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Bertonomics

Looking at the world through the lenses of Singapore A level Economics =D

Month

February 2016

China’s Fragile Financial Sector

What is causing the volatility in the financial sector?

  1. Retail Investors and Herd Behaviour

China’s financial sector is new and unstable which has created increased volatility in the financial market. Unlike most developed countries such as USA and UK where the majority of stocks traded are by institutional investors, or large companies such as Blackrock, the majority of investors in China are retail investors. Retail investors are investors who invest with their own money and not for other parties. Given their low capital compared to large corporations, they are more prone to bubbles and panics.

A simple analogy can be extrapolated from vehicles. Small vehicles have the flexibility of being able to move faster and turn easily while large vehicles often have to be driven with more care since their size prevents them from last minute reversal or turnings. In other words, the flexibility that allows retail investors to react quick due to their low capital increases the risk of panics and unrealistic rise in value in stocks.

The more retail investors there are, the higher the volatility since they are more prone to such trends. On the other hand, large investment funds are price-setters. Their large capital forces them to diversify their risks across a broad based of investment products to minimize risk while maximizing profit. Thus, often a reduction in value in a few stocks will not severely affect their total returns thus they are in no hurry to enter nor exit the market. Moreover, given their capital, they also possess more information that allows them to hold a long-term view as compared to retail investors. They prefer stability to sudden but short burst of profit.

This acts as a stabilizing force thus until China’s financial sector gradually matures, volatility is here to stay.

2. Mishandling the Stock Market

Recent threats to the China’s stock market has placed serious doubts on the Chinese government’s will to pursue further economic reforms in its financial sector. Its series of policies have had the negative impact of causing more panic instead of solving the root cause to the problem.

Previously on 4 Jan 2016, the Chinese government introduced a circuit breaker to the stock market to prevent volatile movement.

The circuit breaker works as follows – the proposed mechanism will be tied to the benchmark CSI300 Index, which tracks the largest listed companies in Shanghai and Shenzhen, where a move of 5 percent in either direction from the index’s previous close will trigger a 30-minute trade suspension. Meanwhile, a 7 percent rise or fall in the CSI300 Index will prompt a trading halt in the Shanghai and Shenzhen stock exchanges for the rest of the day. This works pretty much like the circuit breaker you have at home that will cut off the power supply once there is a short circuit to prevent a fire, the stock market circuit breaker is meant to calm down stock markets after a massive nosedive or unrealistic surge in prices to prevent bubble formation or panic attack.

Circuit breakers are meant to stabilize stock exchanges by calming down the public after a massive buy-in or a massive sell-off. They thus act as stock exchange stabilizers and prevent panic selling or flood buying. They are actually frequently seen in other exchanges such as the New York Stock Exchange where there are three levels set mainly at 7%, 13% and 2o%.

In a newly developed financial sector such as that of China, it is indeed a good idea given its mass number of retail investors. However, the circuit breakers introduced by the Chinese government were badly designed. The trading curbs set were too low and the difference in percentage between the circuit breakers were too low thus instead of reducing panic, the circuit breakers escalated the fall in the indexes. By the second day where the circuit breakers were introduced, the indexes has already fallen to the first level of 5%. This triggered a 30 – minute trade suspension which induced massive panic.

Nothing wrecks the heart more than the unknown and the temporary shut down of the stock exchange merely encourage investors to fire sell their holdings in stocks. By the time the exchange reopened, the index has fallen more than 7% and the second level of circuit breaker is activated, ending the day’s trade.

The circuit breakers were badly designed as no circuit breaker in any exchange has set a maximum trading limit change of 7% – most are designed to be at least 12-17%. The stock market is one that is volatile, especially 1 flooded by animal spirits, thus to place a 7% price change cap is unrealistic and will only induce further panic.

The circuit breakers have since be stripped but it reflects the incompetency of the Chinese government in managing its new booming financial sector and it brings into question of whether it can successfully resolves its massive debt problems and develop a substantial financial sector.

Closing Thoughts

The Chinese government needs to reckon that its attempt to prop up the stock market is misguided. Unlike the US where funds in the stock exchange nearly constitutes 80% of GDP, the China’s stock exchange is small at only around 10% as compared to the massive size of its GDP. In other words, volatility in the stock market is unlikely to affect consumer demand and wealth. It will be better to gradually allow the stock exchange to flow freely and allow market sentiments to do its work. At this important crossroad where it move towards internationalizing the yuan, it must stay wary in any intervention of the financial sector especially in a global environment that is unfavorable.

 

 

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How impossible is the impossible trinity?

Our previous post looked at the reasons for Singapore’s decision to choose a managed exchange rate and free capital flows over a sovereign monetary policy. However, we received questions about why it is impossible to achieve the 3 conditions below and thus we’re attempting to give you a brief understanding of the theory.

Impossible_trinity_diagram.svg

Let’s assume hypothetically that USA attempts to have all 3 of the following economic options at its disposal. Let’s say the government is experiencing a downturn in the business cycle. Given that the government has a sovereign monetary policy at its disposal, it will attempt to stimulate the economy by using expansionary monetary policy.

Thus, the central bank will intervene to increase the money supply through possibly open market operations – purchasing of government bonds or affecting the liquidity ratio. This reduces interest rates, achieving the purpose of reducing the cost of borrowing thus increasing investment through higher expected rate-of-return and consumption on big ticket items.

However, since interest rates has decreased as compared to the world and the country allows FREE CAPITAL FLOW, investors have an incentive to shift their capital from USA into other countries with higher interest rates. In economic terms, hot money flows out of the country. As investors exchange USD for foreign currency, the supply of USD increases in the forex market which places depreciation pressure on the USD. (Recall that exchange rate markets can be thought of just like other goods market with a demand and supply graph, as supply increases, price of USD in terms of foreign currency decreases)

Now, for the country to control exchange rates, the central bank will have to intervene in the forex market to appreciate the currency. It will use its foreign reserves to intervene in the market, purchasing USD from the forex market with foreign currency. This has the effect of decreasing the supply of USD in the forex market. However, by reducing the supply of USD, effectively, it is also a reduction of the money supply (which would cause interest rates to increase) and this is in contrary to the purpose that the central bank wanted to achieve at the beginning to acquire an expansionary monetary policy.

The result is that as the money supply decreases, interest rate return to the original equilibrium. The central bank and government failed to achieve its original purpose and merely allowed investors to benefit from carry trade.

At this point, you finally witness how impossible it is to achieve all 3 conditions in the impossible trinity. Empirical evidence based on historical backgrounds have proven that any attempts to break the impossible trinity (open economy trilemma) often lands in disaster.

 

 

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