When Will It Stop?

Chinese Businessman holding business card with China Flag
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It was a bit of a mixed bag in US trading overnight. The Dow was up slightly, while the S&P 500 was down a bit. Gold put on a few bucks, while oil was the standout performer. Brent Crude and West Texas Intermediate oil both jumped nearly 2.5%.

This bodes well for the three Aussie energy plays I identified for subscribers of Crisis & Opportunity recently. I mentioned this report to you a few weeks back. You can take a look here. The shares have already started to move strongly, though they won’t remain as buys for much longer. If you’re interested in adding some energy exposure to your portfolio, you need to move quickly.

Despite Wall Street being flat overnight, futures indicate that the Aussie market will be weak today. The reason: China. Bloomberg has the story:

Unease is once again permeating China’s financial markets.

The Shanghai Composite Index sank 2.5 percent at the close, the yuan fell toward an eight-year low, while government bonds tumbled, with the one-year sovereign yield rising 15 basis points. Analysts had a long list of reasons for the synchronized selloff, from President-elect Donald Trump’s questioning of the decades-old One China policy, to a regulatory crackdown to insurers’ stock investments, higher money market rates and concern that property prices are poised to fall.

In yesterday’s Daily Reckoning, I questioned China’s economic strength, given the amount of capital that was trying to get out of the economy.

The general rule is that capital flows towards the highest returns. A strong economy should offer the prospect of relatively strong returns. Given China’s economic growth is relatively healthy, you have to ask why capital isn’t interested in hanging around.

Before I have a crack at answering that, let’s have a look at a chart of the Shanghai Composite Index.

As you can see in the chart below, it bottomed earlier this year, along with most other global equity markets. It’s since been grinding its way higher. From the bottom to the recent high in late November, the index has advanced around 25%.

That’s not as impressive as some other global markets, but it’s not bad, either. Yesterday’s fall of 2.5% hasn’t damaged the emerging upward trend that got underway mid-year. (I define an upward trend as getting underway when the moving averages cross to the upside. You can see that happened in August this year).


Source: Optuma
[Click to enlarge]

So the stock market is in recovery mode, after suffering from a big bust in 2015.

There are no signs of major capital flight here.

But stocks are not the main game in town in China. The property market is. But that doesn’t mean that capital flight will show up in the property market, either.

Here’s why…

Bear in mind that this is an educated guess. No one really knows the intricacies of capital flows into and out of China. It’s a complex business, full of conjecture.

As just about everyone knows, China ‘manages’ economic growth by tapping its foot on the credit accelerator. Via state ownership of the banking system, the government can direct the banks to lend (create credit) where it wants.

As Fortune reports:

…lending by any means necessary is a directive coming from the highest levels in China. President Xi Jinping said last year the country must at least post 6.5% annual economic growth through 2020. And China’s state-owned banks have received government directives over the past year to support economic growth by issuing credit.

That means state bankers, whose standing in the Communist Party is equal to that of city or provincial leaders, are rewarded for lending to struggling business, despite the risks. In the 12 months through June, China’s domestic debt ratio rose by an astonishing 28% of GDP.

In other words, credit, or debt growth, is expanding at a much faster pace than economic growth.

Let’s say, for example, that banks extend credit for the construction of a new apartment block. The end recipient of the money — the developer, the marketer, the local government official who brokered the deal, or whoever — ends up with a tidy profit.

They know it is money for jam, and, as the profits pile up from this artificially-directed credit, they have no intention of reinvesting the profits back into the economy.

Instead, they try and get the money out of the country and into ‘safer’ assets. This flow of capital out of China in turn puts pressure on the yuan, and the central bank must sell foreign exchange reserves to manage the decline in the currency.

In effect, the more credit the government creates to try and bolster the economy, the higher the resulting outflow of capital, as profits from the boom try to escape the economy.

This is why you’ve seen the government clamp down on capital controls. They’re trying to plug the gaps, but it’s a losing battle. You either have an economy open to capital flows, or you close it up.

China is trying to liberalise its capital account by allowing the free flow of capital but, in doing so, it’s losing control of its currency. So it has to sell foreign exchange reserves to defend the currency.

But there is no action without a reaction. Falling foreign exchange reserves represent a tightening of liquidity. So the more these reserves fall, the more difficult it will be for China to create the credit needed to meet its growth targets!

Confused?

Don’t be. Just follow the money. Money flowing out of China is not a good sign. But, paradoxically, it is good news for foreign assets. China’s fleeing capital is boosting stocks, house prices and commodities around the world.

Only thing is, no one knows when it will stop…

Regards,

Greg Canavan,
For The Daily Reckoning

PS: Our colleague Callum Newman recently interviewed former News Corporation and Fairfax journalist Michael West.

You can hear the interview on Callum’s podcast, The Newman Show. As Callum told me, West talks about how newspapers are dead, business journalism is a joke in Australia, and no one takes on big end of town.

It’s sure to be an interesting episode.

To subscribe via iTunes, go here.

To subscribe via Stitcher, go here.

Greg Canavan
Greg Canavan is a contributing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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