It’s a Wild West atmosphere and it’s deeply dangerous. The first time the Shanghai index fell, in February, it had a ripple effect around the world. The second time, in April, the rest of the world recovered quite quickly. Nobody knows what the next drop will bring. With China hosting the 2008 Olympics, the government has a close eye on its reputation and wishes to demonstrate nothing but excellence. Managing a stock market bubble has to be part of that.
Therefore, opening Chinese equity markets to foreigners is without doubt a critical source of additional liquidity and, therefore, stability. The presence of big, savvy foreign financial institutions is a kind of “plunge protection team” for China. It’s not beyond the realm of imagination that Treasury Secretary Paulson has made this very point, and that China fully understands it. For China to support and even praise the existence of the U.S. trade deficit, and to commit to holding dollars, is a small price to pay to prevent a second Chinese revolution, one brought on by market failure.
The “alliance” of the U.S. and China in this matter shouldn’t be underestimated. It may turn out to be the real reason the dollar is coming back into favor. It would not be surprising to see the dollar rally considerably over the second half of the year — because of China, not despite China.
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