Recently, I have been thinking about diversifying into foreign stocks, because of the strong possibility of a sharp fall in the value of US dollar denominated assets. The state of the US budget and trade deficits have been getting so ridiculous that even Warren Buffett, who has previously famously eschewed macroeconomic bets, has recently been making currency investments to hedge his holdings against a drop in the value of the US dollar. The Chinese stock market is currently massively overvalued and in the grips of a full-blown speculative bubble, and is an obvious target for shorting.
Why has the Chinese stock market bubble developed? This is mainly the fault of the Chinese central bankers. In the US, inflation is surprisingly tame despite despite the US waging a war and running huge budget and trade deficits. This is because the inflation is essentially being exported to China. When Chinese companies export to the US, the US dollars they earn have to be swapped for the yuan in China for domestic use. By pegging the yuan at artificially low levels to the US dollar, the Chinese central bank is forced to inject large amounts of its own currency into the Chinese economy. At the same time, the Chinese central bank pays a very low interest rate on its own bonds and bank deposits (presumably because it knows its own capital controls are leaky, and higher interest rates will serve to exert further upward pressure on the yuan), causing the Chinese public to seek better investment returns elsewhere. This has caused both real estate and stock market bubbles in China. By exporting cheap goods to the US, China has helped to control inflation in the US and stimulated its own economy to nearly full employment, at the cost of rampant inflation.
The simple fact is, when you peg your currency to another country’s currency, you lose control of your own monetary policy. Chinese monetary policy is now being controlled by the US Federal Bank, which has held interest rates at a level that is appropriate for the lukewarm US economy, but which is too low for the red-hot Chinese economy. Will the Chinese authorities be able to control their speculative bubbles and navigate the economy to a soft landing, or will they crash and burn like the Japanese did a decade ago? The Chinese government has mainly used regulatory measures to try and cool the speculative bubbles (increasing taxes, banning margin for stock investments etc), but is also moving towards real structural changes, such as pegging the yuan to a basket of currencies instead of just the US dollar, and allowing the yuan to gradually rise against the US dollar.
Are there any opportunities for the retail investor in this situation? Chinese capital controls mean that foreigners cannot directly hold the Chinese yuan or buy Chinese stocks. The only Chinese ETFs available today, FXI and PGJ, are based on Chinese ADRs and Hong Kong companies with a large exposure to the Chinese market respectively. These are US denominated assets, and are not highly correlated with the most overheated Shanghai stock market. FXI sports a PE ratio of around 16, and PGJ around 26. In comparison, the Shanghai Composite index has a PE of 45. Furthermore, when the Shanghai stock market dropped 6.5% on May 31, both ETFs were virtually unchanged. Even if one manages to circumvent the capital controls and get ahold of Chinese stocks, stocks cannot be shorted on Chinese stock exchanges, and the futures market is untested and may not be reliable in a stock market rout.
In my opinion, the only way to play this is by shorting companies with weak fundamentals listed in the US stock markets which depend substantially on Chinese consumers. A sharp fall in the Shanghai stock market will immediately curtail Chinese consumption. At this point, however, it is premature to predict a sharp fall in the Chinese stock market. With the Chinese Olympics coming in 2008, the economy is certain to receive a stimulus in the short-term, and widespread public perception is that the Chinese would not allow a severe correction and panic to set in before the Olympics has ended. Furthermore, the Chinese measures to cool the market still has a chance of working. Both the Nikkei and the Nasdaq indexes had PEs of more than 100 before they crashed. Ironically, the higher the Shanghai index climbs before the Olympics, the higher is the chance of a sharp correction after the Olympics. If the Shanghai index climbs above 7000 before the Olympics, I think that the chance of a sharp correction will become high enough for me to actively begin scouting for stocks to short. The end of the Olympics will have a small contraction effect on the local economy, and more importantly, is likely to cause a change in investor psychology, which may well cause the stock market bubble to pop if the Chinese authorities fail to control the bubble now.
