China has been at the top of two big stories in recent days: Falling Chinese stock prices triggered a worldwide stock plunge February 27; and China’s mammoth trade surplus with the United States has led U.S. officials to press for “fair trade” practices that would allow the yuan to strengthen against the U.S. dollar. On February 28, Knowledge at Wharton spoke about both stories with Wharton finance professor Jeremy Siegel. Following is a summary of the conversation.

Knowledge at Wharton: What caused China’s stock markets to plunge?


Siegel: It happened not only in China, but everywhere around the world. This had been a market that had been trending up for many months, which means it attracted a lot of what we call trend followers and momentum players. They ride the trend, and they ride the trend until they see it is broken.


Many trend followers use stop-loss orders to automatically sell stocks when prices fall a pre-determined amount. Thus, a relatively small price decline turns into a plunge when more and more sell orders are triggered. What we saw yesterday, worldwide, was a shakeout of the trend followers. Yes, there was some negative economic news, but certainly nothing justifying a trillion-dollar loss in worldwide markets.


China was the best performing emerging market in 2006…. This [kind of plunge] is very common in markets like this that have been enjoying long-term upturns…. I think ultimately the [pullback] is healthy for the market because it shakes off these trend followers and technical traders, and then the market can trade on fundamentals.


Knowledge at Wharton: Why did the Chinese pullback spread to other markets?


Siegel: Because markets in most of the world had been rising significantly, leaving many traders anxious that a pullback would come. Once traders saw Chinese stocks falling, Everyone said, “All right, the game is over, at least for the short run. I’m getting out of this market.”


Knowledge at Wharton: Some analysts have argued that rising stock prices around the world have made stocks too risky. Do you agree?


Siegel: No. When you have a market that’s going straight up, it’s vulnerable to these straight drops…. We did not get any unbelievable, shocking news: “Oh, my God, the economy’s falling apart…. Nothing like that.


For many markets the February 27 drop was the worst since the September 11, 2001, attacks on the World Trade Center, but the two events are not comparable. The 9/11 attacks did undermine the U.S. economy, while nothing on that order occurred on February 27.


The Chinese economy is still likely to grow at a strong pace, supporting stock gains. And while some of the emerging markets may be risky for the time being, given the big gains of the past year, stocks in Europe and the U.S. do not look overpriced. In the U.S., for example, the ratio of share prices to projected corporate earnings for the next 12 months is 15. That is about the long-term historical average, and low for the past few years.


Knowledge at Wharton: In the U.S. many economists and some officials are pressuring China to allow the yuan to grow stronger against the U.S. dollar. Why do they want this?


Siegel: There’s a feeling, even for me, that we would like to go to a world where the market sets the [exchange] rates rather than government setting rates. Were this to happen, the yuan probably would become stronger, making Chinese goods more expensive in the U.S. and American goods cheaper in China.

That is something a lot of economists say would be good, because it would reduce the U.S. trade deficit with China. To finance the deficit, the U.S. government has to borrow money by selling U.S. Treasury bonds. Reducing the deficit would reduce U.S. borrowing, thereby reducing the interest payments borne by American taxpayers. 

Knowledge at Wharton: Do you agree that a stronger yuan would be good for Americans?


Siegel: I disagree with that. Many Asian countries, especially Japan, have strengthened their economies with policies similar to China’s — i.e., by keeping their goods inexpensive for foreign buyers. They want to build their economies on exports.  In China, the result is a trade surplus that produces cash that is used to buy U.S. Treasuries. In effect, this means using yuan to buy dollars. That demand keeps the price of the dollar high relative to yuan, keeping Chinese goods cheap for buyers paying in dollars.


It also keeps Treasury prices up, Siegel says. This helps keep interest rates — and the rates Americans pay for mortgages and other loans — low, he says. Americans thus can purchase Chinese goods inexpensively and can borrow money at low interest rates. You don’t look a gift horse in the mouth.


While the U.S. trade deficit with China causes the U.S. to borrow, I believe this cost is offset by growth in the U.S. growth economy, stimulated by low interest rates and inexpensive imports. We are creating as many assets as we are losing, the trade deficit with China helps to keep U.S. inflation under control. If the price of the dollar goes down, then the price of imported goods goes up.


Knowledge at Wharton: How much would the yuan appreciate if the Chinese government were to stop supporting the dollar by buying Treasuries?


Siegel: No one knows for sure. My feeling is that it probably would go up by 20%…. If the yuan went up 20% to 30%, the Chinese would have to raise prices of their goods [for U.S. buyers] by 20% to 30%.

, like many Asian countries, is following a mercantilist economic model that emphasizes cheap exports but makes imports expensive for the Chinese. This is tough on the Chinese, but good for Americans.