While the sudden moves in the Chinese currency—and the concurrent concern about a slower economy—are the main cause of China's stock market volatility, the country's stock market structure may itself be exacerbating the selloff.
Most of these "restrictions" were put in place to quell the market volatility that occurred in July and August of last year.
There are several issues.
1) The Chinese "circuit breakers"—which went into effect on Monday—are not wide enough. China's stock market is simply too volatile for the market to close for the day when stocks are down 7 percent, which is the current level that was set. In the United States, there are trading halts for 15 minutes when the S&P 500 drops 7 percent and 13 percent, but will only close for the entire day when the S&P 500 drops 20 percent. That has never happened. Chinese authorities should set the bands, if they want them at all, closer to the U.S. levels.
2) Restricted futures trading. Over the summer, Chinese authorities limited the number of futures contracts that could be held, and limited the amount of trading that could be done in them. That greatly limited the ability of traders to hedge the market.
3) Restrictions on sales by large shareholders. During the height of the market turmoil in late summer, the China Securities Regulatory Commission (CSRC) restricted the ability of large shareholders (those who hold over 5 percent of a company's shares) from selling.
This "lockup" period was supposed to expire this Friday, and traders selling to "get ahead" of that were a primary cause of the drop on Monday.
Chinese authorities have now reversed themselves. After today's close, it was announced that starting January 9, large shareholders can sell a maximum of 1 percent of company shares every three months. They also must disclose any plans to sell shares 15 days in advance.
4) Traders cannot sell stocks on the same day they buy them. Chinese has an unusual "T + 1" settlement system. Simply put, if you buy a stock, you cannot sell it until the next day. This effectively "traps" those who are active traders until the next day.
5) China has developed a "national team" that is buying stocks on behalf of the government.
It works like this: the People's Bank of China (PBOC) funnels money into the China Securities Finance Corporation, which then funnels money into several national brokerages. There is also "indirect" buying initiated by the government: they have ordered state-owned enterprises (SOEs) to buy their own stock, for example. Pension plans and insurance companies, which had limits on how much equities they could own, also had those percentages raised.
Who is behind this national "plunge protection team?" The problem is, the PBOC and the CSRC are not truly independent. They both report to the State Council, the main administrative authority in China, controlled by Premier Li Keqiang, and this is the source of much of the policy confusion.
While many in China's financial community are young and market-oriented, the people they report to at the top are part of the old Communist Party cadre. They are older, more ideological, and far less market-oriented.
They are the ones in favor of more state control, including of the stock market, but they are finding out how difficult that is to do in a more interconnected world, where the Law of Unintended Consequences trumps Mao's Little Red Book.