Can The Chinese Markets Correct?

Looking more closely on the Chinese equity markets: I can only see funds being poured in and nothing much in having a release valve to get out. Foreign funds invested in Chinese stocks have mostly sold down but are still parked in China to re-enter at lower levels. Bank deposits growth has been slackening considerably over the last 6 months as people take funds out of deposits in banks to play the markets.

Liquidity has been growing non-stop for the past 10 years in China. How many times have analysts called for a correction in China properties, especially in major cities. I think I have seen more than two dozen such reports just over the last 3 years. Till today, despite the many increases in interest rates and even land construction tax, we have not seen any sizable correction in properties.

Up till end-2005, Chinese equity markets have had roller coaster days. There were sustained periods of bearishness in the 2003-2005 markets: generally the markets in China behaved like a normal market then. 2006 was a significant year in that daily volume traded surged, and foreign participation via approved funds into China also surged. The froth from China property gains were looking around for the next asset class to speculate and stocks looked very good in 2006. This smacks of a magnet attracting surplus liquidity driven by a good story.

Why the heading "can China equity markets correct?" ... Its because there is NO outlet for the liquidity in the system. The yuan being not convertible outside of China exacerbated the situation. There must be alternatives and options for investors: right now, its just properties, stocks or deposits. The deposit rates are still way too low to be a viable option to attract funds, it has to be at 5% or 6% to start sucking funds from the stockmarkets.

The gap between bank lending rates and deposit rates is way too big - in a way Beijing has been subsidising bank profits this way for way too long, and way too generous.

Hence even with fiscal measures such as the recent 20% property gains tax, it is probably not enough to derail the bull. When there is no alternative or valves to allow steam to be let out, Beijing will have to resort to extreme measures to at least calm the markets down. Beijing cannot afford a 40%-50% meltdown, that will have enormous social repercussions and public reprisals. Neither will there be an alternative investment asset class to lure funds away. Hence it will have to be a devastating fiscal / monetary measure to prick holes in the bull: e.g. a temporary 25% tax on all stock trade gains ( no similar rebate on stock losses) till further notice; jacking up deposit rates to 5% or 6%; tightening brokers' capital requirements and leverage.

We all have to hope that the Beijing politicos are smart enough to know they are not so-smart when it comes to financial markets and financial economics. One must be humble enough to know: its the first time they are trying to go from a planned economy to a market economy; its the first time property and stocks have gone stratospheric; its the first time there is so much surplus and liquidity in the system. If Beijing is wise about that, then they will heed advisors from HK, Singapore and even Washington - the worst scenario is Beijing thinking it knows whats best and go its own way. This is not a new road, you don't need to reinvent the wheel or think that it will be different for China - it will be the same, just take options A, B or C... the rest of the financial world already know the consequences for each option. The thrill/fear now is to see which option China takes.