Archive for January, 2010

Chinese government cornered by inflation, bubbles & rich-poor gap

Thursday, January 7th, 2010

Today, we will continue from our previous article, Hazard ahead for Australia- interim crash in China. Before we delve into the implications for financial markets, we will first look at the stark choices available to the Chinese government.

First, we have to understand the dilemma faced by the Chinese government. Their number one priority is to ensure social stability. But we have to distinguish between social and political stability. As we mentioned before in Will China fall under popular revolt?, we doubt the Chinese people will rebel against their government and drag their nation down into the extreme political chaos that is reminiscent of the first half of the 20th century. But social instability can undo much of economic growth made over the decades, including further roll-back of liberalisation that was made over the years.

Factors that can undermine social stability include: corruption, mass unemployment and inflation. We doubt mass unemployment alone will pose a great threat to social stability. Back in the 1990s, under the leadership of tough, clean and anti-corruption Premier Zhu Rongji, China could still cope when many unprofitable state owned enterprises had to close shop, throwing millions into unemployment. Today, when corruption is probably a much more serious and endemic problem, perhaps mass-employment and/or inflation will become much less tolerable?

Every Chinese knows that corruption is a problem in their country. Inflation, along with its symptoms (e.g. growing rich/poor divide),? is a growing problem. Unemployment is not yet at a critical level. As long as the Chinese government can finely balance between unemployment and inflation, corruption will be tolerated up to a certain extent. Our guess is that when this balance breaks down, public anger may erupt.

That is where the dilemma lies. As long as the yuan is pegged to the USD, the Chinese government cannot control inflation (see Why is China printing so much money?). But the yuan has to be pegged to the USD in order to keep the Chinese exports competitive so that American consumers can fill in the wide gulf between Chinese investments and domestic consumption. By not allowing the yuan to appreciate, the Chinese government shows that at least for now, they fear unemployment and excess capacity more than inflation.

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets. As this gap widens, it will be harder to grow their domestic consumption demand to soak up their growing excess industrial capacity. As there’s a natural limit on how much a human being can consume, this will imply that the growing number of poorer ones will have to consume less (due to inflation), while the richer ones will have more and more of their wealth that cannot be consumed. This will result in them having to ‘invest’ their excess wealth into asset markets, contributing to an even bigger bubble. In other words, the paradox is that the further the Chinese government delay in tackling inflation, the more reliant they will have to rely on American consumers, which means it is harder for them to let the yuan appreciate.

Will the Chinese government have the guts to let the yuan appreciate? All they have to do is to look across the ocean at Japan and that will be enough for them to hesitate. As Satyajit Das wrote in this article,

In 1985, Japan, the US, Britain, Germany and France signed the Plaza Accord, in which they agreed to depreciate the dollar in relation to the yen and the mark by intervention in currency markets. The accord had limited success in reducing the US trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. But the effects on the Japanese economy were disastrous.

The stronger yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that then collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ”The Lost Decade”.

The bigger the bubble in the Chinese economy, the bigger the consequences when the bubble collapses. But if the yuan appreciate too much too fast, it will be pin that pop the bubble.

This is where the next problem for the Chinese lies- the United States. The Chinese cannot allow their yuan to appreciate too much too fast. But the Americans are simply too impatient to wait. With influential voodoo economists like Paul Krugman writing inflammatory articles like this one, we shudder to think we will happen if the Obama Administration heeds his words and bring a trade war between China and the US a step closer.

If there’s a trade war between the Chinese and the US, we can be sure the Chinese government will stir up nationalistic feelings and put the blame on outsiders. This will definitely result in political tensions between both nations.

Short selling, who loans their share?

Tuesday, January 5th, 2010

Recently, one of our readers asked,

I can see how Naked Short Selling is fraud, but I can’t figure out who would knowingly loan shares to someone who wanted to short them? What interest do they get on the loan of shares or risk premium that they will be returned? I am assuming you have to have permission to borrow and sell someone else’s shares and they need to be compensated for the privilege. Especially when some one long company ABC wants to see the stock go up, and keeping their shares off the market helps create the lack of supply that helps that upward dynamic. So why help someone who wants to go short and what do you get from it? It would be great to see a Post about this whole issue of shorting. Especially when I want to sell something short, who have I asked to borrow the shares?

First, for the beginners, let’s explain what short-selling is. Basically, it is a way for traders to profit from falling stock prices. This is how it works:

  1. The trader borrows stocks from someone else.
  2. Then the stocks are sold on the market.
  3. Later, the trader buys back the stocks on the market.
  4. The stocks are returned that someone else.

Between step 2 and 3, if the stock prices fall, the trader will make a profit. On the other hand, if stock prices rise, the trader will make a loss.

What is naked short-selling?

No, it has nothing to do with nudity. Basically, in naked short-selling, step 1 is omitted and in step 4, the stocks are delivered to the buyer instead of to the ‘someone else.’? That is, the trader sells the stocks first without arranging to borrow it from someone else.

The next question you may ask is, how can selling stocks without having any on your hands be possible? If you are a retail investor trading through say, your Internet-based discount broker, it is not possible. This is because most brokers will not allow you to send any sell orders to the market if you don’t own the stocks in the first place. But for traders with the ‘connections’ or independent access to the market, it is possible. Usually, these are the institutional traders. To understand how it works, imagine you are a bidder for a painting in an auction market. You have no money in your bank account. But does that prevent you from placing a bid for the painting? No. The auctioneer is not going to search through all your assets to make sure you have the cash at bank. You can still bid for the painting. But should your bid be successful, you will be legally obliged to cough out the cash. In the same way, the stock exchange is basically an auction of stocks.

You can certainly come up with a short-sell arrangement with your friend. You may borrow your friend’s stocks (by filling in a securities ownership transfer form), sell the stock on the market (through your broker), buy back the stocks later (again, through your broker), and then return your friend’s stocks (by filling another securities ownership transfer form). To be fair, you will also compensate your friend any dividends foregone in the interim period that the stocks are not under his ownership.

If your friend is your bosom buddy, he may verbally agree to such an agreement for free. But in the real world of money, there are legal obligations involved. The terms of loan of stocks will be governed by law, which requires that the stock borrower provides the stock lender with collateral in the form of cash, government securities or letter of credit. Both parties will negotiate a fee for this loan arrangement. If cash is used as collateral, then the borrower is entitled to the interest earned on the cash, of which the borrower may rebate some of the interests as part of the lending fees.

The fees are where the motive for lending stocks come from. Stocks usually pay dividend once or twice a year (or maybe not at all if the business is at a growth phase). Other than that, it is an ‘idle’ asset. If you can lend stocks to short-sellers for a fee, then you will be earning additional income from your stocks. From the point of view of the lender, if he does not have the intention to sell his stocks, then this seems to be an opportunity to earn additional income for nothing- after all, the stock borrower has to compensate the stock lender for any dividends foregone. Indeed, we have seen such an arrangement packaged as financial ‘products’ to entice retail investors to permit their stocks to be lent out. Worse still, we have read newspaper reports of superannuation funds lending out their stocks to short-sellers in order to earn fees to bump up the returns of the funds.

Who are the ones lending the stocks? There is a class of institutions called the “Security Lenders” who have access to ‘lendable’ securities. They include asset managers who have many securities under management (e.g. your superannuation funds), custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian. These institutions include big names like Citibank, Deutsche Bank, Goldman Sachs, HSBC, etc.

Of course, when it is a bull or stagnating market, lending stocks for a fee is a no-brainer way to earn additional income. After all, it is the short-sellers that bear all the risk of losing money in a rising market. The stock lender carries no risk at all as long as stock prices do not plunge.

But when it is a vicious bear market, short-sellers will be the ones making a killing while the stock lenders carry all the losses. That is what happened during the Panic of 2008. Naturally, the supply of stocks to be lent out dried up in such an environment. In a bear market, when everyone wants to sell stocks, no one will be lending them out to short-sellers. That is where naked short-selling comes in. Because short-sellers cannot find stocks to borrow (or the fees were exorbitant) in the Panic of 2008, they naked short-sell.

Naked short-selling becomes a problem when the short-seller fails to deliver the stocks to the buyer. This will result in systemic to the financial system if allowed to go out of hand. During the Panic of 2008, there were newspaper reports of hedge funds deliberately failing to deliver the stocks. By naked short-selling, those hedge funds received payment for the stocks from the buyer first. Then the payment was used to earn interest. As the penalty for failing to deliver the stock was less than earned interest, it made financial sense to drag out the non-delivery of? stocks for as long as possible. In theory, an infinite quantity of stocks can be sold through naked short-selling, overwhelming the market into panic with an avalanche of phantom stocks for sale.

Until not long ago, retail investors do not have access to short-selling. This is because short-selling is seen as too ‘risky.’ This is because in theory, the potential loss of a short-seller is infinite because the upper limit of stock prices is infinity- practically possible in money-printing nations like Zimbabwe. But nowadays, even retail investors can short-sell with their online brokers (e.g. CommSec, Macquarie Prime) either in the form of traditional short-selling or via CFDs (a financial instrument that is not available in the United States).


P.S. We will continue the story from our previous article in the next article.

Hazard ahead for Australia- interim crash in China

Sunday, January 3rd, 2010

This is the first major post of 2010 (the previous post was more for our readers’ entertainment). Today, we will look ahead at a likely hazard facing Australia in 2010 and beyond- an interim crash in China.

First, you may wonder why we used the word “interim” before the word “crash?” To answer this question, you may recall what we wrote in June 2007 at Will the China boom go in a straight line?,

… one of the common stories we hear is this: since China is an ascendant superpower, its demand for commodities will increase in the decades to come, and hence, the commodities super-cycle will have a lot more room to go for a very long time.

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line. Instead, there will be ups and downs, booms and bust and progress and setbacks. Anytime when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

In other words, when we say that a “crash” is coming in China, we do not mean that China will collapse into a heap of total anarchy, civil war, foreign invasions, internal divisions by warlords, etc as in the first half of the 20th century. Instead, as we wrote before, such a “crash” will be a major setback in the bigger scheme of things.

In this new year, this is the theme that investors (especially the highly leveraged property speculators in Australia) should be watching out for. Australia is highly leveraged to the Chinese growth story, both in terms of financial leveraged (look at Australia’s debt level) and population leverage. The word “population leverage” will sound alien to you because this is a phrase that we invented in this article. To understand this phrase, consider this: the entire population of Australia can fit into population of just one major Chinese city (Shanghai) if you include the ‘unofficial’ migrant workers. Because of the colossal size of China, if every Chinese reduce their consumption by 1%, then its effect will be much more than 1% reduction in income on Australia. Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

The Panic of 2008 should be the year whereby a major correction in the Chinese economy could have occurred. Indeed, in late 2008, one newspaper headline in the Sydney Morning Herald was screaming of a great “stall” in the Chinese economy. Indeed, it seemed at that time that what we wrote in January 2008 at Can China really ?de-couple? from a US recession? was coming into fruition.

However, what stopped the major correction in the Chinese economy in its track was a massive government stimulus and ultra-loose monetary policy. The former is concentrated on fixed asset and infrastructure investments (e.g. construction boom, bridge building, etc), while the latter is basically force feeding loans into the economy (see How big is the credit bubble in China? and Is China setting itself up for a credit bust?).

The problem with these government policies is that, while it may have averted a major correction, the structural imbalances in the Chinese economy are being exacebated. To understand the gravity of this situation, consider this simplified line of thought:

  1. Prior to the GFC, the Chinese economy was highly geared towards capital investments in the form of productive capacity for exports.
  2. A contraction in demand in the US/Europe led to a disproportionate contraction in Chinese economic activity (see Can China really ?de-couple? from a US recession? to understand the theory behind this reasoning).
  3. Chinese economic activities that are related to exports suffered the worst of this contraction.
  4. Chinese government stimulus and ultra-loose monetary policies led to increased economic activity in the Chinese economy mostly in the area of capital investments for infrastructure.
  5. Overall the economy ‘grew’, but a lot of them are wasted and ‘leaked’ into mal-investments, asset market bubbles, corruption (see Will China succeed in navigating its way out of the Global Financial Crisis (GFC)? for a juicy story about corruption in China) and trophy projects.

You see the problem here?

Chinese government policies are accentuating the gap between investments in future productive capacity and current consumption of the Chinese people. To further complicate the picture, infrastructure investments produces capital goods (e.g. bridges, roads, highways) that cannot be exported. If Chinese consumption cannot grow fast enough to catch up with huge expansion in productive capacity and American consumption cannot recover enough to fill the gap, then what will happen to those investments?

Obviously, these investments will, at best result in a dismal return and at worst, result in bad debts. And we know bad debts are the roots of a credit crisis.

We believe consumption growth cannot catch up fast enough. As we wrote in Can China really ?de-couple? from a US recession?,

  1. The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built. As we said before in Overproduction or mis-configuration of production?, the issue is not a simple case of overproduction. Rather, it is the mis-configuration of production that is the issue.

Because of the structural imbalance between consumption and investments, a lot of these forced investments are leaked into asset speculation (e.g. look at the massive property bubble in Shanghai alone). To understand this point, consider what we wrote in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

The ultra-loose monetary policies in China resulted in too much money and credit sloshing around in the financial system. The structurally weak and mis-configured domestic consumption market means that there’s not enough avenue for appropriate investments. Hence, a lot of money and credit ended up as speculations in the asset market.

To structurally streghthen the Chinese domestic consumption market, the gap between the rich and poor has to be narrowed. Anecdotal indications suggest that the opposite is happening, thanks to inflation (see Does monetary inflation increase the rich-poor divide?). The bubble in the asset markets is worsening the situation.

By now, you should be able to appreciate the gravity of the situation. The ‘success’ of the Chinese government seems to have averted a major economic correction. But in reality, they are just postponing it for a greater bust in the future.

What is the implication of this in the financial markets? Keep in tune!

Shocking humour: Bridge construction, the Chinese way- just add rubbish inside the bridge

Friday, January 1st, 2010

We often hear of China’s powerful government stimulus spending programs that helped to power the Chinese economy back into stellar growth when the rest of the world (especially the developed Western world) are struggling with the Great Recession.

Most of these stimulus money goes into infrastructure projects like bridge building. For example, as this Chinese article reported, in January last year, a bridge in Shanghai’s Henan Road was renovated. In less than a year, cracks started to appear on the bridge. Next thing, this is what happened:

Rubbish hidden beneath cracks of a bridge in Shanghai

Rubbish hidden beneath cracks of a bridge in Shanghai

So, in order to cut costs (thanks to soaring inflation), parts of the bridge were held together with glue and paste and padded with rubbish!

Elsewhere, in Sichuan province’s Jianyang city, a 40-year bridge was identified as a “danger” bridge after the 2008 Sichuan earthquake. So, it was scheduled to be demolished. Miraculously, despite the brute force of 400 kg of explosives (in 2000 boreholes), that 40-year bridge hardly budged.

Such deterioration in construction quality over 40 years shows the hidden side of inflation.