As Greece has receded from the world financial stage, attention has turned to China’s hemorrhaging stock market.  Chinese equities are battling a confluence of factors with this crisis, with the top two being the obvious bubble in stock prices and a crushing decline in commodity prices.

North America woke up Monday morning to the news that the Shanghai stock index had fallen by 8.5 percent – the largest one-day decline since 2007.  Unlike Greece, however, contagion was obvious and rampant.   European and U.S. stocks have posted losses of 1 percent to 2 percent for most of the week.  Later in the week, we did see a recovery mitigating some of these losses, but it followed the same pattern as before, with Chinese equities plunging, only to be saved a few days later by government intervention.

In Asia particularly, there were echoes of the 1997 currency crisis as several Asian countries saw their currencies erode throughout the week.  China’s currency is, of course, tightly controlled, so investors took their frustrations out on the relatively free-floating currencies of China’s neighbors, which are down 1 percent to 3 percent for the month.  Hit hard was the Australian dollar, which is now at lows not seen since 2009.  

This rout in the equity market centered in large part on the debate over what the Chinese government can and can’t do with its stock market.  Previously, the government intervened in the crisis gradually. But in the latest episode, the government has gone all out to simply buy stocks en masse to stop the bleeding.  Many in the financial community feel strongly that this is not a good move.

At the heart of it, China has a tough choice.  Investors hate both market uncertainty as well as government manipulation.  China has both right now.  Going forward they must either let the market experience volatility, or risk being penalized for being overly aggressive.

Our View: China needs to pull back on its heavy-handed tactics.  Yes, that is asking a lot within a framework that values stability more than just about anything else.  But what is becoming clear is that China’s “price by government decree” mentality is wearing thin and ultimately will not work in the global market, particularly if China wants to continue its development as a financial center.

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