China’s Raging Bull

The current bull market in China shares looks like a lot like any other bull market: frenzied trading volumes, fresh record highs on a regular basis, cheerleading banks upgrading their "price targets".

But there is also a very special rationale involved in the run on China assets. This is not just a bull market this is a fight that could be called “China versus the Speculators.”

Speculators often "go after" a market when they see a weak spot in macro-economic policies. George Soros went after the British pound in the early 1990s, with famous success, because he calculated that the pound was overpriced within the European Exchange Rate Mechanism. Speculators attempted to run down the Hong Kong dollar peg in 1998 both because they thought the currency was overpriced, but also because they detected a technical error in the way the peg was managed.

Speculators are now going after China. This time around they are betting that the currency is undervalued. This is interesting because at one level, the foreigners investing in China are showing they have faith in the country's future.

They are transferring money, knowledge and technology, renting office space and flats, giving people jobs. On the other hand the speculators are in cahoots with China's biggest critics: mainly the Western trade unions and Western politicians (especially American), who are constantly berating China over its currency policy. Investors are essentially backing the theory that China is manipulating its currency and that the policy is unsustainable.

They are proceeding on the basis that if you keep throwing money at the system, it will break. When it does, the yuan will rise: and so investors win, because the property or the stocks they own also rise in value, at least against other currencies.

China compromised a bit on its currency by widening the trading band in 2005 to allow, theoretically, a 6 percent appreciation per year of the renminbi. However, Beijing buys billions of dollars in the forex market each month to keep the renminbi within its trading band. It is doing this because it wants stability, and also because it wants to keep its exports competitively priced.

The downside to fixed or tightly managed currency policies is that it's hard to control money supply. This can lead to overheated economies. Normally monetary officials increase interest rates when they are faced with overheating. But China can't go too far down this avenue: if they raise interest rates then a whole new wave of speculative money would rush in. Hedge fund managers would be doing wheelies in their Porsches.

China is thus forced to rely heavily on "administrative measures" to cool the economy. This is obviously a different approach from the free-market norm. You didn't see the US Congress, for instance, passing laws against the creation of new dotcom firms, or ordering Amazon to disband, during the Internet bubble. Yet China is constantly outlawing investments. Aluminum steel, coal, and cement are just a few sectors in which central authorities forced mass shutdowns in the past few years.

While I am not one of those who believe China's current corruption crackdown is wholly political (instead of simply practical), arrests for economic crimes do rise suspiciously during times of austerity. Thus it's not hard to conclude that arresting businessmen and entrepreneurial cadres is part of the carrot-and-stick approach to cooling the market.

China put a temporary brake on economic overheating in 2004, but in the past year the investment fever has come back with a vengeance. The focus is on property. Not a day goes by without local headlines blaring out a new property deal, despite a slew of anti-speculative measures in the past couple of years, including the virtual outlawing of luxury villas. The authorities prefer mass housing – but if you're interested in a villa, don't worry, there are still plenty going up.

Just a couple of weeks ago China hit the market with a real doozie: the state will now take 30 percent to 60 percent of the difference between what a developer paid for land, and what he fetches for it. This sort of takes the fun, not to mention the incentive, out of the property market. Yet after only a one-day sell-off, China property shares were off and running again.

Why won't the market pay attention? All these things should theoretically be really scary to investors. This is the Communist Party! They have the power to quash markets. A PRC comer may be rich and riding around in his limousine today but tomorrow he could be in jail for violating party ethics. The value of all his associated companies would scatter like dust. Don't investors understand this? This is why this bull market is a form of subversion. It says, "We rule."

Why? China clearly doesn't care if a bunch of foreign investors get burnt – they always come running back anyway. The bull market instead attests to an underlying belief that the people in China actually have power. This may not be the power to vote, send their money abroad, or speak their minds in public. But they have the right to prosper – and the Communist Party doesn't have a foot to stand on if it can't manage this.

Thus speculators will keep throwing money, until they put Beijing in a position where it will have to do something drastic to cool the market. But Beijing won't do something too drastic, the believe, because Beijing is too afraid of the domestic anger that would swell up if the market collapsed.

It is not only the speculating foreigners who realize this. Chinese nationals are obviously playing a lead role in this bull market. According to a January 23 article in the China Daily of all places, they're playing this role because they recognize the limitations of their leaders' policies. The China Daily and polled more than 2,500 Chinese citizens about the real estate market. Almost all respondents said they believed there was a real estate "bubble" – but despite this a whopping 80 percent thought prices would continue to rise this year.

The newspaper had done a similar poll two years ago, and they observed a noticeable shift in view. "The poll results announced yesterday showed another significant change: instead of blaming real estate investors for raising the prices to earn huge profits, as respondents had done two years ago, more people now blame the government's vulnerability in macro-control measures for the malaise. "

In the face of this subversion, China is turning to new tactics. Its latest move is to try talking down the market. On Thursday state TV wheeled out a famous capitalistic speculator, Jim Rogers, the "commodities king" who used to work with Soros on his Quantum Fund.

Rogers looked in the camera's eye and announced that asset prices in China were getting "hysterical". Stock markets in China and Hong Kong hit the dirt. So this round goes to China. Beijing might not be ready to open up its capital account, but it has clearly picked up a few modern tricks of the trade as its wrestles with speculators.

Cathy Holcombe works in institutional sales at Quam Securities in Hong Kong