Many economists have observed that the current global imbalances, meaning US trade deficits financed by overseas capital flows, cannot continue forever. Indeed, there are already signs that foreign central banks are getting uncomfortable with their level of US dollar holdings and have said they plan to diversify their currency holdings (translation: sell dollars) which would lead to a further decline of the dollar.
There are scenarios under which these distortions could unwind without too much disruption, but Nouriel Roubini doesn’t see that happening. He believes that key East Asian players, particularly the Chinese, will try to maintain their currency’s price relative to the dollar (meaning not let their currencies appreciate). That requires them to buy more dollars, which leads to excessive domestic money supply growth, which in turn leads to asset bubbles and inflation. There’s ample evidence that this pattern is already in motion. Since the Asian players are not willing to give up their dollar peg, Roubini expects things to get worse.
Roubini’s grim views are confirmed by this evening’s MarketWatch story, “China’s Irratrional Exuberance:”
China’s Golden Week holiday ensured its rampaging stock markets took an enforced breather, but there has been no letup on the debate on the developing equity bubble.
Since its February hiccup, the Shanghai A-share market has now moved back up 40%, buoyed by a series of successful initial public offerings as the ranks of investors swell at over 200,000 a day. There are now more than 91 million accounts held at brokers or mutual funds.
But some critics argue the way the mainland IPO market is being run systematically fans the irrational expectations of these novice investors with the promise of easy money, storing up trouble ahead. Chinese investors may be notoriously momentum-driven and ignorant of valuations, but they can surely see the IPO market is serving up a bargain.
While stocks in the A-share market trade at stiff premiums to Hong Kong, dual-listed equities often continue to list at a discount in the mainland. This situation is due to the influence of the powerful China Securities Regulatory Commission (CSRC) which micromanages new listings, sets final pricing of IPOs and subsequent fund-raisings as well as deciding who gets to list.
In most other competitive markets, pricing is a commercial compromise based on what companies think they can get and what investment banks think the market can take. A standard move these days is for the CRSR to force companies to set a lower price on their IPOs in the hope of a strong stock market performance. This has undoubtedly contributed to the general market euphoria. The average price-to-earnings ratio of Shanghai and Shenzhen markets is now over 50.
This might also explain why talk of when a market correction would be desirable for the Chinese authorities is heard. Ideally, any pullback should wait until after the 2008 Beijing Olympics, while this autumn the Communist Party convenes its 17th congress to approve the top leadership changes before the National People’s Congress elects a new government in March. A stock market slump would not give the impression of economic buoyancy needed during the sensitive periods of major leadership changes.
In the absence of traditional measures to cool the market such as significantly raising interest rates, another solution the authorities are eyeing to bolster the stock market is by adding better quality companies to soak up excess liquidity. As the theory goes, if you put better companies in the market, you will get a stronger, more stable market.
While traditionally China’s best companies opted for overseas markets such as Hong Kong, now it’s reported the State Council is to approve the first batch of five major red-chip companies, including China Mobile Ltd. and Lenovo Group Ltd.
to issue A-shares soon….
Taking this further, last week a story also ran that venerable HSBC Holdings Plc. was being wooed to list A-shares in China….But again we come back to the issue of price setting for the listing. If the CRSC controls pricing and dictates mainland investors must get to buy in at a discount, it’s likely to be a non starter….
Ultimately, there is no quick fix to provide a stock market that is efficient and less like a state sponsored casino…. As the analysts at BCA Research put it in a recent note: “We have no doubt if China’s market continues to spike up, the stage will be set for a very violent drop.”
And to Roubini’s thesis:
…Asia has learned the wrong lessons from its 1997-98 crisis….
[T]he current East Asia financial and currency policies represent a return to fixed exchange rates as most – but not all – of the policy makers in the region are aggressively preventing a necessary currency appreciation via massive and growing amounts of forex reserve accumulation. Such reserve accumulation has been at the rate of $450 billion in 2006 alone and now at an even faster rate in 2007. By now the stock of forex reserve in Asia is over $2.5 trillion and rising rapidly.
These policies are however creating – via partially sterilized intervention – a massive growth of monetary base and of credit in Asia that is feeding a variety of asset and financial bubbles as well as leading to goods inflation in some countries; these bubbles are dangerous and likely to lead to a financial bust over time.
These currency policies – effectively what has been referred to as the Bretton Woods 2 regime of fixed rates in Asia – have also made East Asia more dependent now than ever before on the US business cycle and on growth developments outside of Asia. Thus, China and Asia are now seriously vulnerable to a US hard landing that now looks more likely.
These Asian currency and financial policies have also contributed to global current account imbalances, to excessive global liquidity, to the bubbly conditions in a variety of global – not just Asian – asset markets and to a serious underpricing of risk in global financial markets.
Thus, Asia is fighting today the last war as vulnerabilities in Asia are very different today from those that led to the 1997-98 crisis. Asia instead is not addressing the financial vulnerabilities created by its currency policies that risk to lead – with or without a US hard landing – to a new and different type of financial crisis in Asia, one triggered by excessive liquidity, excessive credit growth and asset bubbles in many financial markets.
A full version of his paper is available here for premium subscribers.