Global Trends by Martin Khor

Monday 12 February 2018

Behind the stock market turmoil

Was last week’s global stock market sell-off only a “correction” or does it signify a new period of financial instability


The global stock market turmoil last week has sparked concerns that the relatively good economic times in the past couple of years could be ending. 

It is too early yet to understand what has just taken place or predict what comes next.  It is widely agreed that a “correction” has taken place in the US stock market.   But whether this is just a blip, or will progress to a crash, remains to be seen.  

Some analysts say there is nothing to worry about as corrections are normal, while others are more pessimistic, with a few predicting it is the start of the worst bear market ever. What happens this week will be crucial. 

The primacy of Wall Street in setting the global trend has been confirmed.  European equity markets followed the US “correction.”   And Asian stock markets in Asia also followed suit, with big plunges almost daily.

The immediate trigger was the positive news on US jobs, prompting fears of wage increases and inflation that would pressurise the Federal Reserve to raise interest rates more rapidly.  Higher interest has a negative effect on stock markets as they give an incentive to investors to put their money in alternatives especially bonds.

But the larger reason is the jump in equity prices to record levels, due to speculation not backed by fundamentals, and fuelled by the easy money policy that the US government pursued in the hope of stimulating economic growth.  Some of the trillions of dollars pushed into the banking system by “quantitative easing” contributed to the stock market bubble.

Even though quantitative easing has ended and is being reversed, US stock prices continued to rise rapidly in January. It was a matter of time before a downturn occurred.       

The stock market sell-off, if it continues, can have large repercussions on developing countries like Malaysia.     

There is the domestic effect. Affected investors feeling they have less wealth will decrease their spending, reducing GDP growth. Those that borrowed to speculate in the stock market may have debt-repayment problems.  Companies may see their market capitalisation and asset values reduced as the prices of their shares go down.  If the sell-off becomes more prolonged, banks start worrying about non-performing loans.

Then there is a complex of issues related to the interaction with the global financial markets.  The stock-market turbulence could affect global investor confidence in emerging economies, which are seen as riskier than the US.

In good times, a lot of speculative funds flow from the West to the developing countries in search of higher yield.  But in times of global uncertainty, the funds can rapidly flow back, often causing significant damage.

This boom-bust cycle of capital flows has been played out several times over the years. The boom in funds going to developing countries in the 1970s ended in 1982 with the Latin American debt crisis.  The boom in the early 1990s ended in crises in East Asia, Brazil, Russia and Argentina. 


The boom in the early 2000s temporarily stopped with the global crisis in 2008-9 but resumed and has continued to now, with some sharp outflows in 2015 and a return of inflows in 2016 and last year.

It remains to be seen what effect the current stock market turmoil will have on capital flows.

A quite balanced view was given by Tokyo-based Mitsubishi UFJ Kokusai Asset Management, which oversees US$119 bil in assets.  “We’re not going to see the type of euphoria we saw in emerging markets anymore,” said its chief fund manager Hideo Shimomura in an interview with Bloomberg agency. “We’re in a phase where investors are being given a reality check after a great run.  That’s not to say inflows to emerging markets will reverse completely.”

In recent years the developing economies have become more open and to external capital flows.  This has resulted in new vulnerabilities and heightened their exposure to external financial shocks, as pointed out in South Centre papers by its chief economist Yilmaz Akyuz. 

There has been a massive build-up of debt by their non-financial corporations since the 2008 crisis, reaching $25 trillion or 95 per cent of their GDP.  The dollar-denominated debt securities issued by emerging economies increased from some $500 billion in 2008 to $1.25 trillion in 2016, according to the Bank of International Settlements.   

Moreover, the foreign presence in local financial markets has reached unprecedented levels, increasing their susceptibility to global financial boom-bust cycles. Foreigners now own a much larger share of government bonds and of the equities in the stock market of many developing economies.  In Malaysia, foreigners own about a quarter to a third of value of government bonds and about a quarter of the value of shares in the Kuala Lumpur stock exchange. 

Should there be net capital outflows from developing economies, their currencies may depreciate.  This in turn increases capital outflows.  It will also be more costly to service debt, and add to inflationary pressures.  

While their vulnerabilities have grown, the countries have less resilience to prevent or counter a crisis. The current account balances and net foreign asset positions of many developing countries have deteriorated in the past decade.  

In most countries international reserves built up in recent years came from capital inflows rather than current account surpluses. The reserves could decrease if foreigners decide to take their funds back, and they could be inadequate to meet large and sustained outflows of capital.

Thus the stock market turbulence could only be the tip of an iceberg of financial instability and vulnerability.  Ironically, this instability increased in recent years due to efforts to counter the effects of the 2008-9 crisis, but they may have the unintended consequence of building up a new crisis.