China's stock market boom: what's after the bubble?

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Suddenly China's stock market has boomed. In November 2014 the Shanghai Composite Index was around 2700, and today the market has hit 4574.65, a record high in six years. With monetary policies easing and the official media backing, it is no wonder why the stock market is heating up. 

It is noticeable that two groups of people, aside from institutional investors, have played a significant role amid this bullish wave. The first group is senior-aged Chinese women, or dama, who in Chinese tradition are treasurers of the family savings. They have abundant experiences dealing with family portfolios, and sometimes the performance of damas even outstrip that of a professional investment banker. The other group is the gen-90 young people (including me), who invested their generous amount of pocket money into the stock. Not only did the market accumulated mass leverage capital, it also absorbed a considerable proportion of household savings, both of which have contributed to inflated asset prices that have nearly doubled in less than half a year.

The bubble theory emerged again for China's stock market rush, although the bubble can only be observed after it collapses. It is reasonable to deem China's stock prices overvalued at present, taken China's not so satisfying first season economic data into consideration. So what will happen after the bubble burst is of greater concern. Of course, there will be people bearing the loss. But more importantly, what would the mass capital turn to invest after they escaped from the stock? 

On March 30th, tax and rate cut for real estate purchase were finally announced in order to support China's housing market. With high existing inventory and newly added ones, this policy hasn't really taken its effect until now. However, apartment inventories are now declining at fast rate, and it is very possible that between June and September housing price in China's major cities will rise sharply. Traditionally China's individual investors favor housing investment more than stocks and bonds because of its immovable property nature. However, after the 2014 adjustment, real estate investments in China's minor cities are no longer safe. It is therefore a trend-to-be that the mass liquid capital out of the stock market will move into the estate market of China's mega cities in the second half of 2015, and a similar boom in housing price would be witnessed after the stock market bull makes its curtain call.

Pitfalls of China's New Model

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对于中国来说,是三月份一个月会议。首先,中国共产党和中国人民政治协商会议州议会。然后,博鳌亚洲论坛,达沃斯相当于中国人。这标志着在经济意义上的中国新一年的开始,因为进入的政策和发展目标的信号在这些约定好释放。对于2015年,允许较低的增长速度,更多的结构性改革将成为“新常态”,并根据不同的经济部门,保持了7%的增长就足够让中国的十年末达到其目标而这样的年度目标,其实是充满挑战鉴于全球经济形势。更重要的是,新的经济增长引擎正式提出,如互联网产业和技术创新,皮带和道倡议连同其理事机构的AIIB(亚洲基础设施投资银行)。然而,过多的乐观情绪中引起这些镀金的前景和朗朗上口的口号,以支持新的中国模式已经成为微博上的hashtag。然而耐人寻味的新兴企业和互联网企业都,前提是之前中国的经济可能需要依靠 大量的 他们。 


周一,3月30日,伴随着中国的财政部中国人民银行宣布新政策水桶中,除了削减在月初的速度支持住房市场。这包括削减交易税,并要求首付的住房抵押贷款。在财政方面,财政大臣娄肯定,更多的政府债务互换,可能在大约十万亿日元的大小,将全年实行,并且将有大约七万亿日元批准的基础设施投资理财的2015年。我的许多同事,谁比我年长,并一直在做经济研究工作多年,发现今年的政策方向类似,在2009年。  从那时起,  高通胀和咆哮的房价主义及其对扩张性政策和热心市民的反感对不同成长之路。然而,中国的新常态在于较低的增长速度温和通胀和健康的发展道路的精髓。这些后果。而类似的策略重新出现,它们只是旧装置到一个新的末端。

Deflation of the Chinese Characteristics

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China's February statistics are all out today. CPI rose to 1.4% from 0.8%, not adjusted for Lunar New Year's price effect. PPI negative growth deteriorated to (-)4.8%, indicating shrinking industrial activities for the 36th month. Growth in total volume of consumable retail, in added value of above-acale industries, in fixed assets and real estate investment all fell considerably and were around 1% lower than expected. 

Picture Source: Baidu
The official explanation for such malperformance as affected by the holiday do not hold. Traditionally, the pre-holiday season has been a period of shopping spree and housing market boom, as families exchange holiday gifts and brag with relatives about new apartment purchase. Thus even with the vacation factor, such significant decline has been rare historically. While the authority never admits that China has already dipped its forehead into the vicious deflation swamp, the PBoC has already lowered both the RR and the interest rate in February to offset the deflationary pressure. However, these monetary efforts didn't improve the situation until now, nor did they establish a clear supportive signal for the market. The 1980s reform and opening transformed China into a market economy of the Chinese characteristics as an adherence to the nation's founding theory. Since then economic policies have been a mixture of Keynesian theories and plans discussed on the annual State Congress. Many analysts compare today's China to Japan in the 1980s, yet there's one more to beware: China's deflation risk possesses unique traits that could hardly be observed in other economic entities. 

With the deeply-rooted tradition of seeking financial stability, deflation in China will cause much more severe consequences than on other economies. As a market economy built on five-year plans, which is hard to not ignore each and every aspect of the economy, industries struggle harder to recover from the business cycle mechanism and obsolete business funded by state capital may grow to big to fail. Household consumption would also fall sharply during deflation and over-thriftiness will dominate again, both due to shrinking returns on property investment (over 70% of Chinese household wealth) and precautionary worries on rising medical and welfare expenses. Asset prices would be tangled into a downward swirl driven by pessimistic expectations and, because China's social insurance funds were largely invested into the stock market, aging problems would intensify and arouse social upheaval. More importantly, no structural reforms could continue delivering positive support for growth under deflation, let alone business innovation and emerging entrepreneurship. 

Preempting deflation in China's situation requires not only monetary easing or targeting on inflation. Also a strong and clear policy attitude should be expressed. Although allowing a slower growth rate benefits the economy from a structural perspective, public policy should not beat off the bushes and only keep "calm" faced with downward pressure. As the former chief economist of the World Bank Justin Lin Yifu puts it, China still has the potential of annual growth rate at 8% for the next two decades based on his model. Given China's rather low GDP per capita and capital resources per person, this is a necessary rate to ensure the general welfare improvement of the Chinese as well as China's evolution to a developed economy. According to Mr.Lin, fiscal investment on infrastructure should remain the foremost engine for growth and help facilitate reforms in areas such as the financial market. It is noteworthy that many rural areas in China remain underdeveloped and many agricultural facilities are obsolete, both of which yearns for fiscal support. China's economic growth still abounds with more opportunities than challenges. However, lack of policy attention on these under-exploited potentials will hurt more than deflation.

China's Consumer Demand: A Caged Growth Engine

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Last year China failed to achieve its GDP growth target for the first time entering the new century. The authority explained that lower growth is beneficial for structural reform in the long run: consumption, along with emerging enterprises that creates consumer demand, should dominate China's economic growth to replace investment and net export in the next decade. Whatever such economic new normal is visioned to be, the January data cannot disguise the fact that China is on the edge of deflation. Besides another negative PPI for the 35th month and shrinking trade statistics, the January CPI is 0.8%, the lowest in the past five years. Considering the fall in oil price, this is still a dangerous figure indicating weak domestic demand, especially when fresh, usually against-season grocery and transportation tickets are much more expensive around the new year season. Another compelling phenomenon can be observed in most cities, where a considerable amount of small retail shops, department stores, middle-priced restaurants and online shopping logistics were either closed or their business hours were shortened half a month before the Spring Festival holiday starts. Last year, on the contrary, these business worked extra hours during the holiday season. The decline in consumer spending is now hard to be neglected. 

Source: Baidu

Why do consumption fall when the government is actually encouraging spending? Some blame on the anti-corruption initiative that damaged related business supported by public funds, which is an unwarranted excuse made up by those at stake, because the essence of the so-called growth and structural reform just lies in better government transparency and improved state enterprises efficiency. But why do commonplace households cut their spending, too? Stumbled economic growth plays a role in, yet what makes consumer demand even more vulnerable to recession is the extra cost of spending in China. Yes, there are "fifty shades" of the tax policy that abuses Chinese consumers that eventually makes their money flee away from domestic market.

For one, imported consumer goods are subject to an average of 15% custom tax, 17% value added tax and 30% consumption tax for recreational goods (cigar, liquor, cosmetics, and vehicles). A typical Chanel lipstick sold in Beijing charges 20% more than that sold in Manhattan (NY consumer tax included), and the same  bucket of milk powder charges around 30% more in China than in Australia. Since cheaper domestic substitutes are exposed to severe quality problems, the business of "online buyers" emerged. From luxury products to baby food, from Japanese electronic appliances to Laduree's Paris-limited snacks, there are always Chinese people living abroad to purchase these products and sell them online to Mainland China. They either physically bring goods back to China, or use shipping agencies for tax exemption. Even with arbitrage, the price domestic consumers pay is significantly more reasonable. When China's economy was in boom, some better-off people may directly buy domestically, and many of them use cash coupon of large face value (such coupon is now forbidden under the anti-corruption regulation) to make purchase. However, due to economic malperformance and policies suppressing property market growth, household wealth of the Chinese shrank, and they became more prudent to buy only at the lowest possible price. The three new engine for China's economic growth is given by officials as domestic consumption, infrastructure investment and foreign investment. At least for now, the first engine remains a fanciful blueprint rather than a pragmatic instrument unless there are tax cut for imported goods and severer quality supervision for domestic products. 

Another lifelong worry that prevents the Chinese from spending their savings is the lack of social and medical welfare. With no social safe net, spending today means potential life threat tomorrow. Even the richest group of people have these precautionary concerns, and they'd rather invest over 85% of their wealth in the real estate market for financial stability after retirement. Many young couples have to afford the medical and nursing expenses of four parents (usually from rural area, not eligible for free medical insurance) while raising their children. Therefore, the fiscal policy should create purchasing power for households on a life-quality-improving purpose. Most directly, the personal income tax should be collected on a family basis instead of individual by individual to account for average disposable income among family dependents. Tax exemption can also be practiced as an award for those who promoted social good, eg. micro-business entrepreneurs,  blood donators and (dependents of) organ donators, organic agriculture farmers, etc. With a distorted tax structure, the Chinese consumer demand is a caged tiger, niggardly fed by the zoo keeper, highly expected for outperformance in the market circus, and secretly spoiled by the exotic speculating audience. Should it be unchained and appropriately stimulated, this could have been a potent beast to combat deflation and a beauty to attract foreign business investment. 

Finally into the easing club: PBoC to cut reserve ratio by 0.5%

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The PBoC have just announced its decision to cut commercial bank reserve ratio by 0.5%, marking a new round of expansionary cycle for China's monetary policy. Renminbi has depreciated drastically in recent days. In December China have suffered from the greatest capital outflow since 1998. I have analyzed before that China has to implement expansionary measures to preempt domestic deflation risks. While the most efficient policy now may be another interest rate cut, succeeding capital outflow would cause intensified systematic risk for the domestic financial market. With the 20% more reserve ratio an unnecessary barrier to multiplying effect, cutting the RR can serve to both release liquidity and maintain relatively stable exchange rate market.

The timing of this policy is special, too. With China's Lunar New Year two weeks ahead, PBoC has greatly boosted market optimism. I also expect another interest rate cut to be announced before or after National People's Congress coming in March, where China's 2015 growth rate target will be determined. Until then, China will join the club of monetary expansion with Eurozone, Canada, Australia and so on with a real ticket in hand.

Thank you for reading and Happy Spring New Year!

RMB Internationalization: Implications for Exchange Rate

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Stepping into 2015, Renminbi has made several concrete achievements toward the realization of internationalization. According to SWIFT, RMB has become the fifth most frequently used currency in the global market in terms of its share in international payments. It is also noteworthy that the total value of payments transacted in RMB has boomed by 102% within 2014, whereas other currencies only grew on average by 4.4%. Meanwhile, the International Monetary Fund (IMF) will discuss the inclusion of RMB into the SDR basket in November, when the selected group of currencies is re-evaluated every five years. On 21st January, the PBoC has agreed with SNB to establish yuan clearing and the RQFII (RMB Qualified Foreign Institutional Investors) pilot region in Switzerland. 

Picture via Google
In fact, these progress were just in line with RMB's increasing popularity in global trade and retail business, while there remain much potential to explore in RMB-related financial assets. According to Joseph E. Gagnon and Kent Troutman, arbitrage exists between CNH (offshore RMB) and CNY through trade settlement, "the full internationalization of the RMB, and elimination of the CNH–CNY premium and CNH–CNY interest rate differentials requires greater capital account liberalization by China". To further remove these barriers to yuan transaction, the PBoC needs to keep RMB exchange rate in a relatively stable and strong position so as to implement prospectives reforms in the financial market and avoid market-wide risk.

We saw RMB depreciates drastically towards USD in the past two days, which forms the weak expectation on future RMB rate as shown on RMB one-year NDF.  In the long run, however, there is limited space for yuan's further depreciation. Although cheaper yuan stimulates export, to a greater extent China suffers from capital outflow. The PBoC has practiced reverse repo this week to keep stable flow of liquidity, and more discretionary guidance in the currency market are possible after the Federal Reserve announced its interest rate decision. In general, there would not be radical reflation for RMB to stimulate growth in 2015 even if the Fed practices interest rate increase. Instead,  yuan will seek a rebalanced rate with dollars in a gradual manner so as to promote its long term goal of becoming an internationalized reserve currency.