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. Last Updated: 07/27/2016

Investors Think Twice as China Slows Down

Last week's Chinese-led markets correction was a rude awakening for investors, raising fears of a looming liquidity crunch and the specter of a new era of decline.

In three days of trading, almost $100 billion was lopped off the total value of Russian stocks, with both local exchanges losing around 10 percent. Worldwide losses are estimated at $1.5 trillion.

Russian markets leveled off Friday, with MICEX gaining slightly. But given that the correction was made in China -- the proxy for emerging markets everywhere -- analysts were forced to think twice about their forecasts for the future.

"It is quite easy to see the situation in a year's time when people point to the moves this week as the first major sign that the global party is drawing to a close," Roland Nash, chief strategist at Renaissance Capital, said in a market note.

Nash argued that the eight-year party of unprecedented growth in emerging economies had largely resulted from the capital being generated in China and Southeast Asia, and the ease with which investors have been able to borrow this capital and reinvest it, thus keeping world markets liquid and booming.

Last week's correction -- although not a sign of impending crisis on its own -- raised fears that this cycle was breaking down as liquidity begins to dry up.

These fears are far from groundless.

The catalyst for Tuesday's 9 percent drop in Shanghai was a series of reports that the Chinese leadership was taking steps to slow down the country's economy.

"This tightening is going to happen," said Alexander Kantarovich, head of research at MDM Bank. "But of course the Chinese will do their best not to create any sudden shock."

Sudden or not, higher interest rates and a clampdown on markets would mean Chinese capital flows are going to ebb.

At the same time, Nash said that international capital markets had not been efficient at recycling what capital there was, fueling the risk of a liquidity crunch.

"The danger currently is that we are seeing an unfortunate coincidence of both of these possibilities," Nash wrote, adding that this made for a "dangerously unusual situation."

A far more serious threat to global liquidity is the possibility of more Japanese interest rate raises. Before it was raised last July, and then again two weeks ago to 0.5 percent, Japan's interest rate was zero for half a decade.

Investors had taken out vast loans in the Japanese yen and invested them elsewhere. If the rate goes up significantly, these investors will scramble to pay back the loans, cashing in their other investments to do so.

That means hundreds of billions of dollars in equity would be sold off all at once, and the world's biggest source of liquidity -- the "carry trade" of Japanese yen loans -- would start to freeze up.

"It's one of my major concerns," said James Beadle, head of research at Pilgrim Asset Management. "The exchange rate between the yen and the dollar has changed a lot. As long as it keeps moving in this direction, less people are going to borrow in yen."

The last time yen loans became unattractive, shooting up 20 percent in a matter of weeks, was during the worst days of the 1998 financial crisis, when Russia defaulted on its debt and the RTS lost 85 percent of its value.