The Chinese Financial System - Assignment Example

• THE CHINESE FINANCIAL SYSTEM

The China Stock market was previously among the highest performing globally making it hit a rank of being the seventh best performing stock market in the world. At that time, investors both local and foreign piled up as they were motivated by the fall of borrowing rates since the Central Bank is also known as the People’s Bank of China loosened its monetary policies creating an environment that favoured investments. However, unlike other stock markets, more than eighty percent of the Chinese stock market investors are small scale retailers. The good performance was also fuelled by a switch of investment away from property investment. The government also developed laws and policies that liberalised the stock market and made it easy for investment and firms were able to offer shares to the public which was the first time it happened in the history of the Chinese stock market.

According to stock market analysts, the dramatic rise in the economy was greatly driven by momentum rather than being driven by fundamentals of an economy. The stocks were greatly overvalued while the economy was greatly losing steam hence the abrupt rise in many stocks was short term and not sustainable (Katie Allen, 2015). The fall began when a third of the values of A-shares on the Shanghai stock exchange were lost within one month, and this was followed by major and severe aftershocks. The government of China tried to control the crisis through various strategies such as giving money to brokerages to buy stocks, discouraging company executives against selling their shares and also suspending new company listings.

The cause of all the turmoil; over the past year, investors poured more and more into the Chinese stocks even though the economic growth and company profits were weak (Charles Riley and Sophia Yan, 2015). It is believed that the institutional investors and foreign banks were shorting the Chinese stocks. By this, they were borrowing shares and immediately selling them hoping that they can get them later at a lower price and return them to the Chinese stock market and benefit from the difference. A surge of the Chinese stock market is believed to have been caused when the government allowed the use of property as collateral for margin loans and encouraged brokerage firms to buy stocks with cash from People’s Bank of China. It was like a bubble burst, and like all bubbles, it had to pop eventually out. Shares depreciated in a very short time, many firms and companies were reluctant to engage in dealings because they feared that they would lead to huge losses. China did not acknowledge that accounting transparency was necessary for their stock markets to be efficient. China is the world’s second largest economy and the recent slowdowns in manufacturing and commodity coupled with a weaker dollar are behind the falls (John Sudworth, 2015). This decline is characterised by a significant decline in share value on the Shanghai Stock Exchange. The amount of stock lost within the period is a third of the total value within a month. The government of China then intervened to salvage the situation, but the value of the markets still kept reducing. This concern by the government heightened the alarm of a crushing stock market when it tried to intervene by offering interest rate cuts.

• Hedging Techniques during Stock Market Decline

Hedging is an important process that is useful in risk reduction if the economy of a country undergoes a financial crisis. The goal of hedging is to ensure that there is an appreciation in the value of stock so as to offset the depreciation of portfolio in the event of a decline in the market. Hedging is typically a short-term strategy to protect long term positions. It may also be utilised to complete an arbitrage transaction. However, you never want to apply a long-term hedging strategy to a short term position as that would be costly and add more risk in the long run (Scott Rothbort, 2007). The hedging process should be cost effective so that it enhances the preservation of the value of the assets in the face of unstable pricing. In an event that there is a decline in the market, the hedging cost value should be lower than the declining value so as to enable sustainability and efficiency.

Staying in cash is a strategy in hedging however this strategy is short term. It involves selling off the equities. It is one of the easiest hedging strategies but is not viable in the long run. This method has pros and cons. The advantage of cashing the assets is that it gives financial flexibility as one can purchase assets because of the cheap prices as everyone is opting out. Cash, on the other hand, does not decline in value within a short time. The main disadvantage with staying in cash is the difficulty in jumping back in and if there was any return on the assets one will lose on the income. (J.J Zhang, 2014). Another short-term hedge method of cushioning the company from market declines is taking profits from the company as opposed to reinvesting the money in the business. This however is a method that focuses on protection of the business from any potential loses that may be incurred if profits were taken back to the business operation.

Bull spreads strategy is a strategy useful when one expects that the market prices are going to rise. This involves the manager buying a call option with a lower strike price and at the same time, they sell a call option on the same stock with a higher strike price. This agreement that gives the manager a cushion against the expected rise in market price and, therefore, the value of their assets is preserved.

Strangle strategy is used if there is an expected price movement, but the manager is unaware or unsure of the shift position. In this case, the manager does a safe gamble of obtaining a call and a put with different strike prices so as to factor in the unsurely of the price change. The two calls however normally have the same maturity and in the event of large price movement, it is indicative of a profitable business and hence indicative of asset value preservation or improvement.

Buying of a protective put is a hedging strategy. This strategy more or less resembles insurance policy. It is a form of security that upon subscribing to protects the manager from the risk of losing their money. This option requires one to use the money during the purchase of the policy. An example is one purchase a strike that costs a certain amount of money, and this protects a given number of shares if the value drops below the amount agreed upon during the protective put contract. This is however mainly used by investors who have relatively large amounts of money.

Another hedging strategy is a rotation into other sectors of operation. This is characterized by the sale of securities associated with one sector and using the amount raised to purchase securities of another sector. An example is when one shifts from selling electronics to selling food because of the constant consumption. This diversification guarantees the survival of the holdings.

Inverse Equity ETFs are built to increase in value when stock prices fall. Although they are not meant to be bought and forgotten, they can offer temporary shelter in a market decline (Ron DeLegge, 2013). Exchange Traded Fund is useful when done at the right time to avoid reversal and climbing of the markets that may expose the business to loses.

Open call writing is more of income building strategy that is used mainly when the expected market decline is minimal. It is not a complicated method of hedging and can be used by anyone even those familiar with its deep content since it exposes them to less risks. The more sophisticated call options that require expertise include the bear and bull call spreads. The bear spreads is mainly used when the market prices are expected to decline. This involves buying a call option that gives one the right to buy at a higher strike.

• Impact of Chinese Yuan’s Inclusion in IMF Basket of Currency

The Special Drawing Right (SDR) is an international reservoir set that has been established by the International Monetary Fund to supplement countries that are members a privilege of reserving their assets. The value of the SDR is based on the value of exports of a country and the importance of the currency regarding foreign exchange reserves. This describes the importance of currency in the world trade. China has been pushing for the inclusion of its Yuan in the basket. It has met the requirements of SDR inclusion criteria which are sharing in exports globally and ensuring that its currency is ‘freely usable.' To increase Yuan’s convertibility, the government of China has taken up strategies such as expanding foreign access into onshore markets, opening and increasing the number of offshore Yuan clearing centres, increasing and encouraging foreign investors and also by expanding the currency’s trading band. It has also developed and incorporated advanced interest rate scheme by introducing a deposit insurance system. (Bertram Sarmago, 2015)

The inclusion of the Chinese Yuan in the IMF basket plays an important role in sending a signal that the International Monetary Fund believes that the currency has the same global standing as the other currencies currently in the basket. The currencies are the American dollar, the Euro, the sterling pounds, and the Yen. According to IMF`s Managing Director, it is an important milestone in the integration of the Chinese economy into the global financial system. It is also recognition of the progress that the Chinese authorities have made in the past years in reforming Chinas monetary and financial systems (Nandini Rao, 2015). This recognition is significant as it symbolizes the currency to be “freely usable” a factor that will increase its determination by the market forces. The Yuan’s inclusion in the international monetary fund elite basket of reserve currencies may lead to more fluctuations in the value of the Yuan. But you may still get relatively stable returns if you invest in some fixed-income products such as bonds (Eddie Lee, 2015) This may result in the Yuan being used internationally and hence encouraging central banks in other countries of the world to increase their reserves of the Chinese currency. The increase in the reserves will translate to other central banks diversifying their foreign exchange holdings which in turn lead to partnerships with major global organizations such as the World Bank. This marks an economic breakthrough in the long run for Chinas economy.

The inclusion of the Yuan in the IMF basket will have long term effects as it expected that it will lead to an increased demand for the currency from the central banks of other countries and institutional investors resulting in an appreciation in value of the currency. This will be attributed to the global standing achieved by the Chinese Yuen. Appreciation of the currency will have a significant impact since it will encourage the government to gear towards the correction of the economy through reduction of export reliance and creating a focus on consumption hence rebalancing of the economy. This then translates to economic growth.

Its addition to the SDR basket will trigger global investors to look again at China as an important investing destination. The RMB has been a widely accepted trade currency for some time but is not yet a major investment currency (Bo Zhou, 2015). The inclusion may have a limited short term impact, but change is yet to be seen if there is a long-term acceptance by the IMF. On increased acceptance of the Yuan, it will become greatly integrated into global currency markets hence will compel the Chinese central bank to facilitate flexibility in its exchange rate regime to be more favourable in facilitating trade. This will give the Peoples Bank of China more power in setting and controlling the domestic interest rates hence more independence in imposing monetary policies that govern trade and the dealings pertaining the economy.

Appreciation in value of the Yuan will be a motivator to the consumers to purchase goods from other countries and reduce the surplus situation in Chinas current account. This surplus has been for a long time a factor contributing to trade imbalances in the economy. This imbalance has also been causing imbalances globally. The country may also attract flows from external investors mainly because of its suitable monetary policies hence leading to an appreciation of the currency.

The inclusion of the Yuan marks a strategic position for policy makers in the region to engage themselves in the creation of favourable legislation with the goal of marketing and promoting the currency to a world wide scope. There are various changes and reforms that ought to be considered before China transacts business with the rest of the world. This includes the guidelines to enhance the liberalization of capital and regional markets. Once this has been harmonized, it will help achieve increased in flows from external markets.