China’s Black Monday and the Ripple Effect, Explained

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Last August 24th China suffered what has been known as its Black Monday. The Shanghai Stock Exchange suffered its largest loss in a single day in the past 8 years. Commodities (agricultural, farming and raw materials such as wheat, cattle or iron) fell in price to those of the late 90s.

World markets followed suit: Germany’s DAX, Spain’s Bolsa, and the New York Stock Exchange all suffered serious losses that day, with giant seesaws in share values. The chaos was such that at some point in the United States, investment funds dedicated to commodities dropped below the actual price of the commodities they were supposed to purchase.

What led the Shanghai Market to crash?

If you follow economic news, you may know that in the past couple of months the Chinese government which had vowed to stay clean off its market operations in order to lure investors broke its word in several ways. In July they put a 6-month ban on the sale of company shares by major shareholders, executive and directors of any listed companies. The reason for this was to prevent a major cash runoff trend that has been happening for the past few months. I will explain that shortly.

Where it all started:
The Shanghai Stock Market

And just a few days before the crash, the Chinese government devalued the yuan, China’s currency. The truth is that it was a logical adjustment, part of standard monetary policy, and they performed the devaluation as an adjustment to an over-inflation of their currency when compared to the dollar and euro. This would have been fine if they had given a proper explanation, which they did not. Investors, whose nerves were already on edge, grew even more anxious.

A side effect of the devaluation of the yuan is that emerging economies that have been selling commodities to China have to face now that their incomes from those sales are going to be much, much inferior. National budgets will be affected.

What caused this runoff in the Chinese markets?

There are several factors involved in this. For starters, the Chinese economy is slowing down, and the country's expected and announced annual growth of 7% -according to the Chinese government- is likely to be only around 3% according to the latest estimates from outside China.

Copper mines provide one of the
most useful commodities on Earth.

Additionally, the Chinese business character is changing. Up until now China has been the major producer. A large amount of what everyone, worldwide, owns has the tag Made in China. We are used to this. In order for them to produce all these products, they have been the world’s largest importer of commodities. Countries such Australia, South Africa, Venezuela and many developing nations worldwide have exported huge quantities of materials to the Asian giant.

But as I said, this is changing. On the one hand they are shifting their attitude less towards production and more towards consumption. Chinese are turning towards buying and steering away from selling. The shift is slow and gradual but inexorable. It’s a direct response of the government’s relaxation on control of the economy.

Lithium is a commodity that has
 been the source of wealth for many.

This slowing down of the economy mean that earlier this year investors started selling their shares, especially in the commodities market. Unscrupulous speculation, fueled by a lot of internal rumor-mongering, led a large number of small investors to lose their funds in the market. Consumer advocacy groups started pointing fingers at the speculation, and the government took action.

It might have been fine, except that taking action proved large investors’ fears: China will continue to meddle in its market economy, and free an open exchange of shares is no longer guaranteed. Major foreign investors started pulling out, one by one, from the Shanghai market.

But… why did other world markets crash?

Well, the answer to this relates to China, but also the United States. On one hand, China has lowered the yuan, meaning that their imports of raw materials are going to provide less income to those nations selling them to the Asian nation. And the shift from production to consumption means that they are likely to reduce their imports of commodities in the long run.

The other source of instability,
 the Federal Reserve.

On another hand, the United States Federal Reserve has been contemplating raising the interest rates, and there is lots of talk, official and unofficial, on that subject. Now, most people understand that the United States is the preferred place of investment for foreign trade in terms of safety. So, when there is talk of (bond) rates going up, what happens? Investors worldwide turn their eyes back to the United States as preferred place for investment.

This may not be remarkable, if it were not for the fact that those very large-scale international investors have been until now investing in emerging economies’ debt (bonds, and corporate bonds from their commodities’ markets). The very same emerging economies who are selling commodities to China, and for which China is now paying them a lot less money, because they devalued their currency. So, now that the United States is becoming the target of so much interested speculation because the rates are likely to go up soon… those investors sell their investments in the form of national debt of emerging nations, and commodities from the very same nations.

The markets, worldwide, go topsy-turvy.

What will happen now?

China needs to prove that it can handle the freedom of its economic system by allowing private firms to compete with government ones. This show of good faith would boost investment from abroad, which is much needed. World trade has dropped by 4% this year because of this volatile situation.

If China fails to keeps its promises of reform, the emerging economies of the world are going to see a major crisis, because they depend on their exports to China in order to pay their debts to foreign investors.

Yet, in all fairness, China is not doing badly. The internal economy of the nation is doing quite well, based on a solid real estate market that is growing steadily and bubble-free. The aging of the populations leads them towards consumption of goods, which means that the service sector and the goods markets are doing great. Their bank rate is still over 4%, and this gives them a lot of room to play in order to boost the economy. But the key to this puzzle lies in the Chinese government’s ability to keep their hands from the economy and to keep opening up trade internal and externally.

If they get past this stumble and continue to open up their economy, they will pull off the trick of modernizing their economy and becoming a very reliable place to invest. This, however, doesn’t take into account the emerging economies that are going to be trampled in the process. There are going to be huge adjustments worldwide in order to find a new balance in the global economy, and personally I believe that we’re facing a period of global trade turbulence. Buckle up.