The causes and consequences of China's market crash

IT BEGAN innocently enough, with a fall in markets in China that might, at the outset at least, have been mistaken for the healthy clearing of froth from the world's frothiest stockmarket. Yet the plunge that started in Asia (and which followed a nasty drop in American markets on Friday) has continued to gather momentum. It now looks very worrying indeed. When markets in Shanghai closed on Monday, stocks were down 8.5%—the Shanghai Composite’s worst single-day fall in eight years and, given the daily limits on how far individual stocks can fall, very nearly the biggest possible decline. The People's Daily, the Communist party's mouthpiece, declared the day "Black Monday". The nervousness has radiated outward from China. The Nikkei index in Japan slipped by 4.6%. European bourses are down 4-5%. The Dow opened down more than 1,000 points; stocks have since regained some ground but the main indices are still down about 4%. The Eurofirst 300 index has had its worst day since 2009. Germany’s DAX has now lost all the gains it made in 2015.

The pain extends beyond stockmarkets. Emerging-market currencies from the South African rand to the Malaysian ringgit are tumbling. Commodities are also sinking. Oil has hit a six-and-a-half-year low. A broader index of 22 commodities compiled by Bloomberg is at its lowest since 1999. Only safe-haven assets such as government bonds issued by the likes of America and Germany are having good days. Even gold is down: investors who used it as collateral for buying shares and other assets are having to flog it to meet margin calls.

Two immediate questions arise: what has caused the jitters in markets, and how much should investors worry? The first is the easier to answer; the sea of red is down to China and the Fed. Start with China. The proximate cause for all this is a chain of events that began with the surprise devaluation of the yuan on August 11th. More than $5 trillion has been wiped off on global stock prices since then. Today's Chinese-market meltdown seems to have been driven by disappointing data on Friday, which suggested that China's industrial activity is slowing sharply, and by the failure of the Chinese government to unveil bold new market interventions today to prop up equity prices.

A weakening outlook for Chinese growth, and a slip in China's currency, have combined to put pressure on other emerging economies—and especially those whose growth model depends on Chinese demand for industrial and other commodities. Emerging markets have also been squeezed by the Fed, which has been preparing the world economy to expect the first interest rate rise in nearly a decade in September. Tighter monetary conditions in America have led to reduced capital flows to big emerging economies, to a rising dollar, and to more difficult conditions for firms and governments with dollar-denominated loans to repay.

The global economy is right in the middle of a significant transition, in other words, as rich economies try to normalise policy while China tries to rebalance. That transition is proving a difficult one for policymakers to manage, and markets are wobbling under the strain.

How much, then, should we worry? A fall in China’s stockmarket was hardly unlikely given its dizzying climb in the first half of the year. Its tumbling should be put in context: the Shanghai Composite is still up 43% on its level of a year ago. The knock-on effects from market turmoil should be limited, at least in the short run. Relatively little Chinese wealth is stored in shares. More is held in property, the market for which has stablised in recent months. What's more, China's government has yet to unleash its most potent interventions; it has room to cut reserve requirements at banks, for instance.

Meanwhile, a replay of the Asian financial crisis of 1997 looks unlikely. Asian governments are in far better shape to weather these sorts of changes in the economic climate. Currency pegs that triggered trouble in the late 1990s have largely been replaced by floating-rate regimes, foreign-exchange reserve piles are larger, and financial systems are better managed and more robust. Neither does a 2008-style meltdown appear to be on the cards. The global banking system is much more hale than it was on the eve of financial crisis. The mispricing of entire classes of risk-assets and the interconnectedness of vulnerable financial institutions that fueled the panic of 2008 are both absent now.

There is nonetheless good reason for concern, if not for panic. Fundamental questions are being raised about China, an economy which now accounts for 15% of global GDP and around half of global growth. The government's ability to manage market gyrations and animal spirits is very much in question, suggesting that a descent into Japanese-style stagnation is a possibility. The odds of a sharp Chinese slowdown will grow if China's government reacts to market turmoil by ending the process of structural reform that is meant to facilitate a rebalancing.

The global market rout may also represent a definitive end to the period of rip-roaring emerging-market growth that began around 2000. Tumbling emerging-market indexes and currencies, from Brazil to Turkey and Kazakhstan, are further evidence, if more was needed, that the cocktail of Chinese growth, low interest rates and soaring commodity prices that powered emerging-market growth has been yanked away, leaving the developing world to face the hangover. That hangover may not take the form of a broad financial crisis. A protracted slowdown, however, would be plenty painful enough, especially if weak growth leads to political instability.

With emerging markets faltering and Chinese rebalancing incomplete, rich economies are left as the lone engine of economic growth. That is a worrying prospect. Europe's recovery remains fragile and export-dependent. America's is more robust. But while American banks are healthier and consumers less indebted than they have been in more than a decade, the American economy also accounts for a smaller share of global GDP than it did in the 1990s or 2000s, when the American household was often relied upon as the global shopper of last resort.

Perhaps more importantly, rich-world governments have exceptionally little wriggle-room to act to boost up their economies. Interest rates are still at rock bottom, if not negative. Debt and deficits remain at levels that would inhibit recession-busting spending policies—if there were much appetite for such spending, which there is not. In 1998, when troubles in Asia rattled American markets, the Fed swiftly moved to slash its benchmark interest rate, by 75 basis points. The Fed is unable to repeat that feat now, and swooning markets are at least in part a reflection of that fact.

This gloomy outlook was there for all to see before today's market mess. Few seem to have anticipated that it would have such serious effects so soon.