SERIOUS MONEY:Act four, scene one of William Shakespeare's Macbeth contains the words, "Double, double toil and trouble; fire burn and cauldron bubble." The quote is an apt description of China's red-hot stock market, which has advanced by almost 250 per cent since the start of 2006.
The Shanghai Composite Index breached the 3,000 points level for the first time towards the end of February and, despite the well-publicised 9 per cent drop the following day, stock prices have since recovered and closed above 4,000 points last week.
The dramatic rise has seen the amount investors are willing to pay for a unit of earnings increase to more than 50 and several names now trade at a substantial premium to the valuations afforded to the same companies listed in Hong Kong.
Disturbingly, troubled firms, which are on the verge of being delisted, have been among the market leaders, advancing by more than 150 per cent since the beginning of the year or three times the rise in the market index. Speculative activity is increasingly evident and China's bubble troubles are growing.
Bull market enthusiasts will undoubtedly argue that the market's gains are justified on the grounds of solid economic growth and strong earnings gains. However, consecutive earnings increases of 20 per cent in each of the next five years would still see the market, in the absence of any capital appreciation, trade on more than 20 times' earnings in 2012.
Furthermore, according to China's premier, Wen Jiabao, the structure of economic growth has become increasingly unstable and is not sustainable. The investment share of GDP, the most volatile component of output, is approaching 50 per cent while the consumption share has dropped by more than 10 percentage points since the late 1980s. The imbalanced nature of growth could lead to a sharp and potentially disruptive drop in growth during a slowdown.
The People's Bank of China has engaged in what some commentators have described as an aggressive bout of monetary tightening over the past three years. Domestic lending rates have been raised four times while bank reserve ratios have been increased seven times.
However, the results of this campaign have been dismal. Economic growth accelerated in 2005 and then again in 2006 to the highest rate of increase in more than a decade. The economy gathered speed during the first quarter with year-on-year growth of more than 11 per cent. Monetary policy has been ineffective and the reasons why can be traced to China's obsession with its quasi-fixed exchange rate with the dollar.
China has been subsidising its large and growing export sector through a grossly undervalued currency, which according to some respected economists is trading at roughly 40 per cent below fair value relative to the dollar.
To prevent a significant appreciation of its currency in the presence of a large current account surplus and hefty capital inflows, the People's Bank of China has had to engage in substantial currency intervention via the sale of domestic currency and the purchase of foreign exchange reserves.
The accumulation of foreign currency has been staggering. China's foreign exchange holdings have risen sixfold over the past five years and early last year its stock became the world's largest, exceeding those of Japan. The level of reserves exceeded $1 trillion within a matter of months and the rate of accumulation has accelerated recently to roughly $40 billion a month or twice the rate apparent in both 2005 and 2006. The distortions to the economy should not be underestimated.
China's so-called aggressive tightening of monetary policy is a fiction. Current policy is encouraging greater risk-taking by both borrowers and savers. Official interest rates are artificially low due to current exchange rate policy and are several percentage points below both the actual and sustainable rates of nominal economic growth.
Thus, the incentive to borrow and invest remains high.
Meanwhile, the capacity to lend has not been affected by the increase in bank reserve ratios as the actual level of reserves held is a number of percentage points above that currently required while the loan-to-deposits ratio is near an all-time low. Furthermore, households are happy to fund new equity issuance. Savings rates are high due to the dismal public provision of education and healthcare. However, deposit rates are negative in real terms and not surprisingly, given restrictions on capital outflows, cash balances are increasingly being directed to the stock market.
There is no doubting how far China has come since it implemented reforms in the late 1970s. However, current policy is in dire need of an overhaul. Unfortunately, this is unlikely to happen before next year's Olympic Games. China's first "great leap forward" caused a famine that unleashed untold misery on the populace. The second could lead to a crash.
charliefell@sequoia1.ie
