When Shanghai sneezes, the rest of the world is now catching a cold.
Up until recently all eyes looked to Wall Street. Whatever US stocks did overnight set the tone for sentiment and trading across the globe for the following 24 hours. Wall Street is still clearly important, but what happens in Chinese financial markets is starting to compete for trader’s attention.
Signs of this were evident last year when the surprise devaluation of the Chinese currency in August led to a mini-panic across financial markets. It was enough to even stop the US Federal Reserve from raising interest rates in September.
To many, China’s decision to let the Yuan drop against the US dollar was a sign of official panic: it was but a desperate attempt to boost exports given their flagging economy. In turn, that led to fears of a series of destabilising “competitive depreciations” across Asia and the world more broadly.
A few years ago, meanwhile, the wild gyrations in China’s stock market led to little more than a chuckle from western onlookers. Chinese stocks are driven by the fear and greed of local mum & dad investors and bear little relationship to the broader Chinese economy. Last year’s stock market surge led to further chuckles, yet curiously the inevitable collapse in stock prices is now being met with global alarm.
Of course, not helping matters is the apparent ham fisted approach of Chinese authorities to both market regulation and market communication. There’s a sense that while the Government long seemed able to control its economy, it’s having a far harder time controlling its partly deregulated financial markets.
Indeed, its recent attempts to ban equity market selling by large institutions and use of “circuit breakers” to close the market when prices have fallen too far are a case in point. The surprise decisions to suddenly change exchange rate targets against the US dollar are another example.
What’s going on? To my mind we’re in a process of learning. Chinese authorities are learning how to manage financial markets which are themselves in the midst of gradual deregulation. And the rest of the world is now being forced to take notice of and learn about Chinese financial markets and the behaviours of officials in this still largely opaque world. Mistakes are being made by both sides.
As regards to the Chinese, the lack of effective communication with respect to its exchange rate policies is a case in point. Given the US dollar is rising across the globe, it’s not unreasonable for the Chinese to want to allow its currency to depreciate like that of most other nations also. Indeed, the Yuan generally appreciated against the US dollar in earlier years when the greenback was weak, and some of that appreciation is now being unwound. Far from wanting to push the Yuan lower, the Chinese authorities have in fact been intervening in the foreign exchange market to slow the degree to which the market itself would otherwise have pushed Yuan down – as evident from Chinese sales of foreign exchange reserves and purchase of its own currency.
Yuan against Major Currencies
Late last year in fact, the Chinese announced it would now manage the Yuan against a basket of currencies – so it is effectively setting a US dollar rate which keeps the broader exchange rate basket index at a target level. If the US dollar rises against other currencies, the Chinese have no choice but to adjust the peg to the US dollar lower so as to keep the overall exchange rate basket index at its target (if the US-dollar peg were left unchanged, the Yuan would appreciate against all other currencies along with the US dollar).
So what we need to be focusing on this year is where the Chinese allow the overall currency basket index to move – not the bilateral rate against the US dollar per se. At present at least, the Chinese are saying they want the value of the basket index to remain “stable” – which if true, counters view China is embarking on competitive devaluations.
As regards to the share market, China’s use of circuit breakers also seems ham fisted, but we should not forget even the US market has circuit breakers in place to close down Wall Street in the event of unusually large market declines. Indeed, should US stocks drop by 7% intra-day, a trading halt takes pace for 15 minutes. Another halt takes place if stocks drop by 13%, and trading is closed for the remainder of the day if stocks drop by 20%.
The problem for China is that the market is a lot more volatile and driven by less sophisticated mum and dad investors – so the circuit breakers were arguably too narrow relative to the market’s volatility. I suspect a broader set of circuit breakers will be eventually re-established and the market will also simply need to learn how to find its own feet in times of panic.
Most importantly, however, I don’t think recent tremors from China’s foreign exchange and equity markets necessarily suggest the economy is heading for a hard landing – despite what many foreign observers pinning their hopes on the latter would like to believe. On the contrary, to my mind the China’s slowdown and gradual transformation still appear orderly.
That said, with China’s growing importance in world affairs, a lot of learning still needs to take place by both Chinese policy makers and international investors to reduce the level of miscommunication and misunderstanding between them.
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