For months, bears have been agonizing over China's ghost cities or credit expansion. As I wrote in May, I believed their analysis of the underlying factors to be correct but their conclusion to be wrong. I argued that
[the bears] forget the tools a large economy can use to influence short-term trends, even if long-term fundamentals are worrisome.
The last few months have somewhat validated my anti-bearish statement, but there have been some new developments, so I think it's time for an update.
A Quick Overview
What has happened in the last few months? First we saw a bank liquidity scare in June (Source), which caused some waves but went away as the central bank relented to market pressures and began injecting liquidity again. We saw PMI readings deteriorate sharply in June/July ,but then things started getting better.
There were persistent pledges to maintain growth from policymakers, there were better-than-feared growth figures and certain policy measures like the "Shanghai Free Trade Zone" (source) that raised expectations. The stock market plunged after June's liquidity crunch but slowly recovered and the bears were wrong again.
Making Sense of It All
A casual observer or a permabear would find understanding the situation very problematic. One day things seem to be on the verge of a juicy 50% decline, then they gradually improve for months. So what is going on?
My understanding of the overall situation is similar to my previous article on the issue. Reforms that enhance the quality but slow down the short term quantity of growth must be taken (if they are not, the internal dynamics of the current model will push the financial system to a breaking point soon anyway). But if there are too many bears, the negative impact of such reforms is magnified in the short run, which may cause a panic and capital flight.
So policymakers need to walk the tightrope. They need to balance the needs between preventing consensus expectations from cascading into bearishness by keeping economic growth up in the short run (even if it is using the tools, i.e. credit growth, of the old economic model), while enacting the necessary reforms when the market sentiment isn't too bearish.
In June/July, people were too bearish. So the central bank injected liquidity, the economy hummed along again and consensus expectations became more balanced.
Now that the bears have been whacked and capital is actually flooding into the country again, as seen via the huge increase in Q3 forex reserves, policymakers can be confident of having ample room to enact reforms without sending market participants running for cover, which is exactly what they have been doing, such as the latest drive to reduce steel production by 80 million tons in 5 years (still relatively new, so no reports in English yet).
In short, I expect more economic developments out of China that are below consensus in a negative way for the foreseeable future. This is probably not a good time to hold a heavy position in Chinese stocks (FXI). Once QEinfinity expectations are re-anchored and priced in for emerging markets, slowly ebbing optimism in Chinese growth may provide a persistent catalyst for weakening optimism in emerging stocks (EEM).