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Healthy Correction or Start of Deeper Turmoil?

High financial volatility in markets

Stock markets around the world experienced sharp falls since the end of last month. It could be just a short “correction”, or a new phase of financial volatility. With the second week of wild ride and high volatility, it is best to prepare for more shocks and roller coasters ahead, writes Martin Khor.

 

At the end of July the world’s stock markets faced their biggest sudden plunge in a long time. It signified the start of a roller coaster ride for markets around the world that may also affect currencies, capital flows and the “real economy” of production and jobs. The stock market in the United States had its biggest fall in five years. London’s stock market lost all the gains of this year in those same two days.

In Asia the markets also fell. On Friday27 July the Kuala Lumpur composite index dropped 1.9%, while stock market indices fell 4% in South Korea and Taiwan, 2.7% in Hong Kong and 2.4% in Singapore and Japan.

* From credit markets to stock markets
The problems in the credit markets have finally transferred to the stock markets, and thus the financial instability that has been building up has been “mainstreamed”, in that it is now finally hitting ordinary members of the public. US President George Bush has told Americans there is no ground for panic, which of course made people worry that more problems are coming. The US Treasury Secretary Hank Paulson was more candid, describing the selling wave as a “wake up call for investors.”

The “brew” for these events was the crisis in “sub-prime mortgages” in the US, or loans made to not so credit-worthy households to buy houses. Hedge funds and other financial institutions may lose up to US$100bn in non-payment. There was a fall-out on the real economy as sale of new houses in the US fell 6.6% last month, adding to the jitters.

In the week before of last week, banks arranging the financing for buy-outs of Chrysler and Alliance Boots failed to find buyers for the US$20bn of loans required. This led to fears that credit for leveraged buy-outs and acquisition deals had dried up. Signs emerged of a credit crunch for more risky investments, and investors made a quick move towards “safe investments” such as government bonds.

The term being used in the last few days is the “re-pricing of risk”. Financial institutions are charging higher interest for loans and assets that are considered more risky, and reducing the flow of funds in these risky areas. This hit the equity markets. The wide belief is that there will be a lot of volatility in financial markets in the weeks and months ahead.

The roller-coaster ride will also involve currencies and the flow of capital. And it is difficult to predict how various currencies and countries will be affected. For example, it was thought the US dollar would plunge as the crisis originated in its financial sector. And indeed it fell early the week before last week, only to recover at the end of the week as it was the turn of other currencies (New Zealand, Indonesia, the Philippines, Brazil) to decline.

* Warning on yen carry trade
A new worry to emerge is that there will be the unwinding of the “carry trade”. In this trade, loans are taken on currencies or assets with low interest in order to lend out or invest in assets that carry high interest, and thus make a profit from the difference. The low-interest yielding Japanese yen is the favorite of this carry trade. But as its currency rose sharply last weeks, it became more costly holding the yen, and those that borrowed in yen have to quickly repay (or unwind their contracts) to avoid losses.

Just as last week’s volatility hit, the Asian Development Bank gave a timely warning that East Asia’s financial markets are vulnerable to a sudden unwinding of the yen carry trade, and also to a sudden withdrawal of foreign funds and to sharp currency movements downwards. The ADB in a report said the region received a record US$269bn in capital inflows last year, which also boosted Asian currencies this year (the Thai baht by 19.5% and the Filipino peso by 7.4%).

The ADB warned that the possibility of an unwinding of the yen carry trades “exacerbates any volatility in emerging East Asia’s financial markets.” It advised Asian governments to forge ahead with measures to prepare for a sudden reversal of capital flows. Japanese investors have shifted their assets into other currencies that yield higher interest rates as part of the carry trade, but they may suddenly move back to Japanese assets as the Japanese yen soared during the last two week.

The downswing in the equity markets may be a new part of the financial instability that experts have been predicting for some time now. They have pointed to the “global imbalances” in which the US has built up massive foreign trade deficits while other countries (including China) have enormous surpluses.
They also pointed to the destabilizing activities of highly leveraged institutions such as hedge funds, and the freedom of investors and speculators to move their funds across borders, with the potential to cause volatility in currencies and capital flows. Stock market’s dramatic swings could turn out to be just a short “market correction”. However, they could also be the start of months of turmoil, with twists and turns that are not predictable.

Martin Khor is director of the Third World Network, Malaysia.

Recommended citation: Khor, Martin (2007) ‘Healthy Corrections or Start of Deeper Turmoil? High financial volatility in markets’, World Economy & Development In Brief, Luxembourg, 4/Jul-Aug (www.wdev.eu)







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