The circuit breaker has been suspended — four days after its introduction to suppress market volatility. The crowd rejoiced, but we are less sure. Previously, we have discussed how the selling has been omnipresent, not specific to A-shares — even though A-shares’ fall was more than twice as large. We have also discussed the resolve to reform demonstrated in the People’s Daily front-page editorial, and the reform’s short-term sacrifices similar to 1998, as well as the yuan’s depreciation as an agent of deflation.

As such, the circuit breaker is a volatility magnifier, but not the trigger. And if so, its suspension should decelerate, instead of reversing the decline in A-shares to reflect China’s weakening fundamentals.

Last August when the People’s Bank of China suddenly announced the currency reform, and boldly set the yuan fixing higher, Shanghai Composite Index plunged more than 1,000 point in the ensuing two weeks. Again, late last November, the benchmark Shanghai Composite seemingly plunged almost 6 percent on no obvious news (although later on it was whispered that the news about the registration-based IPO was about to break). Neither of these incidents involved the circuit breaker. That is, the market is capable of significant volatility, with or without the circuit breaker.

We can deduce from these observations that volatility seems to be endogenous. In a period of intense market reform and economic restructuring, the risks of growth collapsing and deflationary are rising. It is thus conceivable that earnings volatility will rise, and cannot be suppressed by simply manipulating trading rules. Instead, changing the rules as the game is played, such as introducing the circuit breaker, can confuse market participants, and heighten market volatility, which is against the best intention of the regulators.

In the unpublished work “the Great Wall of China” during his life, Franz Kafka tried to grasp the meaning of the Great Wall, the clarity of which is in stark contrast to the obscurity of its purpose. Yet the Wall seemed to be perching at the edge of his understanding. It was said it was because of the decree to fend off tribes from the north. Yet the high command is no “gathering of mandarins summoned hastily to discuss somebody’s fine dream in a conference as hastily terminated”, Kafka pondered. So the idea to build the wall by the high command must have existed - from all eternity as well. If so, the northern tribes could not have been the reason. Perhaps the answer lies somehow in the heart of the Chinese cultural institution itself.

The circuit breaker was implemented, much to the perplexity of market participants and against their protests. Its existence has been more ephemeral than its memory.

Volatility is endogenous, much like the idea to build the Wall. But to build a “wall” around it seems innate to a culture that is obsessed with planning and controlling. The good news is that the market has cheapened in the first four short days of the New Year, and is rapidly gravitating toward our reasonable trading level of 2,900.

Voices
from insiders

Sinolink Securities

The halt of the newly introduced circuit-breaker mechanism was a proper method in times of irrational drop in the market. However, as the mechanism took place twice in the week, shares connected with margin trading are expected to be sold soon.

Yan Yanming
Analyst at GF Securities

Despite low expectation of the investors, the market will see some beneficial news after the circuit-breaker mechanism was halted. It is suggested the investors, especially the individual buyers, not buy more. For groups holding very few shares, they might conduct reasonable purchase when there is new move from the government.

Li Daxiao
Head of Yingda Securities

The half came as great news as it can effectively stop risks brought by limited understanding of the real market circumstances.

Also unreasonable flux could be prevented. As listed companies have been required not to considerably sell shares, the market is expected to get stable with such efforts from the government.

Nomura Securities

The well-intended circuit breakers have been functioning as super-charged accelerators for investor fears and market volatility.

An alternative would be for buying or selling to take place after the downward or upward circuit breaker is triggered, albeit only at the same prices when the circuit breaker kicked in.

While we don’t think the circuit breaker should take all the blame for A-share market plunge, we note that the timing of the launch was not ideal either, as A shares have been under pressure from multiple factors in the past several weeks.

China’s circuit breaker timeline

In September 2015

China unveiled the circuit breaker proposal after a massive summer rout sent the Shanghai key index diving by more than 40 percent.

Under the rules, a move of 5 percent in the CSI 300, which tracks the stock prices of 300 largest companies listed in Shanghai and Shenzhen, triggers a 15-minute trading halt, while one of 7 percent triggers a trading halt for the rest of the day.

On January 4, 2016

The CSI 300 dropped 5 percent and triggered a 15-minute trading suspension from 1:12pm. After trading resumed, shares slumped further to force the market to close at 1:33pm.

On January 7, 2016

The trading halted around 9:42am as the CSI 300 lost 5 percent and the market closed at around 10am on a 7 percent plummet, 30 minutes after market opened.

Close to mid-night, the China Securities Regulatory Commission said it will suspend the circuit breaker mechanism from January 8.

On January 8, 2016

The Shanghai Composite Index closed 1.97% higher on the news of the circuit breaker suspension.

While the Shenzhen Component rose 1.2%.

Background about circuit breaker mechanism

The United States instituted the circuit breaker mechanism in late 1980s in the wake of 1987’s “Black Monday,” the day when the market tumbled 22.6 percent. The mechanism was triggered only once in 1997. It has been widely adopted by a number of countries including South Korea, Japan and India.

The circuit breaker in the US has three thresholds of 7 percent, 13 percent and 20 percent, while India sets three thresholds at 10 percent, 15 percent and 20 percent.