Is China about to crash?

November 23rd, 2007

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The rampaging Chinese stock market had fallen about 18% from its record high in mid-October. Is this just a correction in an ongoing bull market, a slow-motion deflation or a precursor to a crash? This is an interesting question. As usual, despite the title of this headline, we will not be trying to predict the future in this article. But what we do offer is to show you some warning signs of such a possibility:

  1. Anecdotal experience- From one of our contacts in Shanghai who is involved in an export business, the frantic pace of work seemed to have abated significantly. This is hardly surprising, given that the slowdown of the US economy will curb its consumer demand for imported goods. Assuming that this situation is representative of the Chinese companies involved in the export business, it means that Chinese economic growth will slow as well. What will this do to the Chinese stock market, which had awarded ridiculously high P/E to many businesses? As this news article, US slowdown threatens Chinese export growth says:

    China?s commerce ministry warned on Thursday that a slowing US economy would trigger a drop in Chinese exports that would mark a ?turning point? for China?s rapid economic growth.

  2. Lending freeze- Recently, we saw this news article, China Freezes Lending to Curb Investing Frenzy:

    Even a temporary lending freeze, however, could cast a chill on important segments of the Chinese economy, including the stock market, whose steep run-up over the past year has given rise to fears of a speculative bubble. Though off their highs, Chinese share prices have nearly doubled since late 2006.

    The Chinese are walking on thin ice. They started off with absurdities like price controls (see Result of Chinese price controls) and now, they are resorting to lending controls, which is akin to throwing a spanner into a red-hot running machine- the result is unpredictable. Lending controls can accidentally result in a deflation (see How money & credit can shrink (i.e. deflation)?) by hastening the demise of businesses who have their lifeblood (i.e. funds) cut off, resulting in cascading bad debts. We hold our breath on that one. Gulp! On second thoughts, this may as well be, in order to clean up the excesses and mal-investments in the Chinese economy.

  3. Credit crunch contagion- As if the lending freeze is not enough, this time round, the credit crunch has spread to China. This news article, Credit crisis sweeps Asia reports,

    THE global credit crisis hit Asia with a vengeance this week, triggering a massive flight to safety as investors across the region pull out of risky assets.

    Pay attention to this phrase: “…triggering a massive flight to safety…” As we said before in Danger of China leaking money to overseas stock

    Therefore, when capital flight (from China) happens, China?s foreign currency reserves will be drained out. Of course, the Chinese authorities would probably implement capital controls to prevent capital flight to preserve their reserves. But that is akin to a bank preventing cash withdrawals in order to protect its cash reserves. Either way, if the situation should come to such a stage, serious loss of confidence in the Chinese economy and financial system will result in an ugly state of affairs.

    When this happen, imagine what will happen to the US dollar and price of commodities as China’s US dollar reserves get drained out and repatriated back into the US? Imagine what will happen to the supply of RMB in China when this happen?

It’s time to put on your seat-belts and hope for the best, folks.