How to defuse a time bomb: China worries about liquidity

IF ANYONE had needed more proof of the extent of global economic imbalance, then last week’s inflation figures ought to have been enough. Despite unprecedented monetary ease, America’s inflation rate is running at 0.6 per cent, the lowest level in 53 years. In China, however, money is abundant and inflation is running at 4.4 per cent. That is causing deep unease in the Chinese Communist Party, but it might be a boon for spread betters. The important question, as ever, is whether to go short or long.

Certainly the momentum has mostly been downwards recently. Fears about monetary tightening have driven equity prices down, and the FTSE Xinhau 50 has fallen by 10 per cent over the last two weeks. The People’s Bank of China (PBoC) raised its reserve requirements on Friday in an attempt to suck liquidity out of the system, while the government has threatened to intervene directly in some markets to lower prices. The government has also tried to crack down on state banks deemed to be lending too much – officially there is a 7.5 trillion yuan (£706bn) quota for lending. With further tightening expected, traders might be well advised to go short on Chinese stocks. Conveniently, IG Markets now offers spread betting on the Xinhua 50.

Unfortunately, as Dylan Grice of Societe Generale observes, “the Chinese stock market is crazier than most”, so traders also need to be careful. One reason why the Chinese government has been so keen to interfere with its banks is that there is an awful lot of liquidity in China at the moment. As a result, speculative bubbles have grown up in assets from property to caterpillar fungus – an obscure Chinese medicine that now costs as much as gold. If inflation persists then Chinese savers may seek out more profitable speculative investments, inflating bubbles further.

Grice argues that the Chinese government is struggling to contain Chinese speculators and that they may be forced to engineer a slowdown, “in which case a hard landing shouldn’t be beyond the realms of imagination”. But before that happens, Chinese asset prices could well increase dramatically, so traders need to make sure they are not caught out. Much depends on how effective monetary tightening is seen to be – with rising food prices a global phenomenon, many analysts fear that inflation will persist.

Mark Williams, senior China economist at Capital Economics, is not one of them however. Williams argues that much of the recent increase in food prices was the result of a temporary supply shock, and that inflation ought to recede within a few months. He says there is “no strong evidence of bubbles” and that “while there is the potential for speculative spending to take off”, it isn’t happening yet. According to Williams, the Chinese government is succeeding in suppressing speculation, and China ought to keep growing. As he says, investors “shouldn’t panic”.

But they should perhaps step back a little. Chinese liquidity is rather like an unexploded bomb. Either the PBoC will be able to slowly defuse it, or it will go off. Spread betters need to be careful not to get caught in the blast if that happens.