China’s stock market collapse: contagion?

As I write, I witness the continuation of world stock market turbulence and uncertainty that began in Shanghai since June this year and continues in New York to this minute. The last two days have been much more turbulent on both ends of these financial centers.

“Extreme volatility and huge collapse in value.” Yesterday, Shanghai lost 8.5 percent of its market value. The week before, the same market lost 11.5 percent in five trading days. From June to date, the collapse of the Chinese stock market represents a loss of 40 percent of the market value at its peak.

In New York, the Dow index has fallen sharply in the last two days. It was down eight percent within two weeks, much of that contributed by the drop on Friday’s close and today’s.

Dow’s Monday opening began with a dangerous huge sell-off that hovered at 1,000 points. That degree of drop would have shaved six percent of market value. However, trading stabilized by mid-day and early losses were pared so that the market closed with a drop only of 588 or  three percent of market value.

In Europe and in Asia, markets mimicked the volatility in both continents. Monday’s close for European stocks were down between four and five percent. Asian markets have been slumping, tracking some of the losses suffered by China.

Manila’s PSE index was relatively more insulated from the Chinese troubles at the beginning of the Chinese stock market decline. But on Monday’s close, the PSE index fell in value by 7.9 percent, the highest registered among regional markets, partly because it was spared the drop in markets last Friday when the bourse was on holiday.

“Stock markets are a reflection of real market developments.” Stock markets are more likely to be influenced by sentiments and events. However, they are often linked fundamentally to what happens in the real economy, on the economy’s true potential strength and on its relations with other economies.

So behind these volatile forces, we must look for the eventual causes or factors that move markets. With China’s economy much more closely linked to the economies of other countries, there is the danger of financial contagion.

“China’s early expansion is a wide network of trade links.” For decades, China’s growth was spectacular – at 10 percent per year. This growth enabled China to become a highly industrialized economy, wiping out poverty and becoming a major driver of economic growth in the world economy.

China’s growth has led to the development of substantial trade ties with the rest of the world – first as a supplier of inexpensive industrial goods to much of the global economy. It began to dominate the production of major consumer goods that industrial economies needed.

Initially, the major industrial countries became its markets, but as time went on, this expanded to many emerging countries. As China’s economy grew, it also developed strong trading relations in industrial raw material sourcing with other developing countries within the region, especially neighboring countries in East and Southeast Asia. In this way, its economy developed strong industrial complementarity with other East Asian countries even as they all competed too.

China has also become a major buyer of industrial raw materials – energy, minerals and agricultural commodities essential to its industry. This spread its relations across continents where such commodities were available.

A third major link of China with the rest of the world is capital – as source of investments. To accelerate its growth, it welcomed foreign direct investments. As such, much of its dominance in trade is due in part to the large amount of foreign direct investments that manufactured for world markets. Thus, countries with high foreign direct investments in China are tightly linked with the fate of the Chinese economy.

The spectacular growth of China included the phenomenon of expanding large trade surpluses with major industrial countries. One such unique relationship is that with the US. Large trade surpluses with the US have led China to amass huge financial savings. In turn, these savings enabled China to become a major creditor of the US, because the latter had large fiscal deficits. China has become the highest holder among foreign countries of US debt.

“China on a lower growth path.” Since 2008 when the world economy went into recession, China underwent a transition toward a lower growth path. This was partly the result of lower demand for Chinese goods in foreign markets.

China had to retool its development strategy by directing a new focus on creating domestic demand to push economic growth. This also meant accepting a lower rate of growth for the economy.

For a while this was thought to be eight percent per year. Realistically, this has been reduced to seven percent per year. There are indications that even this rate of domestic growth appears to be difficult to sustain. There have been many examples of failed property projects to illustrate this problem.

In the midst of these changes, China’s domestic costs have also risen. Labor costs have gone up. As a result of this, many industries that formerly depended on inexpensive labor have migrated to lower cost economies in the region, mostly to Southeast Asia.

“Yuan devaluation and exchange rates among countries.” A recent surprise move of Chinese monetary authorities unsettled foreign exchange markets. Two weeks ago, they announced the devaluation of the currency.

China’s yuan has been, as a matter of policy, pegged to the US dollar at a fixed rate. During the years when the dollar was weak, China’s competitiveness thrived well. Part of the rising costs in China, though, has been the strengthening of the US dollar as a consequence of US economic recovery and the continued stagnation in Europe and other parts of the world.

The yuan devaluation was designed to restore improved competitiveness for China. It also set off some exchange rate volatility across the Asian region. An immediate consequence of the yuan devaluation is that the Philippine peso has also depreciated further. Today it is 46.7 pesos to the dollar. Around June, it was 45.5.

It stoked further volatility in the stock markets of various countries with strong trade links with China. The drop in the US stock market was immediately occasioned by the news of the yuan devaluation.

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