Eighteen years ago, Chinese students and intellectuals massed in Tiananmen Square to push through their vision of democratic reforms, egged on by an apparently conflicted central government, where the forces loyal to Deng Xiaoping were seemingly marginalized by those loyal to Zhao Ziyang initially, with tragic results for both the students and China in general.

While the comparison of the events of June 4, 1989, to today’s stock markets appears overly sensational at first, the thrust of recent articles on China, including my previous one, [1] has been on the apparent loss of policy efficacy by the central People’s Bank of China (PBoC) in recent months.

Six months ago, total transaction volumes on the Shanghai and Shenzhen exchanges were less than US$5 billion per day. That figure now stands 10 times as high, at $50 billion per day. This volume is something China can be proud of, barring one minor detail, namely that the central bank and various policymakers would much rather not see it happening.

Even as central bankers exhort the country’s citizens to beware of bubble-like conditions in the stock markets, investors appear unruffled, reversing the policy impact of any announcement. Be they students, farmers or construction workers, every Chinese living in the two big cities of Shanghai and Shenzhen appears now to have a brokerage account. Conversations in the normally noisy dai pai dongs [2] in Guangdong province and Hong Kong drop to a quick hush whenever the subject of stock tips comes up. In short, the stock market today represents a revolution against the diktat of the PBoC, questioning its very authority.

A symphony of bubbles

Experience from the rest of the world shows that stock-market bubbles are neither infrequent nor unpredictable; in most cases, they are compounded by the mistakes of policymakers. The technology bubble of the 1990s is a case in point, as investors chased the dream of a new economy that could offset the apparent physical constraints imposed on the functioning of the real economy, ie, bricks and mortar. Initially, the promise of new technologies wasn’t accompanied by enough listed companies, thereby concentrating the bets of investors. It took a few years for enough listings to appear, but by then the damage had been done to the long-term prospects of the sector.

The dotcom era’s little experiment failed because investors mistook the medium for the message, in other words, that emerging new technologies merely helped to rearrange the habits of consumers but did not necessarily alter the physical provision of products and services. Thus, while book lovers would move away from their local bookshop to an Internet store, they would still be buying books, and perhaps in higher quantities.

To that extent, the zero-sum game was the right strategy for investors, which was to sell the stocks of traditional stores while buying into online stocks. Meanwhile, a number of fancy technologies had no underlying cash flows, thereby rendering guaranteed losses for anyone purchasing them.

As the bubble burst in the early part of this decade, the US Federal Reserve cut interest rates and attempted to shift the consumption dynamic to the housing market. The result was a rapid expansion in house prices across the United States, fueled by a sharp relaxation in lending standards. Starting with the two coasts, the home-price boom moved rapidly inland like a wayward hurricane, uprooting economic assumptions in its wake.

Eventually, the market will have to come to terms with the reality of too many houses for a declining group of richer immigrants and lower-quality employment for anyone remaining in the hinterlands. I have previously written about what is likely in store for the US housing market; [3] recent observations with respect to prices of higher-end residences in New York only serve to strengthen that view. I am well aware that the article upset a number of bullish readers, but such is the problem with propagating unpopular views.

The US housing and stock bubbles positively pale in comparison to the ones being observed in many other markets, including property and stock markets across Asia. There are some notable exceptions such as Thailand, where a combination of policy missteps has left markets relatively stable rather than rising, but in most other places the boom is all too apparent. Even in straitlaced Singapore, house prices have risen broadly over the past two years, wiping out pent-up equity losses from the previous 10 or so years.

Chindia to the fore

But all these markets are mere sideshows compared with what’s going on in China and India. It is well-nigh impossible to complete  secondary market transactions on high-end property in both markets, as a flood of new offers pour in. Most new property developments are sold within the first week of announcement, with the period more likely to be a day or so in the big cities of the two countries. By most estimates, property prices have doubled in the past two years in major Chinese cities, and more than tripled across major Indian cities.

Stocks are very similar, with significant money flows chasing a limited number of listed entities. The lack of selection is the key factor in pushing up overall market valuations to unsustainable levels, and as such is an eerie reminder of the aforementioned technology bubble.

More than India, it is China that faces the threat from investors chasing too few stocks. India’s markets have a much longer history and, more important, many investors still remember the stock-market scandal of the early 1990s that wiped out the nest eggs of a few thousand people. China’s problem is also one of magnitude: with more than 100 million investors directly participating in the markets, the impact of any downturn will be broad, and politically suicidal. As I wrote previously, problems encountered in the government of Hong Kong after a two-thirds decline in house prices since 1997 will help to guide policy direction in mainland China.

India’s central bank has practiced vigilance on asset markets for a longer time, ensuring that banks are not providing easy loans for equity investing, and also tightening the guidelines on property loans in recent months. Rate rises have also played a part in keeping the equity markets below frothy valuations, although that is entirely relative to the excesses observed elsewhere in Asia. In contrast to the market behavior in India, Chinese investors have shrugged off recent rate rises, and banks have circumvented restrictions on lending through other means.

What will happen?

China will have to choose between the lesser of two evils, namely the protection of employment in its export-dominated industries or the safety net being created by investments in property and stocks by millions of its citizens. I believe it will choose to protect people’s wealth more than lower-end manufacturing jobs; therefore a sharp revaluation of the Chinese currency, the yuan, is certain in the next few weeks.

In its aftermath, the economic cognate will have to shift from production to consumption; therefore we should see the stock prices of exporters falling even as those of companies servicing domestic demand will increase. Banks will have to absorb billions of yuan in defaults from the export sector, particularly to the many inefficient state-owned companies in northern China. That will cause a sharp decline initially in their stock prices, but I expect the outlook to improve rapidly thereafter.

For the rest of Asia, a yuan revaluation would set off increased volatility as investors try to take profits and other Asian countries adjust their currency values. In turn, their holdings of US and European government bonds as part of foreign-exchange reserves would diminish, sending up bond yields globally. That is how the adjustment in China would likely set off broader stock-market declines globally as investors come to terms with both higher interest rates and lower Asian appetite for Group of Seven assets. Sharp declines in stock prices would necessarily follow in most major Asian markets.

This correction would prove cathartic to the performance of Asian economies in the decades to come, but in the short term, pain is unavoidable.

1. India 1, China 0, Asia Times Online, March 3.
2. Dai pai dongs are uniquely Cantonese, generally specializing in a limited range of food items. Besides the delicious and cheap food, the eateries are also known for their communal seating, and extremely high noise levels.
3. Hobson’s choice, ATol, March 7.