The effect of the earthquake is increasing uncertainty

The stock market seems to be getting increasingly worried about the economic impact of the earthquake, even though Sichuan province comprises just 4% of China’s GDP production and most of Sichuan’s most developed areas, including its capital Chengdu, were left relatively unscathed.

Still, it seems that uncertainty has increased in a variety of areas and investors don’t know how to respond.t of the reason may be because of the quake’s potential impact on fuel and food stocks. Sichuan is a big agricultural producer (I think I read somewhere that it is the most important province in China for producing pork), but it seems likely that it is going to be a net drain on food supplies for at least the next few months, rather than a net provider. This of course will prolong the period of food scarcity and make it harder for food prices to come down.

The quake may also make fuel shortages worse, thus increasing pressure on the authorities to let fuel prices move a little closer to world prices. According to today’s Bloomberg, Sinopec “has diverted gasoline and diesel supplies from southern and coastal regions to quake-hit Sichuan province and lifted rationing on fuel sales as the recovery effort boosts demand.” According to the company newsletter, the nation’s biggest oil refiner has cut back on supplies to Hunan, Hubei and Guangdong.

The stock market trade up 0.4% last Monday, the day of the earthquake. It dropped 1.8% the next day as we began to get the first indications of its severity, only to shoot up 2.7% by Wednesday, as investors began expecting a big fiscal and monetary push in response to the earthquake.

The stock market started Thursday also very strong, but the release late that morning of the PBoC’s Q1 report, ended the party. The PBoC’s report suggested that excessively high levels of investment and monetary loosening were still a problem, and although they tried to sound positive on inflation, it was clear that they were worried about hot money inflows and rising prices. This report seriously damaged expectations that the PBoC would be forced to loosen considerably in response to the earthquake, and the market closed down 0.5% for the day. It lost another 0.4% Friday, and then continued dragging down by another 0.6% Monday.

Today, however, the market took a real beating. It started the day relatively strong, trading up 0.8% in little more than an hour, but after that it was all downhill. During the last hour of trading the market moved into panic mode, trading volume surged, and prices dropped steeply, handing investors a 4.5% loss for the day. My student Shang Ning tells me that with a very few exceptions (some highway and cement companies based in Sichuan or nearby Chongqing) all sectors of the market were badly hurt. He ends his market roundup with: “I feel the market is now without ideas and very afraid of the effect of the earthquake. Not many investors want to play in the markets now – everyone seems just to want to watch and see what happens.”

The market is now at 3443, about 15% above 3000, which many investors believe is the minimum level below which the government does not want to see the market go. Remember that on April 22 it broke 3000 for a few minutes, and within two days the government announced the reduction of the stamp duty, setting off a rally which drove the market up by over 25% over the next few days to close, on May 5, at 3761.

Given the huge attention being placed on the rescue effort and the fact that most media are discouraged from reporting anything but positive images of the rescue efforts, it is hard to know what exactly is going on in the market and in the minds of the authorities. Obviously their number one concern must be the rescue effort, although by now there is little hope that we will find additional survivors. Still, the PBoC and the financial authorities must be monitoring the stock market closely and they must be working overtime to figure out just how much slack they have for fiscal and, more importantly, monetary loosening.

They must also be worried that today’s market collapse could so harm investor sentiment that within a few days we return to striking distance of 3000. I discussed in my May 6 entry (“Perceptions of market support can add shocks”) that one unfortunate consequence of an investor perception that a major player will intervene to support prices at a certain level is that the market can drop very sharply if the support level is ever breached. We now have the risk that if we continue to see several more very negative days so that the 3000 level is tested, it may be difficult for the government to know how to respond while we are still in the midst of the earthquake crisis.

4 Responses to "The effect of the earthquake is increasing uncertainty"

  1. Rachel   May 20, 2008 at 11:51 am

    Thanks for your rundown of the ways that the earthquake is unmooring expectations. Global Insight suggested that Sichuan produced 10% of the nation’s pork – it had a good summary of the channels by which the devastation of the earthquake might effect agricultural markets.

  2. mikmak   May 20, 2008 at 5:35 pm

    This doesn’t bode well for people who eat, vegetarian or not. The earthquake could raise pork and grain prices (oh well, so much for the decline in meat and other food prices in the US PPI):

  3. Victor   May 20, 2008 at 6:01 pm

    Michael, thanks for the excellent analysis of the market (as usual). The two main effect of the earthquake is that it forces people to take a hard look at some of the balance sheets of firms. Second, it exacerbates inflation pressure, which continues restrictive monetary policy, which affect highly leveraged industries like real estate. "one unfortunate consequence of an investor perception that a major player will intervene to support prices at a certain level is that the market can drop very sharply if the support level is ever breached." I completely agree. Smart money would be getting out about now, while government support is holding.

  4. Michael Pettis   May 21, 2008 at 1:06 am

    Rachel, thanks for the number. I still don’t have a sense of how much pork production in Sichuan will actually be affected, but it is hard to imagine that there won’t be some impact. In addtion the government is sending part of its food reserves to Sichuan for humanitarian needs, and a reduction in the food reserves of course increases the country’s susceptibiluity to any further shocks.Victor, I agree with yor assessment. The question to me is about what comes next. Assume that May and June CPI numbers are higher than we originally expected. What will the response be? Will that help shift the consensus in favor of the monetarists so that they take stronger measures against inflation even at the risk of some higher unemployment, or will the earthquake be used as another reason for doing nothing yet? Of course by then we will be fully into the Olympic countdown so I imagine it is likely to be the latter. My guess is that nothing serious happens for the next few months — by which I mean that they err on the side of relaxation — and then in Q4 we slam on the brakes, although I do notice that the RMB is appreciating again.