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.

Income Inequality: The Rich and the Rest

President Bush has not commented on income inequality much during his two terms. It was never an issue during the candidate debates. But it is a very real and important issue, and finally he brought up the subject in his speech on January 31, 2007 on Wall Street: “The fact is that income inequality is real-it's been rising for more than 25 years. The reason is clear: We have an economy that increasingly rewards education and skills because of that education.” For a long time, income inequality—the gap between the rich and everyone else-- has been growing steadily in the United States. Bush’s speech as drawn some much-needed attention to this topic, but much more needs to be done. Democrats have repined over this issue for years, but the fact that the leader of the Republican Party now acknowledges it has finally stimulated the media into action. And this is not just a U.S. issue. The Wall Street Journal has been writing about the paralleling issue in Asia, specifically China: “China's economic miracle has lifted hundreds of millions of people out of poverty, but the country is showing signs that its poorest citizens are falling further behind.”
Due to the elevated media attention to these issues, I decided to probe the blogosphere and see what others have to say about this topic. I found two very interesting blogs, one dealing with the United States’ current situation and the other with Asia’s. Both comments can be found below.

Comment on Blog 1 about the United States' current situation:

The idea of implementing a progressive income tax (especially when it essentially already exists in the United States) is simply not best means to solve the issue of income inequality. As fellow blogger Kurt9 had mentioned, income inequality itself is not a problem. The main issue lies in unequal opportunities. America has an obligation to ensure that there is not a lack of equal opportunity for all Americans to achieve wealth. And, in that regard, it is higher education that is the main enabler of economic success in this country. However, over the past twenty-five years, the wages of the skilled and educated workers have grown faster than the wages of the less educated. For instance, in 2003, according to the U.S. Census Bureau, four-year college graduates in America earned an average paycheck nearly double that of high school graduates; moreover, holders of doctoral and professional degrees earned three to four times that of a high school graduate (see chart).

Federal Reserve Chairman Ben Bernanke (pictured) said “disparities in education and training are likely the single greatest source of the long-term increase in inequality.” Thus, “policies that boost our national investment in education and training can help reduce inequality while expanding economic opportunity,” he said. The key to income “fairness” is to make sure that the tools necessary for wealth (i.e., higher education) are available to all equally. Don’t look to tax the rich more for what they have earned. Instead, the poor should raise hell about a government-run school system that does an appalling job in educating children, and the high cost of university-level education. Bush has attempted to solve this issue by putting forth two distinctive programs, No Child Left Behind and American Competitiveness Initiative, which serve as vital steps into helping create equal opportunity among Americans. But it is not enough. Dramatic changes in education are needed, and fast. Or the income gap will just widen.

Comment on Blog 2 about Asia's current situation:

Asia’s economy as a whole (including that of China and India) has been growing very fast. With that comes the issue you discuss in your blog about the income inequality. You say that a widening income gap (see chart) is not a large issue to be concerned with. However, the true strength of a country comes from a strong middle class that can carry the load of commercialism. Rising inequality threatens economic growth, especially since it has meant declining or stagnant income growth for lower- and middle-income families. If the vast middle-class families do not see relative income gains (it is not enough “just to be doing better”), they cannot afford to purchase the goods and services that keep the economy moving. Their discretionary income will not be able to keep up with the rising inflation. Asian countries will soon become nations of haves and have-nots. It is good that everyone is “doing better,” and that is something to celebrate. But for long-term economic growth and heath, the income gap needs to be kept in check.