The Major Paradox at the Heart of the Chinese Economy
Comment of the Day

April 15 2015

Commentary by David Fuller

The Major Paradox at the Heart of the Chinese Economy

Here is a brief section from this interesting article from Bloomberg Business.

Xi and Premier Li Keqiang are trying to defuse that debt bomb, rein in banks and local governments and promote the nation’s stock markets as a primary way for innovative and smaller companies to raise capital.

Both leaders say they’ve mapped out more than 300 reforms that over time will reduce state intervention in the economy. Among the initiatives is scaling back energy-price controls that favor manufacturers. The changes are also designed to improve the social safety net and encourage market-driven deposit rates to get Chinese families saving less and spending more.

Few countries with the scale of China’s credit boom have escaped unscathed without experiencing some sort of banking crisis. Research by Michael Pettis, a finance professor at the Guanghua School of Management at Peking University, shows that “every investment-led growth miracle in the last 100 years has broken down.”

Avoiding that fate requires a high-wire balancing act for the government. It needs to wind down the torrent of investment -- 49 percent of China’s GDP from 2010 to 2014 -- without cratering the economy and worsening the situation for indebted local governments or the bad-debt burden of Chinese banks.

“Our goal is to keep China’s economic operation within the proper range,” Premier Li said in a March 31 interview with the Financial Times that was published Wednesday. Achieving the 7 percent target this year “won’t be easy” and requires “vision, perseverance and courage,” Li said, as cited by the newspaper.

Selling slower growth now for greater prosperity later isn’t an easy political sell, even in a one-party state. Xi faces entrenched interests that favor the status quo, such as state-owned nonfinancial enterprises that have $16 trillion in assets and local governments that have benefited from big public works projects and thriving real-estate markets.

There’s also the risk of a disorderly de-leveraging in the banking sector and the jobs-intensive property market. Any crisis there could take growth rates well below the government’s target of about 7 percent. China is already home to income-inequality levels on par with Nigeria and Mexico.

Throw higher unemployment into the mix and the risk of social unrest rises.

David Fuller's view

I have sometimes described China’s economy and stock market as interesting enigmas.  For this reason I have also learned to be wary of highly opinionated forecasts for China from Western commentators. 

However, I have developed some helpful guidelines for monitoring and China’s stock markets.

Pay close attention to price charts for China’s stock market indices (always a good idea in any market, especially if valuations are generally low). Price charts and their trending action always show us in which direction the money is flowing. 

Pay close attention to what Xi Jinping and Li Keqiang are saying, since their influence is enormous.  This is not all that easy to do in the West so you may have to search for it.  Articles summarising what they are saying or doing, particularly by Westerners, are generally less reliable.

So how does China’s price action look today and how much have valuations changed following recent strong gains?

China’s Shanghai A-Share Index (p/e 20.10 & yield 1.60%) is obviously no longer cheap.  In fact, it is now more expensive than Wall Street’s S&P 500 Index (p/e 18.56 & yield 1.97%).  Consequently, SHASHR is now dependent on momentum buying and accommodative monetary policy, if further medium-term gains are to be seen before the next lengthy reaction and consolidation phase occurs. 

Hong Kong’s Hang Seng Index (p/e 11.62 & yield 3.27%) is much more competitively priced and has only recently broken up out of a lengthy ranging phase dating back to November 2010, mostly beneath the psychological 25000 level.  It is currently consolidating gains but should have further upside potential while China’s monetary policy remains accommodative.

The Hang Seng China Enterprises Index (H-Shares) (p/e 10.31 & yield 2.98%) has a similar pattern to HSI above although its range extended back to November 2009.  It has surged over the last three weeks, reaching its highest levels since 2007 to early-2008.  However, the competitive valuations suggest we are likely to see a temporary consolidation followed by further gains, provided Shanghai A-Shares shown above, which led this move, do not see a sharp fall. 

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