The global financial markets reacted very badly to a set of financial developments in China that started with the stock market plunge in the early summer and ended with the recent devaluation of the renminbi. Emerging economies in Asia were particularly hit by the events in China before the developed economies’ stock markets caught the financial virus after the renminbi devaluation.

Is the world on the edge of another global financial crisis of the 2007 magnitude?

I do not think so, but what we are witnessing is an overdue correction both in the emerging and the developed world currencies and share prices. Loose monetary policies in the US, the UK and in Europe that were quickly introduced to prevent the collapse of the global financial system in 2007 have since created bubbles in the global financial system.

Cheap dollars issued by US Federal Reserve under quantitative easing have not boosted productive long-term investments in the real economy in the US, but flown to stock markets everywhere and financed debt-driven growth in emerging economies in search for short-term high yields.

China reacted differently to the 2007 crisis by injecting credit into the real economy to build infrastructure and real estate. By doing so, China helped the global economy achieve growth as well, because China needed to import commodities from emerging economies. Emerging economies benefited both from demand for their commodities from China and the flow of capital from the US and Europe.

Dynamics of growth

The dual factors created bubbles in emerging economy currencies and stock markets. The post-crisis growth in emerging economies, therefore, was not sustainable because the dynamics of growth were external and monetary. They failed to turn this conjunctural benefit into longer-term investments and instead allowed bubbles to develop in their currency, stock and real estate markets.

This “happy state” of unsustainable affairs in China and emerging economies ended in the summer of 2013 when the Fed announced it would consider raising interest rates because the US economy had recovered and inflationary pressures needed to be addressed before it was too late. This was called “tapering” and turned into a “tapering tantrum” as all global financial flows reversed and left the emerging economy markets, because the investment strategies and carry trades based on cheap dollars would no longer be profitable.

In the summer of 2013, the global financial markets experienced a small tsunami with emerging economy currencies and stock markets nosediving, and bond yields in the developed world suddenly jumping. China suffered too because the financial strategies in China were based on borrowing in dollars and investing in appreciating renminmi were no longer profitable.

Unwinding the positions caused havoc in Chinese financial markets back in 2013.

Since 2013, Chinese financial markets have not stabilised and officials failed to come up with a stabilising plan of action and plans for an orderly transition to the post-tapering global economy. When the Fed reintroduced its strong intention to raise the interest rates, in July, China started to play a poker game with the US by devaluing the renminbi to protect its economy.

This basically prevented the US from increasing interest rates because otherwise the life-threatening turmoil in financial markets caused by the expectations of higher dollar interest rates coupled with the weak Chinese economy could turn into a major global financial crisis. By devaluing its currency and causing tremors in global financial markets, China is effectively preventing the US from increasing interest rates.

Serious imbalances

Since the taper tantrum, we have witnessed the start of currency wars in the developed world because the policy needs of the US and other developed countries and China have diverged. The quantitative easing policies have created serious imbalances in the global economy.

On top of this, China is mishandling the internationalisation of its currency and reforming of its financial system. And one would expect institutions like the IMF and World Bank to take a leading role in much-needed policy co-ordination - but they are not.

There is an urgent need to create a new international financial governance framework that takes into consideration the new realities. All of these issues point to a very rough ride ahead for the global financial markets and economy, in which international policy coordination will be desperately needed.

The writer is senior lecturer in banking, Manchester Business School.