- Yuan dropped 0.9% in the offshore driven by concerns over Chinese financial markets.

- The world appears to be entering a new cycle, and even moderately bad Chinese news may lead to a global-scale panic.

- China’s central bank will conduct reforms in interest rates, and foreign exchange rates while also embarking on open market reforms at the same time.

China’s central bank guided The Yuan lower on Monday by 0.9%. However, the lower-than-expected PMI read has exposed the fragility of confidence in the China equity market, and this led to a historical drop in stock prices that eventually led to a halt in trading. The fear then moved on to other global markets and has led to significant selling in stocks-around-the-world.

On the first trading day of 2016, the central bank of China guided the yuan further lower by setting the mid-point rate at 6.5032. The offshore yuan market reacted immediately. In the below five-minute chart, we can see The Yuan dropping against the dollar by 503 bps.

What is Chinese Media Saying about Stock Market Plunge?

Created with tradingview. Prepared by Renee Mu

When the lower-than-expected Caixin PMI release came out at 9:45 UTC, the yuan rate dropped a further 120 bps. This is the 10th consecutive month that PMI has printed below 50, indicating the likelihood of further contraction in Chinese manufacturing. If we compare the ratio to previous reads, especially those in August (47.3) and September (47.2), the December print of 48.2 is not the worst that we’ve seen. More importantly, it is a well-known fact that Chinese manufactory industry is contracting. That is why China has been spent a lot of effort in promoting the One-Belt-One Road initiative to export the excess production.

As a result, it would be disingenuous to blame the PMI print for the entirety of the drop in Yuan and Chiense stocks. But the PMI ratio was certainly the trigger. Five minute after the release of the PMI report, the Shanghai Composite fell 0.7% and the Shenzhen Composite dropped 1.0%, and that was just the beginning. From 10:00 am to 10:15 am local time, the two ratios fell additional 2.7% and 3.5% separately. This highlights the fragility in Chinese equities right now. Chinese investors are extremely sensitive and scared of any bad news after the major market plunges in the second half of last year. So when these investors hear any negative news or see others’ actions (the first five minute drop), they react out of the fear of losing more money or getting long stuck in a halted market. The overreactions might sound irrational, but it reveals the increasing vulnerability of the stock market and reduced tolerance to bad news (even if the news is not that bad).

This fear wasn’t contained to the mainland, and it spread to other markets and the rest of the world in fairly short order. It appears as though much of the world started the trading day (or attempted to) in holiday mode. A hit on a person when they are waking up may cause more damage than when he or she is fully awake. When global investors get scared by the Chinese stock market and feel more concerns around the Chinese economy, they sold the Yuan in the offshore yuan market, which led to The Yuan’s further devaluation.

This is how a butterfly in China can create a financial tidal wave on the other side of the world.

We can also see a new cycle emerging: moderately bad news from China -> Chinese investors panic, hardly think and then react -> China markets jump -> global investors panic, hardly think and then react -> global markets drop

In the message for the New Year, China’s central bank Governor, Zhou Xiaochuan said that the year of 2016 is the opening year that “China moves toward the target of a moderately prosperous society and is the year when China will face the hardest obstacles in structural reforms.” In addition to the economic slowdown, the fragile market confidence is going to be one of the hardest obstacles.

The Head of Investigation & Statistics Department of the PBOC, Sheng Zhusong, said in an interview on Monday that the reforms will be implemented in the following three areas: interest rates formation regime, exchange rates formation regime and capital account open-up. And the main principle when applying these reforms is to eliminate over volatility.

It is like dancing on a piece of ice floating on the water: it has to be balanced in every direction or else it will fall over. As a result, Mr. Sheng said, one reform cannot wait until the finish of another. The reforms in the three areas have to be conducted at the same time.

Written by Renee Mu, DailyFX Research Team