ANALYSIS

This chart shows why the ASX is melting down in 2016

The Australian sharemarket is in the midst of its worst start to a year in decades (it's sunk to a fresh two and a half year low this morning). The Aussie dollar has fallen below the key US70¢ mark.

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Tough day for Australian share market

There are fears of another full-blown currency crisis after the ASX fell to a two-and-a-half-year low and the Aussie dollar plunged further off the back of turmoil in Chinese markets. John McDuling reports.

And it all comes just hours after Sean Penn's weird interview with a powerful Mexican drug overlord landed on the internet. Coincidence? Of course it is. 

In all seriousness, today's market meltdown has nothing to do with drug trafficking or Hollywood. But it is, at least tangentially, related to Mexico (more on that later) and has everything to do with China. 

Investors are fearful that things are even worse in the world's second-largest economy than authorities there are portraying them to be. And that nothing can really be done to stop it. 

Perhaps the best illustration of these concerns is found in China's tightly controlled currency, the yuan. This chart shows how China has been allowing the US dollar to strengthen against the yuan for a while now as its economy slows. 

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In other words, the yuan has been sliding in value, and that slide accelerated noticeably last week. That came as Chinese authorities tried, in vain, to stem another alarming slide in the Chinese stockmarket.  

On Monday, the People's Bank of China let the yuan strengthen, providing a temporary lift for stocks and the Aussie dollar. But people are still fearful that recent yuan weakness could be a harbinger of a serious devaluation of the currency. And that could have considerable knock-on effects. 

A stronger-than-expected Chinese currency devaluation is weighing on the benchmark ASX200 index.
A stronger-than-expected Chinese currency devaluation is weighing on the benchmark ASX200 index. Photo: Tyrone Siu

China of course is Australia's biggest trading partner. Problems there are not good news for us in any way. Yet the latest episode of yuan weakness could be a much deeper issue.

The real worry about a weaker yuan, analysts from Societe Generale wrote this morning, "is both that things in China get even worse and that a domino of defaults will engulf commodities and [emerging markets], ultimately contaminating the full credit universe".

The yuan has been gradually losing value against the Greenback.
The yuan has been gradually losing value against the Greenback. 

In other words, a sharply weaker yuan could  prompt investors in the US and elsewhere to pull money out of other emerging markets (like Mexico) and commodity exporting countries (like Australia), leading to sharp declines for those currencies and risking defaults for the many companies in those countries with debt in US dollars. 

We've seen that movie before. It's called a full blown emerging market currency crisis. No one wants to see it again. 

Fortunately, there's a long way to go before we get there again. And while China is not in a good place at the moment, the world's biggest economy, the US, is showing more signs of strength after posting a solid jobs report last week.

Time to get some popcorn because there are more twists in this story to come.