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Opinion: Jolt for markets may be no bad thing

By Simon Louisson of NZPA

Friday 2nd March 2007

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Foreign exchange and sharemarkets received a nasty jolt this week, although by the week's end it appeared more of a speed hump than something more sinister.

It started on Tuesday with a 9% plunge in China's benchmark Shanghai share index, precipitated by hints from the Chinese government it planned to crack down on illegal share trading.

China has been stoking global economic growth so a major hiccup there understandably sent shockwaves around the globe.

Sharemarkets took a lead from Wall Street, which on Tuesday (Wednesday NZT) experienced its biggest one-day fall since September 11, 2001 -- down 416 points, 3.3%, to 12,636.

The local market slumped over 3% in the first hour on Wednesday, with some panic selling by small investors, but it ended the day less bruised than most at 1.5% down.

The Australian market, which has surged nearly 10% since January 10, tumbled 2.7%.

Simultaneously, the NZ dollar was whacked as the forex market decided the carry trade -- where investors borrow in low interest rate regimes such as Japan and invest in high rate regimes such as News Zealand -- was too risky in such an environment.

The kiwi dollar was dumped 1.5 US cents and 3 yen with milder losses posted against other currencies in heavy trading. Losses continued today (Friday).

Markets recovered yesterday, soothed by words from US Federal Reserve chairman Ben Bernanke who played down the long-term impact of a global plunge in stock prices.

He described the market falls as a correction and said markets appeared to be working well.

However, the mood remains jittery, with rumours of an impending US attack on Iran indicative of the edginess. The Dow Jones index see-sawed wildly. Volatility in markets is often an amber signal.

"Yesterday was a wake up call that volatility may rise as we move into the late stage of a business cycle," said Chris Turner, head of FX strategy at ING in London.

Prominent local sharemarket commentator Arthur Lim of Macquarie Equities said the Chinese-led sharemarkets shakeout was needed and should ultimately be seen as positive.

Markets around the world had been going up in a virtual straight line this year and needed to at least take stock.

"The market was due for a correction anyway... and it is taking its cue from the most feverously high market, which is China."

The Chinese market surged 138% in 2006. Some of that was based on fundamentals due to China's very strong economy, but a lot of it was based on speculation.

Lim said the Chinese government had decided to move on "that rampant speculation by clamping down on illegal trading and less savoury activities".

"That's got to be a positive."

What the Chinese Government was doing was consistent with what it had done for the last decade -- whenever it saw a pocket of excessive activity it acted to stamp on it, Lim said.

"Ultimately markets will wake up to the fact that what's happening in China is something that needed to happen.

"It is positive that the Chinese government is acting to pre-empt some of the excesses in the market, rather than waiting at the bottom of the cliff as we tend to do in New Zealand.

"Ultimately things will come back to fundamentals which say the world is still growing and generally corporates are in reasonably good health."

In the currency market, the damage also appeared to be reasonably ephemeral.

On Wednesday night, nearly $1 billion of new uridashi bonds -- issued in Japan but denominated in NZ dollars -- were issued, suggesting the carry trade was alive and well.

"Overall, market participants still think that NZ fundamentals are supportive for the currency, and appear to be viewing yesterday's slide as a healthy correction from overbought levels," said BNZ currency strategist Danica Hampton. However, ING's Turner notes carry trades are reliant on continued low financial market volatility.

A telling point for the kiwi could be next week's Reserve Bank quarterly monetary policy statement where governor Alan Bollard is widely expected to hike interest rates.

BNZ chief foreign exchange dealer Mike Symonds believes markets have almost fully priced one or two quarter-point rate rises.

"On the day, there might be a small rally in the kiwi, but I think it would be quite limited. If anything, the risks would be pointed down," he said.

Many in the forex market may mistakenly believe a tightening will underpin more gains for the kiwi, said Symonds.

"That's certainly not my belief."

He believes that as investors assess the risk of carry trades as too high, the kiwi may again be priced on the country's relative economic growth rate, rather than relative interest rates.

The last time that happened, the kiwi lost nearly half its value from 1996 to 2000. During that period, the Reserve Bank raised interest rates not because the economy was overheating, but to desperately try to halt the inflation-inducing freefall in the currency.

For a considerable time rate hikes had an inverse effect and the currency fell. That high inflation, low growth, period prompted then bank governor Don Brash to warn of the dangers of "stagflation".

Bollard could finally get the response to credit tightening he has been desiring for years -- pain for an over-exuberant household consumer sector and a leg-up for exporters via a weaker currency.

"Arguably, the best the thing the Reserve Bank could do, in terms of seeing a sustained move lower in the kiwi, is to signal very clearly to financial markets that they are going to get on top of this domestic sector which has continued to bubble away," Symonds said.

Under such a scenario , the domestic economy may be in for a sustained period of low, or negative growth, combined with high inflation caused by a falling exchange rate.

That in turn could sock the housing market. Meanwhile, exporters may finally get a break and the current account deficit may be reined in.

It may be the scenario we need, but it might not be the one we want.

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