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Liquidity's Role in Delusions of Recovery

06-10 08:51 Caijing

Chinese market rallies, commodity prices and U.S. improvements are fueling hopes of an economic turnaround. Don't be fooled.

By Hu Shuli, editor of Caijing

(Caijing Magazine) Mercury on the Chinese capital market's thermometer is rising in tandem with the summer heat. We're seeing a lot of excitement. The Shanghai Stock Index has been hitting highs not seen since last summer. Capital inflow has been explosive. And Hong Kong shares have rallied in ways reminiscent of the 2006 bull market.

The mainland property market is rising again. In the first four months of this year, residential housing sales rose 30 to 40 percent. Land has been selling at a premium. And sales in Beijing more than doubled compared to the same period last year.
Global commodities have rallied. The Reuters/Jefferies CRB Index in May recorded the highest single-month gain in 35 years, and on June 1 scored the largest ever single-day advance in the last two months. The market expects the index to rise another 19 percent by August. Crude oil prices shot up nearly 30 percent in the past month to almost US$ 70 a barrel.

Admittedly, the warming trend is linked to economic recovery. In the United States, the ISM manufacturing index, new factory orders and housing starts have started to look better. A consumer confidence index jumped to a level of 54.9 in April -- the fourth largest monthly rise in 32 years. All these factors indicate a moderating of the economic slide.

In China, the Purchasing Management Index performed better than expected. Export orders in May rose above 50 (on a scale of 0-100) for the first time since November, reflecting a pickup in the export sector that could sustain an economic rebound.

However, these warm spots are no reason for runaway optimism. The crisis may be abating, but the real economy provides limited evidence of a turnaround.

Excess liquidity is the primary reason for the sharp rise in asset prices. We believe the market is likely pumped up on steroids and basking in a liquidity-induced euphoria.

Through the ongoing crisis, central banks of major countries have adopted low or zero-interest rate policies. Governments and central banks injected huge amounts of capital. The Chinese government's 4 trillion yuan stimulus package got a lot of attention, and the U.S. Federal Reserve's "quantitative easing" policy touched the extremes of loose monetary policy.

Each of these short-term stabilization measures point to a key phenomenon -- excess liquidity. This U.S. dollar-led global liquidity binge is pushing up inflation expectations, as well as weakening the dollar's role as a risk haven. As a result, global capital has been rushing into tangible assets and commodities to hedge against inflation.

Rising asset and commodity prices reflect not only the normal bounce after prices bottom out, but also a swelling bubble of speculation. Because the economic recovery is not yet on solid ground, undue market speculation will destabilize the economy. Indulging in liquidity-induced euphoria is worrisome.

In the short run, rallies in China's stock and property markets can only be regarded as a technical bounce -- not a fundamental turnaround. The property market, either in terms of trading volume or investment inflow, is propped by policies: The government cuts the ratio of required capital for developers, relaxes conditions for developers to get land, and lowers land prices, while banks offer easier credit for property projects. In contrast, market factors such as real demand and earnings are unstable. Rising stock indexes may reflect reasonable bounce, but they do not mean macroeconomic conditions and corporate earnings have turned for the better.

This latest rally has all the marks of being fueled by easy credit. Statistics are difficult to come by, but the consensus is that a substantial part of the unusually high level of bank lending since the beginning of the year went into the stock market. 

One possible reason for rising commodity prices is the strong demand for crude oil, copper and iron ore to feed an economic recovery in China. However, a close analysis reveals that only a small portion of recent Chinese imports went toward meeting production demand. A lot of these imported materials were used to build up strategic reserves or restock some Chinese enterprises that wanted to take advantage of low prices. In terms of demand this year, the current increase is not sustainable. Moreover, the global commodity bounce and inflation expectations are self-fulfilling, raising a risk of global stagflation.

From medium- and long-term perspectives, the current financial crisis stems from global economic imbalance. World recovery must start with a new balancing. A precondition is that major countries must readjust economic structures. This takes time and involves many twists and turns.

The 4 trillion yuan stimulus package notwithstanding, China continues to face soft domestic demand and is pinning hopes on rising external demand to absorb new capacity. The United States, searching for a rebalancing of its own, must abandon a model that relies on over-consumption.

But a recovery of U.S. demand is likely to fall short of China's expectations. Recent figures show U.S. personal savings in April rose 5.7 percent -- to the highest level in 14 years. Due to tax cuts, personal disposable income in April rose 1.1 percent. But instead of spending their additional income, Americans put it in savings.

Recent trends indicate overseas demand for Chinese goods is unlikely to recover in the short term. Nor will it return to previous levels of prosperity in the medium term. This puts more pressure on China to expand domestic demand through structural adjustment, while at the same time pursuing important reforms such as income re-distribution and expanding the service industry. It is indeed a tough battle.

Without a doubt, data that shows warming trends can increase the kind of market confidence badly needed in this economic crisis. But solid confidence must be built on fundamental economic improvements and rational expectations. Over-optimism about economic recovery or exaggerated inflation expectations are to be avoided. For now, we must be prudent and optimistic, without being swept away by liquidity-induced euphoria.

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