The Bull in the China Shop

By: Sean Corrigan | Mon, May 21, 2007
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"Under present conditions, no sensible person can expect that owners of dollar balances will wait, undismayed, until the only liquid assets that are the counterpart of their claims vanish... Of course, interest rates tend to decrease at the beginning of inflationary periods because there is an abundant supply of money... The quest for tangibles, gold, real estate, and works of art, which is the inevitable counterpart of reducing cash holdings or assets denominated in currency to a minimum, accounts for all the features of the monetary disruption developing before our eyes..."

Jacques Rueff, The Monetary Sin of the West


Lately, much attention has been focused on the role of the private equity-hedge fund-prime broker nexus in fuelling financial excess and rampant asset price inflation in just about any market one might care to name, but this is not to say that there is no evidence of more traditional market madness taking hold elsewhere.

Take, for example, a Chinese market which seems to have learned from the late excitement in February only that it may ignore, with near impunity, any strictures emanating from Beijing about its unruly behaviour. Indeed, so convinced are both retail and institutional players of the upward trajectory that the index shot to a six-month gain of no less than 179% by mid-May - and this despite yet another two hikes in the reserve ratio and one in the lending rate being announced by the PBoC and with not a moment's thought being given to rumbling of another clampdown on 'suspicious' share movements emanating from the nation's securities regulator.

Three months ago, rumours that state-run asset managers were selling stocks had helped aggravate a sudden double-digit decline. But already, only eight weeks on, this particular tiger seemed have lost its teeth. Certainly, that is the construction we could attach to the total disregard which was paid to comments made in late April by Gao Xiqing of the National Council for Social Security Fund.

Revealing that the Fund would have to sell up to a quarter of its equity holdings (if only in order to come back into compliance with its investment guidelines), Gao told a conference audience that:-

"This market seems to be defying gravity. It's got to come down at some point. We can't risk that, especially given the nature of our fund. The market is making me nervous."

Mr. Gao may well have been biting his nails, but his forebodings were clearly not shared by those investors who bid the CITIC IPO to a point where the bank was valued at approximately half of the worth of that other, less exotic target of insistent desire, ABN AMRO; this despite the fact that the latter not only has an incomparably greater pedigree but that it recorded earnings almost 12 times as large as its Chinese rival last year.

Nor would there appear to be much anxiety being expressed (except of the inverse kind of being left out of a booming market) by those eager, would-be punters in the shares to be issued by BOCOM, China's sixth largest lender; a crowd who between them submitted bids of no less than $188 billion (a total larger than JP Morgan Chase's entire market cap).

Don't think, either, that the feeding frenzy was restricted to financial concerns, for the listing of aluminium giant Chalco's shares in Shanghai saw them triple in value on the opening day- reaching a lofty vantage point where they were double the price of the Hong Kong equivalents and grading the company at a P/E roughly twice that of its two main western competitors, Alcan and 8% shareholders Alcoa. (This should prompt a cynic to wonder if CEO Belda could not do his shareholders a lifetime's service simply by backing the firm into its Chinese partner, using paper issued into the manic, mainland market to effect the transfer).

Of course, while this trend persists, official attempts at cooling the bubble will also prove well-nigh impossible. Given that only some 45% of the record-breaking quarterly foreign exchange reserve influx of $136 bln can be attributed to either the trade surplus ($46.45 bln) or to reported fixed direct investment receipts ($16 bln), we are left with the conclusion that over $20 billion a month has found its way into China - legally or otherwise - in order to speculate on a further appreciation of either the Yuan, or the Composite index, or both (circumstantially, we might note that IPO receipts so far this calendar year amount to some $50-odd billion - surely a close enough correspondence for a conviction to be secured).

Thus, we can expect the Chinese policy dilemma (or 'trilemma', if we adopt Robert Mundell's formulation) to persist for some time yet and, therefore, for the country's undoubted (and already impressive) secular advance to be overlaid by a far less stable, but all too tangible, hothouse atmosphere, driven by a sizzling degree of monetary stimulus.

All well and good, but what are the implications for the commodity investor - or indeed, the hard-pressed commodity producer?

For one, it seems that the inflationary engine may be about to change gears as excess foreign exchange reserves are no longer passively 'recycled' back into holdings of the sovereign and semi-sovereign bonds issued, especially, by the two main external deficit nations, the US and the UK.

It is no secret that the Asians are becoming both a little embarrassed by the sheer scale of their chronic surpluses and a touch disquieted at the depressed returns attainable on these hoards (the second a partial consequence of the first).

One or two of them - as well as a number of their equally accumulative counterparts among the energy-producers - are also keenly aware that, for so long as they choose not to subject their exchange rates to the unchecked caprice of the broader financial market, their only current alternative is to tolerate the heightened inflation which follows unless every last dollar of the forex influx is properly and exhaustively sterilized. They are further beginning to realize that even this policy is an act of fire-fighting which only serves to perpetuate the problem by precluding the imposition of any meaningful monetary restraint upon the prodigals abroad.

Thus, there is much talk of emulating the performance of Singapore, Norway, and Abu Dhabi by using the reserve balance much more actively as an 'investment' vehicle (we use the quotation marks because we are inclined to view the role of the public sector in investment in only a little less jaundiced a fashion than we do its occasional pretensions to exercise an entrepreneurial or managerial function).

Not only have Taiwan, Korea and China publicly begun to muse about such plans, but the Japanese are said to have a prime ministerial task force hard at work on the potentials and pitfalls were they to follow suit with some part of their $900 bln cashpile. Only this week, the Russians became the latest to announce similar intentions - their plan being distinguished mainly by virtue of being furbished with an actual starting date for implementation, namely 1st February next year.

Thus, with all four of the world's four largest owners of surplus currencies (preponderantly denominated in USD) rethinking their utilization, we have before us the following, tantalizing prospect.

Firstly, such of this $3 trillion mountain as is redeployed will presumably shift one cadre of important marginal buyers of financial assets into acting so as to help stabilize the inordinately low risk spreads which currently prevail. Ironically, such funds will probably come to cultivate a penchant for 'alternative' investments, thus providing a hitherto untapped source of leverage by buying into hedge funds, derivatives, and private equity (as has, in fact, already been announced vis-à-vis the Blackstone group).

Secondly, the managers of the new funds will certainly seek out direct participation in 'growth stories' and so may help to underpin the tentative steps already underway which are aimed at delivering more of the thrifty Asians' and other emergent nations' financial capital directly into the tender-cars of their own, regional locomotives, instead of washing though commission-hungry Western intermediaries whose sense of priorities cannot fail to be misaligned with those who ultimately underwrite them.

Thirdly, resource-hungry nations will presumably seek out more of the requisite resources or - at the very least - they will look to acquire meaningful equity participations in the producers and processors of such resources, as also in their equippers and service-suppliers.

After all, if, say, a China can help finance an expansion of output of, say, base metals - all to the good. If such a task turns out to be beyond physical accomplishment - well, at least the rising share price of the miners will provide some sort of offset to the higher import bill to be expected.

Fourthly, by spending more money either on goods or on the co-ownership of productive assets abroad - rather than unimaginatively financing the warfare-welfare states of, and abetting blind real-estate speculation in, the debtor nations, as at present - the process of 'rebalancing' away from an inordinate reliance on Anglo-Saxon overconsumption and financial prestidigitation would be greatly facilitated. In return, the enhanced inward flow of products would mitigate some of the worse impediments to further progress being felt at present in several of the surplus nations.

Moreover, given the possibility that the American house-owning sector might soon be forced to curtail its recent, debt-fuelled over-indulgence, the emergence of such an external source of both capital and sales revenues for viable businesses, there and elsewhere, would be a welcome offset to any temporary diminution of spending which resulted.

Indeed, one could almost imagine a virtuous circle whereby a one-off devaluation of the offending currency was underpinned by a thoroughly salutary reduction in consumptive borrowing (assuming the inflationists at the central bank and the New Dealers in federal government can each resist the urge to interfere too much). This would lead to an overdue re-emphasis on export markets, added value endeavour, and employment income as the mainstay of spending power - and so provide a welcome contrast to the unmatched imports, inflationary finance, and individual improvidence which pose such a profound threat to our general prosperity today.

If, along the way, real resources were to regain an advantage over financial fictions - if more money was then made mining molybdenum than manoeuvring over a merger; if Canadian oil sands performed better than credit default swaps, if manufacturers of hedge cutters earned more than managers of hedge funds - who would we be to argue?



Author: Sean Corrigan

Sean Corrigan,
Chief Investment Strategist,
Diapason Commodities Management,
Lausanne & London

Copyright © 2006-2007 Sean Corrigan

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