KEY POINTS:
The 8.8 per cent decline in the Shanghai A Index on Wednesday resembled a small tsunami as it sent shockwaves though the world's financial markets.
The global correction was material, but it has to be viewed in the context of the fantastic performance of most of the world's sharemarkets since the early 1990s.
Some commentators claimed investors lost hundreds of billions of dollars in a few hours.
This is clearly ridiculous because losses are realised only when securities are sold and the reduction in values was insignificant compared with recent gains.
The table shows that the total market capitalisation of all 51 members of the World Federation of Exchanges rose from US$8893 billion at the end of 1990 to US$54,896 billion at the end of January this year.
By comparison, the total value of the New Zealand economy, as measured by gross domestic product, is US$110 billion.
More exchanges have been added to the federation's database since December 1990, but these are relatively immaterial as the additions had a market capitalisation of only US$4582 billion in their first year of inclusion.
Several factors are behind the strong performance. They include a large increase in the number of listed companies and a substantial rise in the average value per company.
The total number of listed domestic companies has risen from 21,585 to 37,546 since the end of 1990 and the average value from US$0.4 billion to US$1.5 billion.
Globalisation has given companies greater opportunities to grow, but it also creates a ripple effect through financial markets when one market falls sharply, as happened in Shanghai this week.
The bull market in equities has created enormous wealth around the world and this week's correction has taken back less than the gains made during the first few weeks of the year.
This is confirmed by the MSCI All Country World Index, which rose 0.3 per cent in US dollar terms for the first two months of the year.
The index rose 18.8 per cent last year and 8.8 per cent in 2005.
Most sharemarkets have performed extraordinarily well since 1990. The big exception is Tokyo. The Japanese exchange was the world's largest at the end of 1990, in US dollar market capitalisation terms, but the New York Stock Exchange is now 3.3 times bigger.
This reflects the asset price implosion in Japan in the late 1980s and 1990s, and the poor performance of the economy since then.
The Australian sharemarket has performed exceptionally well in recent years but the NZX has lost ground. The ASX now has 2 per cent of total world capitalisation, up from 1.2 per cent at the end of 1990.
The New Zealand sharemarket is less than 0.1 per cent of world sharemarket value. In December 1990, it was just over 0.1 per cent, and at the end of 1995, it was nearly 0.2 per cent.
Shanghai has been one of the best performing markets, particularly over the past six to nine months. The benchmark index rose 130 per cent last year, and was up a further 4 per cent in January.
But the most notable feature was the huge increase in trading volume. The total value of shares traded in January was more than eight times the value traded in January last year.
The value of shares traded in January was just short of the total value traded during the the whole of last year.
China has been a communist country for more than 50 years, but it has a long history of sharemarket investment.
The Shanghai Stock Exchange had its origins in the 1860s, and the city was the financial centre of the Far East in the 1930s.
The exchange closed after the communists came to power in 1949, but was reconstituted in 1990. It began operations on December 19 that year with only a handful of listed companies.
The Shanghai market has had several booms, interrupted by mini-busts, since 1990, but the last few months have been unprecedented for hype, share-price rises and trading volume.
Chinese reports indicated that well connected government officials were selling pre-float shares in dubious companies and indulging in other unethical activities aimed at unsophisticated investors.
As well, retail investors were starting to borrow large sums of money, sometimes secured against their homes, to invest in the market.
On Monday China's State Council announced in Beijing that it had approved the creation of a joint workforce to protect the interests of minority shareholders and curb illegal securities dealings.
The council said many investors were being coaxed into buying so-called "original shares" in companies that were promising to list but had no plans to do so. Investors bought shares in these companies hoping to take a quick profit on listing.
Chinese regulators claimed they had received thousands of letters, phone calls and visits from investors about illegal stock activities.
The Beijing announcement will have a positive effect on the Shanghai market in the longer term but it was the catalyst for this week's big sell-off that reverberated around the world.
This is ironic because some major international brokers had been recommending the Shanghai sharemarket because it performed independently of the world's major markets and would be a haven if Western markets weakened.
The Shanghai collapse spread rapidly because of the consequences of the bottom line figures in the accompanying table.
Sharemarkets have created huge shareholder wealth and have been a winning one-way bet for investors in recent years. Because of this, a wide range of high-risk strategies has been adopted to capitalise on these boom conditions.
They include derivatives, margin trading, private equity structures, hedge fund strategies and bank borrowings to invest in equities.
As soon as there is any problem, many of these investors have to close their long positions.
It is inevitable that sharemarkets develop more and more volatile characteristics as investors become increasingly risk-averse and adopt higher and higher risk strategies during a strong bull run.
It would be naive to think that there won't be more sharp oscillations on world financial markets.
New Zealand's financial markets are not immune from international financial contagion because the NZX has the highest level of overseas sharemarket ownership, we are heavily reliant on overseas borrowing and there is a huge international carry trade in the New Zealand dollar.
We have taken advantage of the positive features of globalisation and must be ready for the negative implications when they occur.
As far as the Shanghai sharemarket is concerned, the large listed companies included in the MSCI Index have a historic price/earnings ratio of 18 and a prospective of 16.
The broader market, which includes many overpriced small and medium companies, has a trailing price/earnings ratio of 35 and a prospective of nearly 30.
Before this week's correction, some brokers were speculating that the Shanghai market still had a long way to go because the price/earnings multiple of the Tokyo market expanded from 30 to 80 during the boom years between 1985 and 1989.
This development would be unwelcome, as the last thing we need is a high-flying and volatile Shanghai market that has a ripple effect around the world after major down days.
