China Plummets: Theory Almost Proven

In my January 29th post titled “China’s Economy: A Ticking Time Bomb,” I had come to believe that, with China’s incredible growth, its economy will eventually spiral out of control. Well, in the wee hours of Tuesday, February 27, 2007, the Chinese stock market plummeted by nearly 9% (see photo of investor in front of the dismal electronic board in a Shanghai stock trading hall), shaking up other stock markets from New York to London, and reaching literally around the world by the end of the next day. ABC News reported that “the Shanghai Composite Index (the major index in China) tumbled 8.8% to close at 2.771.79, its largest decline since it fell 8.9% on February 18, 1997, at the time of the death of Communist Party elder Deng Xiaoping.” Considering the Shanghai market was up 130% last year, what caused this substantial drop? Was it just a temporary “adjustment,” or was it a sign of a much larger economic failure looming ahead?

Many factors provoked the fall of the Chinese market, but two stand out as major contributors. First, investors feared that the Chinese government would soon crack down on speculation that has driven stock prices to record highs. Government officials hinted that a special tax on capital gains may be introduced, thus wreaking panic onto investors as they quickly unloaded Chinese shares as a way to lock in profits before tax changes. Secondly, investors were being proactive; that is, they thought it was simply time for some profit-taking. As Peng Yunliang, senior analyst at the Shanghai Stock Exchange, put it, “People viewed 3,000 as a psychological benchmark. It is understandable they might want to pull back after the market hit that peak after such a long run.” China's Shanghai Index had gained 1.4% on Monday, the day before the plunge, and opened at 3,040.60 (40.60 above the so-called psychological peak). After the fall, it closed at 2.771.79.

Michael Roberts, author of the enticing article “World Stock Markets in Turmoil,” wrote that the “chaos theory applies in the anarchy of world capitalism: when the Beijing butterfly flaps its wings, the snow falls on New York.” The Chinese stock market plunge did not just stay within China; as indicated above, it spread quickly worldwide, causing the stock markets around the world to fall by 3-4% within a matter of hours after the drop in the Shanghai Composite Index. For instance, in Hong Kong, the benchmark Hang Seng Index dropped 1.8% (see photo), while Singapore’s Straits Times Index sank 2%. This "butterfly effect" then reached around the continent to European countries, where major indices dropped similarly: the United Kingdom’s FTSE-100 plunged 2.31%; France’s CAC 40 dropped 3.02%; and Germany’s DAX slid by 2.96%. But, it got worse: the U.S. Dow Jones Industrial Average plummeted with a loss of 200 points in one minute around 3:00 p.m. (see graph); the Dow continued to fall, reaching a loss of 416 points, or 3.3%, serving as the worst one-day drop in the U.S. since September 2001. And, to complete the world picture, Latin American countries were also affected by China’s recent drop. In Brazil, Sao Paulo’s Bovespa Index was off 4.1%, Mexico City’s IPC Index shed 3.4%, the IPSA Index in Santiago was down 3.8%, while in Buenos Aires, the Merval Index dropped 5%.

What is it that makes China’s “butterfly effect” so influential? China is not the only fast growing economy, but it seems to be the one with the most impact: “its contribution to global GDP growth since 2000 has been almost twice as large as that of the next three biggest emerging economies, India, Brazil and Russia, combined.” Jim Jubak, senior markets editor for MSN Money, elaborates on China’s global economic influence in terms everyone can understand: “If every person in China consumed one more tablespoon of soybean oil annually, world trade in soybean oil would double.” China grew on average over 9% in the last 25 years, but trade grew even more, with an unprecedented 12% over the same period. If recent trends continue, China will emerge as the largest economy somewhere between 2030 and 2040, and it will be the largest trading nation before 2020. China serves as a locomotive for the world economy. When China grows, other countries benefit from lower priced goods. Just look at how fast flat-panel TVs are going down in price. However, if growth slows or stops, the people of other countries will feel the pain through higher prices goods, leaving less money for other spending.

Now, back to the original question: was the Chinese stock market drop simply a normal “adjustment” (albeit a strong one), or was it a sign of something more sinister? It is true that as the government denied rumors of such “special tax” measures the day after the plummet, Chinese shares did rebound by nearly 4%. But Barclays Stockbrokers analyst Henk Potts of London confirmed that “there continues to be a lot of nervousness around the stock market.” As a result, world-wide stocks are still closing at low rates as this wave of anxiety (see inset) spreads to investors. In my opinion, Potts is on the right track and there is still much more to come; February 27th was just a small wave hitting the shores of every continent in advance of a huge global tsunami. With the Asian markets still down and the plunging U.S. economy, an emergence of a world crisis will happen. Many people believe that markets will recover. But, the current stock market fall is just an indicator of the future deterioration that will unfold over the next couple of years.