On February 27, the Shanghai and Shenzhen equity markets dropped 8.84% and 9.29% respectively. This marked its largest one-day drop in 10 years. The US markets also registered the largest decline since the September 11 event in 2001. The global investment sentiments turned negative as the markets continued decline for several more sessions. Other financial markets were affected as well, copper and gold futures fell 6.2% and 5% in a week respectively. Some capital fled to the more secure US Treasury bond markets which boosted the treasuries prices up and pushed the yields lower.

Economic growth still solid in major countries

According to the recent economic data released by different countries, the current global markets correction seems not to be caused by the fundamental economic factors.

The Federal Reserve Chairman, Ben Bernanke, said on the next day after the downfall, the stock markets decline was not caused by a single factor while there are no fundamental changes to the US economy.

Based on the US economic data released in February, the US GDP grew 2.2% and 3.3% in the fourth quarter and the whole of 2006 respectively. Its full year growth was even a bit faster than 2005. Its economy continues to grow modestly, in line with the US Government and Federal Reserve expectations. Among the GDP components, private consumption expenditure grew solidly, together with the ramming trade deficits were the key drivers for the GDP growth in the fourth quarter. The effect of the cooling housing market also surfaced, e.g. the decline in residential investment already dragged down the overall GDP growth in the last few quarters, but the Federal Reserve noted that there are signs the housing market is stabilizing.

Another major driver for the global economies, China, continues its rapid growth. In the fourth quarter last year, China GDP increased 10.4% which boosted the full year growth to 10.7%. In addition, the problem of its economic growth imbalance was somewhat alleviated after the People's Central Government implemented a number of tightening measures.

The economic growth in the Euro zone and Japan also rebounded in the fourth quarter. The EU Commission revised its GDP growth forecast upward again to 2.4% for 2007 after its registered strong growth last year. The Bank of Japan also feels optimistic about its economic outlook. It released a report in February saying that the Japanese economy will continue its pace of modest growth.

How big is the China factor?

Someone suggesteel that it was China which led to the current global markets correction. The media all over the world also made such headlines, like China markets decline led to the global markets slump.

However, it might be a landmark event for the history of the capital market development in China. Its importance might only surface after a few years, but how big is the effect of China is really worth our further studies.

The importance of China to the global economy is increasing. It is mainly reflected in the real economic activities. After the entry to the WTO, the economic strength of China has increased rapidly. Its GDP or economic size has jumped from the 6th in the world in 2001 to the 4th in 2005. Its trading volume also increased from the 6th to the 3rd. Because of its huge economic size and the world's largest foreign reserve, the appreciation process of RMB has directly affected the global trade pattern and the exchange rate of other major currencies in the world, even though the capital account of RMB is still under control.

Nevertheless, the effect of China on the global financial market is still rather limited. There are two main reasons attributable to this. The first one is the relatively small scale of its financial markets. Its development is still immature. According to the Financial Times, the market capitalization of the equity markets in China only made up 2.22% of the world markets. The amount of financial assets is a little bit larger, i.e. 4%-5% of the world's amount. However, if we only calculate the free-float market capitalization, its size would become much smaller with less than 1% share. The second reason is the China markets are still not open enough, so it is not able to affect the global markets. Currently, the approved QDII amounts totaled US$13.7 billion, but the amounts of financial products sold to overseas investors was only US$580 million. Most of the financial products are fixed income assets, so its effect to the global markets is limited.

Different Reasons attributable to the downfall of China and US markets

It is believed that there were different causes that led to the decline of China and US markets.

The main reason for China's decline was the changes to the demand and supply structure of its equity markets. On one hand, the regulating authority is actively banning and clearing the problem of illegal investment. The size is estimated to be around $100 billion. On the other hand, after the success of stock holding reforms, there are more stocks become free floating and sold to the markets recently. The amount of these new free floating shares available to sell in the market is estimated to be $18.4 billion. More shares will become free float in the coming two months, its pressure on the markets cannot be underestimated.

There were two reasons that led to the US markets decline. The first one was the former Federal Reserve Chairman, Alan Greenspan, who said that the US economy might face recession risk late this year. But it is obvious that the markets had misinterpreted his meanings. The second reason is the bad debt problems of the sub-prime mortgage sector in the US. This leads HSBC to sharply increase its bad debt provision and the New Century Financial might have to file bankruptcy protection.

High valuation should be the root cause

The changes to the demand and supply structure of China equity markets and the sub-prime mortgage problem in the US should only lead to regional markets correction, not global markets downfall. There should be some other reasons that led to the correction of different financial markets.

The root cause should be excess liquidity in the world financial markets which drives up the global asset prices to very high valuation. There should already be some correction pressure long before the markets decline.

First, the monetary policy in the western world has changed from targeting inflation to creating an accommodative environment since 2001. The Federal Fund Rate was cut 11th times from 6.5% to 1.75% in 2001. It was further reduced to 1% in June 2003. The accommodative environment was sustained for a year. The Euro zone also entered an interest rate cut cycle between May 2001 and June 2003. The European interest rate was reduced from 4.75% to 2%. Japan adopted a zero interest rate policy since 1999. The sustained period of low interest rate has, no doubt, led to economic recovery, but it also led to the problem of excess liquidity.

In addition, petrodollar is another source of excess liquidity. Because of increasing market demand and surging oil prices, the dollar income of the oil-exporting countries has increased rapidly. Between 2002 and 2005, the current account surplus for the Middle East countries has increased from US$30 billion to US$218 billion. The surplus amounted to 30% of the GDP of Saudi Arabia. The Bank of International Settlement estimated that one-third of the petrodollar will flow into the financial markets again.

Obviously, global excess liquidity created the needs for investment. It is not difficult to realize that the global excess liquidity was first channeled to the global property markets in 2003, then moved to speculate oil and commodities prices, further flown into high-yield bonds and foreign currencies, and more recently to the stocks of emerging markets.

Between late 2003 and late 2006, the stock markets around the world rose sharply. The mature US and European stock markets rose 50% to 130% in four years. Emerging markets, like Brazil and India, even rose 300% to 400% in the same period. Property prices also surged endlessly. According to Economists survey, the property prices in the US, UK and Australia rose 100%, 192% and 132% respectively over the past 10 years (most of the increases took place after 2003). It is estimated that the property prices in the US and Australia are already 55% to 70% higher than the long-term averages. OECD estimated that the property prices in the UK and Australia are overestimated by 35% to 50% while the US is overestimated by 20%. Global commodity prices also registered a similar uptrend. The Dow Jones AIG Commodity Price Index rose from 90 in 2002 to have been May 2006.

In the past few years, property and financial assets are rising endlessly without any serious correction. This led to the high valuation of those financial assets, which are estimated to be higher than their fair value. Thus, it will obviously lead to a correction.

On the other hand, capital is now flowing more freely around the globe and the performance of different financial assets or markets are more correlated with each other. For example, institutional investors (including hedge funds) become the agents which link different financial markets together. At the end of last year, the number of hedge funds amounted to more than 8,000, managing over US$1 trillion assets. As those institutional investors leveraged on financial derivatives to seize market opportunities, the amount of financial assets under their control might be even larger.

Capital flows from one market to another and speculates for one type of assets to another in order to earn higher investment return. However, when the investment sentiment or investor confidence turns negative, the sell-off in one type of financial assets will lead to the decline of another. For example, in the recent market correction, the sell-off in equity markets also led to the decline in precious metal and other commodity markets as the investors would like to lock in profits in other markets. This, no doubt, would lead to the decline in nearly all financial markets.

Carry trade intensifies market volatility

Carry trade means investors borrow low interest currency in order to invest or speculate in other high yield financial products. It is rather popular to borrow Japanese yen to make global investment nowadays. But how much carry trade activities are working in the market? Actually, there is no legitimate statistics on it while the market estimated the scale to be around US$100 billion to US$2 trillion. A more reasonable estimation should be around US$200 billion to US$300 billion. Moreover, the market believes that around one-third funding of the hedge funds come from loans in Japanese yen.

The effect of carry trade to the world's financial markets can be observed from the Asia Financial Crisis. Carry trade again has been blamed by the market leading to the current global market correction. Some hedge funds sold their stocks and commodities in order to settle their loans in Japanese yen, causing decline in stock and commodity prices. It is believed that such carry trade does occur in the market and be partly responsible for the market decline, as the Japanese yen has increased rather rapidly recently. However, it would be exaggerated to say carry trade is the root cause of the decline, as settling the loans in Japanese yen can be considered as a way to mitigate risk. There is no evident showing that the hedge funds have created the market volatility deliberately.

Global financial markets are still under correction

On the economic front, there is no sign showing the current economic growth is reversing. The World Economic Outlook released by the IMF last August predicted the world's economy to grow 4.9%, higher than its 4.7% forecast in its spring report.

There are some issues worth our attention during the current market correction.

1. Will the weak investment sentiment lead to over-reaction or over-correction?
   
   
2. Will the sub-prime mortgage problem continue to deteriorate and lead to other economic problems and market correction?
   
   
3. Is the worst of the US housing market already behind us? Will it lead to similar decline in other countries? Will the housing market slowdown reverse the current positive economic performance?
   
   
4. What will be the changes and effects of carry trade activities?

It is difficult to predict future market trend. However, it would be premature to say the investment sentiment has turned negative already. The US sub-prime mortgage problem is still not yet resolved. It is related to cooling housing market and the effect of late payment or default take months to surface fully. The latest housing market data are mixed, but it is better than the straight decline in all data a few months ago. Also, there is no data showing that the cooling housing market in the US has spread to other sectors. In respect of carry trade, the chance of interest rate hike by the Bank of Japan is low, thus the carry trade activities are expected to continue.

Nonetheless, it is worth our attention that the cooling housing market and financial market correction might lower the wealth effect of the US economy. We still need to observe whether it will affect the private consumption in the US? Thus, if the global financial market correction persists, it might bring long lasting effects to the US and global economy.

In the current round of correction, the issues of high valuation have not yet been resolved, indicating further correction might still be possible. It is expected that the global financial market will remain volatile and continue to consolidate in the coming few months.