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By Nariman Benravesh

World stock markets have been pushed down sharply by a convergence of at least four forces recently: 1) a major sell-off in China's overvalued stock market; 2) data releases that have highlighted the weakness of the US economy; 3) signs of stress in US mortgage markets; and 4) ill-timed comments by former Federal Reserve Chairman Alan Greenspan about the possibility of a recession.

While stock markets are likely to suffer through more volatility in the next few months, the fundamentals don't point to an extended bear market. Moreover, this increased volatility will probably only have a small impact (if any) on growth.

China's stock market correction was long overdue, but won't hurt growth.

The nearly 9 percent drop in the Shanghai market on February 27 was relatively small compared with the huge increases in recent months.

During 2006, the Shanghai composite stock index rose 130 percent, compared with only a 16 percent rise for the Dow Jones index. After rising steadily for much of last year, this market has experienced something of a roller coaster in the past two months.

This volatility is largely a function of three factors. First the market is very thin the Chinese government is still the largest stockholder, and only about 10 percent of the shares are traded. Second, 70 percent of the investors are individuals who tend to be less patient and more prone to panic than institutional investors. Finally, the stock turnover in the Shanghai market is three to five times higher than the New York Stock Exchange. This means that the market's volatility is likely to remain high in the near future. Moreover, given the overvaluation of Chinese stocks, further declines in prices seem likely in the coming months.

Despite concerns about the impact of this event, growth in China's economy will probably remain very strong in the coming year. Chinese consumers do not have large equity holdings, and most Chinese companies do not rely on the stock market for financing.

Global Insight continues to believe that China will grow by 10 percent this year, despite the National People's Congress targeting only 8 percent for this year.

While the government is concerned about speculative excesses in the stock market, as well as housing and real estate in Shanghai and Beijing, it is unlikely to do anything that will threaten growth.

China's growth is more important to the global economy than the Chinese stock market.

While the big drop in Shanghai's market was one of the triggers of the recent turmoil in equity markets, evidence of a "rice bowl crash" is very limited.

To begin with, stock market capitalization in the Chinese mainland is small relative to the United States, Europe and Japan. Furthermore, the United States and other major markets are not overvalued. There is little doubt that US stock prices did rise too much in the past few months, given the outlook for sluggish growth in the US economy and single-digit increases in earnings.

However, price/earnings ratios are now below where they were in the mid-1990s. This means that while US financial markets will likely be less calm than in the past few months, stock prices are more likely to move sideways than experience a long contraction.

Consequently, further drops in the Shanghai market will probably have a smaller impact on the US market than occurred on February 27.

Part of the contagion effect from the Chinese stock market to the rest of the world had to do with concerns about the potential impact on the country's growth and, therefore, the impact on export earnings of the United States, European and Japanese companies.

While China only accounts for about 6 percent of the global economy, compared with 30 percent for the United States, the Chinese economy has generated about 15 percent of global growth in the last five years and accounts for an even higher percentage of the profits of many multinational corporations.

This global dependence on China's economy is set to grow in the coming decades. Thus, it was no surprise that in the wake of the stock market turmoil, companies with large export exposure to China were hurt the most.

In the final analysis, the sell-off in Shanghai was more of a wake-up call to investors, who had become too complacent about risk than the beginning of some global financial crisis.

While the US economy will struggle in the coming months, the risk of a recession is still low notwithstanding Greenspan's comments.

One of the larger concerns of investors is the rather shaky outlook for the US economy. Recent data have been more negative than positive, suggesting that growth this year will be slower than previously expected.

On the downside, housing is still stuck in a fairly deep recession, and a recovery is not expected until the end of the year. Prices have been falling by about 5 percent in the most overvalued markets.

While this is beginning to attract some buyers, the inventory of unsold homes is still around seven months, which is uncomfortably high for builders.

In the meantime, as prices slide, the sub-prime mortgage market is beginning to show signs of stress, with delinquency rates rising sharply and expected to go much higher.
 
So far, the impact on the conventional mortgage market and on risk spreads in bond markets has been very limited. However, markets are quite jittery and there has been a flight to quality, as evidenced by falling government bond yields.

More troubling is recent evidence of increasing risk aversion by the corporate sector. As a result, capital spending, which was supposed to be an engine of growth this year, is sputtering.

Similarly, because of the US housing recession and sluggish auto sales, the manufacturing sector is caught in the middle of a major inventory adjustment cycle. Weaker inventory accumulation accounted for half of the downward revision in fourth quarter US growth from 3.5 percent to 2.2 percent. Further efforts by US businesses to cut inventories are likely to keep growth weak in the first half of this year.

On a more positive note, consumer confidence and consumer spending seem to be holding up. This is largely thanks to steady jobs and income growth. In particular, despite the troubles in the manufacturing sectors of the economy, the service sectors are still doing pretty well.

Another source of strength for the US economy is exports, which have been growing at double-digit rates. Further weakness of the dollar, along with strong growth in other parts of the world, means that the US will enjoy export-led growth this year and probably for the next few years.

Global Insight predicts that US economic growth in the first half of this year will be between 2 percent and 2.5 percent. However, we expect growth in subsequent quarters to accelerate modestly, as the housing downturn eases. For the year as a whole, growth will likely be around 2.5 percent.

Despite Greenspan's comments, the risks of a recession are still quite low. While growth could weaken further, if the housing downturn gets worse or companies become more risk averse, it would take one or more big shocks to trigger a recession.

Global Insight assesses the probability of a US recession at 15 percent to 20 percent.

Unless the recent stock market volatility in the US turns into an extended bear market, the impact on growth will be very limited. The 3.3 percent drop in the Down Jones index on February 27 was only the 268th largest drop on record. Increased volatility is unlikely to have an impact on consumer spending, but could make companies a little more risk averse.

The Federal Reserve's job has once again become more difficult.

Until recently, the Fed was expected to keep interest rates at current levels for an extended period of time.

However, the recent market turmoil has increased the downside risks and the odds that the Fed may cut rates in the late spring or over the summer.

Two types of events could influence the Fed's decision about an interest rate cut. First, Federal Reserve Chair Ben S. Bernanke and his colleagues may have no choice but to ease rates if the US economy decelerates further, because of a deeper recession in housing or more weakness in capital spending.

Second, they could move even more aggressively if stock prices fall by a large amount in the next few weeks and months. In the past 20 years, the Fed has moved decisively to limit the damage from large stock market crashes.

Right after the 22.6 percent drop in the Dow Jones index on October 19, 1987, Greenspan assured markets that enough liquidity would be provided to ensure that financial markets would not freeze up. This set the stage for 4.4 percent growth in the following year.

In the final analysis, while the most likely scenario is for the United States to avoid a recession, growth will be weak and financial waters very choppy.

The writer is chief economist of Global Insight, a leading international economic and financial forecasting firm.

(China Daily March 9, 2007)