It is all too easy to dismiss the stock market wobbles in Shanghai with the argument that Chinese equities are largely unconnected with the country's economy.
After all, when the Shanghai stock market doubled in the year before last summer's rout, nobody seriously believed the outlook for the economy was improving. And now that the bubble has burst, it does not mean that China is grinding to a halt even though growth may be slowing.
Yet, as former US Treasury secretary Lawrence Summers observed in a recent Financial Times article, dismissing market moves as reflecting mere speculation is often a serious mistake. Using the US experience as a guide, he noted that markets had understood the gravity of the 2008 global financial crisis well before the Federal Reserve.
Hence, he suggested that the Shanghai share market turmoil might be an indication of deeper trouble to come, rather than a case of market psychology and clumsy policy responses.
One troubling symptom is the capital flight from China.
Mr Summers said: "Experience suggests that the best indicator of a country's future economic prospects is the decisions its citizens make about keeping capital at home or exporting it abroad. The (yuan) is under pressure because Chinese citizens are eager to move their money overseas."
His worries are not unfounded. Since ditching its "soft" peg to the US dollar last year, China has purportedly spent more than US$500 billion (S$720 billion) to prop up the yuan. Last month alone, China was said to have spent US$108 billion on intervention - a sum greater than the foreign reserves of most nations.
Worse, even ordinary Chinese are caught up in the capital-flight jitters. The Wall Street Journal last week reported that some mainland banks faced cash shortages as their customers scrambled to swop yuan for US dollars.
It does not help that analysts are further fostering the insecurities of investors with their incessant debate as to whether a huge one-off devaluation or gradual depreciation of the yuan would serve China better.
What is causing the jitters? The Financial Times columnist Martin Wolf noted that the Chinese economy is extremely unbalanced, with a very high savings rateon the one hand, and wastefully high investment rates and high debts on the other.
"A natural way to solve this problem might be to allow capital outflow and a big depreciation of the (yuan) to allow a re-emergence of large current-account surpluses," he said.
Yet, this may not be a viable option. Mr Wolf noted that the euro zone and Japan are already pursuing the same route as they launch "quantitative easing" and print money in the billions to try and stimulate their respective economies, so any move by China to allow its exchange rate to slump would destabilise the world.
But does China have a choice? Mr Summers noted that examples abound where traders had grasped the unsustainability of the fixed exchange rates in countriessuch as Britain, Mexico and Brazil while their respective authorities were still in denial.
One good example would be the hedge fund manager George Soros, who made US$1 billion in 1992 betting that the overvalued British currency would be forced out of the then European Exchange Rate Mechanism, the forerunner of the euro.
CNBC contributor Larry Kudlow argued that in trying to prop up the yuan, China is creating deflation as it withdraws money from its economy: "China must let market forces determine the currency price... A falling yuan, driven by market-oriented capital outflows, would be stimulative easing policy - if the authorities let it happen."
If only it is so simple: Even if a big drop in the yuan does not trigger a currency war, it may still bring about a huge disruption to China's domestic financial markets - and that would be a big worry for the region's banks and large firms, given their big exposure to the mainland economy.
Data from the Bank of International Settlements shows that mainland Chinese firms have debts totalling US$1.1 trillion.
Will they face difficulties servicing their loans if the yuan plummets?
For big-time traders, one way to benefit from the uncertainties is to "short" the yuan, betting thatthe Chinese central bank will not have the stomach to carry on the fight, as the country's foreign reserves haemorrhage.
Even though China has enjoyed some success in fending off the attacks in Hong Kong by squeezing the supply of yuan and pushing interbank borrowing rates to record high levels, speculators may turn to "shorting" regional currencies such as the South Korean won and Malaysian ringgit, using them as proxies to the yuan.
This will, in turn, destabilise their respective stock markets as their currencies come under attack.
But there is the glimmer of hope that even short-sellers may be badly burnt if they push their luck too far.
Mr Martin Taylor, a British fund manager who decided to close shop rather than cope with the uncertainties, noted that China could solve its problem by using quantitative easing to buy up its banks' non-performing loans.
"If it does, asset prices could soar. As it is impossible to devise a strategy that can deal with the alternatives of a slow-grinding bear market and a sudden bull surge, it is best to stop," he said.
For the rest of us, who do not have the luxury of walking away from it all, keeping plenty of cash may be the best option.
What was cheap in the stock market yesterday may turn out to be even cheaper today.
To ensure that the dust has really settled on the wild swings in the financial markets that have been causing us so much grief, the yuan must stabilise first. This is a simple objective but a difficult one to achieve for now.
This article was first published on Jan 18, 2016.
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