Markets: Brace for a China-led chill

Markets: Brace for a China-led chill
By Chan Akya

Eighteen years ago, Chinese students and intellectuals massed in Tiananmen
Square to push through their vision of democratic reforms, egged on by an
apparently conflicted central government, where the forces loyal to Deng
Xiaoping were seemingly marginalized by those loyal to Zhao Ziyang initially,
with tragic results for both the students and China in general.

While the comparison of the events of June 4, 1989, to today's



stock markets appears overly sensational at first, the thrust of recent articles
on China, including my previous one, [1] has been on the apparent loss of policy
efficacy by the central People's Bank of China (PBoC) in recent months.

Six months ago, total transaction volumes on the Shanghai and Shenzhen exchanges
were less than US$5 billion per day. That figure now stands 10 times as high, at
$50 billion per day. This volume is something China can be proud of, barring one
minor detail, namely that the central bank and various policymakers would much
rather not see it happening.

Even as central bankers exhort the country's citizens to beware of bubble-like
conditions in the stock markets, investors appear unruffled, reversing the
policy impact of any announcement. Be they students, farmers or construction
workers, every Chinese living in the two big cities of Shanghai and Shenzhen
appears now to have a brokerage account. Conversations in the normally noisy dai
pai dongs [2] in Guangdong province and Hong Kong drop to a quick hush whenever
the subject of stock tips comes up. In short, the stock market today represents
a revolution against the diktat of the PBoC, questioning its very authority.

A symphony of bubbles
Experience from the rest of the world shows that stock-market bubbles are
neither infrequent nor unpredictable; in most cases, they are compounded by the
mistakes of policymakers. The technology bubble of the 1990s is a case in point,
as investors chased the dream of a new economy that could offset the apparent
physical constraints imposed on the functioning of the real economy, ie, bricks
and mortar. Initially, the promise of new technologies wasn't accompanied by
enough listed companies, thereby concentrating the bets of investors. It took a
few years for enough listings to appear, but by then the damage had been done to
the long-term prospects of the sector.

The dotcom era's little experiment failed because investors mistook the medium
for the message, in other words, that emerging new technologies merely helped to
rearrange the habits of consumers but did not necessarily alter the physical
provision of products and services. Thus, while book lovers would move away from
their local bookshop to an Internet store, they would still be buying books, and
perhaps in higher quantities.

To that extent, the zero-sum game was the right strategy for investors, which
was to sell the stocks of traditional stores while buying into online stocks.
Meanwhile, a number of fancy technologies had no underlying cash flows, thereby
rendering guaranteed losses for anyone purchasing them.

As the bubble burst in the early part of this decade, the US Federal Reserve cut
interest rates and attempted to shift the consumption dynamic to the housing
market. The result was a rapid expansion in house prices across the United
States, fueled by a sharp relaxation in lending standards. Starting with the two
coasts, the home-price boom moved rapidly inland like a wayward hurricane,
uprooting economic assumptions in its wake.

Eventually, the market will have to come to terms with the reality of too many
houses for a declining group of richer immigrants and lower-quality employment
for anyone remaining in the hinterlands. I have previously written about what is
likely in store for the US housing market; [3] recent observations with respect
to prices of higher-end residences in New York only serve to strengthen that
view. I am well aware that the article upset a number of bullish readers, but
such is the problem with propagating unpopular views.

The US housing and stock bubbles positively pale in comparison to the ones being
observed in many other markets, including
property and stock markets across Asia. There are some notable exceptions such
as Thailand, where a combination of policy missteps has left markets relatively
stable rather than rising, but in most other places the boom is all too
apparent. Even in straitlaced Singapore, house prices have risen broadly over
the past two years, wiping out pent-up equity losses from the previous 10 or so
years.

Chindia to the fore
But all these markets are mere sideshows compared with what's



going on in China and India. It is well-nigh impossible to complete secondary
market transactions on high-end property in both markets, as a flood of new
offers pour in. Most new property developments are sold within the first week of
announcement, with the period more likely to be a day or so in the big cities of
the two countries. By most estimates, property prices have doubled in the past
two years in major Chinese cities, and more than tripled across major Indian
cities.

Stocks are very similar, with significant money flows chasing a limited number
of listed entities. The lack of selection is the key factor in pushing up
overall market valuations to unsustainable levels, and as such is an eerie
reminder of the aforementioned technology bubble.

More than India, it is China that faces the threat from investors chasing too
few stocks. India's markets have a much longer history and, more important, many
investors still remember the stock-market scandal of the early 1990s that wiped
out the nest eggs of a few thousand people. China's problem is also one of
magnitude: with more than 100 million investors directly participating in the
markets, the impact of any downturn will be broad, and politically suicidal. As
I wrote previously, problems encountered in the government of Hong Kong after a
two-thirds decline in house prices since 1997 will help to guide policy
direction in mainland China.

India's central bank has practiced vigilance on asset markets for a longer time,
ensuring that banks are not providing easy loans for equity investing, and also
tightening the guidelines on property loans in recent months. Rate rises have
also played a part in keeping the equity markets below frothy valuations,
although that is entirely relative to the excesses observed elsewhere in Asia.
In contrast to the market behavior in India, Chinese investors have shrugged off
recent rate rises, and banks have circumvented restrictions on lending through
other means.

What will happen?
China will have to choose between the lesser of two evils, namely the protection
of employment in its export-dominated industries or the safety net being created
by investments in property and stocks by millions of its citizens. I believe it
will choose to protect people's wealth more than lower-end manufacturing jobs;
therefore a sharp revaluation of the Chinese currency, the yuan, is certain in
the next few weeks.

In its aftermath, the economic cognate will have to shift from production to
consumption; therefore we should see the stock prices of exporters falling even
as those of companies servicing domestic demand will increase. Banks will have
to absorb billions of yuan in defaults from the export sector, particularly to
the many inefficient state-owned companies in northern China. That will cause a
sharp decline initially in their stock prices, but I expect the outlook to
improve rapidly thereafter.

For the rest of Asia, a yuan revaluation would set off increased volatility as
investors try to take profits and other Asian countries adjust their currency
values. In turn, their holdings of US and European government bonds as part of
foreign-exchange reserves would diminish, sending up bond yields globally. That
is how the adjustment in China would likely set off broader stock-market
declines globally as investors come to terms with both higher interest rates and
lower Asian appetite for Group of Seven assets. Sharp declines in stock prices
would necessarily follow in most major Asian markets.

This correction would prove cathartic to the performance of Asian economies in
the decades to come, but in the short term, pain is unavoidable.

Notes
1. India 1, China 0, Asia Times Online, March 3.
2. Dai pai dongs are uniquely Cantonese, generally specializing in a limited
range of food items. Besides the delicious and cheap food, the eateries are also
known for their communal seating, and extremely high noise levels.
3. Hobson's choice, ATol, March 7.

ATIMES


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