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Why China's stock market and currency policies are bound to fail

Photo: Getty Images.

China is trying to turn back the clock.

Having unleashed the forces of the market to build a bubble in stocks in 2015 to help aid China’s economic transition, the communist nation is now uncomfortable with the fallout from the collapse in prices and the impact that will have on retail investors and the economy.

Likewise with the yuan, China is trying to keep a lid on both the pace of the currency’s depreciation and the capital flows that go with that.

Last night we learnt just what a huge impact this is having on China’s massive hoard of foreign exchange reserves. During December reserves dropped by $108 billion to $3.33 trillion as the central bank sells US dollars and buys Yuan to slow the depreciation of its currency.

The problem with the stock market and currency policy China is trying to follow is that history, and fractal finance theory, tell us China will eventually give in on the currency and expand the triggers on its stock market circuit breakers.

History says Mr Forex Market will win

Misunderstanding the apocryphal story of King Canute holding back the tide, Chinese policy makers are seeking to do something developed economy central banks and governments gave up on during 1970s and ’80s.

After US president Richard Nixon closed the gold window in 1971 governments around the world have increasingly stepped back from trying to manipulate currency and other financial markets.

The reason Nixon, and subsequent governments including Australia which floated the dollar in December 1983, stepped back from markets is that the costs of trying to hold a line against the market, and capital flows, becomes simply too expensive and economically disruptive for the country to bear.

As the Australian experience shows allowing the currency a free float lets the relative moves of the Australian dollar either add (via a depreciation) or subtract (via an appreciation) from economic growth as the economy needs.

The secondary impact is that a free float also frees the central bank up to undertake monetary policy aimed exclusively at the countries economic growth rate free from the artificial constraints of trying to support an overvalued currency.

Certainly China should be letting its currency float. And in time it most likely will.

But don’t forget China only joined the world trade organisation in 2001. It’s become a huge economy since then but neither its institutions, policy tools or majority of the economy has evolved at a pace in keeping with China’s importance to the global economy or markets.

The inventor of market circuit breakers says China got it wrong

Nicholas Brady was the US treasury secretary from 1988 till early 1993. He’s the guy who invented the so-called Brady bonds to help Latin America get out from under its heavy debts in the 80s.

He’s also the guy who set up the circuit breakers on US stock markets in the wake of the 1987 stock market crash.

Brady told Bloomberg overnight that China is “on the wrong track” with its current circuit breakers.

Mercifully it seems the message was received because Chinese authorities have abandoned the 7% circuit breaker rule for the Shanghai stock market.

It’s not that Brady thinks circuit breakers are a bad idea, the S&P 500 has circuit breakers to this day at 7%, 13% and 20%. Rather Brady said China needs “a set of circuit breakers that appropriately reflects their market.”

Fractal finance explains why the currency policy and the current circuit breakers are failing

In his book The (Mis)behaviour Of Markets the father of fractal geometry, and its offshoot fractal finance, Benoit Mandelbrot (and co-author Richard L. Hudson), neatly explained why China’s policies are struggling to work against the market.

It’s simply a function of how markets work, Mandelbrot wrote.

In the chapter devoted to his “Ten Heresies of Finance”, Mandelbrot said “a favourite pastime of cranks and academics is devising the financial equivalent of a perpetual motion machine.”

Mandelbrot means “continuity is a fundamental assumption of conventional finance.” It underlies the teachings in finance of Nobel Laureates Harry Markowitz, William Sharpe and the all-important Black-Scholes options pricing model. These approaches, which underpin financial theory of markets, “all assume continuous change from one price to the next.”

Clearly this theory also underlies the way China is trying to slowly walk the yuan down against the US dollar and manage falls in its stock market.

The trouble is that the assumption of continuity is “false and the math is wrong,” Mandelbrot says.

Almost any experienced trader on any desk in any dealing room, or central bank, would agree with this statement.

Here Mandelbrot says [our emphasis added]:

I contend the capacity for jumps, or discontinuity, is the principle conceptual difference between economics and classical physics… in a financial market, the news that impels an investor can be minor or major. His buying power can be insignificant, or market moving. His decision can be based on an instantaneous change of heart, from bull to bear and back again. The result is a far-wider distribution of price changes: not just price movements but price dislocations.

In summary Mandelbrot is saying “prices often leap, not glide.”

And that’s the problem for China. It is trying to glide prices lower for the yuan and stocks when the market wants to leap.

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