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Wednesday, February 28, 2007

World economy: Exposing the risks


If financial markets doubted China’s rising economic influence, they don’t any longer. A plunge in China’s stockmarket on February 27th triggered a chain reaction, punishing equities in most countries, unnerving currency markets and curbing investor appetite for risky assets. The surge in worldwide volatility brought together on one day nearly every major risk threatening the global economy: speculative investment in China, the yen carry trade, overvalued emerging markets, and fears of a sharp decline in the US dollar.

Nothing fundamental has changed in the global economy in the last day, and the equity sell-off will probably be short-lived. (China’s stockmarket opened lower on Wednesday.) But the sweeping reaction to events in China—and to other big risks, such as a slump in the US economy—says much about the precarious state of financial markets, and suggests volatility will increase. One closely watched indicator of US stock market volatility, the Chicago Board of Trade’s VIX index, soared by more than 60% on Tuesday.

China’s Shanghai and Shenzen 300 Index fell 9.2% yesterday, the most in 10 years, after the government a day earlier said it approved a task force to clamp down on illegal share offerings and rampant stockmarket speculation. The Shanghai and Shenzen index has risen by 135% in the last 12 months and Chinese officials openly worry about an equity bubble. A few years ago, a sharp fall in China’s murky stockmarket would have meant little internationally; today, with China increasingly driving global growth, any disturbance in the world’s third-largest economy has the potential to create contagion in both rich countries and emerging markets. Other factors, though, also contributed to Tuesday’s global panic: January US durable goods orders, a measure of business investment, fell by the most in three years.

Just a sell-off?

Yesterday’s global stockmarket retreat was probably just that; a much-needed sell-off after a period of strong gains. The US Dow Jones Industrials fell 3.3% and the European DJ Stoxx 50 dropped 2.6%. The carnage was worse in emerging markets: Brazil’s stock exchange fell by more than 6% and Mexico’s by almost that amount. Equities also declined in Russia, Turkey and most other emerging markets. But this has happened before—notably in April/May 2006, and the markets soon recovered. Nothing in China’s stockmarket rout, in particular, suggests deeper weakness in the economy. Global investors were looking for an opportunity to take profits, and an equity slump in China was a suitable excuse. The sell-off was also a boon for bonds in the US and Europe, as nervous investors sought a safe haven. The price on the benchmark US Treasury note rose by two-thirds of a percentage point and the yield fell by 9 basis points.

That said, Tuesday’s turmoil exposes deeper fissures in a global economy that has been kept afloat for years by cheap money. US equity markets had been rising more or less steadily for the last eight months, despite slowing economic growth and a declining housing market. Markets have been even more buoyant in Europe. Investors in emerging markets have thrown caution to the wind: risky markets in such far-flung places as Russia, Argentina and Egypt have attracted so much capital that government bond spreads over US Treasuries have plummeted. This heedless approach to risk has been epitomised by the so-called carry trade, in which investors borrow in low-yielding currencies such as the yen and the Swiss franc and invest in securities that bring a higher return, typically in emerging markets.

Carry trade

On Tuesday, the carry trade showed signs of unwinding, at least temporarily. The yen was the world’s best-performing currency, rising by more than 2% against the US dollar as investors sold emerging-market currencies and bought Japan’s to close out speculative positions. The Swiss franc also rose against the dollar, by more than 1%. Most of the popular carry-trade investment currencies, including those in New Zealand, Iceland and South Africa, fell by between 1% and 2.5%.

Economists have been expecting the carry trade to unravel for more than a year, to no avail, and nothing that happened yesterday suggests a sustained reversal. Interest rates remain very low in Japan and Switzerland, and the opportunity to earn profits by borrowing those currencies and investing elsewhere remains attractive. But the carry trade also depends on stable exchange rates; if Tuesday’s gyrations signal a period of greater volatility, the appeal of the carry trade will fade. It is too soon to draw that conclusion; the trade has slowed before, only to accelerate when volatility eased. The Bank of Japan’s decision last week to raise the country’s benchmark interest rate should have depressed the carry trade, but the central bank’s signal that rates won’t rise very sharply during the next year had the effect of reassuring carry trade investors.

The sell-off in emerging markets also highlights the frothy valuations in many of these countries; equity markets in India and Russia, for example, have doubled or tripled in the last two years. Although emerging-market bourses declined by around 25% in April and May 2006, they later rebounded and pushed even higher by year’s end. Morgan Stanley Capital International’s emerging markets index, a composite of 23 stockmarkets, has doubled in the last three years (it fell 3% on Tuesday.) Another measure of investor risk, the composite spread between emerging-market government debt and US Treasuries, has fallen to a record-low of around 165 basis points this year from a 10-year average of around 600 basis points. (The spread on Tuesday was as much as 12 basis points higher than the day before.) The search for yield in emerging markets has, despite ever higher valuations, been relentless.

Chinese froth

The tumult in China’s own market also points to the speculative nature of investment there. Some sectors in China, especially property and construction, have experienced significant overinvestment; surplus capacity in China’s steel industry, for example, exceeds Japan’s entire output of steel. China’s stock market, in particular, has been a casino for the last year. While China’s economy continues to grow rapidly, the government is adopting policies to restrain investment, and there is no clear evidence of overheating. That said, the government’s struggle to manage the stockmarket surge suggests that its wider management of the economy may not always go smoothly.

The global equity sell-off, which was partly fueled by weak US economic data, also suggests the US dollar may be in for a rough ride. The dollar fell sharply at the end of 2006 as the economy slowed, but recent buoyancy in US growth and a likely delay in interest-rate cuts by the Federal Reserve have served to support the dollar this year. The US economy, despite weakness in manufacturing and housing, continues to expand, and the Economist Intelligence Unit still expects growth of around 2.5% in 2007. But the dollar remains vulnerable to even the slightest hint of bad economic news, and with the European and Japanese economies performing well, investors have alternatives to the US.

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