Why are China’s stock markets so volatile?

China is now home to the world's largest equity markets after the US. Yet extreme volatility is still typical, with benchmark indices often swinging as much as 10 per cent in a matter of

hours.

On one day in June, more than $700 billion was wiped off the value of Chinese stocks. Here are some of the main reasons for the volatility:

Retail punters account for 80-90 per cent of trading in the Chinese equity markets. Many of them are new to investing — in May alone more than 14 million trading accounts were opened. That

means millions of people trading stocks have little or no direct memory of the 2007-8 stock market bubble and crash.

Even professional fund managers in China often act with very short-term horizons. Many are measured on monthly or quarterly performance, adding pressure to chase the market higher as it

moves.

Chinese markets are often described as policy-driven. That goes well beyond the direction of monetary policy and deep into securities and banking regulation. Even state-media rhetoric has a

role to play, as shown by recent supportive messages in various government newspapers. But Beijing's pronouncements are often open to interpretation, leading to sharp rises and falls in the

market as millions of investors try to read the runes.

Read MoreChina regulator to probe possible stock market manipulation

Prospects of change — As long as the stock market remains a policy lever for the government, and share indices dominated by state-owned enterprises, Beijing's heavy hand is unlikely to be

significantly weakened.

Beijing has tried to encourage more long-term institutional investors into the market, for example by granting freer access to large foreign asset managers or sovereign wealth funds.

However, progress has been slow.

Margin finance has been cited as major factor behind the market's growth. What is this, and how does it work?

Using borrowed money to trade stocks is a common feature of equity markets globally but in China it has rocketed over the past year. Margin trading as a percentage of overall market

capitalisation reached a record earlier this year, according to Macquarie — far higher than anything seen in any other market at any time in history.

High levels of leverage help explain why stocks ran up so quickly over the past year. But that borrowing leaves the stock market prone to dramatic falls as investors struggle to meet margin

calls.

Prospects of change — The regulators have tried to cut the level of margin lending in the system, which has been a key reason for the recent pull back.

The system for new listings in China remains tightly controlled by the authorities. The state in effect sets the price of new share sales, virtually guaranteeing quick bumper returns for

those able to buy in. Even on days when the Shanghai market has fallen sharply, IPOs have typically risen by the daily limit of 44 per cent.

The result is that investors pull cash from the market ahead of new listings, draining billions of dollars of liquidity for a number of days. That can torpedo the market, but then push it

back up when the funds are unlocked again.

Prospects of change — Regulators are clearly aware of the need for a rethink, and have promised to hand over IPO approval powers to the stock exchanges, perhaps as soon as this year.

However, analysts expect the transition to a more market-based pricing system to take some time.

Although China has introduced a system for short selling stocks, it remains of little use in practical terms. Borrowing costs are high and the availability of stock to borrow is limited. The

only real viable way of hedging exposure is through index futures, which is not helpful for those trading specific stocks or sectors such as tech and healthcare. Instead, traders simply

have to buy or sell to lessen or increase their exposure, which can result in stampedes when sentiment switches.

That regulators have tried to introduce shorting at all shows a recognition of the problem. The April debut of options for shorting small-caps was an important step in the right direction.

However, the steps taken fall far short of what is needed, suggesting that authorities remain wary of the consequences of making short selling easier.

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