Thoughts and Recommendations
by Leo Melamed
BOAO Forum Annual Conference
March 23, 2016
As everyone is well aware the world is experiencing some difficult economic times and volatile markets. And the prospect for near term change is doubtful.
In Europe, the central bank is doing what it can to increase economic activity. Just last week, as expected, the ECB announced another major package of interest rate cuts, bond purchases and ultra-cheap loans. It is the second stimulus in three months. The ECB said it will expand its Quantative Easing (QE) bond buying program to 80 billion euros and will start a buying program of corporate bonds. Clearly, these measures signify a deep concern by the ECB that the economic situation in Europe is not well.
Similarly, in Japan, things have not gotten much better. After two decades of deflationary pressures, Prime Minister Abe several years ago, instituted in April of 2013, what he called "three new arrows," a program of monetary easing, fiscal stimulus, and far-reaching structural reform. The program became known as Abenomics. The program was promising. Unfortunately, it did not work.
Now, nearly three years later, Japan reported that its economy GDP shrank by 1.2% on an annualized basis in the fourth quarter of 2015. Prices in Japan are falling again. The Bank of Japan stepped in and surprised the global financial markets by adopting a negative interest rate policy (NIRP) for the first time in its history in order to prod banks to lend more. It is following a roadmap of NIRP that began in Europe, notably by the ECB. Again, like in Europe, the central bank is signaling that economic conditions are not well.
The economics in China are more complicated. The government has instituted a transformation from an export dependent manufacturing economy to a consumption-driven economy, one powered by internal growth. But such a monumental transformation is not easy nor is it without pain even during normal times. Unfortunately, this transformation encountered a time-frame when most of the major global economies were themselves on the defensive.
China's projected single digit GDP growth is the slowest in 25 years. The official manufacturing purchasing index in February fell to the lowest level in more than 4 years. Recent statistics indicate that China's exports fell 11.2% in January of this year. The Shanghai Stock Index is down 23%. Foreign reserves have fallen nearly $800 billion as the Chinese government attempts to defend the value of the yuan.
Lu Lei, Director General, Research Bureau of the PBOC in his February presentation,1 stated, "the Chinese economy is likely to continue its downward trend in 2016." Mr. Lu believes that external factors and weak aggregate demand in China will cause deflationary pressures to worsen. The momentum for improving aggregated demands is lacking. "China's economy is likely to continue its downward trend with leading indicators showing that the economy will slip even further in the short run," he stated.
Unfortunately, plunging Chinese imports have an immediate and negative impact on economies throughout Asia. Japan exports are declining at a 3.4% pace. South Korea exports fell 18.8%. Singapore non-oil exports fell 9.9% in January. India exports dropped 13.6%, the 14th straight monthly decline. Taiwan's exports fell 13% year over year in January. Taiwan's shipments to China dropped 19.3%. It is not a pretty picture.
In the US the conditions are different. Because the US is further along in its recovery trajectory than are other major economies the US Fed started to raise interest rates. While that may be viewed as a positive sign, this divergence can breed the possibility of regional monetary problems. Major currencies all over the world have depreciated against the dollar and capital has continued to flow out of emerging markets, putting pressure on yuan and other Asian currencies.
However, not all indications are positive in the US. For one thing, corporate earnings are still declining. For another, incomes are stagnant, which in turn creates economic anxiety and political unrest. For the 10th straight year, the US economy is growing by less than 3%. This has not happened since the 1930s. How strong can the US economy get when the economies of its top four trading partners, Canada, China, Mexico and Japan, are all deteriorating? US recovery may be slower than some believe. Little wonder Mr. Lu states that chances for global financial volatility remains high. I agree.
Given these global financial conditions and the lofty levels the Chinese equity markets had reached, it should be no surprise that Chinese markets experienced extreme volatility---no different than the other major equity markets including the US. In my opinion, no one should point exceptional fingers at China or Chinese equity markets. Indeed, I would place very little blame on the actual China Stock Exchange or China Financial Futures Exchange. Neither of these exchanges created the underlying difficult world economic conditions. They simply reflected what is happening in China and around the world.
Indeed, the respected Tsinghua University, under the guiding hands of former PBOC vice president Wu Xiao Ling and Li Jiange, the former deputy director of the research center of the state council, published its conclusion directly after the market crash, stating "the equity index market is not the cause of the stock market turmoil" and encouraged to make the index markets stronger.
Tsinghua is correct in its belief that futures markets in China need to be strengthened. Futures and options markets are of undeniable value in the management of complex business risks and imperative in the development of capital markets. Nations around the globe have embraced the idea and followed the Chicago blueprint. Today there are developed financial futures markets aside from the US, in Australia, Brazil, Canada, France, Germany, India, Japan, S. Korea, Mexico, Singapore, United Kingdom, and of course China. Most of them have equity futures. This fact is of vital importance to China as it takes its place and competes with the world of developed capital markets.
Tsinghua University understands what professor Robert C. Merton, the Nobel Prize winner in economics and professor of finance at MIT stated: "The costs of implementing financial strategies for institutions using derivatives can be one tenth to one twentieth of the cost of using underlying cash market securities."
China's futures entry into finance did not occur until 2006 with the launch of the China Financial Futures Exchange, (CFFEX) to trade in the popular Shanghai Stock Index, the CSI 300. The CFFEX was an instant success, with an overwhelming volume from the very first day. However, while successful, it suffered from the same flaw that all of the Chinese futures markets do. They are primarily domestic and nearly without any global participation. More than 80% of CFFEX volume is from retail participation and dominated by speculation. That is not a constructive ratio of commercial versus speculative participation.
But allow me to put things in perspective. In the midst of great volatility, it is perhaps difficult to remember that virtually all markets periodically suffer from episodes of volatility. In the last 15 years, for example, the US equity market suffered from the bursting of the technology stock bubble in 2000, the credit market related financial crisis in 2007-2009, the onset of European sovereign debt crisis and the "flash crash" incidents in 2010 to name a few. And of course there was the major crash of 1987. Some of these events had macroeconomic causes while others simply emerged from rapidly changing technology and operating environments in the market. However, from this history and experience, we have learned a great deal. Allow me to enumerate some of the most salient lessons.
First, we learned that the market tends to be more stable if there is a broad set of diverse participants. When the set of participants have a high degree of homogeneity, their assessment tends to be similar. Their actions reaffirm one another and breed overconfidence. This could lead to a tendency for markets to become increasingly out of line with the economic reality. That is precisely what happened in China. When a price correction began, the reaction by all the participants was similar as well. It caused the market to crash. Accordingly, instead of a high concentration of "retail speculative investors," it is desirable to encourage the participation of institutions that leverages longer term investments, e.g. pension plans, life and casualty insurance companies, etc. They are often found to be less prone to panic.
To add diversity also means the inclusion of more offshore participants in Chinese markets. It will further lead to a more balanced market. Global participation will strengthen the domestic markets, deepen the liquidity of underlying cash markets, and enhance the price discovery process of its commodity products to benefit the Chinese real economy.
Second, we have learned that there is need for some form of short selling in securities, financial instruments, and futures markets. We have learned that the practice of short selling is not something to be feared. Studies have found that the ban of short selling does not reduce the market volatility or the downward pressure in the market.2 Rather, a ban produces the opposite effect of increasing the cost of trading and reducing liquidity even further. Over the long run, the presence of short sellers tends to help expose inaccurate information and encourages healthy skepticism in the market.
Third, we learned that circuit breakers are an effective tool to manage extreme volatility and avoid "crashes." Over time CME Group has realized that circuit breakers are preferred to daily limits. The purpose of circuit breakers is not to impede the market from finding price equilibrium but rather to ensure an orderly move to that new equilibrium. However, to be effective they must be coordinated with cash markets and judicially placed to provide a maximum effect from both a practical as well as a psychological point of view.
That said, what might work in one jurisdiction does not ensure that the same policy would work in another. While they worked in the US, China's experience was not the same. I believe that has to do with the unbalanced makeup of participants. When a market is predominantly composed by speculators, circuit breakers might not be the correct recipe. I would therefore suggest the issue requires a study period and an educational effort before it is again instituted in China. Most important, rational position limits should be adopted on speculative trading along with reasonable constraints on excessive leverage.
Fourth, institute a major educational effort on the use of futures with a focus on the Chinese commercial world. The adoption of regulatory incentives for Chinese commercial institutions, securities companies, fund and trust managers to encourage them to utilize the hedging capabilities of stock index futures.
Finally, the regulatory system must have rules in place that participants can rely on. Introducing regulatory changes in haste can lead to unintended consequences like panics. In our experience, an open, transparent and predictable process for enacting regulatory improvement is the best approach. In the U.S. all major changes in rules/regulations must be reviewed and agreed upon in full view of market participants, and communicated far in advance of implementation to allow market participants to anticipate changes and adjust their positions as appropriate. We also believe that Chinese regulators would be well-served to place more trust in the markets and the fundamental message they project.
I want to conclude my remarks by congratulating chairman Liu on his appointment to lead the CSRC. I trust he will follow the dictum of President Xi Jinping when he stated, "Let the market play a decisive role."
1 China February Finance 40 Forum Newsletter
2 For example, see the summary of fundings provided by "Market Declines: What is Accomplished by Banning Short-Selling?", Robert Battalio, et al., Federal Reserve Bank of New York Current Issues in Economics and Finance, Volume 18, Number 5, 2012.
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