Financial markets crashed again in China on Thursday, and Chinese regulators halted stock markets after just seven minutes when equities sank by more than 7% as investors and traders raced for the exits on the opening of trading. This was the second time this week that Chinese authorities have had to step in to control extreme volatility in China stock markets.

Of interest, the panic selling was caused by the PBOC unexpectedly weakening the yuan, sparking fears of a “currency war” between China and its Pacific Rim neighbors.

More on China stock markets crashing Thursday

Keep in mind that the Chinese CSI 300 Index dropped 7.2% in less than thirty minutes of trading, then markets were automatically halted for the second time this week, Analysts note that many private funds and hedge funds in China have agreements with investors requiring mandatory liquidation if their holdings drop below a certain value, and that this “mandatory selling” is part of the problem.

In a related move, regulators in China on Thursday promulgated new limits on the amount of stock major corporate shareholders can sell. The CSRC capped the stakes major investors can sell at 1% of a form’s shares for the next quarter (new rules are effective on Jan. 9th. This new rule replaces the current six-month ban on secondary market stock sales set to expire this Friday.

There has also been a great deal of criticism of the new circuit-breaker rule introduced Monday, which the critics claim exacerbates a liquidity squeeze as almost everyone tries to get out before trading alts. The new rule mandates a decline of of 5% suspends trading for 15 minutes, and a decline of 7% closes the market down for the entire day.

“A trading break of 15 minutes or even longer wouldn’t ease their nerves or get them a clear picture of the fundamentals,” commented Polar Zhang, an analyst at BOC International Holdings. “On the contrary, it’s draining liquidity as everybody tries to get out of the door before the door is closed.”

“This is insane,” Chen Gang, chief investment officer at Shanghai Heqi Tongyi Asset Management Co., said in an interview on Thursday. “We were forced to liquidate all our holdings this morning,” said Chen.

Zhang said that if CSRC doesn’t improve the mechanism, he will reduce his trading volume by 20%.

 

Bloomberg is reporting further selling and notes:

The manager of a Chinese hedge fund that returned a surprising 86 percent during last year’s stock rout, Xinhong Investment, plans to sell all its stock holdings on Friday, Chairman Lu Weidong said in an interview. Hedge funds in China generally have agreements with investors spelling out mandatory liquidation levels if their holdings drop below a certain value, and as many as 30 percent of Chinese hedge funds may have reached those levels or are approaching them, Lu said.

“The selling pressure is huge,” Lu, whose firm oversees less than $3 million in assets, said on Thursday from his base in Dongguan in southern China. “They absolutely want to run.”

In the ballpark of 100 Chinese private funds investing in equities are down over 10% in the last 30 days, based on data from Howbuy Investment Management Co. Close to 1,300 Chinese hedge funds liquidated over $5 trillion during the China stock markets selloff during the summer as the value of their equity holdings fell below mandatory levels agreed with investors, according to Howbuy. However, do not worry as there still another 23,700 hedge funds left.

George Soros has added his name to the growing list of prominent investors who are warning of a market crash in China.

Yuan likely needs to fall further, but not too far

China Stock Markets

According to a December 7th report from David Fernandez and team at Barclays, it looks like the PBOC may be targeting faster depreciation to help the currency to reach an “equilibrium” level. It make sense that the Chinese authorities would move to faster depreciation to let the yuan more quickly reach a level that balances capital flows. Although it is possible there will be a faster outflow of capital as the yuan declines, this trend will come to an end when domestic investors believe the currency was at “fair value”. A related idea is that once the yuan is perceived to have reached “fair value” (assuming it stabilizes soon), this may lead to stronger demand from overseas investors such as central banks, who may now want to hold CNY after the decision to include the Chinese currency in the IMF SDR basket. A final reason to rapidly depreciate the yuan to stable levels is that China does not want to spend their foreign exchange reserves too quickly.

The Barclays team argues: “Whatever the reason for the sharper depreciation of the CNY, we do not think that China will let the move get out of control and would prevent a sharper move or any panic in global markets – as it did following the August devaluation,”

Dollar-denominated debt could lead to domestic credit squeeze in China

China Stock Markets

Sean Darby and colleagues at Jefferies argue that a large amount of dollar debt (external US$880bn end-2013) in China is aggravating the PBOC’s current problem. They point out that if the yuan depreciates too much too soon the dollar amount owed will increase, which could result in banks not having enough capital to meet domestic borrowing needs.

Darby et al. note: “China is caught in a catch-22 situation. With Chinese New Year just around the corner, the PBOC will need to do more reverse repos given the jump in demand for deposits over that period.”

UBS opines in a note titled “A problem of the circuit, not the breaker”

Some market comments say the A-share circuit breaker is the source of sudden sellingoff. We think the design of circuit break is indeed suboptimal. But more importantly, we think the frequent triggering of circuit breaker probably means the circuit itself is faulty. In our view, the intrinsic vulnerability of A-shares is the unreasonable valuation of small-caps (ChiNext index still trading above 80x PER as of today). We believe the circuit breaker only exacerbates the herding behaviour to take profits before the lift of share-selling ban tomorrow.

 

George Soros
Chart Via S&P Capital IQ