In a revolution, as in a novel, the most difficult part to invent is the end.” - Alexis de Tocqueville

The first trading week of 2016 saw a sharp fall in worldwide financial markets, which was attributed to the Chinese economic slowdown. This fall happened at the same time as the Chinese economy is gradually opening its financial markets and internationalize its currency (the Renminbi, RMB).

This post aims at briefly analyzing the January fall of the Chinese stock markets as well as the depreciation of Renminbi and their consequences for the Chinese authorities and the country’s economic direction in general.

China’s rogue financial markets

The fall of the Chinese stock markets started on January 4th after the publication of gloomy industrial index reports and declining services sector performance. Nevertheless, these indexes come short to explain a daily drop of 7%, especially as these reports were very much in line with previous months results.

Figure 1: Shanghai index, January 2015 to February 2016

2015-2016 Daily Shanghai Index (January crash)

A more probable explanation comes from Chinese investors’ psychology, anticipation and behavior resulting from the regulation implemented by the Chinese government in order to “manage” the stock markets’ fall of late June 2015.

Indeed, after the 2015 stock market boom and resulting crash, Chinese authorities spent hundred of billions of Renminbi to support their domestic financial markets. In addition, Chinese authorities decided to implement a circuit breaker system to limit stock markets volatility, a measure that temporarily halts trading then indexes or individual stocks decline by a pre-defined level. In this case, a daily limit of 7% (upward or downward) was implemented.  Finally, large shareholders (more than 5% of capital of individual companies) have been temporarily forbidden to sell their shares.

It appears that these rules were successful in halting the downward trend in stock market prices (see figure 1). But their combination would ultimately lead to the early January 2016 decline:

  1. The rule preventing large shareholders from selling their shares was supposed to end on Friday, January 8th, 2016. The prospect of seeing these large shareholders massively selling their shares that day, potentially leading to a significant decline of the stock markets, may have been anticipated by investors who decided to sell their stocks in advance.
  2. The resulting price decline was reinforced by the circuit breaker mechanism: since stock markets would be closed for 15 minutes if prices decline by 5% and for the day if they fall by 7%, wary investors may have anticipated decreasing prices and motivated to sell before the limits that would have closed the stock exchanges. This self-realizing prophecy only accelerated the fall as investors rushed to sell at the same time.

After January 4th’s large decrease, Chinese stock markets remained closed for two days (on Monday 11th and Thursday 12th) and it seems that the following two trading days were supported by the government to avoid a stronger decline.

It appears that the fall of early January 2016 was due to the combination of these two unwillingly self-reinforcing rules: investors had to sell before the expiration of the ban on large shareholders sale and before the circuit breakers system halt trading. This combination leaves very little leeway to investors, thus exacerbating the selling process which eventually led to a crash. In light of these facts, the subsequent decision to suspend the circuit breaker system was probably wise.

Notwithstanding, this event shows that the Chinese government desire to control financial markets (especially when they go south) through the establishment of restrictive rules is inefficient since it only postpones the eventual outcome. On the other hand, direct market intervention of state vehicles (i.e.: State Owned Enterprises) through stock purchases are more efficient but ultimately very costly and induce moral hazard (which is already pervasive in China).

The key lesson is that the Chinese government cannot control financial markets, which might be very frustrating since control of key areas of the economy is a deeply rooted desire of the state.

We should also remember that Chinese stock markets are not stock markets similar to those in other countries for the following reasons: few foreign investors can access it; a limited share of listed companies capital is free floating; the size of the stock markets is small compare to the size of the economy; few players are “real investors” (a majority of investors are households gamblers rather than long term investors). All of this create a situation in which companies’ valuation in the Chinese stock markets is disconnected from real economic performance. As a result, China’s stock markets are actually closer to casinos rather than channels for efficient savings allocation.

Figure 2: Shanghai index, January 2000 to February 2016

2000-2016 Shanghai Index bubbles

The recent events probably created some tension within the Central Committee of the Chinese Communist Party in regard to the course of action to set for the country’s stock markets:

  • An unlikely option would be to close or to tighten the control on the financial markets and isolate them even more from the rest of the world (though as noted above, China financial markets are already quite insulated);
  • Another option would be to keep the current structure while trying to avoid further declines through costly intervention and inefficient regulation;
  • The last option would be to allow more investments from domestic and foreign institutional and private investors.

The first two options appear the most likely in the short to medium term as the last option would require the acceptance from the Chinese government that it cannot fully control financial market and needs to loosen the grip on the economy, which would lead to a progressive opening of the Chinese economy. Given the size of the current vested interests, different ideologies and the number of deep reaching reforms involved, this last option can only be gradual and will thus take time. In addition, it would require taking steps such as releasing capital controls, which may threaten short term economic and social stability.

However, the current situation is not sustainable: Chinese stock markets do not perform their role of savings allocation to productive investments and instead show tendencies to mis-allocate savings, which will eventually lead to reforms in the future. As of today, they are poor indicators of China’s economic performance and are unlikely to create additional panic on foreign stock markets.

A more worrying issue is the evolution of the RMB exchange rate, which is challenging both for China and other economies.

Uncertainties about the People’s Money (RMB)

In recent years, China took several initiatives to allow its currency to move more freely and speed up its internationalization process: in November 2015, the RMB was awarded the reserve currency status from the IMF. As a result, the RMB value is not calculated anymore only against the USD but against a basket of currencies.

A more significant decision was to reform RMB trading by allowing the currency to move around a daily + or -2% band around a midpoint value based on the previous day’s spot market close. It is an important step toward the introduction of more market forces since it is the market that will set the midpoint value, not the People’s Bank of China (PBoC, China’s central bank) who previously used this tool to signal toward which direction the currency should move.

Nevertheless, this decision is also perceived by foreigners as a way to allow more depreciation of the RMB to increase Chinese companies international competitiveness and boost exports at a time when the economy slows down. In a previous article in September, we highlighted why the RMB devaluation makes sense for the following reasons:

  1. Over the last years, the RMB appreciated against most international currencies except the USD;
  2. Currency depreciation is a normal event when the economy slows down as investors have less optimist expectations on economic prospects;
  3. China’s domestic interest rate decreases while it is increasing in the US.

This assessment remains accurate today. The biggest problem and widely acknowledged at the time, is the obvious lack of communication from the PBoC about its target for the RMB’s value. This creates misconception that were already a source of volatility in August. In early 2016, investors still anticipated a strong depreciation of the RMB but because the PBoC controls the depreciation scale, investors translate their anticipation in the offshore RMB. Consequently, there is a widening gap between the exchange rate of the onshore RMB (CNH) and the offshore RMB (CNY). (Figure 3)

Figure 3: USD/CNY (blue line) and USD/CNH (orange line) variation

USD CNY CNH Spread

Source: Bloomberg

The difficulty to interpret the PBoC’s strategy and goals brings volatility and uncertainty in the markets but is also a challenge for the central bank, who claims that eliminating the spread between the two exchange rates is one of its priorities. The current RMB depreciation and the uncertainties about its scale could also lead to additional capital outflows, as it did in August and September 2015. Moreover, if the depreciation is only perceived by the rest of the world as a way to increase competitiveness, there is a real risk of accelerating the (exiting but denied) currency war that will neutralize the potential depreciation gains for China while adding additional volatility to the world economy.

All these factors have a significant cost for the PBoC since it must intervene on the financial markets to avoid more than a 2% daily depreciation, manage the consequences of capital outflows as well as reduce the spread between the CNY and CNH exchange rates (as it did in October 2015). These actions lead to a rapid reduction of the foreign exchange reserves, which have already decreased by USD 213 billions between August and November 2015 (Figure 3). These reserves are likely to deplete faster if further intervention are mandated to support falling stock markets.

Figure 3: Evolution of China’s foreign exchange reserves since January 2012

2012 2015 China FOREX Reserves

The fact that China holds the largest foreign exchange reserves in the world (standing at USD 3 trillion in early 2016) does not matter: the last months have proven that they can be quickly spent. In fact, the PBoC is stuck since it can neither allow a fast depreciation of its currency nor spend all its reserves to support its value.

The RMB internationalization has already taken significant steps, but might be more difficult to manage than the authorities expected. This is especially true as the government’s desire to control the economy is ultimately running against the liberalization of its currency. China is rapidly approaching the time when it will need to chose between one of the three outcomes of the Impossible Trinity (from Wikipedia):

  1. “A stable exchange rate and free capital flows (but not an independent monetary policy because setting a domestic interest rate that is different from the world interest rate would undermine a stable exchange rate due to appreciation or depreciation pressure on the domestic currency).
  2. An independent monetary policy and free capital flows (but not a stable exchange rate).
  3. A stable exchange rate and independent monetary policy (but no free capital flows, which would require the use of capital controls).

In any case, a better communication from the PBoC about its goals would be a good signal to reinforce its credibility and ease the uncertainties and consequent volatility.

China at a crossroad

China’s turbulent stock market and volatile currency reveal how difficult is China’s economic transition, especially as the country attempts to gradually open and internationalize its financial markets at the same time. It also shows the steep learning curve the Chinese government has to go through to better understand and manage financial markets.

2016 promises to be an interesting year, as we will continue to monitor the Chinese government’s decision and whether it chooses to further open and internationalize its economy or decides to bring back its financial markets under tight control as they might be perceived as a threat for the country’s stability. Should China chose to follow the first path, a better communication will be needed to bring more visibility and confidence.

About Nicolas Houilliez

Luxemburg based with strong analytical skills, I worked as market and strategy analyst in large multinational companies. Passionate about China, economics, geopolitics and finance.