What a fall in China’s stock market means to global markets

By Arthur S. Guarino

China’s stock markets are the world’s largest equity market having high volatility.  While China’s markets have grown, they are a source of investor angst.  In Summer 2015 the Shanghai and Shenzhen markets fell 40 percent while in early 2016 they toppled 20 percent.  China’s markets have global investors wondering when the next downward spiral will occur and if its circuit breakers will function.  But the bigger question facing global investors is the economic and financial impact on other markets.

Impact on Global Markets

Financial markets are so interconnected that a ripple in China will cause severe quakes elsewhere.  If the Chinese stock markets took another serious dive, global markets would fall.  For example, when Chinese markets fell in August 2015 approximately £74 billion was erased from the value of the FTSE 100 while the Dow Jones Industrial Average lost more than 1,000 points.  When the Chinese markets nosedived in January 2016, the Dow dropped almost 400 points.  Simultaneously, Japan’s Nikkei Stock Average, Australia’s S&P/ASX 200, and Hong Kong’s Hang Seng Index had losses of more than 2 percent while the Stoxx Europe 600 experienced a 2.2 percent loss after earlier declines as much as 3.6 percent.  On the positive side, the decline in the Chinese stock market had only a slight impact on the broad equity indexes.  For example, the MSCI Emerging Market Index, lost a little over 7 percent since Chinese stocks account for approximately 22 percent of the portfolio and less than 3 percent of most global indexes.  Also, the Dow Jones had record gains recently more than making up the losses of 2015 and 2016.

Rise of the U.S. Dollar

If China’s stock markets fell precipitously again, then it is almost certain that the U.S. dollar will hit new highs on currency markets.  The dollar, the Japanese yen, and the Swiss franc are considered safe havens by global and Chinese investors.  Investors try to avoid risk and will gravitate toward a strong, reliable, and stable dollar.  When the Shanghai market commenced falling in mid-June 2015, the dollar’s value increased 3 percent versus global currencies due to the American economy’s strength and stability.  While this helps global investors protect their financial capital, it also means that a rising dollar will raise the price of American products while hurting GDP due to lower exports by U.S. firms.  On the opposite side, the Chinese government will be concerned of the outflow of money from China, hurting its economy.  This will prompt Chinese economic policymakers to devalue the renminbi making Chinese goods cheaper globally.  The problem is that a massive currency devaluation will cause a rapid global renminbi sell-off, a move toward U.S. dollars, and more shakeups in the Chinese and international stock markets.  These competitive devaluations, or “currency wars”, will have the economic impact of exporting deflation and instigate other trading Asian countries to devalue their currencies.

Flight to Quality

If China’s stock market took a bad slide, global and Chinese investors would make a “flight to quality”.   Global investors will gravitate to less risky investments with a higher degree of liquidity including cash and cash equivalents.  Investors want to minimize their risk in uncertain times ultimately causing upheavals in global markets.  Investors would pull funds out of China and either go with short-term, high grade money market instruments or Treasury bills and notes.  This causes a problem for Chinese policymakers since it means huge capital outflows by investors, slowing China’s economic growth, and increased speculation that the renminbi will weaken.

Investors will not only increase investments in the U.S. dollar, but also to quality American and international companies.  According to economists at Standard Charter, a British multinational banking and financial services company, capital outflows from China rose as high as $900 billion in 2015.  Investors will go to markets where they have greater confidence, a higher degree of trust, and transparency.  For example, Martin Taylor, founder of an emerging markets hedge fund, Nevsky Capital, closed it down because he lacked trust and confidence in the data he needed in order to make good investment decisions, especially from China.  “An ever-growing share of the most important data they produce is simply not credible,” Mr. Taylor stated.

Decline in Commodity Prices

Commodity markets will be affected by a stumble in China’s stock market for various reasons.  First, if investors feel that China’s stock market is falling as a sign that its economy will weaken and not purchase items such as copper and oil, then these commodities prices will fall fast.  China is currently the world’s leading consumer of raw materials and if it no longer needs them, then investors will perceive China’s economic growth as slowing dangerously.

Oil prices will drop which means downward pressure on multinational oil stocks and nations such as Canada, Venezuela, and Russia will be hurt since their export revenues will take a serious hit.  Venezuela could also default on its sovereign bonds since their cash flow from oil sales will drop to dangerously low levels.  Secondly, Chinese investors will sell off assets to raise cash necessary to meet margin calls on their stock investments.  Here any commodities that Chinese investors hold will drop in price, markets will be inundated, and will affect the economies of producers of raw materials such as Australia and Mongolia.

One commodity increasing in value will be gold.  For many investors, gold is a hedge against market uncertainty and protection against financial and economic instability.

Volatility as the New Normal

China’s economy will grow in the long run, despite periodic fluctuations.  Its policymakers are pushing China’s economy at a faster pace than it is prepared for.  But this push also includes deep involvement in China’s stock market creating more harm than good.  From a financial perspective, China is terribly underdeveloped since investors do not have enough investment alternatives, government involvement in the markets, and lacking the sophistication of the New York, London, or Tokyo exchanges.  This makes China’s markets more prone to volatility ultimately affecting global markets.

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Arthur Guarino

Arthur Guarino is a finance professor at Rutgers University in New Jersey. Professor Guarino’s professional career has been deeply involved in the financial services industry with such corporations as TIAA-CREF, Met Life, and The Bank of New York Mellon. He has held various positions in the financial services field including sales, training and development, administration, product development, customer service and relationship, and management. His teaching experience as a full-time instructor has been at Stevens Institute of Technology in Hoboken, New Jersey, and currently at Rutgers University in Newark. His teaching background includes graduate and undergraduate courses in macroeconomics and microeconomics, as well as managerial accounting, financial management, corporate finance, portfolio theory, financial institutions and markets, and investment analysis. Professor Guarino received his B.A. in Political Science, M.B.A. in Finance as well as a graduate certificate in International Business all from Seton Hall University. He also has a Master’s degree in International Relations from the Maxwell School at Syracuse University and received his J.D. from Rutgers University School of Law in Newark.

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