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.

The US Dollar Index’s Seasonality As Barometer For Stocks

``Debtors benefit from inflation and creditors lose; realizing this fact, older historians assumed that debtors were largely poor agrarians and creditors were wealthy merchants and that therefore the former were the main sponsors of inflationary nostrums. But of course, there are no rigid "classes" of creditors and debtors; indeed, wealthy merchants and land speculators are often the heaviest debtors.”-Murray N. Rothbard A History of Money and Banking in the United States: From the Colonial Era to World War II

We have been suggesting that the fate of the US dollar will be the key to the directions of financial asset pricing.

In last week’s Gold As Our Seasonal Barometer followed up by a mid week post Gold As Our Seasonal Barometer (For Stocks) II, we offered another contrarian perspective for analyzing the direction of pricing equity securities.

Instead of ruminating over the seasonal effects of September which has been statistically inauspicious for stocks, we suggested to look at gold instead.

Since US dollar has been the traditional and ideological archrival of gold, from which the former today has been continually bludgeoned even in face of some pressures in select asset markets (say in China), and even considering the combined developments in the political and economic front, any selling pressure is likely to be felt in the US dollar than in stock markets, and thus we proposed gold as a seasonal barometer for stocks.

We finally found two charts confirming the inverse of correlation of gold and the US dollar index.

Figure 7: US Global Investors: Inverse Correlation of Gold and the US dollar Index

Mr. Frank Holmes of the US Global Investors noted that ``September is only second to December in terms of dollar weakness, the average result for the U.S. Trade Weighted Dollar Index (DXY)(13) being a 0.66 percent decline from August. Looking at the 39 Septembers going back to 1970, the dollar has seen negative performance 26 times, more than any other month of the year.” (emphasis added)

Of course I won’t deny my “guilt” of looking for information to confirm my bias over my persistent focus on the US dollar.

That’s because it seems quite naïve, for anyone in my view, to believe that events of the last quarter of 2008 will replay itself in terms of a banking system gridlock, the main source of the US dollar’s rally last year.

That’s an old passé story. Society has learned from last year’s banking shock.

Instead, it would seem like an unnecessary distraction, coming from the mainstream macro perspective, still preoccupied with the deflation bogeyman.

Managing Inflation Expectations

What seems to be more of the locus of political attention has been to keep the price level system afloat through the inflation process.

Mr. Axel Merk of Merk Investments hits the nail on its head with his latest commentary, (all bold highlights mine)

``The conclusion we draw from the Fed’s talk about exit strategies and focus on inflation is mostly just that: talk. While we understand why the Fed is talking – to manage inflationary expectations – we believe the Fed may be playing with fire at our expense.

``Indeed, following Bernanke’s textbook, our interpretation is that the Fed may want to have inflation; and to get there, he may want a cheaper dollar, a substantially cheaper dollar. Bernanke has repeatedly stressed how going off the gold standard during the Great Depression jump started economic activity by allowing the price level to rise (read inflation). Fast-forward to today and think about all those homeowners “underwater” with their mortgages. We could allow those who cannot afford their homes to downsize, i.e. allowing market prices to clear by allowing foreclosures and bankruptcies, amongst others; however, that option seems to be political suicide. An alternative is to induce inflation, allowing the price level to rise; the Fed may not be able to control what prices will rise, but seems to be betting on home price inflation.

``Looking at what at the Fed does, rather than what the Fed says, we believe it is actively working on a weaker dollar.”

Indeed, action speaks louder than words!

From Bloomberg, The Federal Reserve ``bought a greater-than-average amount of mortgage bonds for a second straight week, following a period of reduced purchases…Net purchases totaled $25.4 billion in the week ended yesterday, compared with a weekly average of $23.3 billion since the Fed began the initiative in January, according to data posted on the New York Fed’s Web site today and compiled by Bloomberg.”

The US Dollar Carry Trade?

Besides, the selling pressure won’t just emanate from policy induced inflations, but this time it could be compounded from the lower interest rates spreads.

Figure 8: Wall Street Journal: Dollar Now Cheaper to Borrow Than Yen

For the first time in 17 years, Japanese rates have now popped above US rates.

According to the Wall Street Journal, ``On Wednesday, banks seeking dollars had to pay 0.37188%, which is the three-month dollar Libor, while yen borrowers needed to pay 0.38813%. It is the first time since May 1993 that the rates have flipped.” (emphasis added)

Implication? The US dollar could function as a funding currency for a global carry trade.

There have been worthwhile arguments posited against the US dollar as a funding currency due to its huge current deficits, low savings and heavy borrowing requirements since these are likely to induce relatively higher interest rates.

However, for the time being, it is likely that the US could be earnestly trying to attract capital flows into its system to finance its twin deficits by offering its currency for short term asset arbitrages in “target” (high yield) currencies.

Nevertheless even if we could be wrong here, the actions to bring down interest rates to produce inflation (nearly a Swedish nominal negative interest rate policy approach where banks have to pay interest to its central bank for them to accept deposits) simply exhibits how the US dollar remains under heavy strain.

Bottom line: Inflation is a political process. It would be difficult, if not suicidal, to take a contradictory stand against US authorities, when we recognize that the policy thrust has been to use the technology known as the printing press, to achieve a substantially reduced purchasing power for the US dollar.

In short, don’t fight the newly reappointed Ben Bernanke.