By Emily Zheng (PO ’19)
The People’s Republic of China was the world’s fastest-growing major economy until 2015, and is currently one of the world’s largest economies. Therefore, shockwaves resonated throughout global markets in the first week of 2016 when the trading of shares and index futures in China was abruptly halted after the CSI 300 stock index—a stock market index designed to replicate the performance of 300 stocks traded in the Shanghai and Shenzhen stock exchanges—fell 5%.[1] When markets re-opened, the stock index’s losses reached 7% within seconds, triggering the circuit breakers to completely close the market for the day after only a total of 30 minutes.[2]
As of January 7, 2016, the CSI 300 has fallen 12%.[3] China’s central bank has responded to this drop by announcing it would pump $10.6 billion into the financial system, following an earlier injection of $20 billion. These initiatives are designed to help stocks and stabilize mainland markets, but also signal Chinese leaders’ concern about the economy.[4] At the end of 2015, Chinese markets rallied after a summer crash caused trillions of dollars in losses. The government spent at least $236 billion to stop the slide, cutting interest rates while regulators suspended new share listings and threatened to jail short sellers.[5] These actions do have its consequences, and markets are now anticipating that brokers would unload huge amounts of stock once the ban on selling by major shareholders expire.[6]
Further reports strengthened fears of slower growth in China’s economy. One revealed that China’s services sector grew at the weakest pace in 17 months in December, while another showed that activity had slowed in the country’s key factory sector.[7] Concerns about China have also severely damaged oil prices, which has further unsettled global economies and stocks. As of January 2016, oil is now trading below $33 a barrel.
With concerned investors and governments closely watching China’s economy as it attempts to balance its economic policy with market fluctuations, this stock market free fall has had ramifications around the globe. In order to analyze the effects of the event and the implementation of circuit breakers, we will first examine the purpose of circuit breakers and what they entail. Then, we will review other economic policies in China that contribute to the state of its overall economy. Finally, we will explore the effects of these policies on the United States and the world, and why China should lessen government intervention.
Circuit Breakers
Circuit breakers shut down and close the trading day if the market is down by a specific percent.[8] A new economic policy that was removed after January 8th by the China Securities Regulatory Commission, circuit breakers were used to halt trading in China for 15 minutes if the benchmark index CSI 300 fell 5% in a day, and for the rest of the trading day if the decline were 7% or higher.[9] Circuit breakers are intended to help “prevent panic selling” from collapsing prices too quickly and “restore stability among buyers and sellers in a market.”[10] Overall, their primary function is to prevent a free fall of the market and to restore a balance between buyers and sellers during the halt period. Ironically, however, many analysts have pointed to the circuit breakers as being one of the main causes for China’s stock market collapse during the first week of trading in 2016.
Circuit breakers originated in the United States following the stock market crash of October 19th, 1987, commonly referred to as “Black Monday,” when the Dow Jones lost half a trillion dollars in value (nearly 22% of its total value) in a single day.[11] First implemented in 1989, circuit breakers are still used today by the New York Stock Exchange (NYSE) if the Dow Jones falls by 10%.[12] The duration of the halt depends on the size of the decline. The S&P 500 and many other exchange traded funds (ETFs) make use of circuit breakers as well.[13] In the United States, circuit breakers have been used a number of times since their implementation. For instance, they were vital in preventing a market free fall after the Dotcom bubble burst in the 1990s.[14]
Despite their merits, circuit breakers are often controversial. Chinese regulators decided to suspend their use in order to “‘smooth’ trading operations” and “create stability in equity markets.”[15] However, the purpose of implementing circuit breakers in the first place was to maintain continuity and stability in the markets, which raises some concerns. Some argue that a 7% drop is too small to justify a full day stop, especially because some hedge fund managers and portfolio managers exacerbated the event since they were forced to liquidate positions in order to withdraw cash prior to the halt.[16] In addition, many funds and investors have agreements that dictate “mandatory liquidation levels if their holdings drop below a specified level.” As a result, circuit breakers can actually drive prices even lower since all the fund managers must sell at the same time.
On the other hand, without circuit breakers, a panic-driven free fall could occur without any hindrance. Even so, some free-market advocates argue that “trading halts are artificial barriers to market efficiency” and that “if a market falls 20% or more in a single day, it is because it should be lower by such an amount.”[17] Furthermore, they argue that even if circuit breakers are intended to initially limit losses, they may actually encourage investors to sell more after the cool-down period.[18] Thus, Chinese regulators are divided as to what their options are, because all are prone to criticism.
The main problem with implementing circuit breakers in China is that China’s stock market already uses daily price limits. For instance, individual stock prices cannot fall by more than 10% per day.[19] Furthermore, marginal investors that have the power to affect market prices seem to be “uninformed, speculative, individual investors” according to Kenneth Kim of Forbes. Therefore, using circuit breakers is “not only repetitive to [China’s] price limit system,” continues Kim, “but it also only served to incite panic rather than to reduce it,” especially because China was not transparent to begin with, so investors would—and did—panic once they heard that Chinese regulators were installing circuit breakers in fear of a market crash.[20]
However, there are some justifications for China’s implementation of circuit breakers. After the country’s stock plunge in June that rattled global markets, Chinese authorities have been trying for months to “restore confidence in the country’s stocks” after a “panicked, multibillion-dollar government intervention.”[21] Chinese authorities could not have anticipated China’s market free-fall in early January, despite knowing the consequences of circuit breakers. Mike Brunker of NBC News believes that the spark that “lit the selloff was the Caixin/Markit index of Chinese manufacturing,” a composite index designed to provide an overall view of the manufacturing sector and acts as a leading indicator for China’s economy. “The closely watched gauge fell to 48.2 points in December from 48.6 the previous month, marking contraction for the 10th straight month.” This is especially dire because a value below 50.0 indicates that the manufacturing economy is declining, while a value above 50.0 indicates that the manufacturing economy is expanding.[22] An official manufacturing index also showed a persistent contraction in factory activity despite Beijing’s stimulus measures.[23] Yet, considering the other problems in China’s economy, circuit breakers should not have been implemented in the first place.
Problems in the Chinese Economy and Related Economic Policies
In any economy, policies should not be viewed in a vacuum. Thus, when examining the implementation of circuit breakers that crashed China’s stock market in early 2016, we must also evaluate how circuit breakers have affected other aspects of China’s economy.
Shadow banking constitutes one problem with China’s banks. It refers to financial intermediaries, or “middle men,” who are involved in the creation of credit in the global financial system. However, these members are not subject to regulatory oversight, so the shadow banking system can often refer to unregulated activities by regulated institutions.[24] Hedge funds are one example. The United States suffered from this issue as well in 2008, when shadow banking partly resulted in the crumbling of American financial institutions and systems.[25] Though it presents a significant problem to China’s economy, the government follows shadow banking closely, so it will most likely have little impact on the Chinese economy.
The lack of growth in Chinese domestic consumption also hinders Chinese economic growth. The government has realized that it cannot rely on solely exports to maintain the country’s income and wealth. The Japan Times reported that sales by China’s major exporters, which employ tens of millions of people, shrank by 8.3% in July 2015 from a year earlier.[26] Because of this, they are attempting to shift the economy’s reliance on a more self-sustaining domestic consumption to boost their GDP, instead of relying on net exports. Unfortunately, even among the rising middle class, consumption has failed to expand in recent years.[27] This has prevented the economy from growing as rapidly as it did in the past. A widely held view holds that the share of consumption in total expenditure has been declining because of rising saving rates of Chinese households as “uncertainty over provision of pensions, and healthcare and education costs have increased since the mid-1990s.”[28] However, Jahangir Aziz and Li Cui of the International Monetary Fund find that the rise in saving rate has actually been a minor factor. A larger impact has been “the role of the declining share of household income in national income, which has occurred across-the-board in wages, investment income, and government transfers,” as well as “financial sector weaknesses” that have restricted “firms’ access to bank financing for working capital [and] have played quantitatively a major role in keeping wage and investment income shares low and on a declining trend.”[29]
Other related economic policies include new limits on the amount of stock that major corporate shareholders can sell. This follows a recent government intervention that attempted to prop up shares.[30] Despite attempts to control the economy, authorities are being forced to allow the markets to have more freedom after policy makers spent about $5 trillion to support shares during the summer of 2015, including “ordering stock purchases by state funds, suspending initial public offerings and allowing trading halts that froze hundreds of mainland-listed shares.”[31]
Effects of China’s Economy on the United States
After China’s stock market free fall, United States stocks slumped as well. The first week of trading in 2016 saw the worst four-day start to a year ever for both the Dow and S&P 500.[32] New data on Chinese factory activity “sent a wave of financial concern across the Pacific…on the first day of stock trading in the new year,” further exacerbating the situation and sending major United States market indices—statistical measures of change in an economy or securities market—on a sharp downturn, with the Dow Jones industrial average closing at 276 points down, or nearly 1.6% of its total value.[33] Since the end of 2015 to early January, the Dow Jones has lost 5.2%, the S&P 500 is down 4.9% since December 31, and the NASDAQ is down 6.4%.[34]
“People see the weakness in China and in the overall equity market and think there’s going to be an impact on corporations here in the United States,” said Robert Pavlik, chief market strategist at Boston Private Wealth in New York.[35] Many investing professionals surveyed by CNNMoney listed China as the biggest risk to U.S. stocks.[36] However, contrary to popular belief, U.S.-China trade actually represents a very small portion of the U.S.’s GDP.[37] China currently wants to weaken its currency, known as the RMB or Yuan, because weakening its currency is a proven effective way to boost exports.[38] In January 2016, China set the Yuan’s value at its lowest level since March 2011.[39] Bloomberg reports that China’s central bank is currently “considering new measures to prevent high volatility in the exchange rate and will continue to intervene in the currency market,” including the restricting of arbitrage—the simultaneous purchase and sale of the same securities, commodities, or foreign exchange in different markets to profit from unequal prices—between onshore and offshore rates.[40] A weaker currency can help Chinese exporters and support growth, but it can also push money out of the country and hurt asset values.[41] If the American economy was so dependent on the Chinese economy, a weaker Yuan would be welcome news to the United States, because it would help the Chinese economy and consequently the American economy. However, that depreciation has had little to no effect on the American economy. The current effects of China’s stock market crash on the United States stock market are the results of an overreaction.
Furthermore, when the Yuan falls in value, goods imported into the United States from China become cheaper, which has large consequences on the United States’ economy. American businesses will have lower export sales in China, because their goods will be relatively more expensive. Because many American companies do a substantial portion of their business abroad, a weaker Yuan lowers the value of any income generated in China and could lead to lower earnings for American companies.[42] Despite the negative impacts of a weaker Yuan on the United States, a weak Chinese currency can still produce benefits on the US, because a healthy Chinese economy is necessary to maintain a healthy global economy. Thus, the benefits of a weak Yuan on the United States’ economy are currently indirect.
Implications for the World
“When you have a market that begins a year with weakness, people are sort of suspect anyway,” continues Pavlik. “The economy isn’t moving all that well, the outlook is modest at best, and they don’t want to wait for the long term. China creates more uncertainty.”[43] As China’s market valuations were rapidly dropping, many of the world’s markets followed suit.[44] For instance, European indices fell between 2 and 4% as China’s main index shed 6.9% of its value.[45]
The Yuan’s depreciation has had its effects on the rest of the world’s economies as well. “The Yuan’s depreciation has exceeded investors’ expectations,” said Wang Zheng, Shanghai-based chief investment officer at Jingxi Investment Management Co. “Investors are getting spooked by the declines, which will spur capital outflows.”[46] One such outflow was to Hong Kong. When the Yuan weakened by 0.6%, the Hong Kong Dollar strengthened by 0.4%.[47] Chinese stocks in Hong Kong fell to “the lowest level in four years as mainland shares plunged,” and mainland companies are now 39% more expensive than their Hong Kong peers.[48] “The gap [between China and Hong Kong] will probably widen,” said Paul Chan, Hong Kong-based chief investment officer for Asia excluding Japan at Invesco Ltd., which oversees $791 billion globally. “Earnings-per-share in Hong Kong dollar terms are lower, and I pay Hong Kong dollars for those shares.”[49]
However, some economists believe that the fear surrounding China’s potential economic downfall is unjustified. “The Chinese economy will grow. It is not a matter of if, but when, China will become the world’s largest economy,” affirms Kim of Forbes. China is still in its beginning stages in its transition to a market-based economy, so the economy’s current ability to adjust quickly to new problems demonstrates its resilience and should be viewed as a merit, not a downfall. “My estimate is that during the next 20 years, China will contribute at least a half billion additional people to the global middle class, which is both the engine and benefit of economic growth,” continues Kim.[50] It is important to recognize the lack of transparency in China’s accounting and corporate governance, so the world should take cues from Chinese market fluctuations with a grain of salt, because its rises and falls in reality means very little, especially because the marginal investors who can affect stock prices in China are “uninformed, speculative, [and] individual investors.”[51]
The Future State of the Chinese Economy
In an attempt to stabilize the stock market, the government sharply limited stock sales in early January, allowing major shareholders to unload only 1% of their holdings in any three-month period after disclosing their plans 15 days in advance.[52] This has raised sharp criticism from some economic analysts, who argue that the Chinese government’s intervention in these markets is actually hurting the economy. Mainland stocks are still expensive when compared to corporate profits, and the government’s efforts to support the market are only delaying the inevitable sharp decline in equity prices in the near future.[53] In addition, many believe that this is a “manipulated, distorted market,” according to the director of a China-based consulting firm. “It’s a market that’s not open … there are all sorts of restrictions on selling, and foreign institutions will be very alarmed by this.”[54]
As of now, the direction China should take in terms of the economy is to lessen government intervention. Though intended to alleviate significant issues, intervention often only delays the problem it is intended to address instead of solving it. Thus, when the problem reemerges after a few months of government intervention, not only would the government have to address them again, but the government will also have accumulated large sums of debt from its earlier attempts to prop up the economy. Government officials should closely consider currently enforced economic policies in the country before implementing new policies such as circuit breakers, because their intended effects may be reversed when enforced simultaneously with conflicting policies. This was the case with the circuit breakers and the daily price limits for China’s stock market. However, China should not get rid of government intervention entirely, because that may end up destabilizing the economy.
The market would also benefit from having more participants. By opening the market further and allowing more investors to contribute towards it, fluctuations would have fewer drawbacks. Because China’s economy is still growing and developing, its full impact on the world has yet to be seen. Currently, it seems like the United States has not been significantly affected. However, because the world’s economy is so interconnected, it is important to notice the effects of policies in certain markets. After all, circuit breakers were first introduced in the United States, with very different results. Whether China can continue its economic growth is up for debate, but for now, investors, governments, and citizens alike should pay close attention to the world’s second-largest economy and its economic policies.
[1] Riley, Charles and Barbieri, Rich, “China stock trading abruptly halted after 7% plunge,” CNN Money, 1/7/16.
[2] Ibid.
[3] Riley, Charles and Barbieri, Rich, “China stock trading abruptly halted after 7% plunge,” CNN Money, 1/7/16.
[4] Ibid.
[5] Ibid.
[6] Ibid.
[7] Ibid.
[8] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[9] Hayes, Adam, “Why China is Suspending Market Circuit Breakers,” Investopedia.
[10] Ibid.
[11] Ibid.
[12] Ibid.
[13] Ibid.
[14] “Dotcom Bubble,” Investopedia.
[15] Hayes, Adam, “Why China is Suspending Market Circuit Breakers,” Investopedia.
[16] Ibid.
[17] Ibid.
[18] Riley, Charles and Barbieri, Rich, “China stock trading abruptly halted after 7% plunge,” CNN Money, 1/7/16.
[19] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[20] Ibid.
[21] Brunker, Mike, “China Worries Send U.S. Stocks Tumbling; Dow Down 1.58 Percent,” NBC News, 1/4/16.
[22] “China Caixin Manufacturing PMI,” Investing.com, 2/1/16.
[23] Brunker, Mike, “China Worries Send U.S. Stocks Tumbling; Dow Down 1.58 Percent,” NBC News, 1/4/16.
[24] “Shadow Banking System,” Investopedia.
[25] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[26] McDonald, Joe, “China struggles to control shift to lower growth based on domestic consumption,” The Japan Times, 8/26/15.
[27] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[28] Aziz, Jahangir and Cui, Li, “Explaining China’s Low Consumption: The Neglected Role of Household Income,” International Monetary Fund, 7/07.
[29] Ibid.
[30] “China Suspends Stock Circuit Breaker Days After Introduction,” Bloomberg News, 1/6/16.
[31] Ibid.
[32] Valetkevitch, Caroline, “Dow, S&P off to worst four-day Jan start ever as China fears grow,” Reuters, 1/7/16.
[33] Brunker, Mike, “China Worries Send U.S. Stocks Tumbling; Dow Down 1.58 Percent,” NBC News, 1/4/16.
[34] Valetkevitch, Caroline, “Dow, S&P off to worst four-day Jan start ever as China fears grow,” Reuters, 1/7/16.
[35] Ibid.
[36] Riley, Charles and Barbieri, Rich, “China stock trading abruptly halted after 7% plunge,” CNN Money, 1/7/16.
[37] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[38] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[39] Valetkevitch, Caroline, “Dow, S&P off to worst four-day Jan start ever as China fears grow,” Reuters, 1/7/16.
[40] “China Suspends Stock Circuit Breaker Days After Introduction,” Bloomberg News, 1/6/16.
[41] Riley, Charles and Barbieri, Rich, “China stock trading abruptly halted after 7% plunge,” CNN Money, 1/7/16.
[42] Hjelmgaard, Kim, “Yuan and you: How China’s devalued currency affect U.S. consumers,” USA Today, 8/12/15.
[43] Valetkevitch, Caroline, “Dow, S&P off to worst four-day Jan start ever as China fears grow,” Reuters, 1/7/16.
[44] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[45] Brunker, Mike, “China Worries Send U.S. Stocks Tumbling; Dow Down 1.58 Percent,” NBC News, 1/4/16.
[46] “China Halts Stock Trading After 7% Rout Triggers Circuit Breaker,” Bloomberg Business, 1/6/16.
[47] Ibid.
[48] “China Halts Stock Trading After 7% Rout Triggers Circuit Breaker,” Bloomberg Business, 1/6/16.
[49] Ibid.
[50] Kim, Kenneth, “What’s Going On With China’s Stock Markets and Economy?,” Forbes, 1/18/16.
[51] Ibid.
[52] Ibid.
[53] Ibid.
[54] Ibid.
