Institutional Investor's Alpha Magazine - November 2007 - (Page 72)

Unhedged Commentary t a recent lunch hosted by a brokerage ﬁrm in Greenwich, Connecticut, an extremely enthusiastic economist talked at length about the brilliance of the People’s Bank of China. He cited China’s double-digit gross domestic product growth, record trade surplus and other economic statistics as proof. Although I too am in awe of the massive wealth creation and improvement in living standards that has occurred in China, I don’t think any of the credit should go to the PBC. To the contrary, I fear that the bank’s policies have bred enormous imbalances, creating, quite possibly, the mother of all asset market manias. The PBC has set interest rates too low — arguably at least 1,000 basis points too low. The benchmark one-year deposit rate is 3.87 percent, more than 13 percentage points below nominal GDP growth (a scorching 17.3 percent in the third quarter). Inﬂation in China jumped from 2.2 percent in January to 6.2 percent in September, a violation of the prime Savvy investors directive of modern central banking — to keep inﬂation contained, could beneﬁt when typically in a 2-to-3-percent range. The rocketing Chinese economy the Chinese equity has resulted in other unintended market mania,fanned consequences, including oppressive pollution and glaring income by the People’s Bank inequalities. During all this the PBC has of China,comes to intervened to keep the yuan dramatically undervalued. In spite a crashing end. of China’s double-digit growth, enormous profitability and unprecedented current-account surplus, the yuan has actually weakened over the past four years on a real effective exchange rate basis. This has led to a mammoth misallocation of capital, as investments have poured into resource-intensive, environmentally damaging, export-oriented industries, while consumption has actually declined as a percentage of GDP. As a result of the PBC’s policies, money has poured into China’s equity markets, creating a bubble that is waiting to burst. The Shanghai composite index is up more than 200 percent during the past 12 months and has a price-to-earnings ratio of more than 60 and a price-tobook ratio of more than 7. In the ﬁrst six months of 2007, 28.6 million new investment accounts were opened in China, 5.4 times the total for all of 2006. Average daily Banking on a Bubble A By Kevin Hebner turnover at the Shanghai and Shenzhen stock exchanges has risen more than fivefold this year. Those of us with more than a bit of gray hair have seen this movie before and know that it can only end in tears. Why has the PBC erred so spectacularly? The ﬁrst reason is its lack of independence, a fatal flaw enshrined in the 1995 People’s Bank of China Act, which makes it clear that all monetary policy decisions must be approved by the extremely pro-growth State Council. Second, the responsibilities of the PBC are vague and diffuse. The PBC Act outlines 13 major functions, including regulating the interbank bond market and managing the state treasury, without explicitly mentioning inﬂation even once. Most investment manias have three distinct stages: denial, complacency and, ﬁnally, panic and collapse. When it comes to the Chinese equity bubble, we are long past denial. But how long will China remain in the complacency stage? To monitor the situation, I suggest following several indicators, including the performance of the Chinese banking sector; global commodity prices, especially base metals; the Chinese purchasing managers’ index and new orders; monthly earnings-per-share revisions; and investment ﬂows for both domestic funds and global equity managers. First and foremost, however, investors need to focus on domestic money market rates. As Chen Zhao, managing editor for global investment strategy at Montrealbased BCA Research, has long emphasized, market bubbles are always punctured by rising rates. When the equity bubble does burst, there will be a sense of crisis. But there should also be a sense of relief. A dramatic decline in the Chinese market will produce a negative-wealth effect, to which the government will hastily respond with a huge ﬁscal stimulus plan that will beneﬁt stocks, especially those in infrastructure-related industries. China’s currency stands to beneﬁt too, as economic fundamentals are screaming for a stronger yuan and will continue to do so even if Chinese equities plunge by 50 percent. Although property prices in China will suffer when the market collapses, this could present some terriﬁc buying opportunities. As John F. Kennedy observed: “The Chinese use two brush strokes to write the word ‘crisis.’ One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger — but recognize the opportunity.” Kevin Hebner is global investment strategist at Third Wave Global Investors, a Greenwich, Connecticut–based registered investment adviser specializing in global macro strategies. 72 • INSTITUTIONAL INVESTOR’S ALPHA • NOVEMBER 2007

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - November 2007

Institutional Investor's Alpha Magazine - November 2007 Contents Letter from the Editor Longs & Shorts Pension Corner: Patriot State The Good Guys: College Connection Interview: Currency of Change Cover Story: Comeback Kid Strategies: Masters of Art Research Center: Alpha Awards: Top Technology Providers Top Analysts Alpha Bytes: Critical Choice Unhedged: Commentary: Banking on a Bubble

Institutional Investor's Alpha Magazine - November 2007

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