Xinhua Insight: China mulls circuit breaker to curb wild swings in stock market

Chinese financial regulators are ready to go a step further in their battle against major swings in the stock market by introducing a circuit breaker for a key index of large-cap stocks listed in the Shanghai and Shenzhen exchanges.

China has already set a daily trading limit of 10 percent for the rise and fall of individual stocks. In a joint statement by the two stock bourses and the exchange for trading financial futures on Monday, trading of all stocks, convertible bonds and stock options and futures contracts will be put on hold when the CSI300 index fluctuates beyond a certain level.

The level of fluctuation authorities can tolerate is still under discussion. The gyration since two months ago in the Chinese stock market has seen stock indices in Shanghai and Shenzhen tumbling more than five percent at times. At one point, nearly all gains in the market since the beginning of this year were wiped out.

"Introducing a circuit breaker could help reduce volatility in the market," said Jing Ulrich, vice chairman of Asia Pacific at J.P. Morgan. "We expect the volatilities in the A shares market to continue, given a lot of uncertainties in the global markets including when the Fed will raise interest rate. But I think volatilities should come down from the very high levels back in July."

The stellar rise in stock prices since the second half of last year is largely fueled by margin lending, much of it from unauthorized channels that in some cases can reach 10 times the investor's principal.

A fall in stock prices forced many margin lenders to meet their margin call. Margin lending was estimated at 4.5 trillion yuan during the peak of the stock market in June and has since shrank to 2 trillion by the end of August, according to Xu Gao, chief economist of Everbright Securities.

"I think everybody would love it if the financial market would perfectly mirror underlying fundamentals and would be providing capital in a way that they are best allocated but that's not how investors behave," said Jennifer Blanke, chief economist of World Economic Forum.

Analysts say the market is usually one step ahead of the regulators. In the case of China, some online P2P lending firms, banks and trusts have participated in helping investors to maximize their gains with borrowed funds.

Many retail investors have sought to increase their gains in the stock market through such channels rather than borrowing from the official margin lender, China Securities Finance Corporation.

Though authorities have repeatedly warned of risks against such reckless leverage, it didn't effectively curb such lending until the Shanghai Composite Index reach its peak above 5,000 in mid June, before it plunged over the next two months.

The margin lender was then chosen as the leader of a team of domestic brokerages to stabilize the market.

"What we learn from the sharp correction in the stock market is some of the financial innovations happening in the market were not timely and adequately regulated," said Zhu Ning, a professor who studies financial markets at Shanghai Advanced Institute of Finance (SAIF).

Unlike stock markets in the United States and Europe, China's is dominated by retail investors, who account for nearly 80 percent of trade. Investment decisions are often speculative rather than based on business and economic fundamentals.

Rational behavior, Ulrich said, is more important in China's stock market than ever.

To encourage rational investing, authorities have long tried to introduce more institutional investors into the A-share markets. It has recently allowed pension funds to invest up to 30 percent of their assets in equities and has expanded foreign institutional investors' access to the A-share markets.

"When you have professional investors such as mutual fund managers, corporate annuities managers, they can behave in a much more rational way rather than opportunistically trading day in and day out," Ulrich said.

But boosting the share of institutional investors could take years. In the meantime, SAIF's Zhu said the regulators should focus more on setting rules for market players and make sure everybody plays by the book.

"The least you want to do is to feed the expectation that the government will come to the rescue when the market is down," Zhu said.

"I don't see in the foreseeable future we are getting entirely away from having that kind of fluctuation because that's the nature of the financial markets" Blanke said.

"The goal," she said, "is to get financial markets working more for the real economy." Endi