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Economy

New year brings back old problems in China's markets

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An electronic board in Shanghai's Pudong financial district shows the benchmark Shanghai and Shenzhen stock indexes on Jan. 4.   © Reuters

If the Chinese authorities thought that a new year would allow them to forget the market fiascoes of 2015, they were wrong. With Shanghai and Shenzhen shares plunging more than 7% on Jan. 4 and 7, the first trading of the new year could not have started worse for Chinese policy-makers. They must be livid.

     After the volatility of last summer, the China Securities Regulatory Commission proposed a circuit-breaker system to pause and then stop trading if market moves became too wild. The commission received over 4,000 public comments and submissions in response.

     The resulting system unveiled last month was referenced against the blue-chip CSI 300 Index, and made effective from Jan. 4. A 5% fall in the index from the previous day's close would pause all trading for 15 minutes and an extended fall of 7% would see trading stopped for the rest of the day.

     The regulator hoped the circuit breaker would both firmly stop large price swings in a brutal fashion by closing the market and serve as a warning to investors to rein in erratic trading. Little did regulators think the circuit breaker would be invoked on the first day of implementation.

     It worked fine in capping the day's decline, but failed miserably in warning off would-be share sellers. Already questions have been asked about whether the circuit breaker has helped cause volatility. The CSRC has responded that it is seeking to "perfect" the mechanism.

     The circuit breaker can't solve the market's problems because it doesn't address the reasons for the volatility. The key reason for the turbulence is that the market is facing the same problems as it did last year. The regulators or, more importantly, their political masters, simply don't understand or aren't prepared to embrace markets.

     Tensions between giving market forces a decisive role and maintaining state control are front and center in the ongoing stock market debacle. Evidence of this came in the days following the Jan. 4 fall. The state starting buying up the large cap stocks that dominate the CSI 300 Index and then announced that a six-month ban on large shareholders selling shares, which was introduced in July to stem the fall in the markets, would be extended.

     This is the same failed formula from last year: state share-buying combined with restrictions on stock sales. This may provide short-term stability but it is about the worst possible path to develop the markets. Such is the moral hazard of trading in China.

     As the opening days have already shown, 2016 will be a challenging year for Chinese markets. Not only did shares tumble on Jan. 4 and 7, the currency also fell significantly in the domestic and offshore markets. While the yuan is still highly managed (read: manipulated), with heavy Chinese state intervention, the currency is still down around 6% from last August.

     This is a small move in global currency terms, but it shows that China is doing a very bad job at signaling and managing market expectations. One day the People's Bank of China intervenes heavily at an arbitrary level, only for the currency to fall below that within a week. Is China devaluing its currency or not? Is this the stability which was championed as the yuan was included into the International Monetary Fund's Special Drawing Rights basket?

     Nothing is clear. The yuan is no longer pegged to the U.S. dollar but it is far from open for trading. The central bank has put in a number of restrictions on banks' ability to short the currency and in late December suspended the authorization of three unnamed foreign banks to conduct certain cross-business activities.

     The markets also started the year with the Chinese brokerage industry in disarray, exposed as a hotbed of manipulation and front-running. The markets still face overpriced equities, especially for small cap shares; continuing selling restrictions on large shareholders; a neutered onshore index futures market trading at less than 1% of pre-crash volumes; paranoia over capital flight; and an investor base confused and worried about the inability of the government to move beyond the events of 2015, including hundreds of billions of dollars' worth of shares stockpiled by the government to lend support. The situation looks bleak because it is bleak.

     With this backlog of problems, no one should think the volatility is going away anytime soon. In the Chinese stock markets, the problem isn't that there are too many retail investors or too few institutional investors; it's that all investors are speculative and have short-term views.

     Why wouldn't they? Who knows what may spook the market next? Perhaps rumors of state share-selling or perhaps too many initial public offerings coming on line?

     Being a short-term investor works in China. Building a long-term investing mindset requires that listed companies show long-term viability, but in an economy of vast overcapacity and ever-slowing growth, many are struggling to stay afloat.

     There are no quick fixes for either the market's problems or the economy's. Sadly, the government continues to disappoint by trying the same old policies over and over again.

     For years now, the word "reform" has been touted as the solution but nothing substantive has happened yet. Reform of state-owned enterprises, vital if China wants to move the economy to the next stage, is woefully inadequate.

     None of this implies imminent financial or economic collapse. China isn't Greece or Argentina, but neither is it a miracle economy anymore. Welcome to the new year.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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