Sharp fall in share prices

1. Discuss the effect on China

A sharp fall in share prices will have an impact on price level and inflation. There will be
downward pressure on consumption and less discretionary spending. Consumer
confidence will lower, there will be less profits which will reduce investments. There will
be pressure on the US dollar, decreased exports and increased imports. As a result GDP
will fall and the unemployment rate will increase.
China is the second largest economy and the fastest growing in the world. The GDP value
of China represents 14.9% of the world economy. Its GDP composition is the following:
Y= C (35%) + I (44%) + G (15%) + X (25%) M (20%).
Consumption is a large part of Chinas GDP. A fall in share prices will decrease
consumption. Consumer confidence may be affected, reducing even more spending and
investment, which results in a further fall in share prices.
With low share prices, investors will have less wealth. As the stock market is weakened,
equity is reduced so investment decreases, which has a massive impact on the GDP. Due
to decreased investment, there will be less production which means less exports. This has
a great impact on Chinas current account surplus.
As a result of this the chinese growth rate will slow, the GDP will fall and the Chinese
unemployment rate (currently 4.1%) will increase.

2. How can the authorities in China react?

As the sharp fall in share prices causes a reduction of Chinas GDP, Chinese authorities
must react to try to lower the impact as much as possible. To do this, they need to
implement comprehensive monetary and fiscal policies.
The Peoples Bank of China has the following options:
Expansionary Monetary Policy:

They could decrease reserve requirements in order to increase liquidity in the market. If
Chinese banks have to hold less of their deposits as a reserve, there will be more funds
available to lend out as loans, which will increase borrowing and consumption.
The Peoples Bank of China could also decrease interest rates. This makes borrowing
cheaper and is an incentive to spend. Through the transmission mechanism, lowering the
interest rates will increase liquidity, there will be more borrowing and this will boost
aggregate demand.
The problem with a monetary policy is that it is a blunt instrument and will not allow the
government to have a precise control of the economy. The effects would occur with a lag
and the exact impact in the economy is hard to measure.
Expansionary Fiscal Policy:
China could implement a comprehensive fiscal policy to target specific issues and boost
the economy. It could provide stimulus packages in order to push spending. As a rapid
response to the shock, by providing cash hand outs to chinese people (lump sum
payments), the propensity to consume will increase and the economy would be
stimulated. The effect would depend on the size of the multiplier (Keynsian model).
Another option could be tax cuts or subsidies for companies that export goods, in an
attempt to reduce the impact on Chinas net exports.
China could also increase investment on infrastructure, although it is not very likely due
to the current excess capacity from previous stimulus. A more likely stimulus would be
an increased investment on education, science, patents and technology in order to
improve development and innovation. The effects would be seen in a medium to long
term period.
Another option is to try to stabilise high fluctuations in the exchange rate by pegging it
and devaluating more the Yuan (it is currently undervalued by 30-40%).

Chinese reaction:

The recommended response for China to a sharp fall in share prices is an immediate
fiscal stimulus which will try to absorb a little bit of the impact of the shock and try to
stabilise business and consumer confidence. By giving tax deductions to purchases of
businesses, China will try to respond rapidly to the negative impact of the shock.
3. What impact will all this have on the Australian economy and how can the local
authorities react?
Australian GDP composition is the following: Y= C (53%) + I (22%) + G (24%) + X
(22%) M (24%).
Like China, Australia will have a negative impact to the sharp fall in share prices. Due to
globalisation, if there is a shock, all the open economies will transmit the negative effects
in a rapid way.
Consumption is half of Australias GDP. The shock will decrease consumption and
discretionary spending. Consumer confidence will be weakened even further, reinforcing
the negative impact of the shock, by reducing spending even more.
Like in China, investment in Australia will fall as the stock market weakens. Investors
will have less equity from shares so investment will drop. This will have a huge impact
on Australias GDP. Decreased investment means less production and therefore less
exports.
As a result, Australias GDP will decrease. Inflation will be higher and the unemployment
rate will increase (it is currently 5.8%).
Australian exports to China are 29.5% and consist mainly of commodities such as coal
and iron ore. This shows how reliant the Australian economy is on China. If China
experiences a slowdown, the Australian exports to its major trading partner will fall
significantly, affecting the economy, in particular the mining sector.
As the Chinese economy responds to the fiscal stimulus, Australia will see an
improvement in their exports, but the impact of the shock is very high and Australias
authorities must take matters into their own hands and respond with monetary or fiscal
policies.
To respond to this, Australian options are the following:
3

Expansionary Monetary Policy:

The Reserve Bank of Australia (RBA) could implement an expansionary monetary
policy. By lowering the cash rate (currently 2%) they will attempt to stimulate aggregate
demand. Lower interest rates are an incentive to borrow and may increase consumption.
Through the transmission mechanism, lowering the cash rate will increase liquidity and
will boost the GDP.
It should be noted that fiscal policies have broad impacts and the RBA has already cut
interest rates to record lows, creating a massive incentive to borrow on the basis of
speculative property price increases. This increasing demand for property is placing
pressure on the australian property market and creating a bubble which is arguably going
to burst and create longer term problems. The RBA has warned that massive borrowings
for speculative demand which has pushed property prices to record highs particularly in
key markets of sydney and melbourne will increase the potential that prices will fall
later (the bubble will burst). Such a fall would affect household spending and wealth an
effect that is likely to be spread across a broader range of households than the investors
that contributed to the heightened activity.
The problem with a monetary policy is that it is considered a blunt instrument as it
doesnt provide a precise control of the economy.
Expansionary Fiscal Policy:
Australian governments could spend on productive assets and infrastructure, or could
provide a fiscal stimulus to attempt to boost private sector investment through tax
stimulus (tax cuts, rebates or offsets, such as the recent small business tax concession and
the immediate deduction for equipment purchases up to $20,000 announced in the May
2015 budget). In extreme situations, like the GFC in 2008 and 2009, the Rudd
government stimulus package provided up to $650 as a tax rebate to Australian
consumers through their tax returns. If the shock had large and longer term impacts, the
government could also direct its fiscal policy to consumption by providing such
incentives to increase consumption spending and stimulate the economy.
The problem with a fiscal stimulus in Australia is the countrys low multiplier effect
(Keynesial model), so stimulus packages dont achieve the required objectives. The

magnitude on any fiscal stimulus in the country would have to be large enough to act as a
multiplier and increase consumption.
Australian reaction:
The recommended response for Australia is an immediate fiscal stimulus which will try
to absorb a little bit of the impact of the shock and try to stabilise investment and
consumer confidence. By giving tax deductions to purchases of businesses, Australia will
try to respond rapidly to the negative impact of the shock.

4. Discuss the impact of these developments on BHP. What can they do about it?
BHP Billiton is an Australian leading global resources company. Their purpose is to
create long-term shareholder value through the discovery, acquisition, development and
marketing of natural resources. They are the worlds largest producers of major
commodities, including iron ore, petroleum and potash, copper, aluminum, coal,
manganese, nickel, silver and uranium, and have substantial interests in oil and gas.
33.83% of the revenue comes from exports to China, 14.75% to North America and
10.38% to Japan.
Due to a sharp fall in share prices, consumer confidence drops, there is less consumption
and less investment. As production and manufacturing falls, BHPs commodities will
have a lower demand, affecting the companys revenue. As commodities have long-term
production processes, the company couldnt just lower production levels immediately.
This means that a reduction in sales will cause a surplus of commodities (high
inventories), lowering the price level and share prices even more.

Currency risk:
The US dollar is the functional currency of most operations within the company and as a
result currency exposures arise from transactions and balances in currencies other than
the US dollar.

The Groups potential currency exposures comprise:

translational exposure in respect of non-functional currency monetary items; and
transactional exposure in respect of non-functional currency expenditure and revenues.
BHP foreign currency risk is managed as part of the portfolio risk management strategy.
1 cent movement (depreciation or appreciation?) in Australian dollar would decrease
profit by US$31 million.
Interest rate risk:
BHP is exposed to interest rate risk on its outstanding borrowings and investments from
the possibility that changes in interest rates will affect future cash flows or the fair value
of fixed interest rate financial instruments. Interest rate risk is managed as part of the
portfolio risk management strategy.
The majority of the Groups debt is raised under central borrowing programs. The Group
has entered into interest rate swaps and cross currency interest rate swaps to convert most
of the centrally managed debt into US dollar floating interest rate exposures.

Response to Australias fiscal policy:

As a result of the Australian fiscal policy, BHP would benefit as Australian economy
slowly recovers from the shock, but the impact is massive. As consumer confidence
stabilizes, BHPs situation would improve a little bit, but the company needs to wait until
the GDP recovers and exports pick up again.
What can BHP do?
To protect themselves against the shock, BHP has to rely on their risk management
strategy. Their diversified portfolio of commodities, geographies, currencies, assets and
liabilities is the key element in their risk management approach. If the situation is really
bad, the company would have to stop new projects or shut down high cost mines.