Monetary Tightening Threatens China’s Economic Prospects

China’s role on the global stage has grown tremendously during the past several years. And there are valid reasons to believe this trend will continue. But it will not go as smoothly as many pundits assume …

On Christmas Day, Beijing raised the benchmark deposit and lending rates by 25 basis points (bps) to 2.75 percent and 5.81 percent respectively. This is the second step in the current tightening cycle, following the first surprise 25 bps hike on October 19.

But that’s not all … reserve requirements have also been increased considerably during the year.

This monetary tightening is absolutely necessary, because …

China Has a Dual
Inflationary Problem

First, consumer prices rose 5.1 percent in November from a year earlier, the biggest increase since July 2008. During the same time in the U.S, prices rose just 1 percent.

Second, China’s housing bubble is much bigger than the one that burst in the U.S. In fact, this year China constructed 12 to 15 million residential units. The U.S. built only 2.5 million units at the height of its 2006 housing boom. And as shown in the chart below, China’s housing bubble rivals Japan’s of the late 1980s.

Rising consumer and housing prices are symptoms of China’s easy money policy, which was in response to the 2008 global crisis. Moreover, relative to its GDP, the Chinese government’s stimulus was much larger than the huge programs the U.S. and Europe implemented.

Now Chinese officials have obviously realized they have an inflationary problem. And they are addressing the problem via the only viable policy: Interest rate hikes and higher bank reserve requirements.

That, however, may turn out to be the prick that pops China’s housing bubble. And this bubble is big enough to pose a real threat to China’s short- to- medium-term economic prospects.

Already …

China’s Stock Market Is
Showing Relative Weakness

Interest rate hikes are bearish for the stock market. And this well-known relationship also applies to China. Look at the Shanghai Stock Exchange Composite Index. Since its high in mid-2009, it’s one of the weakest performers globally.

As such it conveys a message … and this message is clearly bearish. The stock market seems to be discounting an unpleasant surprise coming out of China. And to me it looks as if the Chinese stock market has just begun another major down wave.

In the chart below, you can see that the 200-day moving average is falling, and the price momentum oscillator (PMO) is hovering around the zero line. Indeed, the technicals are supporting my bearish interpretation.

My suggestion: Stay tuned. China is on a dangerous road. An unpleasant surprise may be in the offing.

In the meantime, you might consider an inverse exchange traded fund (ETF) to protect yourself from a decline in the Chinese market or even profit from a decline.

The ProShares Short FTSE China 25 (YXI) is one such example …

YXI seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the FTSE China 25 Index. So for every 1 percent decline in the index, YXI is meant to rise 1 percent.

The FTSE China 25 Index is comprised of 25 of the largest and most liquid Chinese stocks listed on the Hong Kong Stock Exchange. And if my misgivings for China become reality, this index is sure to take a beating.

Wishing you a Safe, Happy and Profitable New Year!

Claus

P.S. I have just released my new book, The Global Debt Trap: How to Escape the Danger and Build a Fortune, which I think is timed perfectly for what’s happening in China and the other the events swirling around us.

For the complete foreword of The Global Debt Trap by Martin D. Weiss, click here. For more on the authors, click here.