 "A clerk counts 100 Chinese yuan banknotes at a branch of China Merchants Bank in Hefei, Anhui province")
For the second time in the space of four days, Chinese markets have put the newly-introduced circuit filter system to test. Following a 7% fall on Thursday, trading in Chinese markets was halted for the second time this week. The repercussion of Chinese markets’ fall was felt around the globe, with all Asian markets, including India, falling.
Ideally, the Chinese market should not have a domino effect as few foreign investors are directly investing in China. Investors prefer using the Hong Kong ‘H’ share route to invest in China rather than taking any direct exposure. The current set of rules by Chinese authorities where an investor holding more than 5% equity in a company cannot liquidate will further discourage bigger investors to taking a direct exposure to the country.
So if Chinese markets do not have the capacity to create a ripple effect, why are world markets following China?
The main reason global markets follow China is on account of the fluctuations in the Chinese currency. On Wednesday The People’s Bank of China (PBOC) set the yuan’s daily reference rate at the lowest level since April 2011. The currency dropped by 1.3% in Hong Kong’s freely traded market – the most since the day after surprise devaluation in August – and lost 0.6% in Shanghai in which PBOC intervenes. Both exchange rates were at their weakest levels since March 2011. The gap between the two widened to a record.
Markets getting jittery over the yuan finds credence in the fact that In August 2015 when PBOC first devalued its current and changed the methodology of pegging it to the dollar, emerging markets currencies and stocks corrected sharply.
Being the second largest economy globally, any sharp change in its currencies starts a volatility wave where other country’s currencies gets altered to maintain parity. In doing so, equity markets are affected as foreign funds, especially arbitrage funds and short term funds, withdraw their money from weaker currencies.
Koichi Kurose of Tokyo based Resona Bank said that the devaluation of Chinese currency is not good for the rest of the world. Until China stops weakening the Yuan, global market will struggle to stabilize. Chinese authorities may be trying to prop up the economy by boosting exports, but while that will help one part of China’s economy, it comes at the sacrifice of someone else, he added.
China is compelled to devalue its currency as its domestic economy, especially manufacturing shows no signs of picking up. The government is focusing on boosting its exports which too have been declining for six straight months.
What is also spooking global markets is Chinese authorities’ inconsistent policy. A week ago, Chinese officials were blaming speculators for the fall in the value of the yuan. Within a few days. they themselves reduced the currency peg.
Toby Lawson, head of global markets in Australia at Societe Generale Newedge, in an interview with CNBC said the PBOC needs to more consistent in their policy decisions to retain investor confidence. "The key for investors is to see some transparency, some consistency from the PBOC in terms of its decision-making, its policies in relation to yuan revaluation, fiscal spending and monetary policy, if we get consistency, investors feel more confident that Chinese authorities are in control of the declining growth of their economy."
Ken Chung of Mizuho Bank, Hong Kong, echoed that view, saying “The fixing today flags China’s policy risks. It looks like that they set it in an arbitrary way and the mechanism is not consistent with their policy guidelines. This obviously undermines the PBOC’s policy credibility and investor confidence in the China market."
Rather than looking at how the Chinese equity markets perform, investors will have to keep a track of PBOC’s actions to get an idea of when stability can be restored.
