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Tempus Fugit Memento Mori - Time Flies Remember Death
For Marxists and anti-capitalists, China is the great evil. Lies about bad product, job loss, 'unfair' advantages, and a undervalued currency, populate the media. Yet the most obvious short-term danger posed by China is ignored – its stock market bubble caused by government intervention. If you fear China, this is the real issue and it could impact everything from domestic stability within the middle kingdom, to world-wide economic growth.
One of the main reasons which prevents China from having a flexible exchange rate is the use of capital controls. Capital controls are measures governments use to stop the outflow of hard currency and regulate and channel inflows. Such controls have stimulated an extraordinary rise in Chinese stock markets, with the major index rising by over 100% in the past 7 months.
Capital controls are a sign of an immature and unstable regime – both economically and politically. Imagine you are an average Chinese worker with some savings. The state tells you that you cannot invest or export your capital to any foreign asset class. This means that all foreign stocks, funds or even private firms are off limits to your savings and personal capital. You are forced to use your money locally. Yet the Chinese banks are paying almost zero real interest. Government bonds will cover interest and a meagre profit. What is the other option? Stock markets of course. Individual investors and large investment houses are forced to invest in Chinese stocks – artificially boosting prices.
The ill effects of capital controls are usually enhanced by further government interventionism. Take Petro China for instance, now the world's largest firm by market capitalisation. Fantastically this state-owned, communist-party run organisation is deemed more valuable than private market and more transparent Exxon Mobil. Insane? Certainly. The reason that Petro-China is more valuable than Exxon has to do with how the Chinese government operates its stock markets.
Petro-China's shares trade in New York, Hong Kong and Shanghai. The New York and Hong Kong share prices are trading on a per share basis at a much lower premium than those in Shanghai. The Chinese government in effect has reduced the supply of shares in Shanghai, in order to bid up the price. With only 2.18 percent of the company’s 183.02 billion shares available to Chinese domestic investors, the Chinese government ensures that Petro China’s share price is vastly inflated. With Chinese domestic savings – at about 20% of GDP – having no where else to go, Chinese stocks are being bid up through government distortions. There is no way of course that the 14% publicly held share of Petro China is more valuable than Exxon, or even Google for that matter.
Petro China is but one example of what has been ripping through the Chinese stock market for more than 2 years. Valuations and stock price to earnings multiples are at bubble levels. In the US, the current price-earnings multiple for the largest 500 firms is about 17 or the historical mean average. With earnings still strong in 8 out of 10 economic sectors, it fair to say that on average US stocks are cheap. In China the price earnings multiple is 68 – 12 % away from the NASDAQ highs of the 2000 bubble.
It is clear that the Chinese stock market is in a bubble – but when will it burst? Most likely within two years. Historically what China is doing has been done before – and the result has always been an asset bubble leading to over-inflated valuations and greatly exagerrated expectations of returns. When you have this relationship – over inflated assets and unrealistic and unsustainable return on investment demands – you have a bubble. The mania in China for stocks will peak most likely after the Olympics. At that point if you have money in Chinese funds, you better take your profits and run.
Asset inflation is clearly a government phenomenon. China is holding down interest rates and its currency, in the hope of stimulating jobs, and capital-income liquidity. At some point however, the capital control regime, and the gross manipulation of stock markets and state owned firms by the Chinese state, will result in such a market dislocation, that the entire stock market in China will simply fall apart. It is inevitable.
The repercussions will be large. China is regarded by most multi-nationals as a key part of their current and future earnings strategy. When and if the Shanghai market blows up, the Chinese economy will contract, liquidity will dry up, and the currency will have to revalue. In order to stabilise the currency the government will raise interest rates and liberate some capital controls. Inflation will pick up strength and economic growth will start to cool off.
As China's assset bubble blows up, other international exchanges will contract. US and European exchange appreciation has been largely based on the 'global growth' story, and in particular the China syndrome. When China's asset bubble pops, and deflation follows, then the global growth story becomes less compelling, and stock prices and indices in the US and Europe will drop.
China is already the US' fastest growing export market and is #3 or #4 overall. European GDP as a percentage is even more reliant on China-trade than the US. Both European and US corporations have a huge services trade surplus with China. This massive services profit shows up on the net income statements of large international firms. When China's asset price mania finally explodes, so too will the stock prices of many of these large cap internationals.
None of this is to suggest that the US is correct in beating up on China to unpeg the Yuan from the dollar band it currently supports. The Chinese can't unbundle the Yuan from the dollar, until capital controls are removed [see arguments above]. But you can't eradicate financial controls if your banking and financial systems are unstable, corrupt and full of loans to state firms which are worthless. About 50% of the loans to state owned firms are non-operating i.e. they will never be repaid. Capital controls in China are a necessity because the entire financial system is in a mess. A managed currency regime, along with capital distortions is the basis of the 'Chinese miracle'.
All miracles must end. The US and Europe should work with China to resolve the main issue underlying asset inflation and stock market mania – namely a corrupt and bankrupt financial sector. If capital controls, interest rates, and inflation are not allowed to adjust themselves naturally, then the day of reckoning is inevitable. For China I would give it a maximum of 2 years. If you own Chinese funds, or stocks, I would suggest that you take profits between now and next July, and be fully divested before the Chinese are declared the winners at the next Olympics.
