Bubbles Brewing in Shanghai, Tokyo, and London
"There is a bubble growing. Investors should be concerned about the risks," said Cheng Siwei, vice-chairman of China's National People's Congress in a January 31st interview with the Financial Times. "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.
In what might develop into the third biggest stock market bubble in history, ranked alongside Japan's Nikkei-225 of 1986-89, and the Nasdaq's 1999-2000 bull run, the Shanghai Composite "A" share Index, restricted mainly to Chinese nationals, has posted a 140% gain over the past 12-months, after soaring 46% in the fourth-quarter of 2006 alone. And without deliberate market intervention, the A-share market could inflate into a Nasdaq-like bubble.
How Beijing decides to deal with the Shanghai bubble, can have a great impact on the outlook for the Chinese economy, global commodity markets, and exporters in the region from Australia, Hong Kong, Japan, and Korea. Will Beijing try to prick the bubble and set-off a steep correction, or carefully calibrate a series of tightening measures to take some steam out of the market and simply flatten it out?
Sometimes, markets can boomerang on central banks and torpedo the most carefully designed strategies. Therefore, jawboning is usually the first act of official intervention in the market place, because it's cost free and doesn't change underlying market conditions. Siwei's remarks did trigger a 15% pullback from January's peak, as traders locked in profits from sky-high valuations, figuring that official warnings might turn into concrete steps to cool down the market.
Then on Feb 9th, the People's Bank of China (PBoC) tried to keep the market off balance, by warning that it would use a number of tools to keep flush liquidity conditions in check. "The central bank would use a combination of open market operations and higher required reserves for banks in an effort to stave off a credit-fuelled investment boom, and will make the yuan more flexible," it said.
The Shanghai "A" share index fell 2.5% to an intra-day low of 2,541, within minutes of the PBoC's threats, but then put in a reversal bottom, and closed 2.3% higher on the day. One week later, on February 15th, the "A" share index jumped more than 3% to an all-time closing high of 2,993. A total of 828 stocks rose while only 31 fell, and over 40 stocks in Shanghai rose by their 10% daily limits.
On the smaller Shenzhen market, three new IPO's soared into orbit, suggesting that the Chinese stampede into stocks hasn't run its course. Non-ferrous metals maker Yunnan Luoping Zinc soared to 30.94 yuan, triple its IPO price of 10.08 yuan. Zhejiang Sunwave Communications jumped to 19.65 yuan, double its IPO price of 9.15 yuan. And China Haisun Engineering 002116.SZ surged 178% to 19.16 yuan.
The PBoC put its verbal threats into action on February 16th, when it lifted bank reserve ratios by half-percent to 10%, coming only six weeks after the last hike, and at faster pace of tightening than expected. The hike in bank reserve ratios should drain about 160 billion yuan ($20.7 billion) from the Chinese money markets, and is less expensive to Beijing's budget, that issuing T-bills or raising interest rates.
The reserve ratio hike, the fifth of its kind since last July, was made to deal with "dynamic currency liquidity changes and to consolidate macro-economic controls," said the PBoC in its latest statement. "Imbalanced international payment generated by mounting trade surplus resulted increasing currency liquidity and made another reserve ratio hike necessary," it added.
Shanghai Red-chip Rally fueled by Explosive Money Supply
The PBoC prints yuan in exchange for foreign currency flowing into the country, and until Beijing abandons its crawling peg of the dollar-yuan exchange rate, the M2 money supply growth rate will remain very high. Hot money will continue to flow in Shanghai stocks, feeding the bubble frenzy. The fifth hike in bank reserve ratios since June has only slowed the annual growth rate of China's M2 money supply from an explosive 19.1% to a robust 15.9% rate last month.
So far, the PBoC's open market operations to drain liquidity have only put a floor under Shanghai money market yields rather than pushing them up. The PBoC plays a clever shell game, but is still pegging its 7-day repo rate in a range of 1.50% to 2%, which encourages speculation in stocks. The PBoC bought about $250 billion a year in 2005 and 2006, but only about 75% of such intervention was sterilized.
Until the PBoC lifts interest rates high enough to discourage borrowing, it won't be able to contain the robust growth of the money supply. Official data revealed that yuan-denominated loans jumped 567.6 billion yuan ($74.7 billion) in January, twice as much as last year's monthly average, to 23.1 trillion yuan, up 16% from a year ago. Chinese banks arranged 3.18 trillion yuan in new loans in all of 2006, exceeding the central bank's original target of 2.5 trillion yuan.
Therefore, an interest rate hike seems inevitable, as reserve ratio adjustments and open market operations have failed in curbing liquidity and lending. China's 7-day repo rate has erupted to above 4% on two brief occasions in the past 3-months, linked to strong loan demand for stock market IPO's, but it mostly trades below 2%, due to large to inflows of money from foreign investment and exports.
Is the Shanghai stock market in a Bubble?
It's popular to call a market that triples in value within less than two years, a bubble, but seen from a different angle, the spectacular resurrection of Shanghai "A" share index might have corrected a grossly undervalued position, into closer alignment with the global benchmark MSCI All-World Index, which closed at all-time highs of 1500 last week, up 100% from its low in March 2003.
From 2001 thru 2005, China's economy and the Shanghai "A" share market spent much of time moving in opposite directions. China was emerging as the world's leading manufacturing power, its economy was growing at an frantic 9.5% pace, and exports were tripling, yet the Shanghai A share index, lost half of its value, sliding from a high of 2200 to below 1000 on June 6, 2005.
Daily turnover in Shanghai declined to an average of 8 billion yuan (US$1 billion) at the end of 2005, down more than 25% from the previous year. The overhang of massive blocks of government-owned shares in the listed State-owned enterprises was responsible for much of the decline. Known as "non-tradable shares" (NTS), these share accounted for two-thirds of the $400 billion market value of the companies listed on the Shanghai and Shenzhen stock exchanges.
The threat that Beijing would one day flood the market with NTS shares helped send the mainland share indexes to six-year lows in 2005, although the Chinese economy and exports were booming and other Asian and global markets were posting big gains. On June 6, 2005 the Shanghai stock index dropped to 998.23 points. Two days later, however, the Shanghai and Shenzhen stock exchanges jumped by more than 8 percent. The Shanghai A share index closed at 1,115.58 points.
Beijing announced a new policy to reform the split structure of mainland shares, which took into consideration the rights of holders of exchange traded shares, who bear the risk of decline in share prices when state owned shares are dumped on the market. Compensation is now paid to holders of floating shares when NTS shares are put on the market, and determined at an extraordinary shareholders' meeting, and are subject to prior approval by at least two-thirds of holders of floating shares.
Compensation to floating shareholders was paid with bonus share and supplemented with cash. By July 2006, more than 1,000 listed firms, or 80% of all listed companies had adopted resolutions for the reform of nonnegotiable shares. The ongoing reforms will mean the end of the split share structure, which crippled China's stock markets in recent years, and eventually replaced with one class of shares.
Thus, the black cloud hanging over the Shanghai and Shenzen markets was gradually removed in 2006, and share values were unleashed from artificially low levels, and quickly caught up with other inflated world markets. Gradual yuan appreciation is attracting foreigners to Chinese stocks and encouraging local investors to keep money onshore.
But what disturbs Chinese government officials are signs of a speculative bubble in the stock market. Investors opened 50,000 retail brokerage accounts a day in December and mutual funds raised a record 389 billion yuan ($50 billion) last year, quadruple the 2005 amount. January turnover was five times early 2006 levels. Beijing is now ordering banks to prevent retail borrowing for stock investments.
China's stock markets are dominated by retail investors, who hold 60% of the total trading shares. By comparison, in Hong Kong, which lists a number of mainland Chinese companies, institutional investors account for 70% of daily transactions.
The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. The high P/E ratio is supported by expectations of 25% earnings growth for 2006 and 2007, from the possible new tax policy and new accounting standards starting from 2007. However, if 2006 corporate results fail to meet strong expectations, Chinese investors could easily dump inflated stocks, and send the overall market into a tailspin.
Might Beijing tighten its grip on monetary policy too far in an effort to contain high-flying Shanghai red-chips, even at the risk of triggering a deeper slowdown in the Chinese economy? If history is any guide to the future, the PBoC could control its economy, with a series of small rises instead of infrequent, bigger changes. China should also continue with a gradualist approach to yuan appreciation, and let the currency strengthen by about 5% a year. But would that be fast enough to fend off a protectionist bent US Congress?
Déjà vu in Tokyo, a Stock market Bubble Emerges from Cheap Yen
Is it possible for central banks to devalue their economies to prosperity? Tokyo's financial warlords have the tonic for whatever ails the Japanese economy - a cheap yen. The Japanese yen's real trade-weighted value hit a 21-year low in January energizing its export-driven economy by making Japanese goods cheaper than European and Korean goods, and propelling its exports to a record high in 2006.
Tokyo has pursued a weak yen policy for the past few years by pressuring the Bank of Japan to keep its overnight interest rate near zero percent, and forcing the central bank to monetize about half of its budget deficit. The BoJ buys 1.2 trillion yen of government bonds each month, which if maintained in fiscal 2007, would equal 56% of the projected government budget deficit of 25.5 trillion yen.
Super low interest rates have weakened the yen and helped to boost the local stock indexes. Tokyo's broad equity market, the Topix, touched a 15-year high and the Nikkei-225 is near its highest since May 2000. The two indexes have risen more than 6% and 4% year-to-date, outperforming a number of emerging markets, putting them on a par with high-flying European stock markets.
Foreign investors have pumped 9.1 trillion yen ($76.2 billion) into Japanese stocks and equities over the past three months, and received a timely batch of good news from Tokyo apparatchniks on Feb 16th. Japan's economy grew at a 4.8% annualized clip in the last three months of 2006, the strongest pace in 3-years, and far exceeding July-September's anemic 0.3% annualized growth. Private-sector demand showed a 1.1% gain, rebounding from Q'3 when it dipped 1.1 percent.
It's a big stretch of the imagination to believe that Japan's economy has suddenly vaulted into first place from last place, to become the locomotive for the G-7 industrial nations. But after-all, these are the same government apparatchniks that re-jigged Japan's consumer price index in August, shaving two-thirds off the inflation statistics, to handcuff the BoJ from any further rate hikes since July.
Tokyo boosted its stock market gauges thru manipulation of economic data and abnormally low interest rates that weakened the yen to 21-year lows on a trade weighted basis. But now, Tokyo's schemes are running into opposition from its top trading partners, who are crying foul play, and demand the BoJ lift its interest rates to levels that reflect its $4.7 trillion economy, the world's second largest.
Since the BoJ dropped its overnight loan rate to zero percent in March 2001, the Euro has advanced from around 105-yen to as high as 158.70-yen today. Aided by the Euro's strength against the yen, Japanese exports to the European Union nearly doubled to 1.06-trillion yen in December. But on the flip side, European exports to Japan have waffled between stagnation and deterioration.
Last year, Japan racked up a 18.6 trillion yen ($160 billion) current account surplus, while the Euro zone suffered a 16.8 billion Euro $21.5 billion) deficit. Yet the power of the "yen carry" trade was able to swim against the tide of these trade imbalances, by pushing the Euro 12% higher against the yen last year.
While Japan is a small market for European exporters, Euro zone finance ministers understand that its exporters will suffer in world markets because of cheap competition from Japan in addition to cut-throat competition from China. With the European Central Bank poised to lift its repo rate a quarter-point to 4.00% in the months ahead, the Euro is bound to go higher against the yen, without similar baby-step rate hikes by the BoJ, thus worsening the bi-lateral trade imbalance.
European Central Bank chief Jean "Tricky" Trichet expressed his frustration with Tokyo warlords and their cheap yen scheme on Feb 15th. "I will read again what we just said in Essen, we reaffirm that exchange rates should reflect economic fundamentals. We believe that the Japanese economy is on a sustainable economic path and that exchange rates should reflect these economic fundamentals," Trichet said after Japan released its stellar GDP report.
Central bankers and finance ministers from the Group of Seven industrial powers, that account for 65% of global GDP, warned currency traders on February 10th, that they could get burned by betting in one direction against the yen, with Japan's economy was steaming ahead at a 4.8% clip. "One-way bets in the present circumstances would not be, it seems to us, appropriate. We want the markets to be aware of the risks they contain," ECB chief "Tricky" Trichet warned.
A week earlier, Chicago futures speculators had built-up record short positions against the yen for a third straight week to 173,005 contracts from 164,860 contracts in the prior week, the CFTC said. The large short position left Chicago speculators vulnerable to a minor shake-out from G-7 jawboning. The dollar tumbled 2% to 119-yen, before rebounding to 120.85-yen a few days later. Jawboning ran its course, but the fundamentals of the carry trade haven't changed.
Bank of Japan hikes loan rate to 0.50%, "Too Little, Too Late"
With the yen's trade weighted value against a basket of foreign currencies sinking to a 21-year low, and Tokyo gold climbing to a 21-year high, the Bank of Japan was backed into a corner, and voted 8-1 to hike its overnight loan rate a quarter-point to 0.50%, its highest level in a decade. But the Euro remains resilient, rebounding from a low of 156.25-yen, before climbing to 158.70-yen after the BoJ rate hike.
Japan's interest rates are still be far below the 5.25% fed funds rate in the United States, and next month, the ECB is expected to hike its repo rate to 3.75% while the Bank of England could boost its base rate 5.50%, keeping the yen weak. By dumping the yen after the BoJ rate hike to 0.50%, traders ruled that the central bank's action was "too little, too late" to reverse its long term trend. The BoJ must face a thicket of political wrangling with Tokyo warlords, before it can raise rates again.
Tokyo gold traders track the Euro's performance against the yen for direction, and are not duped by Tokyo's phony claim that consumer prices are only 0.1% higher from a year ago. As long as Tokyo pursues a cheap yen policy, Tokyo gold stays on an uptrend. Would the BoJ continue to hike its interest rates to combat the gold bugs and prevent a bubble from emerging in the Topix index?
"We will continue to adjust interest rate levels slowly," said BoJ chief Toshihiko Fukui on Feb 21st. "If Japan were to achieve real economic growth of around 2%, even amid very low inflation, a policy rate level of 0.50% is, relatively very low. If expectations build up that very low rates will continue for a long time regardless of economic conditions, banks and companies could create excessively tilted positions in the stock, JGB or foreign exchange market," he said.
Meanwhile, Japan's interest rates remain abnormally low and far out of alignment with the rest of the world, and the "yen carry" trade lives on. An estimated $330 billion is invested the yen carry trade worldwide. What can weaken the Euro against the yen, if Tokyo warlords won't allow the BoJ to lift interest rates to normal levels?
"We believe that a weak yen is a reflection of Japanese government policy," said Rep's Charles Rangel, Barney Franks, John Dingell and Sander Levin. "We urge the Japanese government to reverse their weak yen policy through concrete action. Japan should be selling the massive reserves it has accumulated, thereby changing the imbalances with the dollar and the Euro."
Tokyo could quietly sell some of its $874 billion of foreign exchange reserves, mostly held in US dollars and Euros, on the open market to put a lid on the "yen carry" trade. By selling dollars for yen, Tokyo could use the proceeds to pay down some of the 35-trillion yen in short-term debt it acquired in 2003-04, when it intervened on a grand scale, to support the dollar between 104 and 110-yen.
The Bank of England Confesses its Sins
It was the monetary equivalent of "shock and awe". The Bank of England (BoE) delivered a nasty New Year surprise on January 11th, its third quarter-point rise in interest rates in six months. Bank governor Mervyn King and his colleagues had been expected to push up rates in February, but by ambushing the markets with a January move to 5.25%, they may have hoped to make more of an impact.
"The margin of spare capacity in the economy appears limited. It is likely that inflation will rise further above the target in the near term. The risks to inflation now appear more to the upside," the BoE explained. But London's FTSE-100 all but shrugged off the rate hike. It suffered a 30-point fall to as low as 6,140 just after the announcement, but then closed the day 70 points higher. After stabilizing above the 6,200 level, the Footsie-100 tacked on another 5% gain to 6,450 last week.
It wasn't so long ago that even a hint of an interest rate hike sent traders scurrying for the hills. So clearly, like everything else, the markets are putting a positive spin on what would normally have been a nasty surprise. The fact is that interest rates have been too low for too long, and few traders take the BoE seriously. But bringing the UK economy back into balance will unfortunately require a lot more discomfort than the slap delivered by Mervyn King and his chums last month.
For the past four years, the BoE pursued the most radical monetary policy among the Group of Seven central banks, pumping up its money supply to inflate British home prices and the local stock markets. UK home prices rose 10.5% last year, according to Nationwide, a UK home-loan provider, while the UK's Footsie-100 index climbed above the 6400-level last week, to its highest in six years.
But after the UK's M4 money supply expanded by 0.9% in January to stand 13% higher from a year earlier, the Bank of England issued an unusual confession of its past sins. "Investors are likely to take advantage of this ample liquidity and the associated easy credit to purchase other assets, driving risk premiums down and asset prices up," the BoE told parliament's Treasury Committee on Feb 20th.
"In due course, those higher asset prices may be expected to feed through into higher demand for goods and prices, putting upward pressure on the general price level," the BoE concluded. Still, there are plenty of signs of complacency in the Footsie-100 Index, with Sterling Libor futures for June delivery yielding 5.75%, and discounting the possibility of two more BoE rate hikes in the months ahead.
Years of monetary abuse by the BoE are finally coming home to roost. In order to get a handle on the explosive M4 money supply, the BoE would probably have to hike its base rate by at least 75 basis points to 6%, far above the 5.25% US fed funds rate, and the BoJ's 0.50% rate, which could put more upward pressure on the British pound against the Japanese yen and US dollar.
But a stronger British pound could widen the UK's trade deficit with the rest of the world, after it notched its largest annual trade gap on record last year. Britain's goods trade gap grew to 7.1 billion pounds in December,cementing to the largest annual trade deficit in 40-years, with the total trade gap of 55.8 billion pounds in 2006 from 44.6 billion in 2005. The goods balance registered a record deficit of 84.3 billion pounds last year, from 68.8 billion in 2005.
The massive deterioration in the UK trade balance has been accompanied by the British pound's rise to 235-yen, it's highest in 14-years. British manufacturers will find it hard to compete with their Japanese competitors, who enjoy a cheap yen, and super low interest rates at home. Yet if the BoE aims to tackle the explosive M4 money supply by lifting its base rate, without similar rate hikes by the Bank of Japan, it could wreck further damage on Britain's export sector.
How far would the BoE go to contain its money supply and prevent the emergence of asset bubbles? "British interest rates will probably need to rise one more time to keep inflation on track to hit its 2% target," the Bank of England signaled on Feb 14th. Yet one week later, the BoE ratcheted up its hawkish rhetoric by focusing on the explosive growth of M4. Lately, BoE chief King has shown a penchant for the big surprise, outflanking his counterpart Jean "Tricky" Trichet, so stay tuned.
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