Did China Cause The Recent Plunge In Stocks?
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What Caused The Recent Stock Market Meltdown

One month ago today, stock markets around the world fell like dominoes, starting with China, then Europe and finally the US. The Dow Jones Industrial Average plunged 419 points on February 27, losing 3.3% of its value in a single day. Now a month later, the Dow has only recovered about half of what it lost on February 27.

Many analysts described the global market rout on February 27 as a reaction to the plunge in the Chinese stock markets which lost almost 10% of their value on that one day. Most market analysts pointed to the fact that Chinese stocks have been exploding in value, especially this year. The talking heads on the financial shows concluded that it was just a long overdue "correction" in the high-flying Chinese stock markets.

But what if I told you there was much more to it than that? What if I told you that the Chinese government wants its stock market to fall sharply? What if I told you that the Chinese government directly engineered the plunge in its markets on February 27? And what if I told you they may very well do it again? There are those who believe all these things are true.

Our good friends at Stratfor.com have written several very interesting reports over the last few weeks chronicling the recent market events in China. As long-time readers know, I am a big fan of Stratfor and have been a subscriber for many years. I refer to them this week because Stratfor believes everything in the paragraph just above, that the Chinese government engineered its own stock market crash on February 27. Stratfor also believes the Chinese government may be preparing to significantly reduce its vast holdings of dollar-denominated assets (primarily US Treasury bonds).

Rather than attempt to summarize Stratfor's analysis, I have chosen to reprint two of their excellent reports on China released after the February 27 market plunge. You definitely want to read Stratfor's take on these two issues and what may be coming next!

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Global Market Brief: China's Engineered Drop

QUOTE:

Stratfor.com
Global Market Brief: China's Engineered Drop

China's Shanghai Composite Index tumbled 8.84 percent Feb. 27, its largest fall in a decade. Its sister index, the Shenzhen Composite Index, fell 8.54 percent. The size of the drop in China is not significant in and of itself. On a number of occasions during the past year, the Shanghai Stock Exchange has experienced 5 percent plus daily reductions, and it has already boomed and busted once this decade.

But that hardly means the development is insignificant. The fall is important both for how it happened and what it triggered.

How it Happened

This was an engineered drop.

The Chinese government has become increasingly concerned about levels of investment in its economy or, more accurately, the sheer amount of money that is chasing projects. State firms with limitless access to subsidized capital from state banks have used that access to launch thousands of nonprofitable firms. This glut in "investment" money drives up the cost of commodities and adds industrial capacity without actually producing anything of much use, making life more difficult for the average Chinese and unduly harming relations with foreign powers that face a glut of otherwise noncompetitive Chinese goods.

This penchant for overinvestment has now spread to the stock market in two ways. First, the same politically connected government officials who started dud companies are taking out loans to buy shares, or are using shares they already hold as collateral for new loans. Second, ordinary Chinese citizens have started borrowing -- sometimes against their homes -- in order to play the market. In January, the number of total traders [investors] on the Chinese exchanges grew by 1.38 million, an increase of 134 percent from a month earlier, while stock turnover was up 700 percent from a year earlier.

The net result is an absurd stock surge with no basis in fundamentals. At present, some Chinese banks now have price-to-earnings ratios higher than financial behemoths such as Deutsche Bank and Chase, despite deplorable management and a history of highly questionable lending policies.

For the past few months, the government has been working to drive down this speculative investing. On Feb. 26, China's State Council launched a new "special task force" that accurately could be referred to as the "get-those-idiots-to-stop-borrowing-to-gamble-on-the-stock-exchanges" team. Its express goal is to get the Chinese domestic security brokers to lay off such speculative decision-making, while also putting a crimp in the source of the subsidized capital...

So the Chinese deliberately scared the speculators in hopes of engineering a stock crash. Specifically, the State Council formed a new commission charged with clamping down on such credit-to-shares activities. They also tightened up the banks' reserve requirements with intent of choking off some of that credit at its source, as well as floated a rumor that China was about to introduce a capital gains tax.

It worked. Way too well.

Some two-thirds of the stocks on the Shanghai exchange fell by their 10 percent daily limit, forcing a suspension of trading in their shares. Overall the exchange dipped by 8.84 percent, disturbingly close to the maximum theoretically possible. Making matters more politically complicated for the leadership, the sharp drops triggered a raft of margin calls that led to sell-offs in Asia, Europe and finally the Americas... On Feb. 27 the U.S. exchanges were the last to react to the Chinese contagion, with the Dow dropping 3.5 percent.

Day one started by the script, and Beijing is likely quite pleased with the way things are going (or at least it was until its actions unintentionally triggered a global meltdown)...

What it Triggered

... Why the Chinese stock crash occurred was unimportant to the outside world, only that it did -- and that it affected everyone else. For the first time, China has become the trendsetter in the global stock community. Normally, the U.S. exchanges -- especially the S&P 500 index and the Dow Jones Industrial Average -- set the tone for global trading patterns. Not on Feb. 27. This time, China led Asia to a wretched day. The wider the contagion spread, the more margin calls were forced to be called in. (If an account's value falls below a minimum required level, the broker will issue a margin call for the account holder to either deposit more cash or sell securities to fix the problem.)

As the drops snowballed, Europe filed in dutifully behind, mixing the China malaise with its own nervousness about overextended markets in Central Europe and the former Soviet Union. By the time markets opened in the United States -- where investors already were fretting about the subprime mortgage markets -- the only question remaining was how far U.S. markets would descend. In the end, the Dow dropped by the most since the fall triggered by the 9/11 attacks.

So why has this not happened before now? As China's market capitalization has increased, its links to the global system have increased apace. These links have developed very quickly, and with few controls. The Shanghai exchange, for example, more than tripled in total value in 2006 to more than $900 billion -- and much of the rapid-fire initial public offerings (IPOs) of Chinese banks on the Hong Kong and other international exchanges are not included in that little factoid. Indeed, China's mainland exchanges are only the tip of the iceberg -- and they certainly do not include foreign firms that are heavily invested in the mainland.

Two years ago, China's market capitalization was too small for its problems to impact the global system. Now, between ridiculous foreign subscriptions to IPOs, irresponsible corporate policies and irrational valuations all around, that capitalization is to a level -- around $1.3 trillion -- where its integration with the global system via funds and margins makes China a sizable chunk of the international financial landscape. The insulation that once protected international exchanges from Chinese policies is gone, which makes the international system more vulnerable to Chinese crashes.

Feb. 28 and Beyond

Follow-on crashes can come from one of three places.

First, the Chinese believe their exchanges are massively overvalued (hence the engineered crash). They will do this again, and are not (yet) particularly concerned with the international consequences. China planned to dampen its own stock market, not the world's markets. Along with the rest of the world, Beijing did not expect the contagion effect to be so extreme. Yet, for now at least, China's own exchanges are its primary concern, and it will act according to that belief.

Second, everyone else now is going to chew on the fact that Beijing did this intentionally. They will either agree with the Chinese that the exchanges are overvalued and that additional measures are needed, or they will be terrified that Beijing did this intentionally and not care about the reasons. Whether what is sold is a domestic Chinese firm or a foreign firm invested in China does not matter much. Neither does it matter if the stock is on an exchange in China or abroad...

Third, trading in 800 of the 1,400 stocks on the Shanghai exchange was suspended during the sudden drops Feb. 27; they have a lot farther to fall, even without any engineered drops caused by panicky selling.

Considering the flaws on which the Chinese system is based, this certainly will not be the last engineered drop. In theory, the move will make foreign investors far more cautious before diving into the Chinese system...

END QUOTE

Editor's Note: For our newer readers, let me assure you that Stratfor is not one of those outfits that likes to be on the cutting edge of the latest rumor, or that spews forth analysis that is created simply to make headlines. Stratfor is convinced that the Chinese government engineered the recent stock market meltdown, and more importantly, that there may be further surprise drops in the Chinese equity markets in the weeks or months ahead.

The question is, will the global markets react as negatively as they did on February 27 to subsequent actions by the Chinese government to lower its share prices and dampen the speculative fever among it citizens that have jumped on the China bandwagon?

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China's Other Huge Surprise To Come

Obviously, it is important to be aware that the Chinese government wants to quell the rampant speculation in its stock market, and that more manipulated surprise drops may be coming. However, China also has warned recently that it may be about to redirect a large portion of its huge trade surplus, which is now invested largely in US Treasury securities (T-bonds). This move, should it occur, could have significant repercussions in the global equity markets, currency markets and commodities markets. Here again, I will let Stratfor lay it out for you.

QUOTE

China's Impending Big Splash

The vice chairman of China's National People's Congress, Cheng Siwei, said March 8 that the Chinese government needs to put some of its mammoth $1 trillion (as of Jan. 1) in currency reserves to better use. Cheng said he broadly agrees with International Monetary Fund assessments that China needs to keep "only" about $650 billion as reserves, and should apply the remaining amount to more efficient purposes. While Cheng is not ultimately the decision-maker for the reserves, his statements are just the latest in a series of leaks that point to an imminent change in the way Beijing manages its currency reserves. Whatever decision Beijing makes, it will shake the world.

Stratfor normally does not engage in blind speculation. But when a cash-rich government indicates it is about to toss $350 billion or so in spare change at something -- without giving hint as to what that something might be -- speculation really is the only option. The core issue is simply one of scale. That amount represents the single-largest pool of cash that any government has thrown at anything, ever. Adjusted for inflation, the United States' largest effort, the Marshall Plan, comes in at just over $100 billion. [Emphasis added, GDH.]

In essence, China is about to throw a very large rock into the pond without telling anyone where specifically to expect the splash. There are, however, several possible scenarios as to where that splash might occur and what its impact could be.

Investment Fund

From a financial point of view, Chinese investment money is used extraordinarily inefficiently. Money is thrown regularly at suboptimal domestic projects, irrespective of profitability, in order to further social goals such as full employment on the premise that it is better to have workers at work doing nothing of value than to have them unemployed and considering long marches.

By using foreign exchange reserves to launch a major investment fund, China could generate income with Chinese cash, without delving into the politics and pain of reform. At the same time, it could secure a hefty nest egg as a hedge against future crises. Therefore, many Chinese have floated the idea of setting up an investment project modeled after the Government of Singapore Investment Corp. (GIC). The GIC manages the bulk of Singapore's foreign exchange, mostly in a mix of stocks and bonds, and is broadly considered one of the world's most responsible and successful investment agencies.

Any Chinese GIC, however, likely would have a far less conservative profile that would impact far more heavily on global markets.

The GIC does not invest within Singapore, largely because Singapore views its currency reserves as an emergency fund. (If the country is in a state of emergency, then it would be preferable for investments to be held in other parts of the world.) Since China would only be investing about one-third of its reserves in this new project, it still has a cushion of about $650 billion. China, therefore, could afford both structurally and ideologically to go a bit wild with its investments, compared to Singapore, and invest at home as well. That suggests that China would invest far more heavily in more speculative stocks and bonds, and likely far more in property than the 10 percent of total portfolio that GIC limits itself to.

At issue is market depth. Most big investment funds are very careful not to invest in any particular asset to such a degree that their presence impacts pricing. With $350 billion to play with, affecting market values is going to be a constant concern -- and if the way China has so far managed its domestic markets is any indication, the impact will be large and volatile. [Emphasis added, GDH.]

Just as important, the GIC is so respected and successful because it is extraordinarily well run by a group of apolitical technocrats in a country where corruption is nearly nonexistent. China, in comparison, sports reserves of corruption and political malfeasance that are legendary. Taken together with the far larger amounts of cash, the relative suddenness with which the Chinese would enter the market, and far more aggressive investment guidance, the potential for stimulating investment bubbles on a global scale could be massive. [Emphasis added, GDH.]

Infrastructure and Influence

Either independent of or tied to a Chinese government investment fund (as any of these options could be) is the possibility of putting a few hundred billion behind China's efforts to secure its foreign policy and strategic goals.

With such a broad category, this figure could have a seemingly unlimited impact. A few billion here or there could construct nearly any infrastructure needed to ensure that critical commodities become permanently linked to the Chinese economy -- chrome from Congo, platinum from South Africa, natural gas from Turkmenistan, oil firm Equatorial Guinea. What technologies Chinese companies currently lack -- deepwater or sea ice drilling, for example -- could simply be purchased with a generous pile of cash.

Such funding also would allow China to purchase friends by the dozen. Total foreign direct investment in Sub-Saharan Africa in 2006, for example, was only $38 billion. China is looking at a figure that is eight times that amount. Entities that normally fund development efforts -- the World Bank comes to mind -- would find such competition crushing. China often offers cash with minimal strings attached, as values such as transparency and anti-corruption do not rank high within the country, much less in its foreign economic relations.

Unlike the GIC route that would seek to improve returns, going for developing-world infrastructure and influence primarily would be a political goal, with profit a distant concern. As such, the economic impact of such an approach actually could dwarf the economic impact of the GIC model. It is one thing to surge out money in order to seek money via suavely selected investments; it is quite another to surge out money in order to achieve noneconomic goals regardless of profitability. Price explosions and bubbles would be highly likely in any industries related to infrastructure, such as steel, cement and shipping. [Emphasis added, GDH.]

Manipulation of Global Currency Movements

Right now, China's currency reserves are heavily skewed toward the U.S. dollar, with some 60 percent held in U.S. government bonds and U.S. dollars. Many have raised the possibility that China will shift some of this exposure to the euro. Messing with this proportion would dramatically impact Chinese economic orientation.

Right now, the United States is China's top export destination. Keeping the bulk of Chinese currency reserves in U.S. dollars is not only a consequence of that, but also helps reinforce it. So long as China is dumping its reserves into dollars, U.S. interest rates will remain relatively low, thus encouraging U.S. consumers to spend -- and often to spend on Chinese goods. Also, even with U.S. rates low, U.S. government bonds still pay out more than their European counterparts. This is a very sweet deal for the Chinese: It keeps them lashed to the world's largest market and gives the Americans a vested interest in Chinese political stability.

Yet this does not mean China is ideologically committed to keeping its reserves in the dollar. A large-scale shift to the euro, for example, would certainly impact trade flows and threaten that all-important China-U.S. link, but it would have one very interesting side effect: It would dramatically strengthen the euro at the dollar's expense. Since the Chinese yuan remains de facto pegged to the dollar, the yuan would plunge as well, thus spurring both American and Chinese exports to the rest of the world. Washington might not be thrilled with a weaker dollar, but the export boom that would result could be directly credited to China, something that could soothe bilateral relations somewhat. The only limiting factor for China in this scenario is how fast it could physically divest itself of its U.S. bonds without triggering an immediate devaluation of its remaining assets. Again, for a country in which profitability is rarely key, the answer likely is on a shorter time horizon than one might think. [Emphasis added, GDH.]

Internal Rationalization

Another possible model also comes from Singapore: Temasek, a state holding company that manages assets the world over -- companies, not stocks or bonds -- and takes an active role in corporate management. The hands-on, politicized nature of Temasek has raised hackles in many states -- Temasek's involvement in Thai telecoms contributed to the 2006 overthrow of the government of former Thai Prime Minister Thaksin Shinawatra -- and also makes it a likely candidate for a Chinese copy. It really fits perfectly into the Chinese management style.

Under technocratic control, such a holding company would, in theory, bundle China's best and brightest state-owned enterprises into a sort of flagship holding. Then, using the currency reserves as a lever, it would steadily bring more firms into the holding.

That does not mean they would be brought in willingly. The Chinese government has been attempting to force Chinese firms to use capital more efficiently -- largely by attempting to limit their access to money. This has not worked particularly well for two reasons. First, local Chinese leaders own many of these dud firms and use their connections to secure financing, which they then skim for their own purposes. This is as much a center-periphery political turf fight as it is an economic rationality battle. Second, China is so awash in cash that it is difficult to seriously constrict capital availability.

Following the Temasek model would allow the government to knock off these local leaders a few at a time, only picking fights that the center would be sure of winning rather than adjusting the system en masse and risking an economic (and political) meltdown. It also would provide a pool of capital that could be lent out to these star firms -- many of which are small and medium enterprises that have provided the bulk of new jobs in China of late -- that is free of the problems that plague the state banks. In essence, this system could create a new state bank that operated according to Western standards.

Such an effort likely would be piecemeal, painful and slow, but it would not risk any fundamental crashes by tinkering with the financial system. Neither would it address the issue of a nonfunctional banking sector, though it would attack the corruption issue directly at its source in a very real way. It also would have the welcome side effect of consolidating President Hu Jintao's government's political control, hardly an inconsequential impact.

Regardless of what China does with its currency reserves, it is going to have a massive impact -- likely far more than what we have addressed here. The implications would not be limited to euro-dollar exchange rates or Chinese-U.S. export surges. Moving a fair amount of cash out of government securities into, well, anything else, will lead to increased yields for those government securities. That will increase their attractiveness to other investors at the expense of other assets, which could contribute to lower property and/or stock values. Such a spread change would be even more pronounced in whatever assets the Chinese decide to chase as their involvement reduces yields. [Emphasis added, GDH.]

Finally, China needs "only" between $600 billion and $700 billion in currency reserves to maintain economic stability. Since the beginning of 2003, China has added about $200 billion annually to its reserves. The $350-odd billion the country is about to spend is not the end-all, be-all -- it is just the beginning.

END QUOTE

* As always, I appreciate the opportunity to reprint excerpts from Stratfor from time to time. They offer excellent analysis on many geopolitical and other topics. You may want to consider subscribing. Their "Premium Direct" e-mail package is only $99/yr. Go to www.stratfor.com for more information.

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Conclusions - Increased Volatility Ahead

In the first article above, Stratfor makes the case that the Chinese government willfully caused the plunge in its stock markets on February 27, and suggests that additional surprise drops should be expected in the near future. Obviously, there are those who do not agree, in large part because the new stock trading and margin restrictions announced by China on February 26 don't go into effect until May 1. But it is very hard to separate the announcement of these new restrictions on February 26 and the huge market plunge on February 27.

My question is whether the Chinese government anticipated, or even considered, that their announcement would negatively affect stock markets around the world as it did. Whether they did or not, it is now clear that China is the 800 pound gorilla in the room. That fact may influence Chinese policymakers in the future - one way or the other. So, it remains to be seen if more surprise drops are in the pipeline as Stratfor suggests.

Then there is the even greater question: Will China choose to divest itself of hundreds of billions in US Treasury securities in the near future? As noted in the second Stratfor article above, the vice-chairman of the Chinese Congress stated earlier this month that China needs to diversify apprx. one-third of its massive $1 trillion trade surplus into something other than US dollars.

The potential ramifications of such a move are many. Obviously, such a large move out of US Treasuries would send bond yields higher, precisely at a time when the US economy is soft and the sub-prime lending problems are accelerating - assuming the Chinese make such a move this year. In any event, such a move would likely be a negative development for the US and global equity markets, at least temporarily.

With China becoming such a key player on the world stage and in the financial markets, and with the possible developments discussed above, this suggests that market volatility is likely to increase in the weeks and months ahead. I continue to believe that the US economy will begin to rebound later this year or early next year, and this suggests that US equity prices will rebound as well. Even if that forecast is correct, the equity markets could well be a roller-coaster for some time to come.

Given this outlook and the possibility for more China surprises, I continue to recommend that you use "active management" strategies in your equity portfolio. Active management strategies are those that have the flexibility to exit the market, or hedge long positions, should market conditions warrant.

I invite you to consider the carefully selected professional money managers and mutual fund portfolios I recommend. You can call us at 800-348-3601 or you can visit my new website at www.halbertwealth.com. Click on Absolute Return Strategies and you can see the professional money managers and mutual fund portfolios I recommend.

Very best regards,

Gary D. Halbert

Gary Halbert is the president and CEO of ProFutures, Inc. which produces this E-Letter. Mr. Halbert is also president and CEO of Halbert Wealth Management, Inc., an affiliate of ProFutures, Inc. Both firms are located in Austin, Texas. Halbert Wealth Management is a Registered Investment Advisor that offers professional investment management services to a nationwide base of clients, and specializes in risk-managed investments and its recommended programs include mutual funds, managed accounts with professional Investment Advisors and alternative investments. For more information about the programs offered, call 800-348-3601.

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"Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend any product or service advertised herein, unless otherwise specifically noted."

Forecasts & Trends is published by ProFutures, Inc., and Gary D. Halbert is the editor of this publication. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgment of Gary D. Halbert and may change at any time without written notice, and ProFutures assumes no duty to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Halbert Wealth Management are not a solicitation for any investment. Such offer or solicitation can only be made by way of Halbert Wealth Management’s Form ADV Part II, complete disclosures regarding the product and otherwise in accordance with applicable securities laws. Readers are urged to check with their investment counselors and review all disclosures before making a decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Gary D. Halbert, ProFutures, Inc. and all affiliated companies, InvestorsInsight, their officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Securities trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results.




Posted 03-27-2007 5:01 AM by Gary D. Halbert