Chinese stock market crashes, world follows suit (just wait till they start selling dollars)

China's Market Sideshow Turns Into Main Event -- by William Pesek/Bloomberg News

If there's anything surprising about this week's plunge in Chinese stocks it's that anyone would be surprised.

One can debate whether China's equity rally of recent years constitutes a bubble or an outright Ponzi scheme. What isn't debatable is that stocks in Asia's No. 2 economy have more in common with casinos than financial markets. Investors on the losing side this week should've seen this coming.

The real question is whether events in China are a harbinger of increased turbulence in global markets -- or just a replay of May 2006, when emerging markets plunged before rebounding.

It could very well be the former. It's not about being a doomsayer or a cynic -- it's about recognizing that bubble-like conditions are popping in markets from Shanghai to Istanbul to New Delhi and elsewhere.

Marc Chandler, New York-based global head of currency strategy at Brown Brothers Harriman & Co., wasn't exaggerating when he called Tuesday's global slide “a bloodbath in the equity markets.''

Here, it's impossible to overstate the Chinese and Japanese parts of the equation. China needs to be explored because there's as much hype involved in its outlook as potential; Japan because of the global bubble caused by the so-called yen-carry trade.

First, the China angle. “Fueling interest in the emerging markets has been China itself,'' said Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.

U.S. Investors

That's particularly true of U.S. investors. Over the past two years, Quinlan said, U.S. investors sank just over $10 billion into Chinese equities. The 9.2 percent plunge in the Shanghai and Shenzhen 300 Index on Tuesday came at a time when U.S. investors have never been more exposed to emerging markets.

In 2006, Quinlan said, U.S. purchases of emerging-market equities totaled a record $52.7 billion. That followed a stock- buying record of nearly $39 billion in 2005. In 2006 alone, U.S. purchases of Chinese equities jumped to $5.2 billion from $4.9 billion in 2005.

All this means that on a relative basis, China has become the key emerging market for the U.S. “To a significant degree, as China goes, so go the emerging-market returns of U.S. investors,'' Quinlan said.

There you have it -- the world's most developed markets are more vulnerable than ever to the policies of officials in Beijing, regulators in Shanghai and companies throughout the most populous nation. Yes, China has vast potential. It boasts 10 percent-plus growth, $1 trillion in currency reserves and 1.3 billion people, many of whom are becoming richer by the day.

Brave New World

Yet it also has a banking system that's still a transmission mechanism to funnel money into politically connected companies, little transparency, negligible press freedom and a central bank that reports to the Communist Party. China censors the Internet, undermining innovation in an economy that badly needs it. It faces worsening pollution and widespread risks of social instability.

So welcome to the brave new world of global finance, one in which hiccups in Shanghai will increasingly shake up markets across the globe and raise prickly questions about how stable the No. 4 economy really is. China's stock market is no longer a side show, but a main event.

Meanwhile, Japan is still essentially offering free money to any investor who wants to borrow in yen and put that money in riskier assets overseas. Much of the panic selling that followed Tuesday's meltdown involved the unwinding of these carry trades. After all, lots of yen borrowings have made their way into Shanghai real estate and Chinese stocks.

Yen-Carry Trade

Yen borrowings have spread far and wide, involving everything from Mumbai property to shares of Google Inc., Zambian treasury bills, Thai baht, U.S. municipal bonds, bars of gold and South African corporate debt, you name it. A mass exodus out of the trade would slam the global financial system.

The Bank of Japan's reluctance to move its benchmark overnight lending rate above 0.5 percent has created little urgency for investors to rethink carry trades. Yet this week, events in China are doing it for them.

None of this detracts from Japan's long-awaited and ongoing economic recovery. “Japan really should be on investors' radar screens more than it is,'' John Ryding, New York-based chief U.S. economist at Bear Stearns & Co., told me in Tokyo recently.

And he's right. The only problem is that much of the liquidity that could be going into Japanese assets is zooming overseas in search of higher returns. The result is an unpredictable liquidity bubble that's left the global financial system more fragile than financiers like to admit.

Uncertainties Abound

History shows carry trades can go wrong -- very wrong. In late 1998, for example, Russia's debt default accelerated the implosion of Long-Term Capital Management LP and caused a panic in markets. Investors scaling back their positions drove the yen up 20 percent in less than two months.

On top of carry-trade uncertainties, China's economy continues to barrel ahead regardless of what officials in Beijing do to cool things down. One wonders if stock markets in Shanghai will do it for them; the headlines surrounding China's gyrations could go a long way toward capping speculation on the part of foreign investors.

Local investors are another story. If the past is any guide, equity losses will be seen as a buying opportunity for the growing legions of Chinese day traders. Let's hope foreign investors take a more realistic approach.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own. To contact the writer of this column: William Pesek in Tokyo at wpesek@bloomberg.net)