Shanghai Au Revior? Sayonara USD??

Following the listing of Petrochina-A share, the markets in China just continued to tumble. The People's Bank of China announced Thursday it might use a variety of measures, including bank and treasury bond issues and reserve requirement ratios, to control the country's "severe" liquidity problem.

A PBOC report gave no details about the extent of the measures or when or how they would be implemented, but it stressed that absorbing liquidity in banks and strengthening credit control could not fundamentally tackle the constant and rapid accumulation of liquidity and other structural problems. Recent talks about stock market risks by senior economists have also intensified worries about further government measures. China's economic growth is expected to exceed 11 percent for 2007 and growth in the consumer price index (CPI), the main measure for inflation, will be around 4.5 percent year-on-year, though some foreign analysts put the inflation figure to be at 6.0% at least. The latest figures and report by PBOC hints at at least one or maybe two more rate hikes before the year is over. Hence the rate hikes will definitely occur, and that is what's spooking China markets. The effort to maintain the dollar-renminbi exchange rate at a level approved by China’s State Council has already led to an enormous increase in the Chinese economy’s financial liquidity. The consequences of this are now manifested in property and stock market inflation, but not yet in rampant and uncontrolled consumer price inflation – at least for now. But if China does not accelerate the renminbi’s revaluation, the world might see a large burst of consumer inflation in China in the next 12 months. If so, the consequences will be a choice between the destructive runaway inflation and stagflation. The fall-out from this scenario, however, would be largely confined to Asia.

That being the case, the Shanghai and Shenzhen markets will find little incentive to buck the trend. Why bid prices higher when you higher prices will mean pushing PBOC to raise rates even more aggressively or worse, come up with penalising fiscal measures. Hence the China indices is in for a welcome breather. In actual fact, PBOC is not so concerned over higher stock prices as long as its a managed run up. They are more concerned over things like inflation and renminbi. It looks very likely that the yuan will be allowed to rise significantly over the next 2 weeks, it has to happen already - looking at how the USD is weakening, and how the Euro is headed for 1.5 against the USD, and the likelihood of the AUD reaching parity with the USD. Controlling inflationary pressures is utmost in the priority of PBOC, no two ways about it. Raising rates are not having the desired effect (they have done that 5x already this year).

As for the USD, we are seeing a realignment ala 1987, though in a more controlled manner. The Fed seems to be in agreement to have a weaker USD. Bernanke commented on the upside risks to inflation but focused more on the downside risks to growth. The Fed Chairman expects growth to slow noticeably in the fourth quarter, which confirms his dovishness. If he had done the opposite and focused more on inflation like his counterparts in the Eurozone and Australia, the dollar could have rallied. However he chose to spend his time expressing concern that higher energy prices, tighter credit and continued weakness in the US housing market would lead to softer consumer spending. This coincides with the survey results from 10 of the nation’s largest retailers, 7 of which including Wal-Mart and Macy’s reported sales below forecasts. For dollar bears still looking for a recession, the Fed’s acknowledgement that consumer spending could be at risk indicate that they haven’t completely ruled out another rate cut. Although extremely volatile, Fed funds future are now pricing in a 90 percent chance for an interest rate cut next month. Recent trade fairs in Asia mostly showed a 10%-20% drop year on year in order from the US on the credit squeeze in the US, and slowing US consumption due to that. This real evidence should translate to a genuine weakness across the board eventually, thus a flattish to lower fed funds rate will dominate the capital flows over the next 3-6 months, thus prolonging a weaker USD. The weaker USD will sustain interest in the US equity markets but will cap any rise in other equity markets. Another 5% drop from here will ensure that the business and trade dynamics change substantially. The outlook for emerging markets won't be as rosy as it was a year ago. Trade surpluses will start to narrow, and FDIs will slow as well.

Hence the China markets will be forced to find its feet first and consolidate, and we will have to see how much more will the USD be "allowed" to go weaker (I suspect another 5%).