What on earth is going on in the world’s financial markets? On 2 July the Nikkei 225 average, Japan’s benchmark, slid for the 10th consecutive day. By late trading the next day it had climbed a miserable 10 points.

universal studios theme park japan 051206 Big deal? It is. Here’s why.

The world’s third biggest economy dropped 8.1% in the 10-day streak. And get this: It’s the longest 10-day consecutive drop since 1965.

Will it bounce back?

The next day’s trade suggested it would be a dead cat’s bounce. It limped all day and closed lower again. That’s the 11th straight days of loss, the worst since 1953.

The Japanese economy is going nowhere. Jonathan Allum at KBC in London disagrees. He thinks the Nikkei remains better placed than other bourses in Asia. Its performance over the last three months bears that out, he says.

That’s a narrow and insulated worldview. The world economy does not run this way. Japan is no more immune to the shakedown in the world’s markets than any other country. Even the European Union countries are starting to stagger.

Japan’s major car-makers are facing falling car sales in the United States, the world’s largest market. Sinking US car sales is creating huge beads of sweat on the brows of US giants GM and Ford too. Japan needs the US market, just as much as GM and Ford do.

school girls But here’s the thing: since its peak last October the Dow Jones Industrial Average (DJIA) has slumped 21%. It’s officially in bear market territory. If the DJIA gets redder by the month, it’ll hit the Nikkei 225 hard, and even harder if Japanese consumers shut up their wallets.

But Japan’s problem is Asia’s too. The export-import-investment-exchange rate inter-relationships have become much more integral in driving the region’s post-1997 crisis economic revival.

Chinese balms, burns?

But the Chinese balm could turn into costly Chinese burns. The Chinese market may stave off growing international pressures for a while yet. The economy has the size and the benefit of foreign, domestic and state investments to buffer the firestorms approaching its shores - as long as it can maintain aggregate demand roughly where it is now and without creating supply bottlenecks and triggering cost-push or demand-pull inflation. Or both.

china astronaut space programme rockets 140307 prep It may be too late, though.

Chinese inflation is close to 10%. It’s higher in Shanghai and Beijing. Beijing will deny this, of course. But if you distrust Beijing’s bookkeeping, ask any Chinese consumer who’s not awash with cash. China has a lousy record of transparent bookkeeping.

Still, the Beijing Olympics will add the necessary distraction from the growing inflation problem. Imagine the economic boost from the Games. It’ll have a powerful multiplier effect on the economy. That’s sure to lift the inflation rate higher. But unlike Vietnam that’s facing 26% inflation rate and the possibility of stagflation despite depreciating its currency, Beijing would struggle to devalue the yuan without setting off a chain reaction, at least in the Asian region.

China’s premier Wen Jiabao told visiting US Secretary of State Condoleezza Rice that he hoped the US dollar would bounce back off the floor, and he hoped the US sub-prime crisis would soon be licked. He had better light his joss sticks. Both crises aren’t going anywhere in a hurry.

There’s more sub-prime carnage to come. Just look at the nervousness on Wall Street. Wall Street analysts are asking which financial institution is going down next, or run cap-in-hand to Ben Bernanke at the Federal Reserve Board. What Wen expressed to Rice in fact hints of jitters that are starting to rumble down the corridors of the Bank of China.

There’s some good news, but not a lot. China has the population and the economic momentum built over the last 30 years, and the Olympic Games in August, to not worry too soon about an economic slowdown and act in haste. But the sub-prime crisis has created a credit squeeze that’ll hurt Chinese borrowers and lenders alike.

economy china 280706 manufacturing So, as distinct from the US and other countries, the Bank of China may not need to raise interest rates to contain growing inflationary pressures. Not yet. Nor would it need to cut interest rates to seal the economy from a sharp slowdown. But a low US dollar worries China’s exporters.

All depend on wild-eyed Americans armed with green paper to spend, spend, spend.

They won’t. Jitters in the US are spreading too.

Herd-like reaction

The quintessential Starbucks - about as quintessential as the greenback - says it’ll be closing 600 stores and shedding 12,000 full-time and part-time workers. And troubled American Airlines says it’ll cut 8% of its staff worldwide, about 7,000 workers. Like it or not, there’s a psychology behind this trend: it’ll start a herd-like reaction in the real economy, as it will in the financial economy.

us dollar currency 060105 Let’s be clear: the US economy isn’t limping; it’s slumping. And this is what worries China.

The Bank of China and the Bank of Japan must be wondering Fed boss Bernanke’s next monetary policy move. Bernanke faces a grim predicament. If he cuts interest rates, that’ll drag down the greenback’s value even more, but he just may be able to put a floor beneath the real economy whilst he deals with the financial economy’s woes.

Don’t hold your breath, though. In the case of the financial economy Bernanke so far has dithered. If he raises interest rates, he’ll bury the real economy, and the financial economy wouldn’t fare any better. Who’d go to Bear Stearns, say, to borrow funds at higher costs, and then some?

Only fools. Either way, the dollar looks set to sag, no matter what textbook monetary policy theories say.

Which explains why neither Japan nor China has added greenbacks to their US dollar reserves. For years both have been buying USD to keep the dollar afloat and Chinese and Japanese exports competitive. A low US dollar makes US exports competitive against the Chinese and Japanese. But to buy greenbacks now will be an exercise in futility. The downturn in the US economy has picked up momentum.

It could become a self-fulfilling prophecy. There are no winners here, and confidence is the biggest loser.

Currency speculators may just start dumping US dollars. That’ll whack the international financial world sideways. The longer the global credit runs, the greater the risk to the post-Asian crisis global financial architecture.

ben bernanke But Bernanke’s body language doesn’t bode well for confidence, does it? So why is he still head of the Fed? Some renowned analysts on Wall Street and in London have been saying loudly for months now that he should have pushed for international monetary policy coordination. Maybe. It’s not a new idea. It’s been tried before: the 1985 Plaza Accord, the 1989 Louvre Agreement.

But Bernanke (pic) would be silly if he goes down this path.

Up Asian currencies

What is needed is a recalibration of exchange rate policies. It’s not to be done via policy coordination but by East Asian central banks coming clean. Their currencies have long been under-valued relative to the US dollar - deliberately manipulated by Asian central banks.

But any re-appreciation of Asian currencies must be done without destroying the fragility of intra-Asian exchange rate relationships. Otherwise it’ll be messy. Intricate policy layers and political dynamics underscore these intra-relationships.

The other goal is to achieve a re-balancing of world demand, in which American demand is cut at the same time as demand in the rest of the world is stimulated so that the US balance of payments deficit can be corrected without a world recession. Both are going to be needed if the US balance of payments deficit is to be cut to something that may be sustainable without any creating shocks and long-run disruptions to the world economy. That’s the last thing any economy needs.

But here’s the problem. A low greenback is where the Fed and US Treasury ought to want it.

Why? Because this is the best chance the US government has, at a time when the world’s financial markets are burrowing themselves from more distress - a problem of their own creation. With central banks turning a blind eye to these emergent problems for some time now, to take the opportunity to secure a reasonable measure of adjustment of the US balance of payments deficit crisis - one that has been around since 1965 - and primarily against artificially deflated Asian currencies.

The problem isn’t just the world financial economy. The problem is the real world economy.

american product

This is a problem that has grown into an unwieldy monster since 1965, with the US balance of payments entering into record and unsustainable deficit year after year and whose economy has been kept afloat by Arab petrodollars as much as Japan and Germany and now China.

Something was always going to give, and it is here now. The extent of the problem is known.

What cannot be known is how much deeper the problem will go. Scott Haslem, chief economist at UBS in Sydney, says the world is at the end-point of the world financial crisis. Bah, humbug.

Nobody knows where the bottom is - unless Haslem has a crystal ball that nobody else does.

MANJIT BHATIA is an academic and writer and an associate partner of AsiaRisk, a risk analysis consultancy, with specialisation in international economics and politics. His writings have been published in The Wall Street Journal, Business Times Singapore, International Herald Tribune, Financial Times, The Australian, The Australian Financial Review and elsewhere.