Posted On 2016/01/13 By In Business, Economics, News, Research With 615 Views

Why China’s Market Crash is so Unsurprising

One of my predictions for 2016 was that we should expect further Chinese market volatility after last summer’s market crash. I have written before about how the unusual nature of China’s stock markets, which are dominated by small investors and are largely closed to foreigners, makes them prone to volatile behavior.

The latest market slump has highlighted how difficult it is for policy makers to manage volatility in a transition economy where the stock market is still being reformed.

Last week the Chinese authorities tried to limit the fall of the market through the use of so-called circuit breakers. But halting the trading of shares for 15 minutes wasn’t reassuring to investors — especially retail ones, who saw it as preventing them from getting out of the market — so trading was suspended entirely on Monday and Thursday as well. After these failed attempts to halt the decline, the authorities suspended the use of additional circuit breakers.

But the unusual structure of the equities market remains unchanged. Chinese stocks remain prone to large swings in valuations. The stock market was down by nearly half in the first half of last year, which was when the big August sell-off caused global ripples. Then, by autumn, the market was up more than 20%, so it had swung into bull market territory in a matter of months. Now, in the first week of trading in 2016, it is again falling and will likely remain volatile over the next few months.

Notably, just as in other financial markets, retail investors tend to act in “herds,” where if someone pulls money out to take some profit from the bull market, others will follow, believing that the early movers have better information. And it’s worse in China because, unlike in developed country markets, information is less than transparent and the dominance of state firms means the books are not always easy to check.

The Chinese stock market has regularly exhibited such “roller coaster” behavior throughout its two-and-a-half-decade history. The difference now is that China is the world’s second-largest economy, and its market gyrations are monitored by global investors in companies that depend on selling to China. Indeed, the FTSE All-World Index fell 6.1% last week, which is the worst five-day run since that measure of global stocks was established two decades ago.

Importantly, the underlying concern about the health of the Chinese economy also hasn’t changed in the six months or so since the last market crash. Economic reforms take time, and the latest indications are that the economy continues to slow. Making the country’s growth model less breakneck, supported instead by innovation, is no simple task. And Chinese policy makers’ largely ineffective efforts to manage the financial markets aren’t exactly inspiring confidence.

In other words, reforming an economy of such scale as China’s is a tough task. It will require policy makers to adopt transparent and effective policies to fine-tune the economy, which will be a sea change from the diktats and administrative measures that have largely characterized policy making in the transition economy thus far. For instance, to shore up the market, rather than banning large companies from selling shares, policy makers could use taxes to deter excessive trading.

It’ll be a while before China can manage to find the right set of tools for its transition markets and convince investors that policy makers can manage difficult structural reforms of its economy. Understandably, the stock market isn’t developed enough to expect market-based tools, such as imposing transaction costs, to have the same effect as in developed markets.

But repeated failures in regulating the stock market won’t win back the confidence of either domestic or global investors. Failed policies, like the latest circuit breakers and the previous administrative interventions, instead compound the concerns around the health of the Chinese economy. So we should continue to expect volatility in Chinese markets for a while.

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Article: Harvard Business Review / Image: Cory M. Grenier

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Spanning a career of over 25 years in hospitality, and non-profit organizations, Daniel has a proven track record in training and development of people across the spectrum. His expertise in human resources and as President / CEO of a nationwide non-profit gave him a strong foundation in cultural diversity and conflict resolution. Honored as one of the most influential executives under 40 in 2003, Daniel meshes his background in HR training and hospitality management by leading BMG's Global Ready China Seminars.

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