When things can’t get any worse, they often do. After the renminbi’s sudden depreciation last week, global markets are once again roiled by the crisis in Ukraine. During Monday trading, markets from Asia to Europe, and later the US, were falling one-by-one. Shanghai appears to be the last one standing, as the prospects of state-owned enterprise (SOE) reform in the upcoming National People’s Congress (NPC) meetings have excited a few. It is difficult to pinpoint an exact scenario how the contagion effect will ripple through to the China’s largely closed markets In his seminal work of fiction “1984”, George Orwell wrote about how “Ingsoc”, a political dystopia nicknamed “English Socialism”, ran an oppressive regime in the name of a supposed greater good. It is a visionary work, and in a way describes how parts of the world broker peace sometimes at the expense of being uncomfortable. Ukraine is Russia’s national security interest. The West wants to maintain peace due to internal political demand, but does not really want to foot the bill for Ukraine’s revolution. Meanwhile, Ukraine’s large foreign debt can either be repaid by harsh IMF rescue if it leans towards the EU, or by Russian loans. And the country needs Russia’s gas. For Ukraine, it is between a rock and a hard place. But Russia has to pay the price, too – it has raised interest rates to stem capital outflow, and its market fell 10 per cent in just one day. The contagion has started, with eerie reminiscences of Russia’s default in 1998 after a sharp interest rate hike. Many ask why Chinese investors behind capital control should care about what’s happening in Ukraine. We refer to the paired correlation between global market indices – it has plunged to its lows in the past decade. Every time global market performance appears to be diverging to such an extent, or correlation is this low, markets are prone to significant macro risks. For instance, these were apparent in December 2007 just prior to the 2008 global financial crisis; in June 2011 before the US sovereign credit downgrade; and in May 2013 preceding China’s liquidity crunch. It is difficult to pinpoint an exact scenario how the contagion effect will ripple through to the China’s largely closed markets. Yet recently CNH’s [offshore RMB traded in Hong Kong] implied volatility has surged past that of CNY’s [China’s onshore RMB market], to a level not seen since the European debt crisis in September 2011. In fact, offshore renminbi seems to be heralding significant volatility in the near term more than its onshore counterpart. Such a change in the exchange rate regime reminds us of the interest rate surge last June. After all, exchange rate and interest rate are two sides of the same coin. A volatile renminbi will destroy carry trades, and further yuan depreciation could induce capital outflow and subsequently tighter liquidity. If the yuan depreciates further, margins on structural financing products can also be called, but can be difficult to fulfil without fire-sales of assets. This is one of the potential routes of contagion. But there are always more ways than one. After all, in a crisis, the only thing that goes up is correlation. I believe the NPC and Chinese People's Political Consultative Conference (CPPCC) will follow up on the reform process initiated by the Communist Party’s third plenum, and the CPPCC seems to be auguring well for further anti-corruption campaigns. The tolerance of slower growth will be more palpable, and the new growth model will be more tangible. We are likely to see more details on environmental protection, national defence and security, agriculture, and health care. SOE reform could be the most promising area for investment opportunity, and the petrochemical sector will likely benefit. That said, if the plenum with a strong show of resolute to reform had failed to produce a sustainable rally in the market, the NPC and CPPCC are perhaps even less likely to do so – unless they significantly overwhelm. In China, the HSBC PMI indices continue to show economic slowdown, and the decline of official PMI persists. In particular, the new orders and the employment indices show a worrying contraction. In the US, GPD growth has been revised down, mortgage applications are down and jobless claims are up. The US small caps had a winning streak in 14 days out of 15 – an unprecedented event. Despite the S&P rising to a record high, the best performing sectors in the US market indeed fared the worst in late trading last week. Together with rising geopolitical risks, such economic slowdown and market developments are consistent with our view laid out in our 2014 outlook “Dark Horse and Black Swan” in December that argued for a defensive stance after the New Year. Incidentally, our short-term market risk index, with a good track record, suggests elevated risks in the near term. Some speculate there could be government market intervention. But Chinese equities always underperformed when growth slows. We should not buy when the market is weak and requires intervention. Instead, we should buy when the market is strong and does not need intervention. It is never a bad idea to stay guarded when uncertainties abound – unless, of course, this time it’s different. The author is managing director for research at Bank of Communications. Follow him on Sina Weibo .
