Volatility is back and it has caused big swings in the global markets. By the end of the week, the Dow saw the largest drop since the September 11th attacks while the Japanese Yen saw the biggest weekly gain in 14 months on the back of carry trade liquidation.
Although the US economy is beginning to see problems of its own, the real trigger for the break in the markets was the 9 percent slide in Chinas Shanghai Composite Index - China sneezed and the rest of the world did too. Since then, the ebb and tides of the US financial markets has been determined by the overnight fluctuations in the Chinese market, which is a dramatic shift away from the way things normally operate. When the Chinese government denied any plans to take the steam out of the stock market by increasing corporate taxes, the sell-off abruptly stopped. So is the Chinese government the puppet master behind these moves? Have they become the new linchpin for the global markets and can US traders now use the Chinese stock market as a leading indicator for what will happen to the Dow? In order to try to answer these questions, we have to first understand how China gained such a stronghold on the markets.
China Leading the Dow
In the past, the US markets set the tone for overnight trading in the Asian markets, but China has recently become the trendsetter. A play by play of the action in the Chinese stock market (as shown below) reveals that on Tuesday February 27th, the Chinese stock market ended the day down 9 percent. The US stock market then gapped lower at the open a few hours later to end the day down over 400 points. On Wednesday the 28th, the Chinese stock market rebounded and the US stock market did the same. On Thursday the Chinese stock market resumed its slide, triggering a 200 point drop in the US stock market at the open. Finally on Friday, Chinese stocks ended the day higher. This suggests that even if we do not have a positive close in the Dow today, that a rebound could be seen on Monday.
What Has Changed?
In less than three years, China has become a very major player in the global financial markets. Not only have their foreign exchange reserves hit a milestone above $1 trillion, but the market capitalizations of their stock markets are more than $1.3 trillion. Over the past few years, many international companies have become intimately tied with China by either becoming heavily invested into the country or having China heavily invested in them. The wave of initial public offerings last year on the Shanghai and HK stock exchanges have also attracted a great deal of foreign investment that will be eager to bail if the sell-off deepens.
China Needs to Tame the Bubble
For reasons of their own, China needs to tame the speculative stock market bubble. Prior to the latest drop, the Shanghai Composite Index hit a record high on February 26, 2007. This represented a 158 percent rise since January of last year. The turnover in the stock market is up 700 percent while the number of local traders has increased significantly since the beginning of this year. With so many of their citizens dipping into their savings or leveraging their homes to play the markets, China does not want to see a collapse that is reminiscent of the 1997 East Asian financial crisis or the 9/11 induced crash 5 years ago. They have a strong interest in taming the bubble now, when it is still manageable. Today they cut the amount that banks can borrow overseas to stem the hot money flows into the country. On February 16, they raised the reserve ratio that banks are required to 10 percent, which marks the fifth increase in eight months. The measures are showing their effect, but the Chinese government still has a lot more to do. Even with the latest drop, the stock market is up 10 percent year to date.
We suspect that the Chinese government is very happy with the latest movements in their financial markets. We have seen their comments and actions induce both fear and stability into not only their own markets, but markets globally. As the worlds largest holder of foreign reserves, China has what it takes to back what they say. The world is no longer shielded from the fluctuations in the Asian markets and as China continues to grow, they will command an even bigger role in the financial markets. Although the US could easily become the driver for the global stock markets once again, expect China to steal the drivers seat every so often. Anyone trading the US stock markets, US dollar and Japanese Yen will find it worthwhile to keep a close eye on the performance of the Chinese stock market.