Last night, the Shanghai stock index dropped 6.5 percent, the biggest decline since the 9 percent drop 3 months ago. Last night’s move reminds us of the move that happened on February 27th, which as many people may recall, led to a 3.3 percent drop in the Dow.

The Dow is only slightly lower at the time of publishing, but carry trades have still come under pressure on the back of the global stock market liquidation. However we want to remind everyone that on February 27th, the Dow Jones Industrial Average opened lower by only 70 points and it was not until 2pm that the index fell nearly 300 points. At that time, the stock exchange credited the move to a “glitch” in their system. Whether or not this was glitch will be replicated remains to be seen. With China leading the Dow once again, we are faced with the question of whether we could see a wave of weakness similar to the one that we saw in the stock and foreign exchange markets back in late February (see our article titled “Is China the New Puppet Master of the Global Markets”). Three months ago, the markets sold off on the expectation of a possible move by the Chinese government to raise taxes on stock market investments. Yesterday,China tripled its stamp tax on stock trading to 0.3 percent from 0.1 percent in a bid to clamp down on the overheated market. Now that they have actually raised taxes, the latest round of liquidation is actually supported by fact rather than speculation. This move by China comes less than 2 weeks after they raised interest rates, reserve requirements and widened the trading band all in one day. A move once a week makes it clear that China desperately wants to cool their stock market. With the number of stock accounts exceeding 100 million for the first time this month, China is extremely worried about the vulnerability of their people to a sharp contraction in wealth. At some point they may be left with no option other than to free float the Yuan, which would be disastrous for carry trades.



Is a Free Float Around the Corner?

Whether a free float will happen will depend upon how the Chinese and US stock markets react to the policy changes by Chinese the government. Should the US stock markets end the day back up in positive territory, then the lifespan of carry trades will be extended and speculators may jump back in to buy the dip in Chinese stocks. If the Shanghai index does not manage to hold onto its losses and heads back up to record highs, like it did back in February, the Chinese government will become even more anxious. So what does this mean for the financial markets? Expect more aggressive action by the Chinese. Everyone believes that China will not allow their economy to contract significantly before the 2008 Olympics, but if they keep on hitting a brick wall with all of these moves, they may have no choice but to free float their currency. There is no doubt that more flexibility is on its way for the Chinese Yuan and a free float may be right around the corner.

What about the Dow?

With the Chinese stock market, US stock market and carry trades hitting record highs as recently as the past few trading days, the risk appetite of investors has grown significantly. Along the same lines, most traders are aware that they could be riding a wave that is nearing its end, which explains why they are ready to bail at the first sign of trouble. Over the past 24 hours, trouble has come and all it needs at this point is to be confirmed by a big move lower in the Dow. We have yet to see that and we may not for some time, but it is inevitable and at that time it will be clear that China sneezed and the rest of the world did too. Keep an eye on the Chinese stock markets overnight and keep an eye on how the Dow reacts to China because the carry trade will die when the US stock market dies. If the stock market ends the day back up in positive territory, then the lifespan of carry trades will be extended for the time being. The one thing that we are sure of is that China will not back down if their stock market does not cool. This year alone, the Shanghai stock index is up 60 percent while the in the stock market is up 700 percent since last year. With so many of their citizens dipping into their savings or leveraging their homes to play the markets, China does not want to see a collapse that is reminiscent of the 1997 East Asian financial crisis or the 9/11 induced crash 5 years ago. They have a strong interest in taming the bubble now, when it is still manageable. The higher the stock market rises, the more painful the correction. If they act now by continuing to engineer a meaningful reversal that will tempt those who are invested in the stock market to bail and keep those who still want to invest out.

Kathy Lien is the Chief Currency Strategist at FXCM.