C3S Paper No. 0013/2016
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When China’s stock markets exploded in June-July last, the fall in stock values was precipitous and totally unanticipated. The bubble, in fact, had commenced ballooning since 2014 when stock index (CSI) rose by 135%. When the market crashed, though the values fell by one third, they were yet 80% over the previous year. What surprised global markets and the public was the ferocious response of the Chinese authorities to handle the crisis.
A package of drastic measures was adopted. Regulators capped short selling. Some short-sellers were also arrested. Pension funds were advised to enter the market and buy stocks. A ‘national team’ [1]of state-owned financial institutions began to buy shares in a big way. The team was estimated to have acquired 6% of shares. Government suspended initial public offerings with a view to limit the supply of shares and to drive up the value of shares already listed in the market. Brokers created a fund to buy shares which was backed by funds from the central bank. A ban was imposed on sale by those holding chunks (5 percent or more) of shares in listed companies. The ban was to remain in force up to end of December. These measures did not save the market; they bought an uneasy peace.
There were global concerns over the measures taken by the Chinese government, especially in the context of its commitment to pursue reforms in the financial sector. In its China Economic Update Report (June, 2015), World Bank observed that China had gone beyond its role as a regulator and guarantor for financial systems and actively interfered in the market. In the initial draft, it reportedly said, “Instead of promoting the foundations for sound financial development, the state has interfered extensively and directly in allocating resources through administrative and price controls, guarantees, credit guidelines, pervasive ownership of financial institutions and regulatory policies.” Chinese authorities took umbrage to the criticism and it was duly removed from the final report.
Why were the authorities relying so much on the stock market and to defend it? The intention indeed was to establish a western (American?) type stock market to facilitate small and medium entrepreneurs to access capital and to promote projects with new technologies. Big Chinese banks were too involved with massive SOEs (State-owned-enterprises) and tended to neglect or even ignore smaller companies (SMEs). A related objective was to create high values for SOE stocks and to divest them in the market through public offering. They had also allowed foreign participation in stock markets, within limits, to deepen the market. When stocks began to soar in 2014, the authorities were perhaps jubilant, if not complacent. Unfortunately, they were unprepared for the magnitude of the fall that was in the making. Unlike Western markets which are deep and mature and in which major role is played by investment banks and institutional investors who are willing to hold on to shares for longer term, especially when they slide, China’s stock market is populated by millions of individual investors estimated at 6-7 percent of households. For them, stock market is another casino to make huge gains at the earliest. It is not our argument that western stock markets (or even the Indian!) are always stable and players act rationally. They are also subject to herd behaviour.
By August last year, the Chinese markets seemed to be stable. Rather, they were simmering below the placid surface. Some analysts began to wonder how long it would last and when it would burst. It did burst with the beginning of the New Year. I have briefly described the developments in the first week of this year in an earlier piece.[2] There were several factors at work: partly global; mostly local. The crucial factor seems to have been the end of the ban on sale of shares imposed earlier. Curiously, and more importantly, another critical factor which skewed the market behavior was the “circuit breaker” which came into force with the beginning of the New Year.
Last year, when the market seemed to be under control, on September 8, 2015, China Securities Regulatory Commission (CSRC) issued a draft plan to introduce a “circuit breaker” mechanism to prevent further falls in its volatile stock markets or to stabilize them. It expressed the hope that the mechanism would help prevent “excessive reactions of investors.”
On December 4, 2015 Bloomberg carried a report[3] on the new circuit breaker and how it would operate. A move of 5 percent in the CSI 300 Index would trigger a 15-minute halt for stocks, options and index futures while a swing of 7 percent would stop trading for the remainder of the day. As Bloomberg added, “the planned limits or stopping trading are more cautious than in the U.S. which had installed breakers after the 1987 crash.” In the U.S., a 7 percent drop in the S&P 500 Index would trigger a 15-minute halt for companies listed in the NYSE and NASDAQ.
All the stock markets – Shanghai Stock Exchange, Shenzhen Stock Exchange and the China Financial Futures Exchange – announced the introduction of circuit breakers with effect from January 1.[4] A significant feature was this: “Northbound trading via the Shanghai-Hong Kong Stock Connect Scheme will be suspended if the circuit breaker takes effect, but southbound would not be affected.” The idea perhaps was to check the influence of foreign flows via those windows. Deng Ge, a spokesman of the CSRC, said that the circuit breaker would give investors a “calm period” and help stabilize the market when large volatilities occurred in a market dominated by retail investors. Even around that time, some bankers and analysts were skeptical. They felt that while the circuit breakers may help and slow down, they will not have any major impact on the market trend.
Unfortunately for the CSRC, the circuit breakers proved counterproductive and aggravated the stock drop. Rather, they acted as a factor in the drop. After hitting the limit of 5 percent and re-opening after 15 minutes, it took only two minutes to hit down 7 percent which triggered the final halt and closed the market. Those holding chunks of shares and had been banned earlier to sell them in the market, rushed into the floods to cut their losses or save the value of their shares.
Since then, there have been several reports analyzing why the circuit breakers failed in China. Nicholas Brady, former U.S. Treasury Secretary, who headed a committee that recommended curbs on equity trading after 1987 crash [5]said, “They need a set of circuit breakers that appropriately reflects their market.” He also felt that they should have widened the band.
The Wall Street Journal carried a longer report.[6] It leaned heavily on the views of Prof. James Angel of Georgetown University who has done research on circuit breakers. He explained that the halts in China “reinforce how difficult it is to design circuit breakers properly” and they “often cause more problems than they solve.” Circuit breakers cause further falls than calm the market. It is the heavy involvement of individual investors in China’s market which is at the heart of the trouble. As another expert explained, “A lot of the volume is still retail- they are fearful and they want their money out” and people are just trying to escape before the lockout limit is reached. The net result is that it exacerbates volatility rather than limit it.
The views quoted above are those of neoclassical economics who revere free markets. Basically, they take the view circuit breakers cannot work well but would distort the free operations of stock markets and price discovery. Economists who don’t swear by free market theories have expressed contrary views. On date, there is no consensus among economists. We draw selectively on some of these studies.
An in depth study was undertaken by Prof. Lucy Ackert for the U.K. Government.[7] As his report said, “Theoretical and empirical research have examined the role of a trading halt rule in markets but no consensus has developed.” While market theorists argue about “price discovery”, history has shown that price movements do not always reflect changes in economic fundamentals. “A widely set circuit breaker rule accompanied by clear information regarding how the rule is triggered and a mechanism to promote the dissemination of price information during a trading interruption will bolster confidence in the market.” As he concluded, “A world with no impediment to trade is optimal if all traders are rational, do not make errors and are able to develop algorithms that incorporate al possible contingencies. Since we do not live in such a world, safeguards like a market circuit breaker rule with wide thresholds and a limit up-limit down mechanism are prudent.” (Emphasis added.)
Prof. Eskadar Tooma of the American University of Beirut made a critical survey of the working of circuit breakers in many countries.[8] His broad conclusion was that “investors know very little about the effects of such breakers on price dynamics, and the few relevant empirical studies that do exist produced very little results.” As he added, a lot of political economy questions remain to be tested. These are when should markets adopt price limits and what should be the optimal bands to use.
There is an assumption that in advanced countries like the U.S. the breakers have been operated well by regulators. However, there are doubts over this. Prof. Colesanti studied the issues in one paper.[9] He found that between October 2007 and February 2009 when the Dow Jones Industrial Average (DJIA) declined over 40%, the breakers were not triggered once. This raises doubts about their purpose and effect. In his view, breakers “serve best to remind us when volatility has become intolerable, but the measures do little in practicable terms to stymie insufferable declines.” While improvements in market communication and understanding of interconnected market forces may take time, as an interim step he feels that “artificial brakes remain the best means of staving off a complete market breakdown.” They have to be flexible and consistent with the regulators findings and scrutiny.
As narrated in the foregoing analysis, there is no consensus on the impact of circuit breakers. Search for an ideal breaker remains an abstraction or a Holy Cow and there are no unique thresholds applicable across the board to all countries for all times. It appears that the CSRC clutched at the wrong tool and at wrong time. It lifted the standard tools available from the shelves of neocon economics and applied them. The breakers failed. It is not surprising that the CSRC has since decided to scrap the breakers.
Mr. Xiao Gang is the architect of the breaker mechanism. He is a banker with a creditable record. He served in the PBoC for 22 years and rose to become a Deputy Governor. Later, he was appointed Chairman of the Bank of China and worked for a decade. During his stint, the BOC inducted, for the first time, foreign shareholders. It was also then that the BOC completed a $13.7 billion dual listing in Shanghai and Hong Kong in 2006. BOC was the first of China’s big State-Owned Banks to sell shares to the public.[10]
Based on his stellar record, Gang was appointed as chief of CSRC in March 2013. He was specially chosen by the new leadership to steer the reform of the financial structure. Despite his background and experience and the manner in which he tried to calm the market with timely caution, the stocks collapsed in July. Since then he was been subject to severe criticism from domestic small holders and foreign investors. There were reports questioning his captaincy of CSRC. The Communist Party of China (CPC) was said to be interviewing candidates to replace him.[11] “The central leadership is not satisfied with Xiao Gang, but maintaining market stability is the top priority.” However, Gang seems to have survived the attacks mounted in July last.
It got worse with the commencement of the crisis with the beginning of the New Year.[12] He was questioned by China’s Cabinet on the invention he had championed (the circuit breaker) and why it did not work. During his chieftaincy of CSRC had earned the sobriquet of ‘Mr. Circuit Breaker.’ He is increasingly being blamed for having taken missteps and created the crisis.
It is not clear whether Xiao Gang will become a scapegoat for creating the stock crisis. If so, it would be a sad end to a central banker who had steered so much of China’s financial reforms. As analysts would agree, the fault is not in Xiao Gang, but in the tools he was forced to adopt.
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References:
[1] Includes Bank of China Industrial and Commercial Bank of China, China Construction Bank, Bank of Communications, China Petroleum & Corp.’ China, China Mincing Bank, China Everbrite Bank, BOE Technology Group and Petro china.
[2] Subramanian, K (2016): Chinese Stock Market Tantrums: To Control or Not to Control, C3S Paper No.0008/2016, dated January 8.
[3] Bloomberg (2015): China to Start Stock Circuit Breaker in January to Calm Swings, December.
[4]South China Morning Post (2015) Chinas stock markets to introduce circuit breaker from January 1 to stem future routs, 04 December.
[5] See Bloomberg (2016): Ex-Treasury Secretary Brady says halts not suited to market, January 7.
[6] The Wall Street Journal (2016): The Problem With Circuit Breakers, January 7.
[7] Ackert, Lucy F. ( ):The impact of circuit breakers on market outcomes, Economic Impact Assessment EIA, Foresight, Government Office for Science, U.K.,
[8] Tooma, Eskandar 2005): Still in search for Answers: A Critical Survey on Circuit Breaker Regulation, Investment Management and Financial Innovation. See http://businessperspectives.org/joournals_free…./mfi_en_2005-02-Tooma.pdf
[9] Colesanti, J. Scott (2010): Circuit Breakers and the Mission of Stock Market Stability, Hofstra Law Faculty, Winter available at http://scholarlycommon.law.hofstra.edu/faculty_scholarship/687
[10] See Reuter’s (2016): China market tsar in spotlight amid stock market turmoil, January 9.
[11] Asia Times (2016): Will China’s top securities honcho get the boot?
[12] The Wall Street Journal (2016): The Man Behind China’s Circuit Breaker Gets Grilled, Jan.8.
(The writer Mr. K. Subramanian, is an Associate of the Chennai Centre for China Studies – C3S. Email: subrabhama@gmail.com)
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