China and India Join the G-10 Monetary Tightening Campaign
The astonishing rally of commodity prices during the past four years, especially rising energy prices, are finally beginning to push US and global inflation indicators broadly higher. In late 2005, the Reuters' index of 19-exchange traded commodities, surpassed record high levels set in the early 1980's. By mid-May 2006, the CRB Index gained another 10 percent. Behind this year's rise in the Commodity index were unprecedented price increases of individual commodities.
In the first five months of 2006, crude oil prices jumped 14% followed by gains in corn and wheat of about 10 percent. Zinc prices doubled in the first five months of 2006, copper prices rose as much as 80%, silver gained 60% and palladium 50%, tin 40%, gold 35%, aluminum 36%, and platinum had gained 30% respectively. European and Japanese steel makers agreed to a 19% increase in the price of iron ore in May, after a 70% increase the year before.
Meanwhile, back-to-back years of 3.5% plus growth left US factories with less spare capacity than at any time since July 2000. Spare capacity is dwindling globally as well. The IMF projects global growth of 4.9% this year, after 4.8% in 2005 and 5.3% in 2004, the strongest three-year stretch since the early 1970's. That reduces the excess of world supply over demand, and makes it easier for multinational companies to raise prices without fear of losing business to competitors.
And changing demographics in China and India are driving growth in the Asian giants as they chart their course towards becoming two of the world's largest economies. China and India house 2.2 billion citizens, or one third of the world's population, with their economies expanding at annual growth rates of 10% and 8% respectively. At current growth rates, by 2035, the US and Japan, currently the biggest and the third-largest economies respectively, would be relegated to third and fourth place.
So it was highly significant, when the Reserve Bank of India and the People's Bank of China, joined the Group of 10 central bankers, and announced measures aimed at slowing their over-heating economies and explosive money supply growth.
Global market Tops or Corrections in Bull markets?
"A trend in motion will stay in motion, until some major outside force knocks it off its course," and global traders are left wondering if the three-year bull market for global stocks, and the four year rally for gold and commodities have topped out. Gold tumbled 26% from its 26-year highs of $730 per ounce over five weeks, while Japan's Nikkei lost 20% to as low as 14,000, losing $864 billion of market value.
The MSCI All Country World Index, designed to measure equity market performance of 48 developed and emerging market country indices, lost 12% of its value during the initial earthquake in May, and the second tremor in June. Emerging markets in Brazil, India, and Russia lost between 23% and 30%, while gold, silver, and copper were also big casualties of the steep month-long sell-off from Asia to Latin America, as hot money ran for cover into the US dollar and government bonds.
The source of the turbulence had mainly to do with rising interest rates in G-10 industrial countries and signals by central banks that further tightening is on its way. In order to contain global commodity inflation, Jean-Claude Trichet, spokesman for the G10 group of central bank governors warned on May 8th, "It is not the time for complacency, if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation."
The world economy has so far absorbed rising commodity prices well, but the upwards trend is a major risk to the world economy, Bank of Spain chief Jaime Caruana said on June 15th. "This trend (of rising commodity prices) constitutes a risk of the first order to which economic policy must remain vigilant," Caruana said in a speech before the central bank's board.
The second major tremor in the base metals, gold, and global stock markets was triggered by Federal Reserve chief Ben Bernanke, on June 5th. The Fed "will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained. The Fed must continue to resist any tendency for increases in energy and commodity prices to become permanently embedded in core inflation."
By signaling a hike in the fed funds rate above 5.00%, the US central bank is moving beyond the so-called neutral rate, and risks deflating the US housing bubble. But without the co-operation of China and India in slowing global demand for commodities, the G-10 tightening campaign would probably require a few extra steps to climb, and risk pushing the global economy to the brink of recession.
That's certainly not in the best interests of China and South Korea, where 40% of the output is linked to exports. India's economy is mostly domestic market-driven, but imports 70% of its oil needs.
China's booming economy and insatiable appetite for imported raw materials, has often been cited as a major force behind the "Commodity Super Cycle". China is the world's fifth largest importer, and imports in 2006 are running ahead of last year's blistering pace. Chinese imports were valued at US$60.1 billion in May, or 21.7% higher from a year earlier, but fell US$6.4 billion from April. For the first five months of 2006, Chinese oil imports, were up 18.0% from last year at 61.55 million tons, or 2.98 million barrels per day.
China's exports totaled US$73.1 billion in May, up 25.1% from a year ago, but US$3.8 billion less than in April. That still left China with a record trade surplus of US$13 billion. About two-thirds of China's exports come from foreign-owned companies that earn a bigger profit from low-cost labor and lower tax rates in China.
China's trade surplus has continued to grow after hitting a historic high of US$102 billion last year. In the first five months of this year, the surplus totaled US$46.8 billion. China also received $60.3 billion in foreign direct investment in factories and infrastructure last year, and Beijing's hoard of foreign currency reserves have mushroomed above $900 billion and on course to reach $1.1 trillion by year's end.
So any measures adopted by Beijing to rein in its overheating economy, that could slow Chinese imports from abroad, or signs of slower exports to the US, would be of great interest to commodity and gold traders, and speculators in exporter shares in Australia, Brazil, Canada, Japan, and Korea.
China's central bank (PBoC) has to buy incoming US dollars to maintain the yuan's at an artificially low exchange rate. The PBoC prints Chinese yuan in exchange for the US$, pushing up the Chinese M2 money supply and making it more difficult for Beijing to slow the economy by curbing bank lending. Chinese bank lending almost doubled in May from a year earlier to 209.4 billion yuan. New lending through May amounted to almost three quarters of the central bank's target for the whole year,
Annualized growth in China's M2 money supply accelerated to 19.1% in May, well above the PBoC's target of 16%, capping a string of data that signaled the economy is over-heating. Fixed-asset investment in towns and cities climbed 30.3% to 2.54 trillion yuan ($318 billion), industrial output was 17.9% higher YoY in May, the most in two years, while retail sales were 16% higher from a year ago, at the fastest pace in 17 months. China's economy grew at a 10.3% rate in the first quarter.
The PBoC did raise its one-year lending rate on April 27th, for the first time in 18 months, but it proved ineffective, so central bank chief Zhou Xiaochuan vowed on June 15th, to curb the money supply, after Premier Wen Jiabao told local banks to limit lending. The PBoC will "step up open market operations, including selling more bills to banks, to adjust money in the financial system," he said.
"We will remove the firewood from under the cauldron so that banks do not have the money to lend," said deputy central banker Wu Xiaoling. She said banks that led lending to "overheating industries will be forced to buy more central bank bills." In a special operation on June 13th, the central bank absorbed 100 billion yuan ($12.5 billion) from the banking system through the issuance of one-year bills, and it named the banks that were obliged to buy them.
Then on June 16th, the PBoC lifted bank reserve requirements by a half-percent to 8.0% effective July 5th. "Money supply and credit growth is too fast. And also the trade surplus is widening. The increase in bank reserve requirements by 0.5% is aimed at curbing this rapid growth. This increase would help drain 150 billion yuan ($19 billion) from the market," the central bank said. The move would drain a third of the amount of foreign direct investment expected into China this year.
The US dollar brifly fell to 7.9970 Chinese yuan on June 16th, its lowest level since last July's 2.1% revaluation to 8.11. Further appreciation could relieve pressure on the PBoC to print more yuan and therefore make monetary policy easier to manage. The yuan may rise or fall 0.3% from its mid-point each day, since the floating rate regime was introduced last year. In Hong Kong, traders in the 12-month forward market predict the US$ will fall just 3.6% to 7.71 yuan next year.
The transmission between Beijing's monetary policy and its impact on the Chinese economy is difficult to assess by looking at the mainland stocks in Shanghai and Shenzhen, due to their lack of transparency and different accounting standards. Instead, Hong Kong is a better indicator, because it is already an established international financial center with a business-friendly and investor-friendly environment, and duly listed Chinese shares.
Hong Kong is an export bridge between the Mainland and the rest of the world. Hong Kong's trade is predominantly re-exports to and from China, a role that has helped the territory expand by more than 7% annually for the past two years. Hong Kong's economy grew a strong 2.4% in the first quarter, four times the pace of the fourth quarter, on the back of robust consumption and solid exports, From a year earlier, Hong Kong's economy grew 8.2%, above a 7.5% annual rate in the fourth quarter.
Hong Kong's exports in April rose 9.4% by value to $HK188.8 billion from a year earlier, but slowing from 14.7% year-on-year gains in March. Re-exports from the mainland in April grew 8.6% to $HK178.5 billion, while domestic exports increased 27.6% to $HK10.3 billion. For the first four months, total exports of goods were up 11.4% over the same period in 2005. Of this total, the value of re-exports increased by 10.1%, while the value of domestic exports rose 35.8 pct.
Three of the five busiest deep sea ports in the world are in Hong Kong, Shanghai and Shenzhen. In 2005, the Port of Hong Kong handled 22.6 million containers, the Shanghai Municipal Port handled 18 million, up 24.7% from 2004, and the port of Shenzhen, in the strong economic region of the Pearl River Delta, handled 16 million containers in 2005, up 18.6% over 2004. Shenzhen province accounts for nearly 12% of China's GDP and 31% of its total imports and exports. By 2015, it is predicted that China will account for 48% of container traffic in Asia.
So far, the Hong Kong economy has withstood the adverse impact of higher interest rates with domestic demand enjoying strong support from improved incomes and job security. HK's jobless rate stood at 5.1% in April, the lowest in five years. But the global stock market meltdowns, higher HK interest rates, a possible slackening of US demand due to higher US interest rates, and the impact of China's economic tightening measures, could put the HK economy at risk of a slowdown.
Hong Kong's benchmark stock index, the Hang Seng, fell as much as 12.6% from its May 11th highs, on fears the G-10 central banks will keep raising interest rates. The Fed has raised its key rate 16 times in a row to keep inflation at bay, increases the Hong Kong Monetary Authority has matched to help maintain the local currency's peg at 7.8 to the US dollar. Twelve-month Hong Kong inter-bank rates climbed to an offer of 5.00%, last Friday, from 4.25% in the first week of March.
The value of short selling in Hong Kong averaged $HK$2.7 billion last week, double the 2006 average so far, and the highest since 1998, as concern rising global interest rates will hurt economic growth led to stock market slides worldwide. Investors can short 288 of the more than 2,800 securities listed on the exchange. HSBC has the largest market value and is often viewed as a global bellwether stock.
Beijing's decision to allow its financial institutions to invest overseas drove trading volumes on the Hong Kong stock exchanges to near-record highs in the first three months of the year. Daily turnover on the HK's exchange's main board averaged HK$31 billion in January-March, a 70% jump over 2005's average HK$18.3 billion. But Beijing also lifted a year long ban on new IPO's, which could bring a glut of new shares to the market, worth at least a combined US$20 billion from Bank of China and Industrial and Commercial Bank of China.
The recent slide in the Hang Seng index, has been highly correlated with a weaker gold market in Hong Kong. Speculative sentiment towards gold and base metal mining stocks in the city has also turned sour, knocking gold miner Zijin Mining 2899.HK, Lingbao Gold 3330.HK, Jiangxi Copper, and top zinc producer Hunan Nonferrous Metals 2626.HK sharply lower.
Beijing has often vowed to rein in the explosive growth of its economy in the past, but usually fails to live up to its promises. Beijing is slow to move and simply tries to tweak its economic growth rate to prevent overheating. The ruling elite are very afraid of any real stringent tightening measures that could lead to a hard landing. But this time, Beijing might be a serious ally of the G-10 central banks, in an effort to tame the "Commodity Super Cycle" which wreaks havoc on its importers.
India Caught in the Eye of the Global Storm
After experiencing a near-relentless climb over the preceding three years, the Bombay Sensex stock index touched an all-time high of 12,612 on May 10th, before slipping into a free-fall of 3,600 points, or more than 28.5%, in just four weeks. The Bombay Sensex had moved from 5,000 in July 2004 to 12,612 on May 10th, 2006. The persistent and rapid rise had taken the price-earnings ratio of Sensex companies from 14.5 in July 2004 to 22.2 on May 10th, 2006.
The euphoria behind the Bombay Sensex reflected the confidence of a robust Indian economy, which expanded at an impressive 9.3% rate in the first quarter, second only to China. India's economy has averaged 8% growth for the past three years, and even if global growth decelerates due to a Chinese or US economic slowdown, India's economy could be less affected than other Asian markets because it has a bigger captive domestic market and is only 10% export-oriented.
Commodity traders are now debating whether the latest turmoil in the Indian stock market reflects global risk aversion or signals of an impending slowdown in the Indian and global economy. The 28% slide in the Bombay Sensex index wiped out $244 billion of its market capitalization. At its peak, the market was worth $745 billion, nearly equivalent to the GDP of Asia's third-largest economy. A sustained drop in India's stock market, coupled with a tighter RBI monetary policy, come slow import demand from one of the world's fastest growing economies this year.
India's booming economy has also been cited as a key factor that fuels the "Commodity Super Cycle." So traders watch for trends in Indian imports could have an impact on commodity prices. India's oil imports for instance, stood at $4.15 billion in May, which was 27.3% higher than a year earlier, Non-oil imports, a key indicator of industrial activity, were 19.24% higher in May to $9.04 billion from $7.58 billion in May 2005. Crude oil has held up better than base metals thru the global storm.
India's exports rose 29.6% in May from a year earlier to $9.36 billion. Manufacturing output, which makes up more than three quarters of India's industrial production, was 10.4% higher in April from a year earlier, after annualized gains of 8.9% in March and 9.5% in February. The sizzling performance boosted industrial output, which contributes a quarter of India's GDP, to 9.5% in April.
For the past three years, the "India story" depicted the country's vast potential market of 1.1 billion people, and booming economy, lifting the Bombay Sensex index 400% higher. The Indian rupee stabilized between 43.5 to 46 per US dollar, and India's 10-year bond yield fell from a high of 11.5% in 2000 to as low as 5.10% in 2004. PM Manmohan Singh eliminated the capital gains tax and reduced corporate tax rates since 2004, all key linchpins supporting high-flying Bombay Sensex Index.
Foreign institutional investors (FII's) were behind the surge in Bombay's Sensex index, pumping in an average $1.8 billion during 1999 to 2002, then falling to $377 million in 2002. Then FII investments surged to an average $9.6 billion a year during 2003-04. More recently, FIIs are estimated to have pumped in $10.7 billion into India's stock markets in 2005 and a further $5 billion thru May 11th, 2006. Indian retail investors only account for 15% to 20% ownership of Bombay Sensex shares.
India received capital inflows of US$65 billion in the last three years. However, net Foreign Direct Investment (FDI) totaled only US$11 billion in this period. Cumulatively, for the past three years, non-FDI flows into Indian bonds, short term deposits, and stocks, accounted for about 83% of total capital flows in India, compared with 32% for the top emerging markets. The RBI has said that over 75% of net foreign capital inflows into India are hot money.
But historically high oil prices combined with an annualized 18.5% growth rate for India's M3 money supply is fueling inflation at a 4.73% clip in India's $775 billion economy. After the price of gold soared 75% to over 32,000 rupees per ounce by May 2005, the RBI was forced to shore up confidence in the rupee by hiking its overnight rate 0.25% to 5.75%, or about 1% above the inflation rate.
"GDP growth has been quite strong. The price situation will require greater sensitivity. The effort of our monetary policy is to contain inflation in a range of 5.0-5.5%," Reddy said. But Reddy faces pressure from PM Manmohan Singh to keep borrowing costs low to spur spending and investment, and help accelerate the annual growth rate to as much as 10% over the next decade as the government attempts to eradicate poverty.
The Reserve Bank of India's surprise rate hike was synchronized with a quarter-point ECB rate hike to 2.75%, and at least five Federal Reserve officials who are strongly hinting at a continuation of its rate-tightening spree. The RBI wants to avoid a narrowing of interest rate differentials between the Indian rupee, the Euro, and the US$, to head off a possible outflow of foreign portfolio investments.
"Several central banks have been increasing interest rates and our monetary policy stance cannot be too much out of synch. Global factors are accorded more weight than before," Reddy explained. India's central bank is expected to raise its key interest rate for the third time this year by 0.25%to 6.00% at its July 25th meeting, to match future hikes by the Fed, ECB, and Bank of Japan.
On June 12th, Indian Finance Minister Palaniappan Chidambaram backed the central bank's move to raise interest rates, "It was necessary for the Bank to be ahead of the curve especially after the European bank raised rates and there is a clear hint that the Fed also will increase its rate." He said the domestic stock markets were overdue for a correction. "The P/E ratios are in a comfort zone and we expect the market to stabilize," said Chidambaram.
On June 16th, the Bombay Sensex was valued at 15.2 times estimated earnings for the current year, down from a high of 20.5 times on May 10th. The price-earnings ratio is still above the MSCI emerging-markets index's 12.2 times. Still, a lower p/e ratio would be reasonable if India's 10-year bond yield climbs above 8% in the weeks ahead. The RBI is doubling the size of the June 22nd bond auction to dry up liquidity in the banking system and to push yields further ahead of the inflation curve.
Indian bond yields have jumped a quarter-point to 7.90% since the last RBI rate hike on June 8th, as dealers sell their bond holdings in the face of rising RBI interest rates and decreasing liquidity. The outlook for the upcoming bond auction is gloomy, with the increased size unnerving market players. However, hot money flows into and out of India could start to wind down during a summer of global monetary tightening.
Bank of Japan draining global liquidity
After draining some 20 trillion yen ($174.4 billion) from the banking system since April, the Bank of Japan is expected to withdraw another 6 trillion yen in June to finish the process. The BOJ says it will decide when to raise the overnight loan rate above zero percent based on improving economic fundamentals and rising prices. Futures traders expect the BoJ to lift borrowing costs at the July 14th meeting.
But with the Nikkei-225 getting hammered, there is a chance the BoJ could delay tightening for an extra month. The BoJ might be more responsible for the global stock meltdown and commodities sell-off, through its massive draining operation, than the Federal Reserve or the European Central Bank. Hedge funds use the Japanese yen, with its zero interest rate, as a funding currency to purchase commodities and global stocks. As long as the Federal Reserve keeps lifting the fed funds rate, the US dollar manages to elevate against the yen.
The Bank of Int'l Settlements said that in the seven quarters to the end of 2005, borrowing in Japanese yen at zero percent surged by $161 billion, with three quarters of this lending channeled to international financial centers such as the United Kingdom, Singapore, and the Cayman Islands, favorite havens for hedge funds. But not much un-winding appears to be happening, with the US dollar trading above the mid-point of its 109-yen to 119-yen trading range in 2006.
Japan's monetary base fell at the fastest pace on record in May from a year earlier, reflecting the growing effects of the Bank of Japan's policy shift. The monetary base, money in circulation plus bank deposits fell 15.3% in May from a year earlier, and has been on a rapid decline since the BOJ on March 9th ended its five-year-old policy of flooding the banking system with excess funds.
According to futures traders, the BOJ won't be discouraged from lifting its overnight loan rate to a half-percent this year, even after the severe damage to the Nikkei-225. "We have to monitor what kind of influences share prices will have on the economy. So far, they have not had a strong impact on economic fundamentals at home and abroad," BOJ chief Fukui told a parliamentary committee on June 13th.
And the European Central Bank is taking the decline in global stock markets in stride, but could wait until September before lifting its repo rate to 3 percent. "There is at the moment, a decline in the usual market constellations," said Bundesbank chief Axel Weber on June 19th. "The normalization of global monetary policy has led to some shifts in asset portfolios. This leads to changes on the markets, but these are correct, these are healthy," he said.
But the world is still awash with cheap money. Japan's overnight loan rate isn't expected to go above a half-percent this year, and traders can borrow in Swiss francs below 2% thru December, to fund purchases in global stocks and commodities. On the other hand, quick footed speculators might be under-estimating the length of the G-10 and global central bank tightening campaign in the months ahead. Therefore, traders should also remember how to short sell on big rallies, after three years of being programmed to buy on dips.
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