Markets

Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

Turbulence in Shanghai stocks has global investors on edge though really it's the Chinese currency they need to be watching to assess the risk of a full-blown contagion.

The reason is simple. Share ownership is still a small part of Chinese household wealth. Price gyrations -- like the 7 percent drop in the CSI 300 index Monday -- do affect market valuations globally. But beyond short-term jitters, the sharp declines don't mean much. Mostly, they're a reflection of pent-up selling pressure, such as the impending removal of a ban on major shareholders' equity sales. To a more limited extent, they're a handy barometer of investor despondence over authorities' seeming inability to stabilize GDP growth at anywhere near their stated 7 percent target.

China's Shock Devaluation
Yuan's drop against the U.S. dollar since Aug. 10 has been second biggest of any Asian currency

But just how that weakness in Chinese demand might reverberate through neighboring Asian economies -- the most likely starting point of any contagion -- is the more important story, one that's better told by the 5 percent drop in the yuan against the U.S. dollar since just before last year's surprise Aug. 11 devaluation.

To see why this slide matters, consider the 800-odd non-Chinese, non-financial companies in Asia that, according to their filings, garner 80 percent or more of their revenue from China, Europe or America. This motley group of Asian exporters includes Australian commodity companies such as Fortescue Metals, Singapore-based smartphone casing fabricator Hi-P International, nearly all Indian software services companies, and Hartalega Holdings, a Malaysian maker of latex gloves.

Focus next on these exporters' combined annual net profit, which rose from $40 billion in 2010 to $50 billion in 2013, but has since slumped to a little less than $45 billion. Competing against Chinese rivals who have the advantage of a weaker currency could push some of them out of business, and force many more to fire workers and cancel investments. The more the yuan weakens against its trading partners' currencies, the greater the risk that weak corporate profitability will infect the region's banking systems:

Asian Exporters' Profit Crunch
Aggregate earnings of about* 800 companies
Source: Bloomberg
*808 non-Chinese, non-financial companies with 80 percent of revenue from China, Europe and America

This is how the 1997 Asian crisis unfolded, following a 1994 devaluation in the yuan. And while the region's banks are generally better capitalized than they were back then -- with India being a notable exception -- it's once again the most obvious way panic could spread quickly through other parts of the continent. The natural corollary of such a crisis of confidence will be capital outflows, and a sharp depreciation in Asian currencies. To some extent, it might help Asian exporters recoup some of the competitiveness they're losing now to China. But that will be a rather slow and painful adjustment.

Yuan Gains Competitiveness
Cumulative change in real effective exchange rates since Aug. 14, 2015
Source: Westpac

To be sure, not all Asian exporters will be equally affected by a weak yuan -- Indian software vendors face hardly any competition from rivals in the People's Republic. But a significant depreciation in the Chinese currency could easily expose other vulnerabilities. For instance, Indian steelmakers are already a disproportionately large source of bad loans for the nation's poorly run state-owned banks; many more of them could be forced to welsh on their debt if the Chinese yuan depreciates by, say, another 5 percent this year. Similar fault lines exist in other Asian economies as well. Foreign banks' loans to Thailand have swelled by 2.6 times since the first quarter of 2009.

Considering lenders are going to be in investors' cross-hairs if contagion risks do arise, the very threat of a weaker yuan is the big risk for Asia in 2016, much more than vacillating Chinese stock prices.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Andy Mukherjee in Singapore at amukherjee@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net