Trader Talk

Why China's trading restrictions are making matters worse

A stockbroker works in front of a screen displaying share prices at a securities brokerage in Hong Kong, China, on Wednesday, July 8, 2015.
Jerome Favre | Bloomberg | Getty Images

China's restrictions on trading has shut down large parts of the market.

Well, that isn't working so well. A day or so after China announced major restrictions on trading, halted IPOs, and initiated a major effort to buy stocks, half of the entire stock market has been frozen.

The closed down 5.9 percent, and the Shenzhen fell 2.5 percent. The fact the Shanghai is still up 8 percent for the year, and the Shenzhen 33 percent, is beside the point.

The Shenzhen is 40 percent off its highs. That's what matters—because millions of investors have come into the market in the last few months.

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We have no idea what the Chinese stock market is doing, since suspensions of trading and daily limit falls of 10 percent or more have made it impossible to determine stock values.

However, U.S.-based China ETFs are trading, and markets here seem to be pricing in another down day in China. The X-trackers CSI 300, the largest of the mainland China ETFs, is opening down 7 percent.

Stocks falling? Let's stop trading! That will help.

It's understandable that Beijing is concerned about the drop in stock prices. The hope was that private individuals flooding into the stock market would recapitalize cash-strapped industries, solving a major problem.

But Beijing's crazy policies of interest rate cuts combined with lowering margin requirements and encouraging the opening of millions of new brokerage accounts from inexperienced investors created a separate bubble that has created a whole new problem: The private savings of millions of citizens have been wiped out.

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Never mind the Chinese stock market has no correlation with the Chinese economy.

Never mind there are only 90 million retail accounts in China, a mere 27 percent of the roughly 400 million households in the country (a little more than half the roughly 50 percent of households that own stocks in the U.S.). Never mind that the stock market is only roughly 10 percent of household net worth.

The number of investors may be small, and the amounts they have invested—in most cases, a few hundred to a few thousand dollars—may be small, but tens of millions of these investors have only begun investing this year, which means a substantial portion are likely under water.

Right now, anyone who invested in the Shanghai exchange since the middle of March is under water. That's the period—March to June—that saw a huge explosion in new brokerage accounts.

In other words, a lot of investors have top-ticked the market.

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That means millions of investors are unhappy, and the government fears that could result in social unrest.

Mom and pop investors taking to the streets?

We have faced these issues before. In 2008-2009, we all wondered what would happen to the millions of factory workers put out of work by the global economic slowdown, and whether those layoffs would lead to massive unrest.

It didn't happen, because Beijing pumped billions of renminbi into the economy, first into real estate, then the shadow banking system, where it wound its way into the general economy.

Now the money has flooded into the stock market, and Beijing is trying to let the air out of another bubble.

The government's heavy-handed response indicates it believes social unrest is a very real possibility.

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One thing seems certain: The government response is part of the problem. First it was a halt to IPOs. Now there are more restrictions on trading:

1) Companies can ask for trading in their stock to be suspended; hundreds have already been suspended, with no clear indication of how long they will last. These are focused on small-cap names because retail investors are most margined in small cap stocks. They are turning that market off to protect those investors. But how do deleverage when your account is essentially frozen and you can't sell large parts of it?

2) China's Futures Exchange has imposed restriction on trading futures.

This much is true: Restrictions on trading activities do not usually keep stock from sliding, and they significantly reduce volumes.

We have seen this many times. Futures trading declined dramatically in Japan in the 1990s after the government there imposed restrictions on futures trading after the Japanese market correction.

That did a lot of good (Not).

There were bans on short selling financial stock in the U.S. and Europe after the financial crisis as well; volumes dropped there too.

Of course, the U.S., Europe, and Japan have little room to act holier than thou. Critics for years have claimed that the Fed's QE2 program distorted markets. In the U.S. we are talking about bond buying programs, not stock programs, but critics argue this is a matter of degree, not of kind.

And the Japanese are already buying stocks, through their pension funds.