ultimate successful circuit-breaker, at least for global markets.
