China's Latest Market Lesson

China is getting there - getting close to workable financial markets. But the road isn't smooth. And that's reflected in today's wild market action on the Shanghai exchange, which has triggered market declines around the world.

The Chinese thought they had their stock market issues solved after last summer's huge decline. You may remember that the Chinese government panicked at their stock market selloff -- halting trading in many stocks, sending billions in liquidity to major brokerage firms, and ultimately closing the markets. It was no demonstration of faith in the ability of free markets to set prices. And the Chinese were much criticized for their actions.

So they took a page from the rulebooks of the U.S. stock and futures markets, instituting a system of "circuit breakers" - temporary trading halts intended to stem a catastrophic market decline. But they weren't very good students of our systems. Instead, their circuit breakers contributed to the decline, making things worse.

They had set up two basic "market stops." The first would be a 15-minute trading halt, which would go into effect if their CSI 300 index fell 5 percent. The second circuit-breaker would go into effect if the index fell 7 percent. If that happened the market would close for the day.

Now, what would you do if you were on the trading floor at the end of the 15-minute trading halt? You'd rush to sell so you wouldn't be locked in overnight if the market fell further! And that's exactly what happened last night. That predictable rush to the exits occurred swiftly when trading resumed after the first halt. The 7 percent decline mark was reached in minutes after the market reopened. And then Chinese markets closed for the day.

Clearly, after decades of central control, the Chinese do not fully understand how markets work. Not only were the circuit breakers badly designed, the movement limits were set too low. Last summer, between June and September, the market moved by 5 percent more than 20 times! And it exceeded the 7 percent mark on half of those moves. It was like trying to contain a typhoon in a bottle!

China will likely restructure their system of trading halts to get it right. But fixing the source of the problem won't be that easy. The Chinese stock market declines were initially triggered by a weekend report showing their manufacturing economy slowing even further.

That dreary statistic spread fear of an ongoing global slowdown, impacting markets around the world - not the least of which was the Dow Jones Industrial Average. It is a small world, after all. And although the Chinese stock market may not have a wide global following, its economy and currency do impact other nations, especially developing countries and those with commodity-based economies. And that includes much of South America.

Since South American countries have borrowed in dollars, they are under increasing pressure to get dollars to repay their debts. Their currencies (Brazil, Argentina, Venezuela) have fallen in value as their exports (oil, soybeans, metals) are in less demand from China and the rest of the world. It doesn't help that the Fed raised interest rates, increasing the value of the dollar against global currencies.

Last year the dollar rose 49 percent against the Brazilian Real! It even rose 19.5 percent against the Canadian dollar, since Canada is also a commodities-based country. The dollar rose only 4.4 percent against the Chinese Renminbi - but that currency continues to move downward as it becomes less attractive based on slowing growth in China.

A lower Renminbi doesn't seem to bother the Chinese government, because it makes Chinese manufacturing exports more attractive to other countries - especially the United States, but also to its Asian trading partners.

And a higher dollar doesn't seem to bother the Fed, which raised interest rates making the dollar more attractive, and making our exports more expensive.

Since last fall, when the Chinese currency became part of the global trading market basket, the Chinese have been playing a bigger role in the global financial markets. They already had learned how to be the manufacturers to the world. Now they are learning tough lessons about being financial market participants.

Our own Federal Reserve has demonstrated how difficult it is to get those decisions right - on both direction and timing. Now the Chinese will find out how little control over markets they really have. And that's The Savage Truth.