China’s Central Bank recently devalued the yuan by nearly 3% against the U.S. dollar aiming to give Chinese exporters an advantage. And with the yuan now sitting at its lowest level against the dollar in four years, fears have surfaced that China could launch a currency war to boost its sagging exports. The repercussions across world markets have been staggering. The Dow dropped 599 points on August 24 after its worst week since 2011. The European stock markets also suffered their worst days trading since 2011. Australia’s market suffered its biggest fall since 2009 and Japan’s Nikkei slumped over 4%. However, China was the worst hit, with the Shanghai composite index dropping 8.5%, the biggest selloff since 2007.
How did this happen? The Shanghai Composite Index has been sliding since mid-June and the value of the renminbi has also tumbled. The declines stem from a stimulus program initiated by the Chinese government that pumped massive amounts of liquidity into the system. The idea was to shield China from the 2008 financial crisis. That was accomplished and, at the same time, many unsophisticated small investors jumped into the stock market.
Although still less than 1% of the Chinese people invest in the stock market, the slowing Chinese economy has exposed the folly of investing at high valuations. And the selloff has begun in earnest.
In Chinese Stocks: What’s Behind the Great Market Tumble?, Ann Lee, adjunct professor of economics and finance at New York University and a U.S.-China economic relationship expert, adds that many small investors are on margin calls, which is only exacerbating the sell-off.
Lee stresses what investors are now beginning to realize that after more than two decades of growth, there are limits to China’s growth potential. “It’s impossible for an economy the size of China to grow at double digits forever,” she says. “To put it in perspective, if China were to grow at 10% now, it would be like growing the size of Saudi Arabia in one year. That’s almost impossible to achieve. Yes, China inevitably has to slow down.”
If the world’s largest trading nation is struggling, that will continue to have repercussions for the rest of the world. Lee points to government projects, such as the Silk Road (a road running through Southeast and South Asia) and the AIIB (Asian Infrastructure Investment Bank, a financial institution China initiated and 49 other countries support) that will act like “levers to generate job growth as well as other commercial opportunities that will keep the economy going.” But that will take time.
In the meantime, the sudden and extreme nature of China’s currency move has investors wondering what’s next. Stay tuned. But don’t let this or any news deter you from sticking to your investment plan assuming you have an investment policy statement, use low-cost investments and are globally diversified.