Is the real reason behind the Shanghai rout due to something else?

February 28th, 2007

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Last night, the Shanghai casino (stock market) fell in a stampede of panic, triggering a worldwide sell-off. For us, we are not the least surprised to see that. In fact, as we advised back in January this year in Discerning a stock market bubble, that was the time to exit the Chinese stock market. Coincidentally, within less than a week after our warning, it corrected. Yesterday was the second major correction within a month.

Now that the dust had settled, we are wondering why did a Chinese sell-off create such a ripple effect to the rest of the world?s stock market. The previous correction of 4.92% at the end of January was hardly news at all. Surely, the magnitude of yesterday?s correction, though greater than the previous one, should not be the reason for such a contagion?

The ?official? reason for this market correction was that a rumour of the Chinese government?s intention to crackdown on speculation triggered the sell-off in Shanghai. While this reason may be true in the general sense, we guess nobody knows the real underlying reason. Here, we offer our speculative hunch (which require more investigation to confirm)?this may have something to do with the yen carry trade. Back in January, in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned about Marc Faber?s prediction about a coming severe correction in all assets class in the coming months. Though he did not fully explain the underlying reason behind this prediction, he did mention about the idea of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of liquidity). Thus, we believe that when he made that prediction, he saw a coming liquidity crunch in the days ahead. Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we did ask this thought provoking question: Are we now ripe for a contraction in liquidity?

A week ago, in Another source of potential financial crisis?reversal of yen carry trade, we did mention about the ramifications of a potential disorderly reversal of the yen carry trade. Much of the world?s liquidity can find its source in Japan through its near zero interest rate policy. However, it is obvious that the Japanese will normalise their interest rates sooner or later, which means the yen carry trade will have to end one day. The question is, whether this end comes through an orderly or a disorderly process. A disorderly process means that non-Japanese assets will have to be quickly liquidated and yen re-purchased to pay back the yen-denominated credit. This will result in a rapidly falling non-Japanese asset prices and a swiftly appreciating yen. Recently, Japan had raised its interest rates to 0.5%. Also, Japanese inflation is picking up and their stock market is trending up. The indications point towards the Japanese tightening up their liquidity. Perhaps someone reversing their yen carry trade on frothy Chinese stocks started the Shanghai rout?

Anyway, this is just our hunch?we are prepared to be proven wrong on this. But if our hunch is right, this means that there will be more corrections to come. That may explain the severe reaction of the global stock market.

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