Chinese Stock Market Correction: A look at the fundamentals

In the previous post and in the press there is a lot of talk about the causes of the 9% correction in the Chinese stock market (after recent highs note).

The reasons suggested by commentators are (1) a potential slow down in Chinese growth and (2) a rise in inflation.

For one thing (1) might be driven by a fall in exports - this in turn would be driven by a fall in the growth in the US or Europe.

To get an idea of the Chinese growth situation it is worth looking at the recent World Bank report on China. This is the story as reported in China Daily. This article is dated 15th Feb. 2007. Key phrases are in bold.

China's growth to slow in 2007 - World Bank

China's economic growth is expected to fall to 9.6 percent this year from 10.7 percent last year amid a mild slowdown in exports, the World Bank has said.

Export growth is likely to decline to 20 percent this year, in real terms, from 24 percent in 2006, the World Bank said in its 21-page quarterly update on China.

"A resilient world economy means that export demand prospects remain good, although less buoyant than in 2006," the report said Wednesday.

The World Bank said productivity growth meant exporters would probably be able to continue absorbing the effect of a rising currency and the gradual lowering of export tax rebates.

Investment, a main engine of growth in the world's fourth largest economy in recent years, is unlikely to slow drastically in early 2007, while consumption should grow solidly, it said.

"With rising profit growth and ample liquidity in the banking system, the fundamental drivers of enterprise investment are still present," the report said.

"Consumption (will be) underpinned by income growth and to a lesser extent the shift in government spending towards health and education, but held back by food price increases," it said.

The World Bank urged China to increasingly rely on new sources of growth in the medium term, with a re-allocation of labor out of agriculture and into services, and labor-intensive urban growth, seen as key.

This could boost urban employment, wages and household incomes and reduce rural-urban disparities, while mitigating external imbalances, the bank added.

"Re-balancing the pattern of growth, featuring a move to more labour intensive urban growth, will need to be a key part of an effort to boost the role of consumption in the economy and to reduce the trade surplus," it said.

So predictions from the World Bank are for only a very small fall in Chinese growth. 9.6% is still massive. Perhaps of more concern is the inflationary trend in China. Again this article is from China Daily and is dated 12th Feb. 2007. The bold print this time tells its own story. "Stock market bubble" is mentioned.

Inflation may hold close to two-year high

China's inflation probably held close to an almost two-year high on food prices, increasing the likelihood of the central bank raising interest rates.

Consumer prices rose 2.6 percent in January from a year earlier, according to the median estimate of 22 economists surveyed by Bloomberg News. That would be down from 2.8 percent in December, the biggest increase since February 2005. The statistics bureau will release the figures at 10 a.m. on Feb. 14.

"The probability of an interest rate raise in the coming few months has increased and a second rate hike is also possible this year," said Ma Jun, chief China economist at Deutsche Bank AG in Hong Kong. Besides accelerating inflation, he cited concerns over a potential stock market bubble and a rebound in investment.
China is trying to prevent the overheating of the world's fourth-biggest economy, which last year expanded 10.7 percent, the fastest pace since 1995. An export boom drove a US$177.5 billion trade surplus that is pumping cash into the financial system.

Economists surveyed by Bloomberg News last month expect the central bank to raise interest rates and curb bank lending in the first half. The one-year benchmark lending rate is 6.12 percent.

Central bank Governor Zhou Xiaochuan is seeking inflation of less than 3 percent this year. Food accounts for a third of the consumer price index.

Grain Prices

Corn futures on the Dalian Commodity Exchange jumped 25 percent in 2006 as soaring demand swallowed a record harvest. The world's most populous nation may struggle to meet its grain needs as farmland shrinks amid rapid urbanization, the Ministry of Agriculture said Jan. 26.

"Unless the government has massive food stockpiles to dump on the market that we are not aware of, we may see prices soar even higher in the months ahead," said Carl Weinberg, chief economist at High Frequency Economics Ltd. in New York.

The inflation figures will be affected by the timing of China's Lunar New Year holiday which fell partly in January last year. Chinese people buy extra food for holiday feasts.

M2, the broadest measure of money supply which includes cash and all deposits, probably grew 16.5 percent in January from a year earlier, the Bloomberg News survey showed. The central bank will release the figures as early as Monday.

Producer prices likely rose 3 percent in January from a year earlier, the survey showed. The statistics bureau will release the figures tomorrow.

The increase in money supply also needs to be considered. The ECON101 general rule is that if the MS increases, the interest rate falls, investment increases (cheaper borrowing), inflation increases. Put another way, if business confidence increases (as it has in China), investment increases, and without an accomodating increase in money supply we would get an increase in interest rates that might dampen investment.

Interesting times.