It was an ominous start to the year for China's stock market with trading lasting a brief 14 minutes on Thursday last week. Here are four points to help you understand the events.
Trading on Thursday was suspended by a newly implemented system of automatic circuit breakers which were set off when the market dropped 7%.
China's circuit breakers were only installed at the start of the year - the idea being that they would prevent a selling frenzy if the market depreciated too much by giving investors time to 'cool off'. While economists continue to speculate about what caused the market to fall in the first place, it appears that the circuit breakers actually worsened the situation.
13 minutes into the day's trading, a first circuit breaker was set off when the markets dropped 5%, prompting a 15 minute break in trading. When trading resumed, a second circuit breaker went off a minute later when the markets dropped by 7%, causing trading to be suspended for the rest of the day.
In other words, the circuit breakers which were meant to save the market, contributed to the crash. The first circuit breaker sent everyone into a panic, so when trading resumed, investors flocked to sell their stocks as fast as possible, causing the market to drop a further 2% in less than a minute.
Beijing has now done away with the circuit breakers, realising the adverse effects they caused.
Chinese government policy
The main problem with China's stock market is that it is extremely volatile. Even before the circuit breakers were installed, the market regularly fluctuated by more than 5%, making it extremely difficult to predict. While the volatility of China's stock market can be put down to a range of factors, it goes hand in hand with its transformation from a manufacturing to consumer led economy.
Navigating this is no simple task, but Beijing consistently steps in to try and shore up the stock market. In 2015 alone, the government banned large companies from selling more than 1% of their shares over 6 months and it injected huge amounts of capital whenever the stock market depreciated. This was all done in the hope of keeping good economic performance.
The result is that China's stock market does not reflect the reality of the financial situation on the ground. A comparison between Shanghai's stock and Hong Kong's stock with their respective GDPs in the table below outlines this perfectly.
The idea is that if the economy is doing well, the stock market should follow suit. However, this is clearly not the case of the Shanghai index.
The problem is that Beijing's interventions have created the opposite effect. Stock markets are the best way to raise money and represent capitalism at its very core. Beijing, on the other hand, has always tightly controlled its economy using regulations, capital injections and other means to ensure its good performance. If there is one thing stock markets do not respond well to, it's highly active government intervention.
Economic growth as national security
So if government intervention is causing the stock market to misrepresent the real financial situation of the country, why continue?
When China threw out its socialist economy and reformed to capitalism, the reason for the party's existence was threatened. It therefore sought to portray itself as the facilitator of economic progress for China's 1.4 billion citizens. It was a narrative which worked well. The economy grew, people got rich and China became a global economic and manufacturing powerhouse. Most people are supporters of the party because of the economic gains they have made.
Therefore, if the economy performs badly, the reason for the CCP's existence becomes threatened. Continued economic prosperity is up there with Taiwan and Tibet as matters of national security.
This explains the government's heavy handed interventions in the market. For example, when stocks plunged last year, Beijing's massive capital injections ensured that investors wouldn't make a loss. Unfortunately, this skewers the markets meaning investors don't make picks based on free market principles: the single most important question for Chinese investors is which companies does the government support?
The Chinese shutdown affected stock markets around the world. The Dow Jones closed at -5.2%, the worst year-beginning since the index started in 1928. The sheer size of China's economy means that any changes will undoubtedly have spillover effects. However, understanding the long term trends of China's growth, coupled with its continuing shift to a consumer led economy should allow foreign investors to take a more cautious approach.
Beijing also continues to actively control the value of the Renminbi in order to keep Chinese exports competitive and the economy stable, leading many analysts to fret about a currency war. However, this is extremely unlikely considering that China's shift to a consumer led economy will gradually require a strong renminbi.
Unless government intervention stops, China's stock market will continue to be volatile. The problem is that any relaxing of government control would undoubtedly lead to a crash, but the numbers would settle based on free market principles, consequently allowing the market to grow healthily in the long term. Beijing's dilemma is simple: it wants to embrace free market thinking, without relinquishing heavy state control of the economy. In the end, something will have to give. For the sake of the world's economy, let's hope it is the latter.