Abstract: A summary of how an exaggeration of Chinese money has been used to accelerate the growth of bubbles across global markets. New wealth creates economic distortions as less thought and experience is applied in negotiating prices when allocating investments. Token evidence of this can be used to convince other investors around the world to also enter the market looking for quick gains. The effect is compounded by the youth and inexperience of both China’s central government and their domestic finance & wealth management industry. A clear problem as this industry is the key to supporting China’s aging population. As China’s finance industry matures it is likely that money will move from overpriced assets into more productive endeavors.
I should begin by saying that this is a pure opinion piece. Nothing written here constitutes financial advice. I do not profess to have the investigative prowess of a journalist nor the professional credentials of an economist. I’m simply an avid observer and casual writer.
The New Paradigm
Studies into market bubbles break a bubble’s lifecycle into several stages. The last pre-crisis stage is often referred to as the New Paradigm. At this point, the market has reached new dizzying heights that even exaggerated statistics and reports fail to rationalise the price. At this point, any further growth is supported by the sheer will power of those that wish to get rich. The New Paradigm is defined as a tautology that justifies future price growth and is conveniently vague on facts, yet difficult to disprove. The significant evidence required to disprove the tautology is often unavailable due to incomplete data, easily manipulated statistics or a complete lack of reporting. It’s not hard to guess what has been a commonly used tautology in recent years. You probably have heard it repeated many times around the world already; “the Chinese will buy it”.
The interesting aspect of this particular New Paradigm is that it has been used in not just one bubble, but several which are all at varying stages of their lifecycle. The spot price of uranium peaked at about $300/pound on the back of assumptions that China’s unquenchable thirst for energy would drive it to build dozens of nuclear power plants. The inconvenient truth is that nuclear power plants can take up to a decade to construct. At the time of writing, the spot price has been languishing at about $36/pound for almost half a decade. With gold being a cultural icon and traditional store of wealth in China and India, speculators pushed the price of gold above $1900/ounce before dropping to the current price around $1100. Earlier this year, the price of iron ore and coal both peaked at $140/ton and $112/ton respectively. Now they are barely clinging to $56/ton and $49/ton after bouncing off record lows. Further price declines are anticipated as all the major miners are still ramping up production previously planned and funded on the expectation of continued Chinese demand. Their analysts lazily predicted that China would reach the perfectly round estimate of 1 billion tons of annual steel output, when reality peaked at approximately 700 million. Cryptocurrencies like bitcoin also saw huge rises and falls from speculation on Chinese involvement before their government clamped down on the cryptocurrency.
As bubbles are only defined the moment they pop, it would be premature to infer that any market “dominated” by the Chinese is suffering from inflated values. That said, the Australian housing market continues to chart new heights on the assumption that Chinese buyers and developers will continue to bring their millions over. This is despite Chinese government restrictions on capital outflows, a corruption crackdown in progress, and Australian government rules limiting foreign property purchases.
The Chinese are equally victims of recent bubbles. If they are buying in at the top end of the market then they are likely to suffer the greatest loses in a correction. As the largest consumers of commodities like iron ore, coal and copper, they have been paying inflated prices on these resources for many years now. Cultural misunderstandings like numerology are being propagated to further asset price growth. Xenophobic sentiments brew in those priced out, when all the blame is misdirected at the manipulated instead of the manipulators. However, even the manipulated must be responsible for their actions. While the New Paradigm is often far from reality, there needs to be just enough truth to it to make it believable.
The Asian generations of the last few decades are an inspiring tribute to how perseverance and hard work produce success if given the right opportunity. Stories of lonely pig farmers who go on to make millions, former soldiers who rise up the ranks of the business elite, and glass polishers who set out on their own to become the dominant global force in their trade. These are economic fairy tales the world hasn’t seen in decades. Despite all they have achieved, it would be a lot to expect them to revolutionise their respective industries, and also learn to manage their newfound wealth in a responsible way. Unlike established wealth, these newly minted millionaires cannot look to family and friends for guidance or example. In my own experience, my parents do not trust or understand the stock market. Their generation created wealth through trading in tangible goods. Being of Chinese heritage, my grandparents set aside and labelled small chunks of gold as our inheritance. A concept that seemed odd, awkward and somewhat inconvenient when a nugget named Kevin was first revealed to me. A transition that spanned three generations in my family is unfolding in a country with over a billion people who have only embraced capitalism in the last 35 years!
This is not a problem unique to emerging economies. You can see the same underdeveloped or misdirected use of fortunes in young Silicon Valley entrepreneurs, mining barons of Australia and the oil sheiks of the Middle East. It’s no surprise that each of these regions has exhibited a hot property market. Billionaires are economic distortions. Bill Gates is the richest person in the world and he built most of his early wealth on inflated profit margins on hundred dollar copies of Windows software. Too preoccupied with revolutionising the home personal computer market, Mr Gates conveniently neglected to reinvent the pricing model in a new world of 5 cents compact disc manufacturing & online distribution. The most popular version of Windows was released over 20 years ago, and it’s only in the last 5 years that Google have fixed this pricing problem by releasing the free Android OS. More recently, the billion dollar valuations of sharing economy startup giants are supported by revolutionary business models that sidestep regulation and promote tax evasion. Tax legislation in many countries has not adapted to technology’s ability to create multi-national companies with tiny local footprints that turn over billions of dollars of revenue. Locally, Australian miners grew immensely rich due to government mining royalties that failed to track commodity prices, thus diverting the wealth of the nation into the pockets of the lucky few. When someone holds wealth that they cannot reasonably spend in one lifetime, they make irresponsible decisions. Asia is minting new billionaires at a record pace and the result is that their newfound wealth is contributing to the creation of market distortions across an increasingly interconnected global economy.
The problem is exacerbated in China by the fact that the Chinese government heavily restricts cash flows in and out of the country. Much of the new wealth generated in the country is forced to rely on an equally fledgling wealth management industry within China. A huge shadow banking system operates outside of government regulation. Their stock exchange is still dominated by novice retail investors trading penny stocks for a gamble on capital gain. The small role the Chinese stock market plays in the economy is highlighted by the low proportion of market stabilising institutional investors and the relatively low 11% of household wealth invested in stocks. Compare this with the only other economy larger than China’s; around 30% of US household wealth is invested in stocks. Meanwhile international investment houses are restricted in what Chinese stocks they can invest in and by how much. The wealth that does escape the country through dark channels is too questionable in origin to enter highly regulated wealth management institutions who are obligated to report suspicious funds, and ends up inflating asset prices in destination countries.
The inexperience of China’s financial system and governing body is apparent in their government’s initial reaction to their recent share market correction. The Chinese leadership intervened directly to try to prevent short selling and publicly ordered various bodies to begin buying shares to support prices. The initial domestic mum & dad investor panic quickly into institutional and foreign investor panic. With a lot of professional & institutional investors, removing access to investment tools like short selling breaks their risk management and hedging models. This increases the risks on their investment thus obligating them to sell the shares they do hold to move their client’s funds into stable cash positions until they can adjust their models to the new operating environment. Government intervention and tampering with market dynamics also adds to ongoing media coverage, further propagating the panic across the globe. Investor panic is a monthly occurrence in world markets, panic in a nation’s leadership is a rarer, more concerning event. The swift co-ordinated effort by many government controlled institutions does lead me to think that there is a greater plan in play and that they simply miscalculated how quickly the market would rise and how soon the next correction would take place. It is evident that they are positioning multiple large investment institutions like the 5 billion dollar state pension fund into a market stabilisation role (much like in the West). This correction should be treated as an opportunity to educate the many retail investor on the merits of understanding fundamentals and on the benefits of prioritising dividends on blue chip stocks over capital gains on penny stocks. In the developed world, stock markets are used heavily in growing and managing retirement savings. China is facing a huge demographic problem of an aging Chinese population accelerated by decades of the One-Child Policy. Their stock market is going to have to play a pivotal role in supporting the next generation of retirees.
It’s a complex problem that will take time to untangle. There are good reasons why there is a lot of protectionism around the Chinese financial industry. Like most developing nations, it seeks to preserve the country’s resources and opportunities to benefit their people, by limiting access to foreign investors. Throughout much of Indonesia’s development, the government has forced foreign nationals to create joint ventures with local entities to foster knowledge & technological transfer and ensure some of the profits are returned to the people. In a similar fashion, the Chinese government would rather see their millionaires support the development of a home grown finance and wealth industry. Understandable in light of the reputational loss experienced by Wall Street when the global financial crisis exposed the rampant greed endemic to finance corporate culture. The Chinese government also strongly promoted share market investment prior to the recent market rise as a way to ensure their citizens will front run the huge international investment that would come when the MSCI includes China A-shares in its benchmark indices. When this global economic milestone is reached, hundreds of index linked funds will be forced to invest in the Chinese stock market to keep pace with the MSCI index. The flood of foreign capital will propel the wealth of those already invested. In a country with a track record for copying the rest of the world, it is only a matter of time before a Chinese Warren Buffett, Ray Dalio or Kerr Neilson emerges. It’s no coincidence that Mr Neilson was an early investor in China and is now doubling down on his highly profitable early bets made a decade ago. While the Chinese government’s measures are well-meaning, they have produced unforeseen results with global consequences. Co-ordinating more than a billion people to orchestrate the creation of an economic powerhouse to rival the United States is no mean feat.
Mistakes do eventually get corrected, and while many lament China’s leaders’ iron fist rule, I can’t deny that their ruling party’s unquestionable authority has led China to sidestep or resolve every type of catastrophic economic blunder made by many other developing nations. It would appear that Xi Jinping’s reforms are far from being thrown off track. The New Paradigm won’t hold forever. As China’s finance system liberalises and matures, the market distortions will unravel and soon enough, the Chinese will be selling.
Read on in the next section: The Investors.
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