China sends investors scurrying out of risky assets

In a single day, China has reminded everyone that asset markets can be a risky place to be in.

On 27 February, China's Shanghai and Shenzhen 300 Index fell 9.2 percent, the most in 10 years, after the government initiated moves to crack down on illegal stock-trading and rumours circulated about the introduction of a capital gains tax for equities, rumours that were subsequently reportedly denied by a government spokesmen. Although the market recovered somewhat later, the index still ended the week 6.3 percent lower and its fall had a dramatic effect on other markets.

Other Asian markets fell with the Chinese on 27 February, Singapore's Straits Times Index for example falling by 2.3 percent. Once the European markets opened, so did they, the Dow Jones Stoxx 600 falling 3.0 percent that day. Despite its distance in time and space, the US stock market was not spared, the Standard & Poor's 500 Index falling 3.5 percent that day.

By the end of the week, the carnage in global stock markets was quite evident. The Morgan Stanley Capital International Asia-Pacific Index dropped 3.5 percent last week, the biggest weekly fall since last July. Japan's Nikkei 225 fell 5.3 percent, the biggest weekly fall since last June. The Dow Jones Stoxx 600 lost 5.2 percent, the biggest weekly fall since March 2003. The S&P 500 fell 4.4 percent, its worst weekly performance since January 2003.

As stock markets fell, risk aversion rose among investors. The Chicago Board Options Exchange volatility index jumped by 70 percent to an intra-day high of 19.01 on 27 February and largely stayed around those levels over the next few days as investors suddenly realised that market volatility could get higher than what they had expected.

Stock markets were not the only ones that suffered. Prices of commodities also fell last week, including those of base metals like copper as well as gold. Oil bucked the trend, though, as refinery problems and falling inventories in the US offset concerns over a slower economy to keep prices up over the week, although prices did fall on Friday.

Money leaving risky assets went to safer ones as bond prices rose and yields fell over the week. The yield on the 10-year US Treasury note fell 16 basis points last week to 4.5 percent. Significantly also, the yen carry trade unwound as the yen rose to about 116.8 per US dollar from about 121.1 at the end of the previous week.

On the whole, the recent episode appears similar to what happened in May 2006, when a similar rise in risk aversion caused risky assets to sell off. At that time, the threat of concerted action by the major world central banks to tighten monetary policy caused investors to sell risky assets.

This time around, the trigger for the market turbulence was undoubtedly the fall in the Chinese stock market. The latter itself is widely attributed to the fear that the Chinese authorities would be taking action to curb what they considered to be excessive speculation in the stock market. In fact, the stock market plunge occurred just after the latest hike in the required reserve ratio for banks in China to 10 percent took effect.

Market turbulence, especially in the West, was exacerbated by economic news out of the US. On 27 February, the day the market sell-off began, US data showed that orders for durable goods fell 7.8 percent in January. The following day, the US Commerce Department reported that fourth quarter GDP growth was 2.2 percent, much lower than initially reported, while new home sales fell 16.6 percent, the largest decrease since January 1994.

However, other data last week showed that things might not be so bad. US manufacturing recovered somewhat in February with the Institute for Supply Management's index of national factory activity rising to 52.3 from 49.3 in January. In addition, a Commerce Department report on 1 March showed that personal income and spending were strong in January.

So investors need to keep level-headed amid the market turmoil. Fundamental conditions have probably not changed dramatically. The large fall in the Chinese stock market is as much due to an over-extended market as anything else. From the beginning of 2006 until its peak on 26 February, the Shanghai and Shenzhen 300 Index had almost trebled. At its peak, the market had traded at 42 times earnings.

Furthermore, the effect of any action to be taken by the Chinese authorities to restrict stock trading activity is likely to be largely limited to the Chinese stock market. Certainly, the Chinese authorities have over the past few years been reluctant to take one obvious step it could to drain excess liquidity and hence curtail market activity in the rest of the world: revalue the Chinese currency.

The main threat to markets probably remains action by the major central banks to tighten monetary policy. But this threat does not appear overly ominous at the moment. While the Bank of England and the European Central Bank maintain tough stances on inflation -- indeed, the latter is widely expected to raise interest rates later this week -- the Federal Reserve appears to be on hold for an extended period, as is the Bank of Japan after having raised interest rates to 0.5 percent on 21 February.

Having said that, market movements over the next few weeks are likely to be dominated by sentiment, and at the moment, sentiment has clearly turned more risk averse.