Day 43 The black swan theory

The black swan theory

Before the first black swan was discovered in Australia, European believed that there were only white swans existing throughout the world. Economists, therefore, used this metaphor to describe the drastic and unexpected events which have substantial effect over financial markets. For example, US ‘911’ terrorist attack, unpredictable government police implementation, and sudden decline in the crude oil price create fluctuation on financial markets which cannot possibly to be explained by the financial model are the black swan effects. Until now, there were three major black swan events affecting the global market in 2015. On purpose for a concise measure, we are going to study the reasons behind the capital inflow and outflow on the Chinese market. Thereby we will have a brief idea about the ‘trigger’ of these events.

Why is the net capital flow important for us on financial decision making?Under macroeconomics study, the supply of funds on the domestic financial market is based on national savings and foreign investments. We also know that financial products price rise when the demand to invest increases, due to the simple demand-supply relationship. We will use the share price to represent all other financial products next for convenience. As a consequence, the net capital inflow will raise the share price, and on the other hand, the net capital outflow will cause the share price to decline. According to the EPFR group statistic, the net capital outflow in China last week was 2.036 billion USD. This will put a potential downward pressure over the share price. Hence we can study the incentives of the net capital outflow, in order to compensate the source of fluctuations.

The first black swan event in 2015 was the World Bank lowered the global economic growth rate forecast. It stated that in the following two years, the growth in worldwide economy will be restrained by the trouble in euro-zone and major crude oil exporters. In this report, the growth rate in China would decline by 0.4%. A country’s GDP growth has large effect on its financial market, hence, the international investor withdrew from China, and the funds will flow towards America/India for the risk-averse purpose.That can be proved by the dramatic decline in CNY/USD exchange rate, because investor supply more CNY and demand more USD. As discussed before, that will have a negative impact over financial markets.

In addition, the Swiss National Bank(SNB) unexpectedly unplugged its three-year policy that maintained franc weaker than 1.20 per euro. Three years ago, the Swiss Nation Bank implemented an exchange rate ceiling towards the euro. At that time, Europe was experiencing the debit crisis, therefore the cap implied by SNB aimed to sustain the net export for Swiss. As a result, the franc has become the risk-averse heaven for European investors, which added a constant up-ward pressure over franc. However, the recent euro zone contraction has made the euro depreciated drastically. In order to maintain the exchange rate for franc towards the euro, the SNB had to use its USD reserve to purchase franc and supply in the market. This action caused heavy burden over the Swiss’ banking system, plus it forced the SNB apply a negative nominal interest rate at -0.25% in 2014. Eventually, the SNB predicted the euro would continue to depreciate against USD, therefore it stopped the exchange rate ceiling to lose this dead-weight. Right after this announcement, the franc appreciated by 30% towards euro and 22% towards USD. That caused a chain effect, firstly, the net export for Swiss would be damaged, which led the further decrease in nominal interest rate to -0.75%, because the SNB wished to force the commercial bank to supply more funds into the market. Secondly, the euro zone is wounded badly, that made the euro exchange rate fell 1.3% on the same day of the announcement. Moreover, a lot of international investors who expected a depreciation of Swiss franc suffered a tremendous loss. That also explained the net capital outflow from China, since the investors were pursuing the favorable appreciation of franc. 

The last unexpected even that tumbled the Chinese share market is the investigation proceeded by the China Securities Regulatory Commission(CSRC) over the stock price manipulation. There were 18 companies on the list, hence the share price declined corresponding to this event. Due to the principle of conservatism, both foreign and domestic investors will hold on their actions to avoid the uncertainties in the market.

The black swan events specified on the sudden variations internally or externally that affect the market. It cannot be predicted, thereby cannot be eliminated.Other factors like US economy’s recovery and the Federal Reserve System to rise interest rate normally are not classified as black swan events. Although they also led the net capital outflow from China, they can be reasonable expected.