Written by Kathleen Walsh.

The recent equity market volatility in China is unlikely to derail plans for the internationalisation of the Renminbi (RMB).

Why? Because China is too far down the track, most of the changes needed are for domestic reasons and the market “hiccups” are merely a sign of a new stock market finding its feet.

Granted, the new market is currently the second biggest equity market in the world and is set to be the biggest by 2025 therefore the impact of any hiccups are far reaching.

The first week of trading in 2016 on the Shanghai and Shenzhen equity markets saw the introduction of a new circuit breaker system designed to restrict excessive fluctuations. The system tracks the movements of the CSI300 Index and imposes a 15 minute suspension if the market moves by 5% and a one day suspension for a 7% move.

The system is not dissimilar, albeit more conservative, to the US system where a 10% movement on the DOW results in a one hour suspension on the NYSE (with further measures at higher levels of volatility). It seems that the tight threshold of the circuit breaker coupled with a revised ban on selling by major shareholders spooked the largely retail investor base in an environment of increased economic uncertainty and potential deflation. This led to an increase rather than a reduction of equity market volatility.

Within days of the introduction the circuit breakers have been tripped twice with trading on January 6 only lasting 29 minutes from the open. After only four days the circuit breaker was suspended.

One of the central issues here is the internationalisation of the RMB. Internationalisation of a currency occurs when it is widely used offshore for trade, investment and reserve currency purposes.

It requires few, if any, capital controls, a floating exchange rate, deregulated interest rates and sound regulatory and corporate governance frameworks. China is making deliberate steps to internationalise its currency and this objective has been openly and officially pursued.

This will see China’s financial relations with the rest of the world matching its trade relations and the size of its economy.

Unfortunately, the equity market turbulence coincided with renewed fears that China would devalue the RMB. News surrounding the exchange rate, reserve levels and oil prices caused havoc in international markets and resulted in many markets experiencing the worst start to the year on record.

However impact of this turbulence has been somewhat exaggerated as it has been reported by some as “clumsy” and “ineffective” policy decision making by China and suggests that China is not ready to internationalise its currency. This is far from accurate. China needs to fit decades of capital market learning into a handful of years and there is no doubt that the road from a planned economy will be a little bumpy.

I have co-authored two reports on this topic and in the 2014 report we estimated a 10 year horizon but revised that to a five year clock in the 2015 report. This change reflects the increased pace of change and commitment by China. However this is the timeframe for access – more time may be needed for confidence, especially with regard to corporate governance and investor protection.

There are four things we need to consider in terms of confidence:

  • Shanghai and Shenzhen markets are dominated by retail investors. According to Reuters about 85% of the trades on the Chinese stock market are retail. Therefore traditional methods to combat volatility may not be appropriate in this market
  • Access to China is limited so at present it is somewhat insulated with between 1 and 2% participation from international investors.
  • Despite China’s recent attempts, we know that free markets cannot be managed and we still expect to see a few rookie errors (for example “asking” State Owned Enterprises (SOEs) to buy stocks in order to prop up equity prices and restricting selling by large shareholders is unsustainable)
  • SOE reform is paramount to establishing confidence in equity markets and greater reform in this area remains vital if the Government is to succeed in its objective of internationalising the currency, opening up China’s capital markets and improving domestic resource allocation.

China will soon realise that there is a tipping point when moving from a managed to a market economy and you can’t continue to stem the tide. Prices will set themselves.

Kathleen Walsh is an Associate Professor of Finance at the Australian National University. This article was first published on The Conversation and can be found here. Image credit: CC by Tomas Roggero/Flickr.