Slaying the Dragon of ‘Stagflation’

by Nigel Bolton-Shaw on August 21, 2012

Chinese Banking Regulator Tells Lenders To Get Tough On Housing Developers, As Credit Conditions Deteriorate … Options traders are charging the biggest premium since March to protect against losses in Chinese companies on signs that a slowdown in the world’s second-largest economy is worse than economists estimated. The AlphaShares Chinese Volatility Index, derived from options on companies listed in Hong Kong, traded at a premium of as much as 41 percent over the Chicago Board Options Exchange Volatility Index last week, the biggest gap since March 29. The spread compares with a 10 percent discount a year ago. The Bloomberg China-US Equity Index of the most-traded Chinese companies in New York fell 0.8 percent last week and Hong Kong’s Hang Seng China Enterprises Index slid 0.7 percent. – Bloomberg

When mainland China sneezes, Hong Kong catches cold. Yesterday, both Hong Kong and China turned a bit sickly.

Shares tumbled generally throughout the region after reports that the Chinese central bank was going to keep a tighter rein on lending. This comes on top of evidence that mainland China’s growth is slowing markedly and that its exports are slowing as well.

You could say both Hong Kong and China are suffering from a kind of monetary flu. Symptoms? Slow growth plus inflation. 50 years ago, Keynesians would have denied the possibility. Today, economists of all persuasions have a term for it:

Stagflation.

This is a serious matter, mind you. Careers depend on a successful outcome. Some have speculated that the fate of the Chinese Communist Party hangs in the balance as well.

If the party doesn’t continue to deliver at least moderate growth, its moral authority could begin to slip away, soon followed by its ability to lead. Keeping China growing is job number one for Chinese authorities.

A growing economy hides a multitude of flaws including a sociopolitical environment that might seem confining and even authoritarian to Western eyes.

And the Chinese themselves are all too aware of the corruption that infects the party’s lower ranks. If the political establishment is going to succeed in the 21st century as it has in the 20th, it will have to keep up a significant growth rate.

That’s easier said than done these days because many of China’s trading partners are experiencing significant problems. Given that the West generally is stuttering economically, the Chinese will count on homegrown growth … at least that’s the plan.

Is it workable? Some will say it’s too late for China, and that a 30-year old economic boom is simply bound to subside of its own weight. And yet … one can make all sorts of projections and it is easy to be fooled by the sheer size and scale of the economy.

Optimism is often called for in such situations. you can see an article on that here: “I Made a Ton of Money Being an Optimist!”

China is perhaps a situation where optimism is called for.  Or at least a steadfast perspective. What seems overheated to some and even out of control from a monetary standpoint can be looked at as growing pains from the standpoint of others, including investors and central bank technicians. The fall in Chinese stock prices on US markets presents opportunities because the drop has been indiscriminate taking good as well as bad down with it. Fitzroy McLean gives an excellent breakdown of what you should be looking for to gain covert profits here.

Fundamentally, China is two separate nations. There is the nation of 800 billion that has participated at least somewhat in the past 30 years of economic upturn. Then there is a nation of 400-500 billion that remains predominately agrarian and impoverished.

These people live as best they can on very little. Perhaps they are farmers or migrant workers. It is this “nation” that Chinese officials hope to develop.

It is a pool of impoverished people larger than the whole of the United States or even Europe. The question then becomes whether Chinese authorities can force the monetary economy to continue to provide benefits for the “real” economy.

From the point of view of Chinese technocrats, there’s another whole nation to build and monetary policy will simply have to fall in line. And thus they tinker. And when tinkering doesn’t work, they try something more forceful. They are not shy about trying to extend the “Chinese Miracle.”

After a good spell when prices seemed to have subsided, July data showed a rise in housing prices after nine months. This was what hit the Chinese markets. Here’s information on the markets from a Reuters article on monday’s market action:

The CSI300 Index of top Shanghai and Shenzhen listings slipped 0.51 percent, while the Shanghai Composite Index shed 0.38 percent after earlier plumbing a near 3-1/2 year low at midday.

The Hang Seng Index shed 0.06 percent to 20,104.27, paring midday losses to return above the 20,000-point level that it has finished above for the bulk of the last two weeks.

All four benchmark indexes recovered to finish near the session’s highs, but losses came in weak volume that traders said were partly the reason for choppy trade on the day. Mainland Chinese markets suffered mainly because money supply stayed tight.

“It’s a case of the Monday blues,” said Jackson Wong, vice-president for equity sales at Tanrich Securities. “There’s definitely some fatigue because people have been going into the weekends expecting Beijing to act and nothing happens.”

Of course, that’s just the point. It’s not merely Monday blues.  Obviously the Chinese want to wring price inflation out of the system. And they’re willing to do quite a bit in terms of restraining the money supply to do so.

Ultimately, they’ll have to slow the velocity of money, which means damping demand. But damp demand too much and it can be hard to restart.

It’s a balancing act. And how well the Chinese manage it will have a big impact on markets both in Hong Kong and China

Expect more choppy trading sessions in China as officials struggle to contain prices while igniting the consumerist demand of China’s “second nation.”

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