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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