Wednesday, February 18, 2009

Inflationary Policies Drives China’s Shanghai Market; Clues of Reflexivity Theory at Work

This is an example of what I refer to as liquidity or inflationary policy driven and not earnings or economic driven markets.

From Bloomberg, (bold highlights mine)

``Chinese companies may be using record bank lending to invest in stocks, fueling a rally that’s made the benchmark Shanghai Composite Index the world’s best performer this year, according to Shenyin & Wanguo Securities Co.

``As much as 660 billion yuan ($97 billion) may have been converted by companies into term deposits or used to buy equities, Li Huiyong, Shanghai-based analyst at Shenyin Wanguo, said in a phone interview today, citing money supply figures.

``China’s banks lent a record 1.62 trillion yuan in January as part of a government drive to stimulate the world’s third- largest economy, while M2, the broadest measure of money supply, climbed 18.8 percent from a year earlier. The Shanghai Composite has surged 29 percent since the start of 2009, compared with a 10 percent decline in the MSCI World Index.

``“Part of the liquidity flowing into the stock market could be from companies using borrowed funds to invest in the stock market instead of working requirements,” said Li….

``Equity transactions rose last week to the highest in at least three years. The Shanghai and Shenzhen exchanges handled a combined 32 billion shares Feb. 13, the most since Bloomberg started compiling the data in January 2006. An average of 17.3 billion shares have changed hands daily this year, compared with 9.8 billion shares in 2008…

``“Corporates are in need of working capital right now,” said Gondard, who helps oversee about $7.2 billion. “There may be exceptions, but it’s not big enough an impact to explain the rally.”

``China’s domestic stock market capitalization has increased by $743.1 billion since November, when the government announced its 4 trillion yuan stimulus plan.

``The rally has drawn more Chinese investors. About 224,000 accounts were opened to trade equities on the Shanghai and Shenzhen exchanges last week, the fastest pace in almost two months. That’s still about a quarter of the record 1.07 million set up in the week to Sept. 7, 2007.”

Some may argue that this isn’t about the $580+ billion stimulus at all. This perspective sees only half of the picture.

There are two basic government policy measures: one is fiscal stimulus and the other is monetary stimulus.

Apparently, the Chinese government embarked on easing monetary policies since December of 2008.

From CCTV.com (all bold highlight mine),

``To begin with, China will implement a moderately easy monetary policy to promote reasonable growth in money supply and credit. It will also use various measures, including required reserves, interest rates and the exchange rate, to ensure an adequate supply of liquidity in the banking system. China will also add 100 billion yuan to the loan quota for policy banks by the end of the year.

``Meanwhile, local governments will be urged to inject money into credit guarantee firms and provide subsidies for them.

``More measures will be taken to stabilize stock markets and increase bond issuance. Infrastructure bonds in particular will be encouraged.

``Other moves include promoting insurance related to agriculture, the buying of houses and cars, healthcare and pensions. China will encourage insurance companies to invest in transport, communications, energy and other infrastructure projects.

``In addition, China will provide new financing channels, including loans for mergers and acquisitions, real estate investment trusts, private equity funds and private lending.

``Authorities will improve their management of foreign exchange to facilitate trade, while also upgrading its payments system. China will increase fiscal support to financial institutions to help tackle problems arising from non-performing loans.

``And finally, China will enhance the control of risk to ensure financial security.

The above chart shows how China has rapidly cut its interest rates.

And as the news account say, the recent rally in the Shanghai index may have been fueled by a surge in corporate bank lending which had been channeled into stocks. This signifies China's inflationary policies at its incipient phase of gaining traction.

And this is what we have been saying all along; the directives or thrusts to drag down rates below market levels compels the public to speculate or "hunt for yields".

In today’s environment where there is a marked downdraft in the real economy, long term investments are likely to be postponed until the inflationary policies succeeds to alter people’s outlook.

Look at this news from Shanghai Daily,

``FOREIGN direct investment in China tumbled 32.7 percent to US$7.54 billion in January year on year, the fourth straight monthly decline, as companies scaled back spending in the face of the international financial turmoil, the Ministry of Commerce said yesterday.”

Hence, the propensity to speculate has resulted to a sharp ascent of the Shanghai index over the past week, but had been equally met by a drastic decline of late.

Today, the Shanghai index was down by over 4% following yesterday’s 2.93%.

Skeptics have disparaged the recent the signs of recovery as some “false dawn”, where the 2 day slump have been quickly cheered as a reality check.

We aren’t convinced.

The Shanghai index has met some significant resistance at its 200—day moving averages (red line), which if it had succeeded to breakaway from, could have reinforced its progression to the advance phase.

However, what needs to be pointed out is that the Shanghai Index has been in an extremely overbought condition and deserves its much needed hiatus.

It could make another attempt for the 200-day moving average sometime in the near future after clearing its overbought state.

The furious pace of global central banks collectively printing money is bound to end up somewhere, and the above data serves only to validate this view.

Finally, markets aren't just about traditional economics or conventional finance. It is mostly about psychology or how government inflationary policies may trigger significant "reflexivity" in market psychology.

To quote anew the chief architect of the reflexivity theory, [The Alchemy of Finance p. 318], Mr. George Soros...

``The structure of events that have no thinking participants is simple: one fact follows another ending in an unending casual chain. The presence of thinking participants complicates the structure of events enormously: the participants thinking affects the course of action and the course of action affects the participants thinking. To make matters worst, participants influence and affect each other. If the participants’ thinking bore some determinate relationship to the facts there would be no problem: the scientific observer could ignore the participants’ thinking and focus on the facts. But the relationship cannot be accurately determined for the simple reason that the participants’ thinking does not relate to facts; it relates to events in which they participate, and these events become facts only after the participants’ thinking has made its impact on them. Thus the causal chain does not lead directly from fact to fact, but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.

``How does this complex structure affect the ability of an observer to make valid statements about the course of events? His statements must also be more complex. In particular, they must allow for a fundamental difference between past and future: past events are a matter of record, while the future is inherently unpredictable. Explanation becomes easier than prediction.” (all emphasize mine)

The reflexivity theory applied to the Shanghai's index suggests that if the course of actions (inflationary policies) succeeds to alter participants thinking, then the subsequent changes in perception will ultimately be followed by changes in the facts.

Put differently, if the Shanghai Index's will continue to rally, it will be 'rationalized' by the public as a recovery (perception), when this is all about central banks' massive 'serial bubble blowing' inflation (fact).

Eventually when the perception of recovery is reinforced by economic data, (fact) the market trend deepens (perception).


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