Market analysis: Greek debt crisis and China’s market turmoil complicate Fed policy

An investor monitors trading on the Chinese stock market. The Shanghai Composite index has dropped 32 per cent from its mid-June peak. Wu Hong / EPA

Financial markets in each region have their own idiosyncratic issues to grapple with at the moment.

Asia is grieving over the sinking Chinese equity market, Europe has Grexit risks to consider, Australia, Canada and New Zealand are agonising over falling commodity prices, while the United States contemplates all of the above and awaits the Federal Reserve to start tightening monetary policy. For the Middle East, falling oil prices are the main stumbling block in the way of recovery.

In this environment, it is logical to see a safe haven bid pushing sovereign bonds higher and equity indexes lower. The forex markets remain cautious, but safe haven bids are also evident in the firmness of the Japanese yen, while commodity currencies in particular have fallen out of favour.

While the Greece crisis has resembled a slow motion train wreck playing out over a number of months, if not years, the collapse in Chinese equities has taken the markets much more by surprise. In turn this is fuelling weakness across other markets, including commodities and especially oil. Commodity prices started to drop as a result of a change in risk sentiment sparked by Greece’s “No” vote in its referendum but are now being dragged down further by concerns about the health of China’s economy.

China’s significance for global markets reflects its status as the second-largest economy in the world, with the second-largest equity market, and as one of the largest global commodity players.

The Shanghai Composite index has dropped 32 per cent from its mid-June peak having previously rallied 160 per cent from 2,000 points in the middle of last year to a high of 5,190 points in the middle of this year. That rally even occurred as economic growth was slowing down in China, illustrating that equities had long ago become divorced from underlying fundamentals as well as from valuations.

Not surprisingly, that rally was also accompanied by significant accumulation of leverage which was propelled by increased participation of first-time retail investors.

According to Bloomberg, in the past year, margin finance has increased from 400 billion yuan (Dh240.5bn) to 1.6 trillion yuan, which is equivalent to 4 per cent of market capitalisation and 2.5 per cent of GDP. It is worth noting that before the correction started, as much as 4.4 million trading accounts were opened in the final week of May this year alone.

As well as obviously being concerned that further steep losses will increase the chances of an economic hard landing, the involvement of retail and first-time investors is making the government especially worried about the social impact of the sharp fall in stock prices, especially small and midcap names.

Research shows that when asset bubbles are fuelled by leverage, they increase financial crisis risks, and when they burst they produce deeper recessions and slower economic recoveries.

This is amply illustrated by the slowness of the recoveries in developed economies hit worst by the 2008-09 financial market crash. Hence the Chinese government has taken a number of steps to intervene directly into equity markets to support them.

The government has asked state-owned brokerage firms to buy stocks, set up a market stabilisation fund, provided liquidity to brokerages, halted IPOs and even raised margin requirements for shorting contracts on the small-cap CSI 500 index.

Additionally, the government has banned major shareholders from selling their stake in companies and asked banks to roll over loans backed by stocks. Some 1,400 midcap stocks have also been halted from trading.

Taken together these measures amount to an unprecedented level of direct intervention; they may actually exacerbate the markets’ unease about valuations and about the medium-term outlook for Chinese equities, as well as for the economy as a whole.

Already, the 7 per cent growth rate targeted by the Chinese government is looking unlikely to be met, and depending on the eventual outcome a hard landing will also weigh on the rest of the world.

By extension it will also weigh on other financial markets, and on policymakers’ reaction functions. This may include the Fed, which has still to make a decision about when to raise interest rates, but which is now facing the complication of two overseas headwinds. Both the Greece crisis and now the situation in China are likely to make the final decision much more finely balanced.

Tim Fox is the head of research and chief economist at Emirates NBD.

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