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Big Bubble In Little China!

June 12, 2015

OK pardon the play on a 1986 Kurt Russell action adventure flick entitled “Big Trouble in Little China”. China isn’t little but the bubble is potentially big. Apparently, the Chinese stock market has boomed to a value of $6.5 trillion in the past year. That still leaves the Chinese stock market well short of the NYSE whose value in February 2015 was $16.6 trillion. The Shanghai Stock Exchange (SSEC) is up 58% thus far in 2015 and a 152% since the low of 2014. To put that in some perspective the SSEC was up in 2007 129% to the top in October and had run 293% from the low of 2006.  The current market is still about 20% below the highs of 2007.


But there are differences in the 2015 bull market and the 2007 bull market. In 2007, the Chinese economy was still growing at well over 10% annually. Today GDP growth has fallen under 7% and could go lower.  P/E valuations of small cap stocks have moved into NASDAQ late 1990’s levels; leverage has soared with loans to stock investors at record levels; and, finally the current stock market is being fueled by smaller traders seeking quick profits. One study suggested that two-thirds of new stock market investors hadn’t completed high school. If there is a silver lining, it is that the SSEC is still trading at P/E valuations somewhat in line with its longer-term average.

Nonetheless, many are calling the Chinese market a bubble. China has seen massive loan growth since the 2008 financial crash with numerous firms leveraging up particularly in the real estate industry. Corporations have almost exclusively relied on debt financing since 2008. Local governments have borrowed some $4 trillion since 2008. That’s more than the GDP of Germany. Many call the Chinese real estate market an accident waiting to happen. There have already been some high profile bankruptcies. Despite that there are many who expect the Chinese bull to continue. The PBOC has followed a generally easy monetary policy in an attempt to “goose” the Chinese economy back to previous levels. Inflation levels have fallen and recent PPI numbers even suggested deflation.

Other signs of slowing in the Chinese economy are that both imports and exports fell in May 2015. Fixed asset investment has fallen back to levels last seen in 2000. This past week China received word that the New York based MSCI Index decided against including Chinese stocks. The Chinese dominate the Chinese stock markets with foreigners less than 6% of the market. A report from UBS and PWC says that China produces a new billionaire every week. It is a demonstration that wealth is shifting from the West to the East. Still, the US remains in the lead. According to figures, the US had 570 billionaires in 2014 while China had 200. But the Chinese billionaire growth has been faster.

Then there is the “rumble in the South China Seas”. This all a part of what many call the new Cold War. The US has demanded that China immediately cease all land reclamation activities in the South China Seas. At issue is a group of islands known as the Spratly islands where China is actively extending the islands and apparently installing military installations including runways. The Spratly’s are a disputed group of reefs, islets, atolls, cays and islands claimed by a number of countries including China, Taiwan, Vietnam, Philippines and Malaysia. There is no indigenous population. The area offers rich fishing grounds and may contain significant reserves of oil and gas.

The US has been in the process of deploying significant military assets in the region including nuclear submarines, aircraft carriers, and stealth bombers along with numerous other military weapons. The US claims that China will block a significant shipping channel or overflights although there is little evidence that is the case. The US has declared there is no military solution to the problem but they have as noted deployed significant military assets in the region. China has shown no signs of backing down and there has already been a significant “cat and mouse” game in the region.

There are some who believe the spat over the Spratly islands masks the real reasons for the dispute. China is leading the way on the creation of the $100 billion BRICS Development Bank a bank that is similar to the US dominated IMF. The bank is being set up to help foster greater financial development amongst emerging markets. It is interesting to note that the BRICS nations now make up 56% of the world’s GDP and contain 85% of the world’s population. They also control about 70% of the world’s foreign exchange reserves.

China is also the leader in the creation of the Asian Infrastructure Investment Bank (AIIB) an international financial institution being created to provide finance for Asian infrastructure projects. The AIIB is seen as a rival for the US dominated institutions of the IMF, the World Bank and the Asian Development Bank (ADB). Numerous major countries outside of Asia have signed up to join the AIIB much to the chagrin of the US who tried to persuade European countries in particular to not join. The US, Japan and Canada are notable exceptions to joining the AIIB.

China is notably being excluded from the US led Trans Pacific Partnership (TPP) a regulatory treaty for trade and investment. Canada and Japan are notably a part of the TPP. But on the other side China is leading the way on what is known as the “New Silk Road” a project that envisions the resurrection of the ancient Silk Road that could run from Shanghai to Berlin.

The road would extend for 8,000 miles traversing China, Mongolia, Russia, Belarus, Poland and Germany and create an economic trade zone that covers a third of the earth. The plan envisions high-speed railways, roads and highways and would include energy transmission and distribution networks and fiber optic networks. There would also be a “Maritime Silk Road” that would link China with the Persian Gulf and the Mediterranean connecting three continents – Asia, Europe and Africa. That area covers a population of 4.4 billion and economic output of $21 trillion.

Key to all of this is that the development banks and the Silk Road would be Yuan based not US$ based. That would be a direct threat to the economic hegemony of the US. China also wants the Yuan in the SDR (Special Drawing Rights). SDR’s are supplementary foreign reserves administered and managed by the IMF. The IMF is resisting the entry of the Yuan in SDR’s. China is prepared to allow the Yuan to trade freely and many believe that China would also announce they are backing the Yuan with gold and would reveal their gold reserves.

China and Russia have been forging closer ties. Russia and China have signed energy deals for pipelines that would ship Russian oil and gas to China and Asia. Russia and China have forged trade deals that would be denominated in Yuan and Rubles and not in US$ as is normally the case for trade deals. Russia is seeking ways to breakout under the yoke of Western sanctions and forge relationships that lessen their dependency on Europe for trade and for Russia’s huge reserves of oil and gas.

China is too powerful militarily for the US to engage. So while a “cat and mouse” game may continue in the South China Seas nothing is expected to happen – unless of course there was an accident. Instead, expect heightened propaganda aimed against China, possible attacks on Chinese markets, even sanctions as with Russia although that would hurt the US as well, support for dissidents, intrusions into Chinese waters while trying to avoid a direct confrontation and even support for jihadists who are looking to create a caliphate in Western China. US/China trade is estimated at $600 billion although the US ran a $343 billion trade deficit with China in 2014.

The Chinese stock market has moved into the stratospheres. The background is, however, anything  but friendly to the Chinese stock markets. Some monthly indicators are at extremes that were seen prior to the collapse in 2008. In 2008, the Shanghai Stock Exchange collapsed 72%. That was a drop that exceeded the drop in the major US stock markets. Today the Chinese stock market is potentially more dangerous than it was in 2007 prior to the 2008 collapse. A bubble waiting to be burst? If the Chinese bubble stock market were to burst, it would not be surprising that its bursting was accompanied by a collapse in global stock markets as well. That would not be a pleasant thought.                           


Copyright 2015 All rights reserved David Chapman             

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David Chapman regularly writes articles of interest for the investing public. David has over 40 years of experience as an authority on finance and investments via his range of work experience and in-depth market knowledge.

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