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Volume 1.9 China's Reflation Experiment Aug 11 2009

Volume 1.9 China's Reflation Experiment Aug 11 2009

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Published by: sasa332138 on Nov 14, 2011
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Boeckh Investments Inc., 1750-1002 Sherbrooke St. W., Montreal, Qc. H3A 3L6 Tel. 514-904-0551, info@bccl.ca
V
OLUME
1.9A
UGUST
11,
 
2009
 
V
OLUME
1.9A
UGUST
11,
 
2009
China’s Reflation Experiment:
Short Term Gain / Long Term Pain? 
By all appearances, China’s success in stimulating its way out of the globalrecession has been wildly successful. GDP growth was 8% annualized last quarterdespite ongoing export weakness. The stimulus package, consisting mainly of acombination of infrastructure spending (U.S. $590 b) and state-directed expansion ofbusiness lending ($1,084 b), is by far the largest as a share of GDP of any nation. Taxrebates and other incentives have increased domestic consumption dramatically. Forthe first time, more cars were sold in China than in the U.S. in the first half of this year.This success masks a growing set of imbalances. GDP growth has increasinglybeen driven by capital investment, as exports and profits have both declined over thelast two years (Chart 1). At a time when most businesses outside of China areretrenching by reducing leverage and cost cutting, large Chinese corporations are doing just the opposite. Capacity expansion with weak exports will lead to a growing outputgap that will further reduce profitability. Due to state control of the banking system afinancial crisis is unlikely. However, investors should be concerned particularly giventhe high valuations of most Chinese equities (P/E ratio averages 38 for stocks in theShanghai composite index).
 
 
The
Boeckh Investment Letter
2
 
C
HART
1
Rapidly expanding excess capacity is likely to depress consumer prices and yetasset price inflation is thriving once again. The close relationship between moneysupply and property prices (Chart 2) indicates that prices are likely to move upsubstantially over the next 6 to 12 months. The stock market has surged 85% from thebottom last fall, although it is still off 45% from the peak in 2007. This past week,Chinese policy makers sounded the alarm over reckless domestic lending practices andemerging bubbles in asset prices, real estate in particular. Regulators have directedbanks to ensure that new loans are channeled towards the real economy and not intospeculative investments. This clearly signals that the authorities are taking the threat ofanother bubble seriously.
 
 
The
Boeckh Investment Letter
3
 
C
HART
2
Domestic consumption has held up well despite the global downturn. Given thatthe sector is a relatively small portion of GDP, the Chinese economy continues to bedependent on the export market and will be for years to come. Exports remaindepressed due to ongoing consumer retrenchment in the U.S. and Europe, China’sbiggest customers. Social unrest due to rising unemployment is considered the mostimmediate threat to the regime. If asset bubbles are the price of stimulatingemployment, the authorities will keep pumping up credit.Capital flows into China in the first half of this year have been huge, driving thecapital account surplus to U.S. $178 billion in the last quarter. While there has beenmuch concern over the unwillingness of the Chinese to continue accumulatingtreasuries, the fact is that they do not have any alternatives. The recent surplus has

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