Sunday, January 24, 2010

China Economy Clocked at 107mph in an 80mph Zone

The China economy is now the third largest economy, ahead of Germany and seems like a lock to move ahead of the fragile economy of Japan soon. This growth is creating both risk and opportunity. The challenge is to recognize which one at the right time. I have found two sources of insight into the China economy. One is Andy Xie, an economist who has been a guest economist in the Finance and Economics section of Caijing, a popular periodical in China with an English version web site, until November. He has stopped writing there, reportedly as a result of being censored by the government, according to an Asia Daily report. Xie was educated at M. I. T. and was Morgan Stanley's Chief Economist for Asia Pacific from 1997 to 2006. The other expert is Gary Dorsch, a currency expert with institutional trading expertise for many years.

Some of Xie's 2009 articles are still timely and provoking. With the advantage of a little hindsight, we can see that his expectations have been accurate and his timing guesses have been early. I highly recommend taking a few minutes to read his article dated 8/5/2009 titled Andy Xie: China Counts Down to the Next Bubble Burst. He writes about the China economy, its bubbles and sensitivity to the dollar.

I have been reading his work again due to my interest on the condition of the economy of China. There is so much good news about the economy, such as real estate values increasing, personal consumption increasing and fourth quarter GDP of about 10.7% (mph), annualized. These are signs of a fast growing economy. They are also too familiar. My fear is when the China economy slows, the markets that are supported by it will collapse. I am thinking most about the commodity markets, though certainly stocks and bonds too. Andy Xie did write about this back in August. He begins by describing the threats to bubbles he see's in China.

Xie makes the following observation in August 2009...
For now, I think Chinese stocks and properties are 50 to 100 percent overvalued. Chinese asset markets have become a giant Ponzi scheme, with prices supported by appreciation expectations. As more people and liquidity are sucked in, surging prices validate expectations, prompting more people to join the party.

Typically, this sort of bubble ends when there isn't enough liquidity to continue feeding the beast. But liquidity isn't a constraint in China -- yet. Even though loans grew 24.4 percent in the first half this year in China, to 7.4 trillion yuan, the loan-deposit ratio increased only to 66.6 percent in June from 65 percent in December 2008. That means a lot of the borrowed money was not spent on activities in the real economy but merely supplied leverage for asset market transactions. China's property market is following a course very similar to what was seen in Hong Kong in 1997.

In terms of estimating what causes the end of bubbles Xie has this to say...
It's not too hard to predict a timetable for a bubble burst. When the dollar becomes strong again, sufficient amounts of liquidity could leave China to pop the bubble. What's occurring in China now is no different from what happened in other emerging markets in the past: A weak dollar led to bubbles in hot, emerging economies, and when the dollar turned around, the bubbles inevitably burst.

The timing of the next dollar turnaround is difficult to forecast. The dollar entered a bear market in 1985 after the Plaza Accord and bottomed 10 years later in 1995. It then rode a seven-year bull market, followed by the current bear market that began in 2002. Since then, the dollar index (DXY) has lost about 35 percent. If the last bear market is any guide, the current one could last until 2012. But there is no guarantee. The IT revolution started the most recent dollar bull market; odds are another technological revolution will be needed before a sustainable bull market for the dollar returns.

For me Andy Xie sets the stage for the need to maintain high interest in the China economy. It recently reported GDP growth in it's fourth quarter at an annualized rate of 10.7%. That set off renewed interest because it has a current target for GDP growth at 8.0% (mph) and it is well covered that the government consistently does whatever is necessary to hit that target. China's economic machine is largely owned by, or controlled by, the government.

Gary Dorsch has a timely article posted on Safe Haven on January 22, 2010. It is timely because the China government is announcing changes to it's monetary policy. Last week they announced an order to the national banks that lending standards must be tightened to reduce the number of loans made, primarily to cool the hot real estate bubble market. This policy followed the earlier Peoples Bank of China (PBOC) announcement to require slightly greater bank reserves, increasing the reserve ratio by 0.50% from 15.50% for large banks and from 13.50 for small banks. The ratio refers to the proportion of deposits that banks are required to hold at the central bank.

Dorsch is describing various elements of the PBOC policy and the risks that it is facing.
China's economy expanded at a 10.7% annualized rate in the fourth quarter, and retail sales in December were 17.5% higher than a year ago. However, about of quarter of last year's new loans were siphoned into the Shanghai stock market, and speculators in real estate took out mortgages at record levels. Developers were snapping up land, and the banks were eagerly funding them. In Shanghai, prices for high-end real estate were up 54% through September, to $500 /square foot. In November alone, housing prices in 70 major cities jumped 5.7%, while housing starts soared 194-percent.

The real estate binge is fueling fears of a US-style bubble that could burst, and once the bubble pops, China's economic growth could be badly impaired. China Premier Wen Jiabao told the Xinhua on Dec 27th, that "property prices have risen too quickly," and pledged a crackdown on speculators. Thus, Beijing must tweak its monetary policy carefully, "The government must strengthen macro-economic control and carefully handle managing inflation expectations," PM Wen warned on January 20th.

However, "To withdraw macro-economic policies too early will likely ruin the efforts made before and reverse the economic development," Wen added. Thus, in weaning the Chinese economy off its addiction to high powered liquidity, the PBoC is expected to gradually withdraw the stimulus in the months ahead.
My conclusion is to expect some weakness in the commodity markets in the short term because China has been the buyer of a large percentage of the worlds natural resources. That buying could begin to slow as it has enormous stockpiles and political pressure on liquidity is beginning to show. I believe that most weakness was seen last week. Technical observations help me reach this conclusion.