Black Monday: China isn't the cause of this meltdown in markets

Global growth hasn't been shaping up to optimistic expectations

August 25, 2015
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China's equity market fell by 8.5 per cent on Monday and around 6 per cent on Tuesday as the authorities, having reportedly spent over $200bn trying to prop it up, seemingly gave in. Global markets took their cue, falling sharply in ways that reminded us of the collapse in 2009. In China, the market action was promptly labelled Black Monday, echoing the collapse in the US and other markets in October 1987. It's a misnomer, of course, because the real Black Monday saw the US Market fall 22.6 per cent.  In the US and other advanced nations, the fall in equity markets has been widely attributed to developments in China, specifically, the 35 per cent decline in the equity market since mid-June, and more recently the mini-devaluation of the yuan two weeks ago, which was taken as a sign that all is not well with the Chinese economy. And indeed it isn't.

This year, the penny has dropped regarding China. Ironically, it has taken a crunch in the stock market—which matters little for the Chinese economy and for global markets—and a small currency depreciation to remind markets and commentators that China itself is facing a growth crisis. China is transitioning from a political and economic model that was shaped 20-30 years ago to something different as yet unknown. It is doing so in a political environment which is designed to facilitate change but is at the same time complicating and stifling it. The upshot is likely to be a sustained economic slowdown to around 4 or 5 per cent over the next couple of years. In itself, this need not be a disaster in China or elsewhere, but no one knows what the transition will look like, how it will be managed, or what policy errors will be made along the way. So this, maybe, is what markets are now starting to sense.

Yet, tempting as it is to find something convenient and easy to blame, China isn't the principal cause for the meltdown in markets, even if it is the proximate catalyst. Market professionals, concerned about the overvaluation of stocks and the disappointing picture and prospects for company earnings, have been expecting a relatively serious equity market correction for a long time, certainly since the beginning of 2015. Remember, equities have been rising pretty much continuously since major central banks launched QE programmes and cut interest rates to zero. No one really expected stock markets to turn wobbly until there was a serious possibility that the US Federal Reserve was poised to raise interest rates for the first time in a decade. That moment is—or was—imminent. We shall soon see.

Many economists have also warned that global growth wasn't shaping up to optimistic expectations. The US economy, while putting in a relatively decent growth performance, has disappointed forecasters persistently this year, and the consensus for economic growth has dropped by over 1 per cent. Europe was never really in the running for an economic recovery award, but Japan hasn't fulfilled expectations either, while emerging markets—the great hyped hope for global growth—have been struggling with a growth crisis and falling currencies for nearly two years.

Read more on Black Monday:

Black Monday: is the Chinese "miracle" over, asks Isabel Hilton

China isn’t the cause of this meltdown in markets, says George Magnus

What is going on is not, as some have opined, as re-run of the Asian crisis in 1997-98, much less of the Great Financial Crisis of 2008-09. In the former, the problem was chronic over-borrowing in US dollars and misallocation of capital in a swathe of Asian economies. There is no parallel today, except in some specific individual countries in the emerging universe. In the latter, the problem was chronic over-leverage, especially in the finance sector. Today, leverage ratios may still be too high for comfort, but generally, they are appreciably lower.

Rather, global debt has continued to rise as a share of global GDP, especially among European sovereign countries, and non-financial companies in emerging countries. It's fair to say that high levels of debt are a drag on economic growth, and to that extent, markets are also reacting with a lag. Signs of faltering global growth have been evident too in world trade. For some time it has been clear that the normal pattern in which world trade grew at twice the rate of world income has ended. Since the financial crisis, trade and income have grown in line. This year though, there is some evidence to suggest that world trade has actually been falling.

Three major questions have to be answered. First, how far will this stock market correction go? Second, will it deter the Federal Reserve from raising interest rates next month, as has been widely expected? Third, will there be material adverse consequences for the global economy?  We will doubtless have many occasions to revisit these issues. Market strategists have an array of views about how far this will go. It could well go further—there are a lot of long positions, to coin a phrase, that are being cut back. Liquidation, in other words. But my fear about a substantial decline, say 20 per cent or more, would be validated only if it really looked like the world was going into recession again. I don't think it is. One day, of course, but not for the time being.

Weakness in equity markets could deter enough Federal Reserve board members from voting for a rise in interest rates in September, though it is clear that most actually think the time has come to do so. If the markets have calmed down by the time the Fed meeting occurs, I would wager that it will still happen, but equally, fear of bad timing could get the decision pushed back to December, or even March 2016. Finally, the consequences of the market mess are unlikely to be of great consequence, provided that this is just a bout of nerves-cum-bear market correction. The so called wealth effect of market falls is variable and uncertain anyway, and there would be concerns only if it looked like the decline in stock markets were telling us something about collapsing profits and global recession. Hostage to fortune it may be, but I don't think it is.