International | Jul 30 2009
By Greg Peel
“A rumour began inChina yesterday that the Chinese government would intensify its austerity measures intended to crimp a raging economy by introducing a capital gains tax. The Shanghai index fell 8.8% from its record high the day before – the biggest single day fall since the death of Deng Xiaoping in 1997.”
This is an excerpt from a story I wrote in February, 2007 (China Tanks And The World Follows Suit; FYI; 28/02/07). The Wall Street response to this event was:
“This was the biggest points fall since the market reopened after 9/11, and at one stage the Dow was down 546.”
This was the famed “Shanghai Surprise”. The world didn’t know it at the time, but realistically this was the canary in the coal mine of what became the Global Financial Crisis. The sudden drop in what had been a raging Chinese stock market to that point sent shivers of fear through Wall Street. The emerging market trade had been one of the most profitable among all the asset trades available on cheap funding provided by historically low US interest rates from 2004. Another highly profitable trade at the time was investment in high-yielding, sub-prime CDOs. While the Dow may have tumbled, the CDO market really took a bath that day.
Sub what?
The stock market quickly recovered and ultimately surged on the new highs. CDOs were quickly forgotten. At least they were forgotten by the stock market, because behind the smokescreen of over-the-counter opacity, the CDO market never recovered. Within a few more months two large Bear Stearns CDO hedge funds would hit the wall. The rest is history.
Yesterday the Shanghai index closed down 5% after having been down close to 8% at one point. The drop prompted a sudden rush back into the US dollar as once again emerging market positions – a highly profitable trade in 2009 – were hastily unwound. The initial Wall Street response to the 2007 Shanghai Surprise reflected a sudden realisation that Wall Street was carrying an enormous amount of risk, all funded on cheap US lending rates and still cheaper Japanese lending rates (the famous yen carry trade). The Fed funds rate had risen from 1% in 2004 to 5.25% by 2007, but the Japanese rate remained at 0.5%. Today the Japanese rate is 0.25%, and the Fed funds rate is zero (0-0.25%).
Should we be concerned?
Early this year the Chinese government made a forecast, or at least set a target, of 8% GDP growth for 2009. In the June quarter the annualised quarterly growth rate reached – well blow me down – 7.9%. Interpolating this annualised figure implies a quarterly growth rate (Australia measures its GDP growth quarter by quarter) of over 16%. In the 2004-07 boom, China’s annual growth rate peaked at 13%. The June figure would imply that not only is China back, but it’s potentially back bigger and better than before.
Yet during the boom, China’s export market represented over two-thirds of its GDP growth. That market has now shrunk by over 30%. This implies exceptional June quarter growth is all about domestic economic stimulus. Demand for Chinese exports in the “West” has all but dried up. The question therefore – as is always the case with official Chinese economic data – is can we trust the numbers?
Clearly the “West” has trusted the numbers, because just as was the case in the boom, China has been inundated with “hot money”. Hot money refers to foreign investment in Chinese assets such as stocks and property. (See China: Global Saviour Or New Bubble?). Given foreigners are restricted from owning stocks and property in China, these investments are indirect, such as through exchange-traded funds. The Chinese government is scornful of hot money. For one thing, the Chinese do not like foreigners buying Chinese assets (the other way around is perfectly acceptable of course). For another, foreign speculation only serves to inflate asset prices already being inflated by gamble-loving Chinese nationals. The risk is a bubble-and-bust scenario, and China suffered enough of those in the nineties, thank you very much.
Even more aggravating to the Chinese government is that hot money also becomes a natural currency play. The renminbi is pegged in a range to the US dollar, and if the Chinese authorities fear the economy is bubbling they allow the renminbi to appreciate. This keeps a curb on inflation, but at the same time it provides additional profits for foreign investors when they repatriate back to the US dollar or other home currency. This reality is most frustrating.
The solution is to crimp hot money inflows (and domestic over-enthusiasm) by some monetary or fiscal measure. In the February 2007 example, it was a fear of a rise in capital gains tax which spooked the market. Other measures include restricting domestic borrowing by rasing rates, or raising bank capital ratios, or some other such ploy. Last night there was a sudden fear China would do something. The Shanghai stock market has risen 80% since November.
Yesterday the fifth major Chinese IPO of 2009 took place as the China State Construction Engineering Corp was listed for public investment. It was the biggest IPO this year, and at 56% attracted the biggest opening premium. Chinese IPOs may have a track record of being fabulous stag opportunities, but a 56% premium in a market already up 80% in a GFC might be getting just a bit silly. And clearly that’s just what the Chinese thought as they sold down everything else in a hurry.
The Chinese authorities have a difficult decision to make. If they act to crimp this latest economic surge (assuming there really is one) before Western economies have recovered enough to start buying Chinese exports again, they run the risk of defeating the policy of domestic stimulus. If asset prices in China suddenly back off in a hurry – more than just last night’s 5% in the stock market – the rest of the world will likely panic. The Shanghai stock market might be one thing, but it is suspected a lot of the commodity “restocking” that’s been going on in 2009 represents significant speculation by local traders. The idea is to buy copper, for example, early and then feed it into actual infrastructure project demand at higher prices down the track. If such commodity traders become panicky and start dumping their stockpiles, look out global share market rally.
It would be all over bar the shouting.
The current wisdom suggests, therefore, that Chinese authorities will not act to stymie this recent economic revival. (See When Will China Pull In The Reins?). China will wait until Western economies are sufficiently back on their feet and start demanding Chinese manufactured goods exports again before implementing any economy-cooling strategies. To do so now could prove fatal. Indeed, perhaps a 7.9% GDP growth rate is really only smoke and mirrors – designed to provide the confidence needed by the rest of the world. If this is the case, it might actually prove a successful placebo.
If it is not the case, and it’s all legitimate, then the world can indeed justify its current confidence. But China does not want to get found out. Yesterday’s 5% drop in the Shanghai index, although healthy in normal stock market terms, is indicative of a level of nervousness.