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What’s going on in China?

China’s stock exchanges halted trading for the second time in the week on Thursday. 

All trading involves risk. Losses can exceed deposits.
China Oriental
Source: Bloomberg

The CSI 300 only traded for a total of 29 minutes, where 15 minutes were attributed to a trading suspension after the index slumped 5%.

During that suspension, traders swung into panic mode and fed the system more sell orders. As soon as the market reopened, the 7% limit down rule was set off, punching out the rest of the day for the Chinese stock exchanges.

The new circuit breakers were supposed to act as stabilisers in the stock market, by allowing a cooling period for frantic traders. However, they seemed to produce the opposite effect, as market participants rush to exit positions before getting locked out by the trading halts, which exacerbated the decline.

It’s hard to see how the circuit breakers can remain in their current form, seeing that they contribute to the volatility in the Chinese market, instead of calming it. Even China’s securities watchdog, the China Securities Regulatory Commission (CSRC), acknowledged the teething issues. CSRC spokesperson Deng Ge said on Tuesday, 5 January, that policy makers need to 'gradually explore, gain experience and make adjustment' to the rules.

Many stock exchanges across the world find it necessary to implement circuit breakers to protect markets and investors from excess volatility. As such, it is not that China’s circuit breakers are useless, but that they need to be calibrated to work properly.

It is quite possible that adjusting the percentages which trigger a suspension, may help to improve the system. The thresholds for the current market-wide circuit breakers (MWCBs) implemented on the CSI 300 might be too tight given the recent volatility in the Chinese stock markets.

In the US, the S&P 500 has several levels of thresholds.  If the index touches 7%, the market will shut down for 15 minutes. If it drops past the 13% threshold, the market halts for another 15 minutes. If S&P 500 is to decline by 20%, the entire market would then have to be shut for the rest of the trading day.

Closer to Asia, Thailand has a similar system. If the index drops by 10%, the market shuts for 30 minutes. If the 20% threshold is breached, it closes for 60 minutes. Both these markets generally have a lower average volatility compared to China. As a corollary, the Chinese authorities may need to widen the thresholds.

They need to understand that what will stop the markets from going into a selling frenzy is a sense that they are still able to exit their positions, in good time.

Setting the type of circuit breakers may also be as important. Essentially, there are two main types – static and dynamic. Static limits are typically calculated at the start of the trading session or at the end of the previous day’s trading. China’s new circuit breakers are static limits, which is similar to the US system.

Singapore uses dynamic limits, which varies along with the price in real time. Its single-stock circuit breaker has a 10% trading band around the last traded price of the security from at least five minutes ago. Dynamic limits may ease the traders’ fear that they will be locked out of the halts if they are not quick enough with their market orders.

The favourite question that has come up after the 12% plummet in Chinese equities so far this week is how far they could fall. Beijing is still keeping some of the rescue measures in place, and also utilise state intervention in the markets to prop up the stock market. They reportedly announced that they will keep the six-month selling ban on major shareholders in place until new rules can be worked out.

The problem with the Chinese stock bailout is that it keeps the market from finding the ‘true bottom’ where stock valuations become attractive and not inflated. Judging from other similar state interventions, the eventual selloff is only delayed to a later date.

Deflation risk necessitates a cheaper Yuan

While the massive fall in Chinese equities captured the limelight, we should be more concerned about the resumption of yuan’s weakening trend. The largest one-day devaluation of the CNY mid-point since August on Thursday, 7 January, has raised worries of a global competitive currency depreciation.

Many in the financial markets are speculating that China is guiding its currency lower to boost exports and stimulate the slowing economy. Certainly, this view seems to hold water. The real effective exchange rate of the CNY was estimated to be 10-15% overvalued back in mid-2015.

This has clearly affected Chinese export competitiveness. The August devaluation saw the onshore CNY weakened by around 6.2%. This means there could be another 3.8-8.8% of weakening to go before the currency reaches a neutral value.

Bear in mind that the August devaluation also contained a shift to a more market-determined mid-point fixing. The daily fixing is now based on the previous day’s closing level, instead of an arbitrary whim. This means that if China wants to move the yuan to a specific level, it has to do this via intervention in the FX market, which will affect the closing price of yuan. This also signals a more costly way to move the currency where they want it than before.

But the primary concern for Beijing is the persistent deflation, which is mostly driven by worldwide slump in commodity prices. China would probably need to devalue CNY further to assuage the deflationary pressures on the economy as well as maintain an equilibrium in the monetary conditions. Unfortunately, the weakening of yuan means that deflation could be exported out of China, which heightens the risk of a currency war.

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