China’s Attempt To Quash Its Homegrown Bubble

``Indeed, there are two potential scenarios for EM stock prices: either a full-fledged mania will develop with multiples continuing to expand, or, a setback/period of indigestion will occur before a new upleg develops. Currently, the odds of a mania-type pattern developing in emerging markets are not significant. If a mania were to develop, Chinese stocks would be at the epicenter because China has the fastest growth rate”-BCA Research, Emerging Markets Appear To Be Fully Priced

China seems bowing to international pressure.

Since she has been accused of fostering or blowing bubbles, where even popular fund manager James Chanos has openly declared shorting China which became a recent controversy in his debate with Jim Rogers [see Jim Chanos Goes From Micro To Macro With Bet Against China], over the past 3 weeks, China has responded by engaging in a series of implied tightening measures, i.e. by allowing T-Bill rates to increase, by raising bank reserves, and last week by verbally arm twisting her banks to curtail credit expansion. It’s almost like one intervention per week.

And when government intervenes in the marketplace we expect the impact in the direction of the planned intervention to manifest itself over the short term. And that’s the reason why China’s markets have underperformed the G-7 and its emerging market peers.

However, in my view, the argument over bubbles seems grossly misunderstood. A Bubble is essentially a cyclical process, where government interventions in the economy, primarily via interest rate manipulations and compounded by other regulations, lead to massive distortions in the patterns of production and capital allocation, which eventually results to relative overinvestments [as discussed in What’s The Yield Curve Saying About Asia And The Bubble Cycle?].

In short, such process is exhibited through phases. And one of the symptoms is that suppressed interest rates with the accompanying credit expansion make long term investments appealing.

And we seem to be getting anecdotal evidences from these;

From Edmund Harriss of Guinness Atkinson, ``Economic growth of near 10% in the past year has been fuelled by domestic growth, almost all in­vestment, on the back of huge injections of liquidity and increased debt. Over $1 trillion of new credit has been extended and while we can see that the bulk is intended for medium- and long-term investment rather than short-term there is no doubt that money has found its way into the stock and real-estate markets. The appearance of state companies at land auctions (those who have had no prior interest in buying land) is significant. This has contributed to soaring land prices and helped a recent land sale in Guangzhou to achieve a record price of $852 per square meter ($78 per square foot), some 54% above the offer price.”

From Robert J. Horrocks, PhD and Andrew Foster of Matthews Asia, ``Nevertheless, it is prudent to be cautious about bank lending—not because we fear an unmanageable amount of nonperforming loans for the economy, but because Chinese banks generally made 3-year loans for projects with decade-long payoff periods (i.e., loans that were not appropriately matched to cash flows). Banks may have lent on the assumption of local government backing, which ultimately may not be provided.”

The other symptom is that increased money supply fosters rising prices in the economic system which leads to pressures to raise interest rates (see figure 4)

Figure 4: Danske Bank: China’s Rising Inflation

As you can see, while China has indeed been exhibiting symptoms of a formative bubble, as manifested above via investments in long term projects, aside from sporadic signs of frothy prices and emergent inflation, there seems to be less convincing evidences yet [see China And The Bubble Cycle In Pictures] that she has transitioned into the culmination stage or the manic phase -where bubbles have reached its maximum point of elasticity which is usually in response to the rollback of easy money policies by the government.

Besides, manic phases usually don’t draw in many and vocal skeptics. Instead the public will most likely be talking of a NEW PARADIGM. In other words, a manic phase would translate to a capitulation of pessimists, cynics and skeptics.

Hence, credit expansion is a necessary but not a sufficient condition for a bubble ripe for implosion. The other necessary ingredients to complete the recipe would be an asset price melt-up (intensive overvaluations) backed by euphoric public (hallucinatory bullish sentiment).

In addition, China seems reluctant to directly raise interest rates.

That’s because we think that policy arbitrage could work to induce the aggravation of China’s bubble cycle despite her rigid capital regulatory regime. And so far these have been manifested by the waves of capital flows into her system-indirectly or via unregulated channels. (see figure 5)

Figure 5: Danske Bank: China’s Staggering Hot Money Flows

China’s reserve accumulation has been a product of direct and indirect foreign money flows into the system (left window) which is likewise manifested through record accumulation of reserves (right window).

According to Danske’ Flemming J. Nielsen, ``We see no signs that China’s reserve accumulation is easing in today’s data and it appears that speculative hot money inflows has become a major policy challenge for China. Firstly, Peoples Bank of China (PBoC) will be struggling to neutralize the liquidity impact from its massive purchase of foreign exchange. This might be one reason for PBoC raising its reserve requirement for banks earlier in the week. Secondly it underlines that despite China’s capital controls, capital flows has become more important and it has become more difficult for China to maintain an independent monetary policy, while simultaneously maintaining a quasi peg to USD.” (all bold highlights mine)

And it is also one reason why the Chinese government has utilized unorthodox means of curbing the credit process through “verbal persuasion” over her banking sector.

So yes, over the interim perhaps we should expect the Chinese government to constantly apply further pressure on its system in an attempt to wring out hot money and reduce credit expansion to avert a full blown bubble from developing. And this could equally translate to possible weakness in China’s stock markets over the interim, as the market adjusts to the conditions of repeated interventions of the Chinese government.

But no, if her asset markets begin to recover even amidst these attempts or if markets start to disregard such policies then watch out, the asset melt up phase could commence.

And as we earlier described in Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff, the more China tightens via the interest rate tool, the bigger the odds for a melt up as the spread of interest rates between China and G-7 economies widens. This would emanate from policy divergences- a tightening China, while the US, UK, Japan and EU remain loose-which becomes the fodder to the next bubble in motion.