China’s moment of reckoning

At the moment, all eyes are on China.  It is that country experiencing one of the strongest growth.  It has a market outperforming many others.  It is a major source of funding for states and companies alike.  But when will China’s “bubble” burst?

US had 1929, Japan had 1989, and Asia had 1997. When is China’s moment, Andy Xie asks. He believes it could be ten years from now.

From FT:

The question is crucial, not just for those investing in Asia today, but for the wider global market. For as investors around the world reel from the recent financial crisis, many have clung to the idea of a Chinese boom, as the one bright spot of hope in an otherwise grim world. The trouble is that history suggests that much of this optimism may be misplaced.

Financial markets have a way of working themselves into a frenzy during rapid economic development, which ends up leading to disaster. It is the ultimate testimony to the gross inefficiency of markets. The problem is the unique mix of extreme optimism and rampant liquidity that occurs during periods of rapid economic development.

Given the Chinese stimulus, the story of bubbles has once again emerged.  Sure, it’s good that Chinese banks are lending.  But the issue centers around the idea that the loans don’t go to business start-ups or infrastructure projects.  Instead the moneys are pumped into the stock market, which is why there has been so much volatility in the Chinese markets.  Four or five percent moves to the upside and down are becoming normal; it’s like when the crisis was just beginning and the Dow was following such huge swings.  Xie made the following comments regarding the stock market:

But when businesses make profits from, rather than for, the stock market, it becomes a negative sum game. It needs continuing liquidity inflows to sustain it. This is why high growth and a high savings rate are vital.

On the other hand, such a market essentially subsidises capital formation. The capital subsidy leads to overcapacity and low returns on capital. This is why poor profitability, high asset prices, and high economic growth rates can coexist. Indeed, they must exist together.

China’s economic development is undoubtedly going to be the most important economic event for the next decade or two. But the semi-permanent bubble situation makes it extremely difficult for financial investors to participate in this story.

“Buy and hold” simply won’t work. Value investing doesn’t work because value investors base their decisions on price/earnings ratios and price/book value ratios falling below certain levels.

Chinese stocks never get there.

I think right now, there’s the notion that the Chinese can do no wrong.  There are other good points in the article made by the author but there are two interesting things to take note of:

  • Will China really have its moment?
  • If so, how will it unfold?

Source: FT

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