Beijing's rules intended to stem market panic only made things worse. Blame human nature.
- By David WertimeDavid Wertime is a senior editor at Foreign Policy, where he manages its China section, Tea Leaf Nation. In 2011, he co-founded Tea Leaf Nation as a private company translating and analyzing Chinese social media, which the FP Group acquired in September 2013. David has since created two new miniseries and launched FP’s Chinese-language service. His culture-bridging work has been profiled in books including The Athena Doctrine and Digital Cosmopolitans and magazines including Psychology Today. David frequently discusses China on television and radio and has testified before the U.S.-China Economic and Security Review Commission. In his spare time, David is an avid marathon runner, a kitchen volunteer at So Others Might Eat, and an expert mentor at 1776, a Washington, D.C.-based incubator and seed fund. Originally from Jenkintown, Pennsylvania, David is a proud returned Peace Corps volunteer. He holds an English degree from Yale University and a law degree from Harvard University.
It was an embarrassing about-face for Chinese securities regulators. Just days after introducing “circuit breaker” policies on Jan. 4 — which paused stock markets for 15 minutes on a five percent drop and shut them down for the day on a seven percent drop — Beijing announced Jan. 7 that it would suspend the new rules, effective immediately.
The circuit breakers had been intended to stem market panic. But Beijing’s latest move did precisely the reverse; on both Jan. 4 and Jan. 7, stocks experienced a rout, with trading halted on Jan. 7, a Thursday, just 29 minutes after it had begun. Chinese netizens are again calling for the ouster of top securities regulator Xiao Gang, a man they have loved to hate since at least July 2015, and making fun of the circuit breaker policy. (One online commenter joked that state media should be forced to pause broadcasts for 15 minutes after making five factual errors.)
How did the policy backfire so badly? Call it human nature. By pausing during a trading rout, the logic goes, circuit breakers enable investors to re-focus on the actual value of what they’re trading, instead of looking over their shoulders at what everyone else is doing. (And any trading algorithms run amok can be corrected before bringing down the whole system.) But something else happened: When the self-interested calculations of reasonable, individual investors clashed with Beijing’s efforts to regulate China’s volatile stock market into submission, the individuals won. And Chinese policymakers, who won a reputation for competence as economic stewards during the nation’s quarter century of torrid growth, suffered yet another black eye.
Chinese stocks have sustained massive losses in rent months, particularly over the summer of 2015, before embarking on a mild rally in late 2015. But on Jan. 4, the first on which circuit breakers were introduced — surely in the hopes their mere presence would deter big drops, obviating the need to enact them — stocks plummeted, triggering the dreaded circuit breaker. Markets closed early, and traders went home without knowing just how far stocks would have fallen if given the chance.
The next two days were calmer, but the anxiety remained. On top of stock market losses, the value of the renminbi (RMB), China’s currency, had been falling in offshore trading. That development depresses the value of all assets denominated in RMB, and incentivizes people to sell them off before the RMB drops further.
On the fateful morning of Jan. 7, a randomly selected trader of Chinese stocks could be forgiven for not knowing what stocks were actually worth. Large shareholders in China are banned from selling their positions; circuit breakers mean many stocks have not had a chance to fall so low that they look like a good deal to buyers. The bottom, in other words, was hard to glimpse.
As soon as markets opened on, Jan. 7, traders went looking for it. In offshore trading, the RMB had already depreciated around one percent by the time stock markets opened (although authorities later intervened to reverse the drop). Stocks quickly plummeted, and the first switch on the circuit breaker, which requires a 15 minute “cool down” after a five percent loss, was ripe to be triggered. A seven percent drop closing the entire day’s trading could not have felt far off.
A Chinese trader in this situation, minutes after the opening bell, could reasonably think it near-inevitable that his holdings would lose another two percent. Worse, he would be blocked from selling for the rest of the day, putting him in the exact same position the next morning, only poorer. Clients could be forgiven for demanding to know why their trader sat on his hands while everyone else was selling before they lost even more money.
A trader in this situation would have been highly likely to sell — and for good reason. But in making that individual decision, each actor became part of a collective cascade of sell orders trying to clear before markets shut down. It was like a surge of people racing for a single, closing exit door. Not everyone was going to get through; not all sellers were going to find buyers. To entice a buyer, a reasonable trader would have priced his or her sell order for a stock even lower than its last trade price. After all, everyone thought they knew the markets would fall further.
Some got out in time; some did not. But the psychology behind the mad rush to sell before circuit breakers kicked in explains precisely why they haven’t worked. Chinese securities regulators hoped to stem market panics by limiting losses in any given day, letting cooler heads prevail. Instead, the circuit breakers have introduced wrenching anxiety into Chinese stock markets, compressing the time frame in which traders feel they can cash out, and leaving everyone wondering — still — where the bottom truly lies.
To be sure, Chinese policymakers did not invent the idea of circuit breakers; U.S. markets have them too. But those only trigger in the case of much steeper losses, and U.S. markets are historically less volatile than China’s.
Chen Zhiwu, a professor of finance at the Yale School of Management, thinks that Chinese security regulators are eventually going to get it right. “I am confident that they will learn quickly and adapt accordingly. Such episodes, while painful when they are happening, are good and positive if looked at from a long-term perspective,” he told Foreign Policy. In the meantime, the failure of these new rules has spooked investors in China and elsewhere, and further sullied Beijing’s image for technocratic competence in finance and economics. The rest of the investing world can only hope Chen is eventually proven correct.