“Free markets for Free men”, was a slogan etched on the floor jackets of several traders at the Chicago Mercantile Exchange in the 1980’s. But today, the slogan for traders is “Rigged markets for Central bankers,” who try to move currency and stock markets with their control of the money spigots and timely “jawboning” to the media outlets, when markets become unruly. Today, trading in currencies, precious metals, and stock market indexes has turned into a game of central bank watching.
Right now, two of the most important pieces of the global market jig-saw puzzle are the Shanghai Stock Index bubble and the Tug-of-war over the “Euro /yen” carry trade. What happens in Shanghai can have a big influence over China’s monetary policy, and is of great interest to commodity traders and Asian stock markets. The upcoming battle over the Euro /yen exchange rate can have a big influence over Japanese monetary policy and stock markets in Europe.
How will Beijing Deal with the Shanghai Bubble?
The 9% plunge in the Shanghai stock market on Feb 27th, was widely blamed for igniting the $1.5 trillion global stock market shake-out. Within hours of the Shanghai plunge, the Dow Jones Industrials (NYSEARCA:DIA) fell as much as 550-points, forcing the US Treasury to issue a plea for calm. Yet the market which ignited the global panic in the first place, was the first to recover and then rumbled to new all-time highs.
The Shanghai Composite Index (NYSE:CAF) climbed to a new all-time high of 3,144-points four weeks later, overcoming heavy profit-taking, and is now beginning a new leg up. Technical analysis suggests an initial upside target of 3,250 with support at the January and February peaks around 3,000. The Shanghai index has already tripled since May 2005 and is up 17.5% so far this year, with many stocks trading at multiples above 40 times earnings, the most expensive in Asia.
Yet without a tighter Chinese monetary policy, the Shanghai A-share market could inflate into a Nasdaq-like bubble, and if it should burst from much higher levels, it could deal a big blow to China’s economy, and have a chilling effect on Hong Kong-listed stocks (NYSEARCA:FXI). But it remains an open question of how far Beijing is actually willing to tighten its money spigots to keep this raging bull market under wraps.
It’s a long war, and a determined central bank with enormous financial resources can eventually gain the upper hand over market speculators, if it is willing to pay the price. So far this year, Beijing has launched three salvos aimed at local stock market operators, in an effort to cap the Shanghai Composite Index of “A” and “B” shares below the psychological 3,000 level, but hasn’t yet pricked the market bubble.
The opening salvo aimed at Shanghai traders was launched on Jan 31st, by Cheng Siwei, vice-chairman of the National People’s Congress. “There is a bubble growing. Investors should be concerned about the risks. But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice,” Cheng warned.
“Jawboning” is usually the first weapon of choice for government interventionists, because it’s cost free. Cheng’s scare tactic worked for a week, knocking Shanghai red-chips into a 15% swoon by February 7th. However, two weeks later, the buoyant Shanghai stock index was climbing above 3,000 for a second time. The PBoC turned jawboning into action, by lifting bank reserve ratios 0.5% to 10% on Feb 19th.
The PBoC surprised the Shanghai money markets, and the 7-day repo rate briefly spiked upward by 1% to 2.65%, greasing the skids for the 9% plunge in Shanghai red-chips on Feb 27th. But the surge in the 7-day repo rate was a false alarm, and when the liquidity gauge drifted down to as low as 1.42% on March 13th, the Shanghai stock Index mounted its third attempt to breach the 3,000-mark
The third attempt to douse the Shanghai red-chips rally was unleashed on March 16th, when the PBoC hiked its deposit and lending rates by 0.27 percent. But China’s money markets are still flush with cash. China’s 5-year Treasury bond yield of 2.85% is barely above the 2.7% consumer inflation rate, offering a zero percent real rate of return. The 5-year Chinese bond yield is far below the peak of 4.55% set in 2004, the last time Beijing admitted to a flare-up of inflation.
The PBoC sells T-bills to soak up yuan and then re-invests the money into higher yielding foreign currency bonds, - otherwise known as a “carry trader”. China held $353.6 billion in US Treasury securities in January, second only to Japan in value of Treasuries held, but holds most of its $1.07 trillion in FX reserves in US institutional bonds, corporate bonds, and mortgage-backed securities, the PBoC said on March 18th. Its holdings also include a range of currencies besides the US dollar, such as the Euro, the Japanese yen and the British pound.
The PBoC’s T-bill sales are calibrated to siphon off roughly $25 billion of monthly currency inflows from foreign trade and investment, but are not indicative of a tighter money policy. Recently however, the PBoC was more aggressive in draining liquidity, selling a net 540 billion yuan ($70 billion) of T-bills, and guiding the 7-day repo rate from a low of 1.42% to as high as 1.95% on March 27th.
Shanghai Bubble Inflated by “cheap yuan” Policy
China’s economy expanded 10.7% in 2006, led by a 27% surge in exports to a record $969 billion, and notching up double-digit growth for the fourth year in a row. One of the ingredients to China’s stunning success is its manipulation of the yuan, which is undervalued on a trade weighted basis by 35 percent. China earned a $177 billion trade surplus last year and attracted $63 billion in foreign direct investment.
The Chinese central bank prints massive amounts of yuan to buy the foreign currency that is flooding into the country. For the past four years, China’s M2 money supply has increased between an annualized 13.5% to as high as 21.5%, with an average rate of 17.5 percent. In other words, China’s M2 money supply is 70% higher from four years ago, and its economy has grown by over 40 percent.
But the PBoC hasn’t raised interest rates high enough to slow loan demand, which is essential to bring its M2 money supply under control. Lending surged by 413.8 billion yuan in February, compared with an increase of 149.1 billion yuan in February 2006. M2 money growth jumped to an annualized 17.8% in February from 15.9% in January. So Shanghai red-chip speculators are inclined to bid share prices higher, with so much easy money floating around in a red-hot economy.
Beijing’s Mixed Blessing with a cheap US Dollar
China’s leaders have opted into a gentleman’s agreement with the Bush administration, buying large amounts of depreciating US bonds, in return for assurances of a Bush veto against protectionist legislation from angry Democrats in Congress. China reaped a record trade surplus of $232.5 billion with the United States last year. In the first two months of 2007, China posted a trade surplus of $39.7 billion, triple the total from a year ago.
Yet for China, its massive investment in US T-Notes, when measured against gold or yuan, has sunk to a six year low. And matters are only going to get worse, with Beijing forced to shoot itself in the foot, by devaluing its US dollar assets by about 5% this year against the Chinese yuan. But by Beijing’s calculations, the benefits outweigh the costs, after figuring for net interest income and its massive trade surplus with the United States.
But it will become much harder for Beijing to support the US dollar, once the Federal Reserve begins to lower the federal funds rate and injects more US dollars into the banking system. Former Fed chief “Easy” Al Greenspan said on March 15th, there was a risk that rising defaults in sub-prime mortgage markets could spill over into other economic sectors, raising the odds of a recession.
Greenspan, who helped create and nurture the sub-prime loan debacle in the first place, said much of the strength in US consumer spending over the past five years could be traced to capital gains, both realized and unrealized, on surging housing prices. If US home prices turn south, due to rising loan defaults and foreclosures, it could sink the broader US economy towards zero percent growth.
It’s quite a balancing act for Beijing, printing yuan on the one hand to cushion the dollar’s downfall, while raising bank reserve ratios and interest rates on the other hand, to slow down bank lending. And the high-wire act is a bit more treacherous for the PBoC, after the US dollar’s 5-year bond yield fell from a high of +230 basis points over 5-year Chinese bond yields on Feb 1st, to as low as +153 bp last week.
So far, the PBoC has printed enough yuan to limit the dollar’s depreciation to just 1% since the beginning of the year. But the slow rate of yuan appreciation might not satisfy the US Congress, which is crafting protectionist legislation against Chinese imports this year. And by printing massive amounts of yuan to offset hot money and trade inflows into the Chinese currency, the PBoC risks generating higher inflation and a bigger stock market bubble in Shanghai. What a tangled web we weave!