Why All The Volatility In China?

Includes: CNY, CYB, FXCH, FXI
by: Wall Street Daily

By Tim Maverick

So far in 2016, financial markets around the world have been buffeted by what's occurring in China.

The mainstream financial media likes to play the situation up as if China is in dire straits. As someone who's seen pundits proclaim the end of the Chinese economic boom for well over 20 years, I can tell you China's economy isn't falling off a cliff.

But there are substantial changes occurring, as this centrally planned economy allows the markets to operate more freely in China. So just what is going on there? And why is there such turmoil in China's markets?

There are three reasons...

Reason #1: Failed Circuit Breakers

One cause of turmoil in the Chinese stock market is the failed circuit breaker experiment.

The concept was sound. After all, the world's major stock markets all have circuit breakers in place to halt a collapse in stock prices.

But Chinese regulators - remember, this is all new to them - placed their circuit breakers in a range that was too narrow. Trading was halted for the day after only a 7% drop in prices. They should have adopted the U.S. model, which shuts down the market only after a 20% price drop.

Now the circuit breakers are gone. What remains is a halt in individual stocks after a 10% drop in price.

I wouldn't be surprised to see China reintroduce circuit breakers at some future date, with a much wider trading band.

Reason #2: Unsophisticated Traders

Another reason for all the volatility in China's markets is that on the mainland, most of the trading (about 85%) is still done by individual mom-and-pop investors. Many simply didn't grasp the concept of circuit breakers, which was poorly explained by the regulators.

The country has yet to develop a deep pool of institutional investors like in the developed markets, which would create stability.

China also doesn't have a Warren Buffett-type figure yet. A person like him saying all is well, and that he is buying stocks, would keep flighty individual investors from panicking.

Reason #3: It's the Currency, Stupid

The most important reason for global turmoil is China's currency, the renminbi or yuan. And here I have to point the finger at global, and particularly U.S., money managers.

When China's currency was accepted as a reserve currency by the IMF, the country said it would free up trading and make it a more representative currency.

In other words, its currency would more accurately reflect what's going on with its economy and global trade. Along these lines, Chinese authorities announced last month that the renminbi's value would now be based on a basket of 13 of its main trading partners' currencies, not the U.S. dollar alone.

The main reason behind this change is that the strong U.S. dollar was making China's yuan uncompetitive. The renminbi has climbed 35% versus its non-U.S. trading partners' currencies in the past six years.

Yet, money managers continue to be focused on the U.S. dollar-yuan exchange rate. All this turmoil in the first week of the new year was caused by a mere 1.5% weakening in the yuan versus the dollar to about 6.59 yuan.

Much of the turmoil was caused by U.S.-based hedge funds. They began trading the offshore (Hong Kong) renminbi in an effort to challenge the PBOC (People's Bank of China) as to how fast the renminbi would move.

The PBOC quickly learned that becoming one of the world's elite currencies wasn't all that great. But they are learning. On January 11, they began intervening directly in the offshore market, in an effort to force out these U.S. hedge funds looking to make a quick buck.

What It Means

Should the average U.S. retail investor be concerned about these currency gyrations?

To me, it was much ado about nothing. Especially when one considers that against the basket of currencies, China's currency was practically unchanged.

My hope is that U.S. money managers get over the fact that China now believes the U.S. dollar is no longer the center of the financial universe.

More adjustments against the dollar are coming, albeit in a very gradual manner. After all, China's government doesn't want to wallop all the Chinese companies that have taken out dollar-denominated debt.

I expect China to eventually push the yuan back to the 6.83 level versus the dollar, where it was for many years. That's less than a 4% move.

That may cause another hissy fit from U.S.-based fund managers. But stay calm and stick to your financial plan. This too shall pass.

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