June 01, 2007

Global Market Brief: How Not to Slow a Runaway Stock Market

Source: Stratfor
May 31, 2007 19 19 GMT

The Shanghai Stock Exchange plunged 6.5 percent May 30 after the Chinese government announced a tripling of stock trading taxes to 0.3 percent. The following day the market shrugged off early losses to close up 1.4 percent.

Despite protectionist sentiments in many states, it is rather rare for governments to attempt to directly protect share values. In China the issue has been turned on its head: Rather than fearing that the markets are crashing without reason, the government fears the markets are surging without reason.

Luckily for Beijing, getting markets to fall is much easier than propping them up, as the Thai well know. However, China's markets not only do not trade on their fundamentals, but most of the tools a state could use to suppress stock trading will not work in China.

The easiest way to contain a runaway stock market is to let it self-destruct. When a speculative bubble forms, sooner or later it will pop and the market will suffer a series of cataclysmic crashes. Such events are traumatic, but they are essential to both restoring rational values and impressing upon overenthusiastic investors that the stock market is not a one-way trip to riches.

That is critically important when one considers that cadres of individual investors in China -- holding more than 70 percent of shares on the Shanghai Stock Exchange -- have invested their entire livelihoods into their equity stakes. Thus, the potential for social unrest and violence is much higher for disgruntled Chinese than U.S. investors.

Avoiding that catastrophic crash requires some sort of mechanism to slow the exchanges' rise, but Chinese exchanges have not had time to develop self-regulating or built-in cool-down mechanisms to shape expectations. Unlike the New York Stock Exchange or Germany's DAX, where accurate information flows regularly and provisions against insider trading are rigorously enforced, in China the stock exchange is a cauldron of manipulation by the politically connected. Thus, any statistics used to evaluate equities in the rest of the world have very little meaning in China, disguising the nature and scope of the bubble already in place.

Consider some of the characteristics of the Chinese stock and financial markets:

Immature market structure: The Chinese stock market really only sports a decade of stuttered operations since reopening in 1991, after more than 40 years of no action.

Lack of established regulatory framework: The Chinese government has proven unable to set up guidelines to establish multiple investment channels, whereas in the United States 401k or individual retirement account programs proliferate in order to offer more structured investment options with lower risk.

Lack of effective oversight: Most of the stocks on the Chinese exchanges have been handpicked by the government as the "fastest risers" -- either in terms of operating revenues, profit and the like or in terms of good political connections. Simply put, the quality of the equities has been vetted by connected government personnel, not the market.

Immature buyers/investors: Western investors are very active because information is easy to come by and the system's structure mitigates risk; they can easily trade online or via large brokerages or funds. Those Chinese investors who are not politically active must invest directly into specific stocks with minimal guidance, making their investments far more volatile.

Immature sellers: Chinese listing firms do not follow a set standard, some break what rules there are, and others do not even know what rules exist.

Beijing's problem in dealing with such characteristics, however, is that the "normal" tools to rein in an overheated stock market would actually cause more problems than they would solve.

Perhaps the most reliable way to cool off any portion of an economy -- stock markets included -- is to jack up interest rates. Reducing access to capital slows investments of all types and certainly makes dubious practices that are common in China -- like taking out a second mortgage or other loan to purchase shares -- less attractive. It also would make traditional savings accounts far more appealing.

But such an obvious option is a nonstarter in China. The defining characteristic of the Chinese economic system has traditionally been cheap capital made possible by interest rates held below the rate of inflation. This cheap capital in turn is used for two key objectives: first, to prop up any and all state bank-funded projects that help ensure maximum employment and thus contain social pressures; second, to fund Chinese government purchases of U.S. Treasury bills, which helps contain the pace of the yuan's appreciation. Though benchmark interest rates have been increased four times in the last year alone, such increases have been minor and aimed exclusively at dampening lending, not at changing savings patterns.

But the cheap capital ultimately has to come from somewhere -- in this case, the famed Asian savings rate. Some of that cash has obviously leaked out of urban dwellers into the stock market in a manner that is flirting with disaster, but should the core cash that China's millions of savers funnel to the state via their deposits actually pay meaningful interest the result would be disastrous. Should China lose the ability to capture that cash, interest rates would have to climb to maintain the size of this deposit pool. The subsequent shortage of cash would make it more expensive for banks to issue loans to loss-making state-owned enterprises, potentially causing some state-subsidized sectors to screech to a halt if not collapse outright.

Which means the only real way to slow the surge of liquidity into the stock markets is to offer more options. Of course the question then becomes: What options? Products like the U.S. 401k require a far deeper, more sophisticated and better regulated system. There are always property markets, but they already are suffering from a bubble more dangerous than the stock markets.

China does not yet have a mature corporate bond market, and its derivatives market and commodity markets are so new and underdeveloped that a large surge of capital into them now would simply institutionalize all of the stock market's shortcomings into them as well. This leaves Chinese investors with few options -- and Beijing with a stock market that simply cannot slow down without collapsing altogether.

BRAZIL: Brazil's Ministry of Justice announced May 30 the creation of a General Coordinator of Analysis of Public Purchase Infractions office as part of the Department of Economic Protection and Defense. The new office will be responsible for investigating cartels abusing federal, state and municipal contracting for public works. This is a direct reaction to a large public works corruption scandal uncovered in the past month by the Federal Police's Operation Navalha. Such activity by cartels costs the public coffers an estimated $40 billion annually. Brazil's Secretariat of Economic Development estimates that public contracts are generally overestimated by 25 percent to 40 percent. Companies that come under scrutiny could be fined up to 30 percent of the value of their invoices and could lose their licenses to bid for public contracts. If this new office is effective -- and there is an outside shot of this -- it could significantly alter the political and financial dynamics of the construction sector in Brazil and put a dent in the culture of endemic corruption.

THAILAND: The Thai Constitutional Tribunal, Thailand's highest court, found the Thai Rak Thai Party (TRT) guilty of electoral fraud but acquitted the Democrat Party of all charges late May 30. TRT was found guilty of election fraud in the April 2006 election, and of allowing its former leader, ousted Prime Minister Thaksin Shinawatra, to abuse elections as a "tool for monopolizing power." TRT will now be disbanded and all of its present and former executives will be banned from domestic politics for five years. Though TRT executives are no longer able to participate in the scheduled December 2007 election, full acquittal of the other top opposition party has allayed foreign investor fears that all key opposition politicians would be blocked from participation. After the last nine months of political instability and unpredictable government economic policies, foreign investors interpreted the tribunal decision as a sign of greater political certainty to come; the Thailand Stock Exchange surged 1.32 percent following news of the Democrats' acquittal.

GERMANY: Germany's largest utility company, E.On, will build 18 new power plants in Europe as part of an $81 billion investment plan, E.On CEO Wulf Bernotat said May 31. The generators are part of a three-year plan to boost the company's generation capacity by 50 percent. Seventy percent of the funds will be spent on additional growth, but much of the rest -- in line with the EU's new energy policy -- will go toward climate-friendly and renewable energy. Around $16 billion will be spent on climate-friendly power plants and $4 billion will go toward renewable energy, particularly wind power plants. Another $13.5 billion will go toward enhancing E.On's natural gas operations, including exploration, production and transportation -- particularly on the Baltic Sea pipeline -- and liquefied natural gas terminals. Another $8 billion will be set aside for growth in Russia, Turkey and Southeastern Europe. In March, the European Union unveiled a plan to have 20 percent of all EU energy come from renewable sources by 2020 and called for Europe to burn 13 percent less energy by 2020. E.On's plans show how European companies are taking note.

U.K./RUSSIA/LIBYA: British oil firm BP announced May 29 that it will sign a $900 million natural gas exploration deal in Libya, after a 33-year cessation of Libyan deals following Libyan leader Moammar Gadhafi's seizure of foreign oil company assets. The agreement will give Libya some much-desired investment in its energy sector while giving the European Union another means to lighten its dependence on Russia for energy. BP will have the opportunity to expand in a new market just as its Russian operations could be snapped up. Nearly all of BP's Russian investments are locked into the TNK-BP venture, a deal personally brokered by BP CEO Lord Browne, British Prime Minister Tony Blair and Russian President Vladimir Putin. Unfortunately for BP, Russia is consolidating its energy industry -- and BP will no longer have the protection of the high-level political players who guaranteed the deal, as Browne has resigned and Blair will soon leave office. By venturing into Libya, BP will hedge its losses in Russia.

NIGERIA: Nigeria inaugurated President Umaru Yaradua on May 29, in the first civilian-to-civilian transfer of power since the end of military rule in 1999. Despite this harbinger of political stability, the month leading up to Yaradua's inauguration was fraught with strikes targeting companies, protesting the election itself and protesting the government sale of state assets. It also was one of the most violent months on record in the Niger Delta. The underlying causes of these strikes and violence have carried over into the Yaradua administration. Despite Yaradua's peaceful assumption of power, conditions for oil companies operating in the Niger Delta are unlikely to change. As Yaradua works to establish political credibility within the networks of loyalties that characterize Nigerian politics, Niger Delta militant groups will continue to press their demands by attacking oil infrastructure and kidnapping oil workers.


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