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OPINION

A Look at the Current Global Financial Crisis

A Look at the Current Global Financial Crisis

During the last month, global markets have been roiled by the financial crisis that emanated from China and propagated to other parts of the world. To put things into perspective, during the month of August, more than $5 trillion has been lost from global equity values amid fears that the growth rate and prospects for the world’s second largest economy, China, are worse than previously expected. On top of that, the US Fed seems to be ready to raise interest rates (either in the fall or early next year) after many years of a low interest-rate environment, despite the slowing global economic growth. Some argue that the current crisis is reminiscent of the East Asian crisis of 1997 that started from Thailand, and spread quickly to other East Asian tigers such as Indonesia, Malaysia, Philippines, and South Korea.  Currencies and stock markets plunged across the region, even in places as far as Latin America, threatening a global recession. 

So, how this crisis started and what did are the fundamental reasons behind it?

 

How did it start?

Chinese stock markets and their benchmark, the Shanghai Composite Index, have been rising rapidly in the last few years, with some fearing that it was a bubble about to burst. This index peaked by mid-June and then began to fall at an accelerated pace. In an effort to save the capital markets, the government used aggressive tactics such as banning short sales, stopping initial public offerings, prohibiting the sales of shares by all major investors, and instructing state-owned funds as well as investors to buy up shares to raise prices. 

Then, in an unprecedented move just prior to the opening of the markets on August 11, the Chinese Central Bank decided to devalue the Chinese yuan by around 2% against the dollar and thus de-peg it from the US currency. Only two days after this decision, Chinese officials decided to reverse this decision and halt the devaluation by intervening in the currency markets when needed. Since then, they have spent almost $200bn in currency markets to halt this devaluation that they themselves started. The Chinese market has also lost around $4.5tn since the peak of the market in early June.  

The shocks from China did not go unnoticed in other places around the globe, with stock markets tumbling one after the other. Just in the US, more than $2tn in value has been wiped out from stock markets in the last month, while the MSCI All-Country World Index dropped 6.5% in August, its biggest drop since May 2012. 

The begging question, of course, is what are the fundamental reasons behind this crisis? 

 

Fundamental reasons behind the crisis

Certainly, one reason behind the current crisis emanating from China is the realization from global investors that the growth in the Chinese economy is slowing down. The growth of China’s GDP of 7.4% for last year was the slowest in the last 24 years, while the expectation is that this year China will not be able to achieve its target of 7%. At the same time, investors seem to have lost faith in the incoherent policy actions of the Chinese officials, given what has happened in the last month. Furthermore, given the recent good US economic conditions, US officials are poised to raise interest rates soon (the first time since 2006) fearing about future high levels of inflation after years of monetary easing. 

This expectation puts more pressure on global equities, and that is why we have been observing a movement of investors to safe havens, i.e. away from the dollar and moving to the euro and the yen, as well as to safe Treasury securities (this is described as “flight to quality”). 

Lastly, some argue that what we have been experiencing these days is a correction of prices, i.e. equity prices around the globe were inflated, and now investors are moving the prices back to their fundamental value. 

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