The brakes are off.

Photographer: Philippe Lopez/AFP/Getty Images

China Has the Tools to Arrest Stock Slide

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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Doing the right thing for the long term sometimes causes short-term pain.

That could be the case over the next few weeks after China’s decision on Thursday to abandon the circuit breakers that it had implemented to limit destabilizing volatility in its stock markers. Fortunately, there are steps the Chinese government can take to ensure that the pain is temporary and contained.

QuickTake China’s Managed Markets

The government had put in place the narrow circuit breakers as a way of limiting the incidence and magnitude of panic-driven plunges in stock prices. Specifically, a 5 percent decline would halt trading for 15 minutes, and a 7 percent drop would shut the market for the day.

These circuit breakers were triggered twice this week as retail investors rushed for the exits in response to concerns about the Chinese economy that were amplified by rising geopolitical threats in the Middle East and Asia. Regrettably, the circumstances in which the halts were triggered -- in one instance, on Thursday, after just 15 minutes of trading -- only served to unnerve market sentiment, and threatened to precipitate further selling and a cascading sequence of dislocations.

By Thursday evening, Chinese regulators publicly recognized that the design and implementation of the circuit breakers were proving counterproductive, and they announced that the automatic shutdowns would be suspended. This decision is likely to be a good long-term move, but its timing is delicate and its packaging is questionable.

Unless it is accompanied by significant government-influenced buying, the suspension could fuel some more market instability over the next few weeks. 

To limit further financial destabilization and, crucially, counter adverse spillovers from the stock turmoil to the real economy, the Chinese government needs to take a more comprehensive approach.

Most urgently, it must make the circuit-breaker suspension just one element of a clear and consistent response that accelerates structural reforms and deals with the pockets of excessive indebtedness. In doing so, it would not only stabilize the stock market, but also regain influence in the offshore currency market, which poses the biggest threat of adverse contagion. The last thing China -- and the global economy -- need is a futile effort to prop up an offshore rate’s disorderly depreciation.

The slowing Chinese economy doesn’t have to undergo a chaotic collapse caused by financial instability. The authorities have significant policy flexibility and a range of effective tools. The turmoil in the stock market and, increasingly, the offshore currency market, are largely self-inflicted wounds rather than the inevitable consequence of disorderly deleveraging. And the country’s huge financial reserves can limit the effect of recent policy mistakes.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net