The aim of an equity market circuit breaker is to provide safeguards to address market volatility and inspire investor confidence. It’s hard to argue with the rationale, but this week’s new measure in China has had unintended consequences for the world’s second largest economy. And it’s not the first time that the China Securities Regulatory Commission (CSRC) has made such an error of judgement.
Under previous rules, trading in individual mainland Chinese stocks had to remain within a 10 per cent price limit based on the prior day’s close. Monday’s innovation extended restrictions to the entire CSI 300 index, however; this time at even tighter boundaries of 5 per cent and 7 per cent. In essence, if an upward or downward move exceeds 5 per cent, the index goes into auction mode (when trades may be submitted but not executed). A subsequent move to the 7 per cent boundary means all stocks are suspended.
The near proximity of the market-wide price limits helped to fuel the dramatic sell-off that made the first few days of 2016 the bleakest start ever for Chinese equities. The rout was compounded by the tenth consecutive monthly contraction of the country’s vast manufacturing sector, and the impending lift of the selling ban on investors holding more than 5 per cent of domestic companies, equivalent to around 1.6trn renminbi ($243bn) worth of stock. On Thursday, after circuit breakers shut the market a second time, regulators made that ban permanent.
The sell-off is ironic because Chinese policymakers intended their action to prevent a repeat of the investor behaviour that deepened the correction last June, when the 10 per cent single stock limit had an unexpected side effect. As the market corrected, companies hit the limit and were halted from trading. Investors facing margin calls, redemptions or merely looking to reduce their equities exposure, moved on to other companies and pushed those down to the limit in turn. Vast swathes of the market were forced down by 10 per cent as a result and halted from trading.
China’s new market-wide circuit breaker was introduced to counter such contagion. The problem faced by the regulator in setting up this new rule is the restriction imposed by the 10 per cent limit already in place on individual stocks. For a single stock, faced with idiosyncratic and market risks, a 10 per cent limit can be tight. Taiwan has similar rules and, as HTC showed last June, investors can be limited from selling certain companies for a matter of days until a clearing price emerges. To speed up the path to a clearing price, and avoid an exhaustion of liquidity that could trigger a crash, the US set single stock circuit breakers at 5 per cent, 10 per cent and 20 per cent based on the price five minutes immediately before the move.
The difficulty for the Chinese index comes because the market-wide circuit breakers must be tighter than the single stock range to have any material impact. Hence the CSI 300 index has the tightest bands in the world, when looser and more flexible models are a more successful formula for emerging markets. By way of stark contrast, should the US S&P 500 fall by 7 per cent and 13 per cent it will go into auction, while suspension only kicks in after a 20 per cent decline.
China’s benchmark CSI 300 has also breached the 5 per cent auction threshold more than 100 times in the last 10 years, which will clearly inhibit normal market operation going forward. More importantly, this situation threatens to further undermine the market’s confidence in Chinese regulators, whose gold-plated status as dexterous managers of an immense yet slowing economy is already tarnished by the previous miscalculations.
The CSRC would be well served to follow the lead of other emerging countries that have applied less restrictive and more successful circuit breakers. It could raise the 10 per cent stock range – Taiwan raised its boundary from 7 per cent to 10 per cent so a move is not unprecedented –but may be sceptical about the such a measure because it could result in increased single stock volatility.
Still, South Korea’s Kospi, a market capitalisation-weighted index of all common shares on the Korean Stock Exchange, has circuit breakers at 8 per cent, 15 per cent and 20 per cent, while comparative levels for India are 10 per cent, 15 per cent and 20 per cent. China’s level of development falls somewhere between these two countries, indicating how out of step its mechanism is with its peers.
With the current situation as it stands, China’s policymakers should perhaps look beyond their border for some circuit training. Beijing is still learning the ropes, but it has tied itself up in knots.
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