Just another bad day in the office for China's lonely stock traders

Assume you’re a trader and your job involves buying and selling on the Shanghai/ Shenzhen stock exchanges. You’ve just returned to work from your 1 January New Year break. You’re feeling bearish for a number of reasons.

First, you know the six-month ban on selling shares imposed on major stock owners of Chinese companies will expire this Friday January 8. The ban was imposed following the stock market rout of early July 2015 that saw the mainland markets lose US$4 trillion in value. Its aim was to prevent major shareholders with more than 5% in mainland A-share companies from selling their stakes. The expiry of this ban will see a number of major new potential sellers entering the market as of next week, with some analysts predicting that over 1 trillion yuan of shares may be dumped.

Second, you know that a new rule introduced late in 2015, also in response to August volatility, will come into effect today, Monday January 4, the first trading day of 2016. The new rule introduces a circuit breaker for Chinese markets, under which all trading in stocks, index futures and options is suspended whenever the CSI 300 index falls or rises by 5%. If and when the index moves by 7%, all trading for the rest of the session is halted. This means you are aware that if the index begins to fall, you want to sell and get out quickly before trading is stopped and you lose your chance.

Third, you are aware that the Caixin Purchasing Managers’ Index (PMI) released on Sunday (January 2) fell to 48.2 in December, down from 48.6 in November, contracting for a 10th month in a row. China’s factories and manufacturing sector are key to the health of the world’s biggest economy. A PMI above 50 signals expansion, while anything below indicates a weakening economy.

Fourth, you are aware of the bigger, background economic picture: China’s economy grew at its slowest place since the 1990s in 2014 and stalled even further in 2015 as Beijing struggled to transform China’s investment and manufacturing driven growth model to a more sustainable consumption and services-based economy.

So you head to work on Monday with all this in your head and trading stumbles slowly into action over the morning session as traders exchange New Year pleasantries and absorb the market news. It’s not very long at all before it becomes very obvious that the CSI 300 is heading down, down - with little or no buying relief in sight.

So of course you join the exit selling rush before you lose your chance, and of course every other trader is doing exactly the same thing.

Small wonder then that by shortly after midday (at 1.12pm to be precise) the index has fallen by 5% – triggering the first circuit breaker and causing trading to be suspended for 15 minutes. This then triggers even more panic selling when trading resumes so that by 1.33pm the 7% trigger is reached and trading is halted for the rest of the day.

Chinese stock market investors have also been in for a wild ride. Kim Kyung Hoon/Reuters

Nothing to do with the fact that China has just landed a test flight on a new airfield on the disputed Spratly Islands. Nothing to do with the “disappearance” of people connected to a Hong Kong bookstore selling books critical of the mainland government. Just another bout of flu caused by the prevailing belief that if China’s factories sneeze, the world economy catches cold.

This time it’s combined with the new circuit breaker rule, which may itself have been a large part of the problem.

The Chinese circuit breaker is similar to one introduced in the US in 1988 following the “Black Monday” market plunge of October 1987, and also found in South Korea and India. The aim of circuit breaker rules is to provide time for a volatile market to cool, and for financial institutions and listed firms to release information allowing the market to stabilise around an agreed set of valuations. Circuit breakers also allow authorities to investigate any possible skulduggery (market manipulation) that may have caused unwanted downward volatility. But there are crucial differences between the US circuit breaker and the new Chinese rule.

First, the level at which the first circuit breaker trigger cuts in – a drop of 5% – is possibly too low for a market as volatile as China’s. Under the US system-wide circuit breaker rules as revised in 2012, the market halts for 15 minutes if the S&P 500 drops 7%, and then 13% before 3.25pm ET. A similar decline after 3.25pm will not halt trading. It needs a decline of 20% or more (regardless of when it occurs) to halt trading for the whole day.

Monday January 4 was the first day the Chinese circuit breaker went into effect. The speed at which the market fell from down 5% to down 7% (about two minutes) suggests that a more gradual and staged circuit breaker system could be more effective in stabilising China’s markets over the longer term.

The other thing that could, and probably will eventually serve to stabilise China’s markets over the longer term is to continue the process of linking the Chinese markets into other markets via “stock connect” schemes such as the Shanghai-Hong Kong stock connect launched in 2015. The stock connect remains limited to designated dual-listed A-shares, and has yet to be expanded to include bonds or other securities. Nor has the Shenzhen-Hong Kong stock connect, originally planned for late 2015, yet been launched.

The London Stock Exchange has agreed to study a possible link-up between it and the Shanghai Stock Exchange. Establishing and broadening such linkages would help connect China’s markets to those in the rest of the world and would put pressure on Chinese regulators to improve local operational mechanisms.