Doublewood: What’s Up With China? – Part 1

Many are asking similar questions about China’s economic and financial stability. First, I will talk about the current financial market situation.


Stock Market — There is still considerable excess leverage that has to be whittled down, before you get to a market in which valuation matters. Further selling pressure will periodically rear its head, and sends shock waves and tremors to the stock market. For example, one of the reasons for the precipitous drop in the stock indices since the start of the new year was the government announcement to lift the freeze on stock sales by some categories of major shareholders (the freeze was put on last year to provide market support and prevent further market free-fall). Many pent-up sellers came out this time to sell becasue they had to cover debts secured by their shares at the height of the market run, when prices were 50% to 100% higher. That is only a portion of the leverage that has to be worked down. There are also other parties on line to sell when given the permission and opportunity, such as IPO lock-ups that have expired. [The circuit-breaker was just an ill-timed and not-yet-perfectly-designed mechanism that happened to accelerate the intra-day fall in prices during the current sell-down. It is not the cause of it.]

Other causes for this latest round of market rout will be investigated, and confirmed in due course.

Over the long-term, Chinese equity still has good value and growth. The market took off in the third qtr of 2014 and skyrocketed 150% in 9 months, much of which due to extreme leverage (up to 5 times, instead of the average regulatory limit of 70%, which of course was illegal). When the market finally crashed in June, 2015, there were massive margin debts to unwind. The process is not finished yet.

Eventually, stocks will be of good value as prices will inevitably go down excessively. But that may not be for some time. Besides de-leveraging pressure in China, the currency and liquidity issues triggered by it are risk factors that need to work its way through also. Those issues have domino effects and are international in scope. The rumblings, tremors and quakes will be with us for a while, and may yet build up to something else.

[I have said before: “do not try to bottom-fish — that is tantamount to juggling with razor-blades”. This is a good time to learn that lesson. Be patient. Look for repeating and confirmed buy signals. Then enter in several rounds, not all at once. At the moment, one should be worried, not greedy.]

Currency and Liquidity — Since the run-up to the RMB inclusion in the IMF’s SDR basket, China has started to allow (or experiment with) the free floating of its currency. The result is actually quite encouraging. With the most recent round of market-driven depreciation of the RMB (by almost 3%), the market rate of RMB now reflects more closely the basket of foreign currencies it aims to peg against, instead of exclusively against the US Dollar. (In other words, since the USD appreciated significantly against all other currencies in the past year, the RMB had been dragged along and appreciated against the other currencies. The current market-driven adjustment helps the RMB realign itself in accordance with the country’s volume distribution of trade and foreign investment activities.) In that respect, the RMB is likely to be more stable in a market-driven context than previously thought.

However, over the course of this year at least, that stability will be challenged by the potentially dramatic volatility in the global flows of funds. China will be a big factor and a main actor in that drama.

The financial de-leveraging pressure that we have been witnessing in the stock market signals that potential liquidity squeezes will continue to emanate from China and may be more substantial in size. Other parts of the economic reform will also force de-leveraging; the stock market is not the only part. But China still has almost USD 4 trillion of foreign currency reserves with which to … well … print more money if necessary. The government has ample other resources, economic and political, that can be mobilised to contain any excessive financial fall-out, including when global stability is severely affected. It will not let the bottom fall off.

The reform initiatives, of which the financial market aspects are a key part, are designed to yield substantial long-term dividends. But, as with any form of exercise, there will not be meaningful gains without some requisite measure of pains.

Seat-belt, S’il-vou-plait — I will end this first installment by reminding everyone to please find a beat-belt and fasten it. The Chinese financial markets will likely be relatively turbullent for a while yet. China will experiment more with market dynamics in its financial reform program. That will affect global funding, currency stability and capital market volatility. There will be some roller-coasting before the system achieves the necessary adjustments and starts functioning in a more stable and efficient mode.

In the meantime, do npt panic. The reform is likely to succeed. Both the RMB and the Chinese stock market will be relatively robust. The question is: when? The answer is: not now.

Be patient. Hold more cash and enhance overall liquidity. Within that, keeping 20-30% of liquidity in gold is still a valid, albeit not mandatory, allocation (for example, if you have reason to need to hedge against an eventual turnaround of current USD strength).

It is not a good time for speculation. That is because the downside risk far outweighs the upside potential at the moment. You don’t hit any jackpot in a roller-coaster market. You can suffer high blood pressure and mood swings instead.


In the next installment, I will try to explain China’s current economic reform program, in Peter-Rabbit language.


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