Thursday, August 6, 2009

Chinese Market - Tick..Tick..Tick

The benchmark Shanghai Composite is up some 84.33% this year. The main reason why Asia has led global markets out of their doldrums. The Chinese central government has promised its citizens 8% growth - Hell Or High Water. But of late Chinese leaders have grown wary of such lofty domestic returns. The leaders are worried that their recent stimulus efforts as well as the roughly $1T lending binge that has gone on by state run banks has been diverted to stocks and real estate. What the leaders are worried about are the potential dangers of a boom/bust cycle and higher inflation in terms of prices as well as asset values. This is less then 2 years removed from the last major correction.



China is trying to control the credit system without hurting their economy/market. The real problem is there is no growth in private sector demand, so trying to reign in lending could lead to asset prices deflating.

The recent lending/market surge that China has enjoyed so far this year has helped regional economies thus assisting the global economy.

China's had 7.9% growth year over year, while Europe and US had a severe recession. This surge was driven by $586B in stimulus to pump up domestic demand via infrastructure projects. What has happened is the stimulus helped lending/infrastructure spending, but it didn't help retail/private sector.

Bank credit exploded to $1.1T in the first 6 months of the year. This rate is still accelerating. Some 15% of this money has been put into the stock market. So we have levered money invested in stocks without any pickup in demand growth.

It looks like more and more Chinese are trading stocks today. The number of new trading accounts opened in the past week was some 109K, with a total 128MM accounts in all. So 1 in 10 Chinese trade stocks.

The Shanghai Composite is so levered and volatile that any talk of muting gains has drastic effects. Last week a bank regulator issued a statement to institutions not to encourage speculation, the index dropped 5%.

Chinese officials have alerted their state run banks to buy Chinese Bonds instead of increasing credit growth.

So is the Chinese Market just another time bomb waiting to go off? Another Ponzi Scheme erected by reckless banks?

Can't really say at the moment. The stock market is levered. The economy is levered. The banks are levered. But the system in general is not. China Balance Sheet is AAA. They have so much USD denominated assets in their vaults that $586B was like passing out shells at the beach. The only thing that can seriously hurt them is a stronger USD and much higher long term bond yields. Both of which I am predicting, although I am not that encouraged with the USD action.

China definitely has a real estate asset problem. The prices are supported by unrealistic appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast. Sound familiar?

Liquidity is not such a concern, see above comments, but lending/leverage is. Lending increased by some 25% in the first 6 months, but deposit growth is up only 1%. This means that many loans have not been spent in real economic activities and have merely supplied leverage for asset market transactions. China’s property market is very similar to Hong Kong’s in 1997.

The origin of the asset bubble in China is excess liquidity as reflected in high level of foreign exchange reserves and low loan deposit ratio. The massive buildup of liquidity in China was due to weak dollar and strong exports. As the dollar entered a bear market in 2002, China currency followed it down. The appreciation expectation drove liquidity to China.

China’s productivity rose rapidly after it joined the WTO. The massive buildup in infrastructure and the relocation of manufacturing sectors to China pushed up Chinese labor’s productivity rapidly. At the same time, Chinese currency declined as it rose against the dollar less than its decline. The combination of rising productivity and weak currency led to the massive export growth. The resulting dollar earnings pumped up China’s monetary system. Presto!

While China is experiencing weak exports now, the weak dollar allows China to release the liquidity saved up during the boom in the past five year without worrying about currency depreciation.

If and when we have a flight to quality once again, the dollar will rally, and liquidity will exit emerging markets. What will and is happening to China is the same as in other emerging markets. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

If and when the USD wakes up is anyone's guess. Currency trends take many years even decades to form.
The USD was in a bear market from 1985-1995, then for 7 years it rallied until 2002. Since 2002, we have been in a bear market. The last time the USD rallied, it was the beginning of the US IT revolution with Windows 95 and such. Barring any real innovation, I don't see significant sustainable gains in USD, but I do see much higher Treasury Yields.

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