Worrisome economic approached by CHINA

On May 11, China's stock market slipped into official bear market territory so quietly you'd think it was no big deal. The Shanghai Composite Index fell 1.9%, putting it down 21% from its Nov. 23 high.
What's next? Predictions fall into two diametrically opposed camps.
More on the People's Bank of China

There are the China bulls, like old China hand Mark Mobius of Templeton Asset Management, who see the bear market as a buying opportunity. Stocks in the Shanghai index now trade at 20.2 times the trailing 12-month earnings. That's cheap compared with a 49.5 price-to-earnings ratio for the market at the October 2007 high.

And there are the China bears such as GloomBoomDoom.com Publisher Marc Faber, hedge fund manager and short-seller Jim Chanos and Harvard economist Ken Rogoff, who are all expecting China to crash in the next six to 18 months.

Why the extremes of opinion?
Because China is trying to execute a maneuver that almost no country or central bank ever gets right. Beijing is trying to:
* Slow its economy, which grew at an annual rate of 11.9% in the first quarter of 2010.
* Control inflation, which grew at a 2.8% annual rate in April and threatens to run out of control.
* Deflate a bubble in assets such as real estate, which saw prices grow at a record 12.8% annualized rate in April.
All of that without crashing its economy or its financial markets.
The Federal Reserve hasn't been able to pull off this kind of move. The European Central Bank doesn't even try. So why, the bears ask, with good reason, should we think that China can?
 
Because, say the bulls, China is different. Its state-controlled economy gives the government and the People's Bank of China vastly more control than any government or central bank has in the more-free-market economies of the developed world. And that will let the government thread the narrow path between slowdown and bust.


My opinion? It's not only too early to tell whether Beijing can deflate its bubble without crashing China's economy, but we're only just entering the really, really dangerous period when Beijing could actually make a mistake big enough to cause a crash. A crash in China's controlled economy and financial markets wouldn't be anything like a crash in the United States, of course. A company or an entire industry in China is bankrupt only when the government says it's bankrupt. But even a controlled China-style crash would be very painful for investors.

I think the trend in China's stock markets is still downward, even if the bulls prove ultimately correct, as the Chinese government tries another round of fixes. In my opinion, investors will get a buying opportunity in China this year at prices below current levels, even if China doesn't crash (whatever "crash" means in the Chinese financial system). I'm advising building some cash so you'll be ready to take advantage of that opportunity but keeping that pot of China cash on the sidelines until you see how the story comes out over the next few months.

Hitting the brakes -- and failing


Here's what we know about this bear market so far:
The story to date is pretty straightforward. Chinese financial markets and China's economy have been bending gradually under pressure as the Beijing government tries to fight inflation and slow real-estate and stock market speculation without tanking the market or the economy. The steps to date have been frequent but small. For example, the People's Bank has raised reserve requirements three times this year, most recently May 3. Banks in China are now required to keep on reserve cash equal to 17% of their loans.

Add to that restrictions on second and third mortgages, limits on how many houses a family can buy, warnings to banks about uncollateralized loans, lower lending quotas and higher yields on money banks leave on deposit with the central bank and you've got an impressive series of measured steps to slow lending, speculation and the economy.

Trouble is, these measured steps don't look like they've had much effect. China's rate of increase in real-estate prices in April was its highest on record. Overseas money continues to flood into China as investors and speculators bet on continued fast growth in the Chinese economy and a revaluation of the renminbi. Foreign direct investment rose in April for the ninth month in a row at a 25% annual rate. Bank lending slowed, but banks still extended $110 billion in new loans in April. That, if continued, would put bank lending on a path to $1.3 trillion for 2010. That's disappointingly close to the record $1.4 trillion in new loans in 2009 that the government had vowed to reduce. - Jim Jubak worrisome