Global Volatility: Rising in the East and Setting in the West

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Global Volatility: Rising in the East and Setting in the West.

Larry Williams:
Global share markets have had a volatile time over the last few weeks with the drama over Greece's future in Europe going down to the wire and a large selloff in the Chinese share market. What's the latest, what are you seeing?

Roger Garrett:
There was certainly doom and gloom in the markets last week with a Greek exit from the Euro looking more and more likely and the Chinese share market in free fall. However, it's all changed this week with investors giving a qualified thumbs-up to recent developments.

Also the seemingly never-ending Greek saga is close to an end game. After all the grandstanding that has occurred, it has been a resounding win for the creditors. Greece has eaten humble pie and accepted all of Europe's final demands, which ended up being more severe than originally asked for and includes extensive tax and pension reform, and a plan to place valuable assets such as ports, regional airports and toll road operators into a privatisation fund supervised by the EU.

The challenge in this process is for the Greek Parliament to pass the reforms into law. Greece then gets the bailout money on a very tight leash. They try to maintain an illusion of stability but essentially it's just kicking the can down the road. Unfortunately Greece is essentially insolvent — it simply can't pay back the money that it owes. So while it looks like one problem is averted for now, the bailout really doesn't address the fundamental problem. What the Greeks need is some form of debt restructuring. This may come in time and it appears the problem is solved for now but I don't believe this ongoing Greek saga is over just yet.

Larry Williams:
Yes and as we've been talking earlier, this hasn't got past the Greek parliament yet so this could all implode, we'll have to wait and see. So let's move on to China then — tell us about the events that has caused the Chinese equity market to correct so much.

Roger Garrett:
The Chinese equity market crash is a little less complex than the Greek situation — it's actually a bit of an own goal for the Chinese government. Over a year ago the Chinese authorities were faced with a slowing economy and rising debt levels so they started actively promoting share market investment partly due to the positive wealth effect a rallying share market would give.

They did this in many ways:

  • They made it easier for foreigners to buy into the local market
  • They made it easier for local individuals to set up share accounts and to borrow to invest in the share market
  • They actively promoted the virtues of investing in equities including advertising in official newspapers and on TV

These measures had an astonishing impact on retail investment behaviour and were a key driver behind a 150% increase in the share market in China.

Larry Williams:
So what's your take on what caused the share market to correct so suddenly?

Roger Garrett:
There are a number of factors but ultimately there was a huge speculative element in the market. So much of the run up in shares was due to local investors borrowing to invest. They usually did this on margin with their stockbrokers but it also occurred with unregulated margin lenders. How this works is if I buy $100 worth of shares, I deposit $30 with my stockbroker and borrow the rest from that broker using the shares as collateral.

This introduces a significant amount of leverage or debt funded buying into the equity market. In the China situation it pushed up the market causing it to trade a long way away from its fundamental values. So when we started to see some selling pressure, the brokerage companies asked for more cash from retail investors as the value of shares held as collateral fell. In many cases these investors didn't have the cash so started selling the shares and as they did this the buyers disappeared quickly, so it became a vicious downward spiral.

This whole deleveraging process has seen about 3 trillion wiped off the value of the market. To put this into perspective, it is equivalent to the combined market caps of France, Spain and Italy.

Larry Williams:
Do you think the situation is contained?

Roger Garrett:
It's still early days but the market has stabilised for now and there is much less leverage in the system now.

The measures taken are meaningful:

  • They banned principal shareholders selling their own companies
  • The central bank is financing a fund that will provide buying support in the market
  • There's also a ban on short selling and a temporary ban on new companies listing

I would expect these measures to work but if they don't, except for passing a law that states stocks can't go down, they'll do whatever it takes to maintain stability.

Larry Williams:
With what impact on their economy do you think?

Roger Garrett:
It's very limited at this stage. There doesn't seem to be a high correlation between the equity market and retail sales in China. Consumption is more driven by income and that has been growing and financial institutions are generally well capitalised too so certainly a somewhat limited impact. The negative impact could be a more medium term one where incidents like this may make the authorities less aggressive on much needed reforms in the country.


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