Asian stock markets have endured another rough session with the Shanghai Composite down 7.6 per cent and indices in Japan and Hong Kong also posting losses, but market analysts at Capital Economics believe the world is not on the brink of another financial crisis.
The past three months have been turbulent ones for markets, with losses in the Shanghai index approaching 30 per cent in sterling terms after fears of slowing Chinese growth and high valuations battered investor sentiment.
Worries about a Chinese hard landing have also spread to the developed world – the FTSE 100 is down more than 16 per cent over three months, with much of this slide coming over the past week or so.
Price performance of indices over 3 months
Source: FE Analytics
Financial headlines are now dominated by the Asian market sell-off and what it means for the rest of the investment world. In the following article Capital Economics’ Daniel Martin and Gareth Leather, who specialise in the region, talk us through the five most important issues around it.
Why are financial markets falling?
Chinese mainland stocks markets have been beset by problems for a number of months, following the rapid ramp-up in valuations that took place after the launch of the Shanghai-Hong Kong Stock Connect programme and stimulus from the authorities.
However, the more recent falls appear to have been driven by China’s decision to allow the renminbi to devalue against the dollar, looming deflationary forces and a lack of further stimulative action from the government.
Price performance of index since 1 Jun 2014
Source: FE Analytics
Martin and Leather said: “Disappointment over China’s decision not to announce further policy loosening over the weekend looks to have been the main trigger behind [the recent] sell-off.”
“It comes amid renewed concerns, which have intensified following the weak flash PMI on Friday that China’s economy might be heading for a ‘hard landing’. Our own view is that the downside risks to short-term growth in China are overstated but investors are likely to remain wary until there is improvement in the data.”
What will the economic impact of equity and currency falls be?
Although there are genuine worries about the health of the Chinese economy and others in Asia, Capital Economics believes that the economic impact of the stock and currency falls will be “fairly limited”.
Performance of emerging market currencies vs US dollar over 2015
Source: FE Analytics
“It is commonly argued that stock market moves can affect the real economy through wealth effects. However, given that equity holdings form a small share of household assets in most parts of Asia, any wealth effects are likely to be small,” the economists said.
“Meanwhile, relatively low levels of foreign currency debt (Malaysia is the key exception) mean recent currency declines are unlikely to pose a major threat to financial stability. Weaker currencies could also push up inflation. However, with inflation in most Asian countries below 2 per cent year-on-year (with a few countries actually in deflation), we doubt central banks will be too worried about price pressures especially since commodity prices are still falling in annual terms.”
Are we heading for a repeat of the Asian financial crisis?
The market sell-off in Asia has prompted fresh concerns that the region could be heading towards a financial crisis akin to the one it suffered in the late 1990s. The crisis started in 1997 in Thailand after the collapse of the bhat and spread to the rest of the region, eventually raising worry of a worldwide economic meltdown.
However, the macroeconomic forecasting consultancy believes the situation is much different this time around.
Capital Economics said: “In fact, with the exception of Malaysia, there are more differences than similarities between the situation now and the position many Asian countries found themselves in 1997-98. Currency pegs have been replaced by freely-floating exchange rates, which has meant there has been no dangerous build-up in imbalances.”
“It is notable that of the countries that were hardest hit 18 years ago, Indonesia is the only one still running a current account deficit. Foreign exchange reserves are also much bigger, giving policymakers ammunition to support their currencies. And again, foreign currency debt is much lower.”
How will policymakers respond?
Given one of the contributing factors to the sell-off was a lack of action from Chinese policymakers, investors have been watching from the sidelines to see if any others will step in to stimulate growth and stem the market rout.
However, as Capital Economics points out, not too much can be expected in the main – aside from China’s 25 basis point cut to interest rates. This was the fifth cut to rates since November, while it has also lowered banks' reserve requirement ratio by 50 basis points.
Martin and Leather said: “A number of central bankers in the region have said they stand ready to take action to ensure financial market stability, but with inflation low and exports in the doldrums, most policymakers will probably welcome a bit of currency weakness. For the most part, intervention is likely to mean little more than selling some of their foreign exchange reserves to slow the pace of depreciation.”
“The two possible exceptions are Malaysia and Indonesia, where we wouldn’t rule out a rate hike if the currency sell-off became a rout. Since the impact of the equity declines on growth is likely to be limited, we doubt policymakers will be rushing to follow China in propping up markets.”
How vulnerable is Asia to a hard landing in China?
China’s economic growth has been slowing for some time. The country is targeting growth of around 7 per cent in 2015 and the latest official figures suggested this was on track – however, economists suggest it is actually much lower, with some even saying the economy could be expanding by just 5 per cent a year.
The definition of an economic ‘hard landing’ is subjective, but generally means a rapid shift from strong or decent growth to low or flat growth. Many are concerned that China could be on the brink of this, should the authorities’ plans to restructure the economy backfire.
“Although we think the chances of it happening are slim, Chinese hard landing is undeniably one of the biggest risks facing the region. The most obvious way in which Asian economies are exposed to China is through their exports. Exports to China are equivalent to almost 18 per cent of Taiwan’s GDP in value-added terms, while Hong Kong, Malaysia and Korea are also heavily exposed by this measure,” Capital Economics analysts said.
“That said, the majority of Asia’s exports to China are intermediate goods, a large proportion of which are used to make goods that are then shipped to other markets. The main exceptions are Malaysia and Indonesia, which are both big commodity exporters and would be hard hit if a hard landing in China led to further falls in commodity prices. India stands out as the Asian economy that is least vulnerable to a Chinese hard landing.”