China Rate Hikes

After yesterday's cautious comments on China's economy by Premier Wen Jiabao, China is raising rates:

China's central bank said Saturday it will raise interest rates in an effort to rein in the country's red-hot economy, according to published reports.

The People's Bank of China will raise rates 27 basis points, lifting the benchmark one-year lending rate to 6.39% and the one-year deposit rate to 2.79%. The changes will take effect Sunday.

More context here (Reuters):

The yuan has now appreciated about 4.8 percent against the dollar since Beijing revalued it by 2.1 percent and set it free from a dollar peg to float within managed bands in July 2005. It touched a post-revaluation high on Friday.

But many economists say the only way to close off the tap of liquidity at the source is to let the yuan strengthen even more so as to make Chinese exports more expensive.

That would help ease the swelling trade surplus, which hit a near-record $23.76 billion in February, far more than expected.

The central bank, in an effort to keep the yuan stable, buys most of the dollars generated by the surplus, for which it must in turn print yuan, thus flooding the banking system with cash.

Gao Shanwen, chief economist at Everbright Securities in Shanghai, said he thought the interest rate rise would only exacerbate that problem.

"Higher interest rate rises can help slow down investment and domestic consumption. With domestic consumption weakening, more and more goods would have no market at home and have to be exported abroad, which would make the trade surplus even larger," Gao said.

Gao has a point: many skyscrapers, consumer goods etc. are made on the premise that consumption will grow sufficiently over the coming year to fulfill orders and demand in the future. If consumption comes off, then this means exports play an increasingly important role in the growth of China's economy. That means you need a very strong U.S. economy to swallow up the excess consumption which cannot be provided for at home, as well as an increased addition of foreign investment to keep those new skyscrapers full.

The effects a rate hike like this - and future rate hikes - may have on global commodity prices will be interesting to see. I pointed out this week that steel may become a lay casualty (for the above reasons), while also pointing to pending rate hikes in China and India, and the consequences of such (Steel & The Carry Trade: Reflexive Market Duality).

Further notable commentary from Aaron Task today at thestreet.com too over next week's implications (Coming Week: Spotlight On Central Banks):

In the wildcard department, Chinese Premier Wen Jiabao made some eye-opening comments Friday, characterizing his country's growth as "unstable, imbalanced, uncoordinated and unsustainable," Bloomberg reported.

The reaction to Wen's comments was notably muted Friday, which may suggest Asian markets' late-February rout was an isolated event. But similar to the time the premier's Chinese New Year holiday declaration about corruption and fraud spurred those massive losses in Shanghai, investors will have two days to mull Wen's latest comments, as detailed here.

In addition to any postmull reaction to Wen's warnings and the subsequent rate hike by the People's Bank of China Saturday, Monday is also the first day of a two-day BOJ policy meeting. Japan's central bank is largely expected to keep rates unchanged at 0.5%. But any comments about future rate hikes could revive fears of an unwinding of the yen carry trade -- or even actual unwinding of trades made by borrowing yen to finance investments in high-yielding securities around the world.

Summary: Markets in Asia Monday/Tuesday (and knock-on effects on the Dow) will be notable.

China's Premier: Growth "Too High"

China's Premier goes on record today in Beijing about unsustainable growth in the country:

March 16 (Bloomberg) -- China's economic expansion, the source of about a 10th of global growth last year, is unstable and environmentally unsustainable, Premier Wen Jiabao said.       

``China's investment growth is too high, lending growth too fast, liquidity excessive and trade and international payments very imbalanced,'' Wen said at a press conference in Beijing today. Energy efficiency and environmental protection issues haven't been ``properly resolved,'' he said.                

Wen's comments underscore government concern that too many factories are being built in China, worsening pollution and leaving the world's fastest-growing major economy vulnerable to a slowdown in demand. A record $177.5 billion trade surplus has flooded the economy with cash, making it harder for the government to cool investment by reining in bank lending.      

``China has maintained relatively steady and fast growth over the past few years, but this is not a time for complacency,'' Wen told reporters at the National People's Congress meeting. ``The biggest problem in China's economy is that the growth is unstable, imbalanced, uncoordinated and unsustainable.'

This is very big news, and effectively amounts to an admittance that the next growth revisions we will probably see for the country will be around 8 - 9%. While this is still strong, it will have wide-ranging impacts for demand in commodities in particular, to growth in the south east Asian region.

The reaction by Chinese markets however seems small: just a dip of 0.72% in the Shanghai  Composite Index to 2930.48, barely a blink from the Hang Seng, down 0.08% at 18,953.50, and even the heavily leveraged and volatile B-share index in China is off just 1.36% to finish the week at 170.21. There is almost certainly bigger declines headed for Monday/Tuesday, especially if the sub-prime fiasco in the U.S. continues to make waves across the world over revised import trends.

*UPDATE* 12.04 pm Further context at thestreet.com where I'm looking at this situation in more detail (Another Shot Across Asia's Bow):

In Hong Kong, investors were speculating over the potential effects of the debacle surrounding subprime mortgages in the U.S. and revisiting the importance of the yen carry trade -- the borrowing of yen to finance investment in higher-yielding assets elsewhere. The broadest consensus is that the subprime mortgage deterioration, despite constituting less than 10% of America's mortgages, will prompt banks to tighten credit standards. That could undermine U.S. consumer spending and prove a drag on Asian exports.

Chisato Haganuma, a senior Japan strategist for Nomura Bank in Hong Kong, says Asian exports -- a crucial source of income to the region -- will "soften considerably" and that the second-quarter outlook for the region is "gloomy".

Just as appetites for risk were starting to normalize again, fears that the U.S. subprime dilemma may have a further destabilizing impact on exports are prompting renewed concerns about an unwinding of the carry trade.

Steel (& The Carry Trade): Reflexive Market Duality

Over at thestreet.com today, I'm taking a look at the potential impacts of the recent Asian emerging market mayhem on the price of steel, and what this says for the global economy (Steel Could Be the Next Victim):

Steel's bulls and bears do agree that global interest rate hikes are coming. If the price of steel continues to climb, then a large segment of manufacturing becomes more expensive, potentially resulting in higher consumer price inflation as producers seek to pass along the price hikes. But those who see the price of steel as already overvalued also see this as a consequence of overheated emerging-market economies, which are overdue for interest rate hikes.

"Both China and India have not raised interest rates sufficiently to cool their economies, while infrastructure project demand is still germinating," says Darby.

Furthermore, if global rate hikes are afoot, growth of emerging-market economies would slow, pushing the price of steel down as oversupply in these economies materializes.

It's kind of a rate hike Catch-22, with steel caught right in the middle as both a product and casualty of volatility in consumption, and hence global markets. I would say at this stage steel is in the process of going from becoming a tool by which you can gage market reactions to one which is driving certain market reactions, especially in duality with the yen carry trade. The problem is, it's also - just like the carry trade - reacting to market reactions as well, creating a reflexive tension (and this is why you're seeing so much volatility right now, with the Dow swinging wildly below the 12,000 level intraday for the first time since December today).

More on the carry trade later.

Japan is still strong

Remember what I said about the Nikkei being a buying opportunity?

This is one reason why: Japan's Economy Grows at Fastest Pace in Three Years (Bloomberg):

March 12 (Bloomberg) -- Japan's economy expanded 5.5 percent in the fourth quarter, the fastest pace in three years, as surging exports prompted companies to increase spending on factories and machinery.         

Growth in the world's second-largest economy exceeded the government's initial 4.8 percent estimate in the three months ended Dec. 31, the Cabinet Office said today in Tokyo. The result was more than the 5.1 percent median forecast of 23 economists surveyed by Bloomberg News.         

``Japan's economy is solid and will keep expanding, driven by a solid corporate sector,'' said Takuji Aida, chief economist for Japan at Barclays Capital in Tokyo. ``The economy is likely to exceed at least its potential growth rate of 1.8 percent in the first quarter.''

I will get around to expounding the Japanese argument, but suffice it to say for now this is a great zone for foreign investment, principally because it's a great bridge between Chinese and U.S. growth.

It's the economy most of us have been longing for - pretty stable U.S-style fundamentals (especially given that lots of the accounting discrepancies have been ironed out since the early-90's debacle) with immediate access to Asia's boom-bust market sex-appeal.

India's 36 Billionaires & The Billion With Just $36

This has to be the most naive piece of propaganda-masquerading-as-financial-journalism I've seen in a long time:

Beijing, Mar 11: Indians topping Forbes' list of Asian billionaires, replacing the Japanese, have flabbergasted the Chinese, who are regularly reading that India is not shining as reported by the Western media and experts.

"I am surprised that Indians have topped the Forbes' list of Asian billionaires," Chen Yu, a media consultant said.

"I must change my distorted impressions about India," she said.

With 36 of its citizens worth over a billion dollars, India replaced Japan as Asia's top breeding ground for the super-rich, the Forbes 2007 listing of billionaires said this week.

Amongst the top dozen Asian billionaires, there were eight Indians led by steel baron, L N Mittal. Asia added 54 new billionaires in the last one year, 14 of which were from India. In other words, every fourth new Asian billionaire was from India.

Compared to the impressive performance by Indian entrepreneurs, the only mainland Chinese to figure among the top 70 richest amongst Asians was Yan Cheung, the self-made woman entrepreneur of Nine Dragon Paper Co, who is the richest in China.

Unfortunately, the assumptions made herein are all too often made by people lacking understanding in what constitutes a successful economic environment, but it makes a good point about the often forgotten ingredients of capitalism.

It's often assumed that the richer the people in an economy, the more impressive it is. In fact, more often than not, nothing could be further from the truth.

Here is what the message of the article really reads: compared to India, China resembles a hub of stability and economic growth (this alone should sound warning signals to those thinking of investing in India right now too). Because when you have a country with piss-poor infrastructure development, more than 80% of the entire country living below the international poverty line, and weakly power outages, all having the highest number of billionaires in the region says is that compounded to these problems, you have an enormous wealth distribution problem, where a disproportionate amount of capital is concentrated within a very thin slice of your society.

One of the criticisms most of often lobbed at a system of open-markets is the inherent inequality such a system creates, but in reality nothing could be further from the truth. It's the reason economies like the U.S.A. and the U.K. are, for example, stronger and more stable than say, the Chinese or the Indian economies. The fact is, in order to have an efficient market system, with long-term sustainable growth created by constant re-investment and spending, the ideal system is one in which more people have more-or-less the same reasonable level of capital available to them, rather than one where a slice of society owns everything. This is only logical: the more market actors, the broader the spread of investment and spending in an economy.

This article is also a a great example of another often-made mistake by even quite senior market analysts: that you can use the same comparables for emerging markets as you can for developed countries. The reason it's impressive when an economy such as the United States' announces the number of billionaires has increased is that proportionately speaking, there's a pretty good spread of the wealth in the economy already, so the number generally indicates a surge in entrepreneurial activity prompted by aggressive capital markets. In India, where one billion people would be happy with $36, 36 billionaires is quite another story altogether.

By advertising that despite shaky capital markets, inefficient transportation, loose power lines (and that's being generous), 75% of her female population currently completely illiterate, India has the highest number of billionaires in Asia, the country only serves to re-enforce the risks and inefficiency in her economy. That's not to wipe India off the emerging markets watch-list, but it is a red light.

U.S.A. & China

Anyone following the performance of the Asian markets this week can be forgiven for feeling a little uncertain about what's going on right now. On Tuesday, the Shanghai stock exchange tanked nearly 9%, bringing the Dow Jones down 415 points with it and making news across the world, the next day it rebounded 3.9%, Thursday the market slumped again nearly 3% and in today's trading it inched up 1.23% again. Tarrying the performance with other markets in Asia only leaves one more confused: on Wednesday when China was strong, the Hang Seng and the Nikkei continued their spiral in the other direction. Only the past two days have we seen some kind of conformity in Hong Kong and China's market performance, but it's safe to say that by and large results are mixed, and even then, as these markets have finally regained a small footing (the Hang Seng ended the day up 95.41 points yesterday at 19,442.01), Japan fell further today and at the time of writing the Dow is trading down 75 points at 12.159.44.

While all this is a volatility trader's reprise for the several months of straight vertical performance we've had in world markets, it doesn't say much about what's to come for the majority of us.

First of all, while there may seem like a general feeling right now that things are not good for markets, this is a gross over-simplification of what's going on, so I'll explain the general arguments and then then I'll give my take.

In China, the most widely-touted argument going around right now is that while market performance is uncertain and stocks may be overbought, the underlying economic growth of the country is actually pretty strong. In other words, keep buying into China and doing deals there, just stay away from the Shanghai and other regional stock exchanges right now. This has to be the most misleading piece of economic propaganda I've heard come out of the region in a long time. Just relate it to the argument being made about the U.S.A and you'll realize it makes no sense at all.

In America, the argument is that the economic performance of the country is slowing down, and so markets too don't look such an attractive bet right now. The U.S. global goods report released last week, indicating that perhaps we'd all just got a little ahead of ourselves with our positive forecasts, was in part responsible for the big reaction on Tuesday, and this type of data is still having an impact on the shelling spree we are seeing in the Dow, the NASDAQ and the S&P. In fact what we are seeing in the markets now is exactly the type of scenario I predicted we would see in Q3, it just came earlier than expected. This makes sense given the Asia context too, which many forecast as inevitable but "earlier than expected".

The point is, you don't get strong economic growth and slumping markets in an open economy - at least not for long, because such disparities contradict one of the most fundamental principles of macro-economics: that if there's a buying opportunity, someone will see it and snap it up. In other words, if it was possible that you could have a booming domestic economy with weak domestic markets, it wouldn't be for a very long period because it would be an enormous arbitrage opportunity that everyone would see and buy into until markets reflected economic performance, and the situation returned to parity.

So, if China's economy is still booming and America's is falling apart at the heels we should seize this opportunity to buy China and go along with all the bears in the U.S. and sell the Dow, right? Completely wrong, and here the argument gets slighty more complex. Once a market is established in a country as a primary force of capital entry and exit, that economy in which the market operates is to a large degree affected by that market's performance, with little abstractions. Remember the period 1996 - 2000? U.S. markets were surging upwards, and the economy followed. Business was created, companies had more capital to play with, and everyone by and large got richer; if they didn't actually get any richer they at least felt richer (i.e. that an opportunity was 'just around the corner') and they spent more, meaning business got richer again.

What China has done over the past few years is viciously promote its own domestic markets - sometimes to the point where she declared she had no need for U.S. capital since her domestic markets were flush with cash - and as a result, China has come to resemble a typical open market-based economy. Now, what happens to a market-based economy when it's way overbought? You can answer that question by looking at the United States in either 1929 or 1999/2000. The market spirals, and all the processes described above during that period go into reverse.

Here's a practical example. Let's say a year ago someone came to you with a hot new Chinese company idea and said "we're raising $50 million right now, do you want in?" You'd be stupid not to say yes. And what about if the same thing happened today? You'd be more hesitant, and so would everyone else, which means either the capital needed to start the company wouldn't materialize and it would never get off the ground, or that it would take longer to materialize and it would be delayed. Which means either no more jobs created by the new company or jobs created by the new company would come open later. The point is, either situation doesn't encourage faster, and deeper economic growth.

By taking such enormous state-owned companies like the big banks and industrials to market with such a fanfare, China has pegged her economy to the market, and what we are seeing now and about to see is the first example. Her economy is far more led by her local markets than people are willing to let on right now, or even realize. Just because the country is far away and has a billion plus people, it does not mean her economy works differently. A market-based economy is a market-based economy.

Now, in the U.S., we've all forgotten that even a year ago markets were way, way underbought given economic performance, so right now, that doesn't necessarily mean they are overbought. And they're not. The next few weeks will be a fun time for value traders to pick up some cheap deals which were just about looking like they were going to get too expensive quickly. And the economic data isn't that bad. It just says that the U.S. is a huge economy, and it takes time for huge things to grow (i.e. they don't grow at the same pace as they do in the much smaller emerging economies).

This is why my consensus is distinctly for now: buy U.S., sell China. It's not the end for China, but it is a longer term problem than people are making it out to be. And that's a healthy thing, because it shows how far the country has come on in resembling a fully-functioning open market society.