By Keith Fitz-Gerald
Unlike the United States Federal Reserve, which seems to be content with a dollar policy of benign neglect, the Chinese central bank actually has real power and isn't afraid to use it to protect and nurture the country's economic health.
Most recently, China's central bank – The People's Bank of China – boosted the key reserve requirement for the nation's commercial banks by half a percentage point to 13.5%. The central bank also raised deposit rates and key savings figures.
I realize that this may not strike readers as interesting at a time when the U.S. stock markets are struggling, but it provides an important confirmation of two things:
- First, it shows us just how strong China's economy really is.
- And, second, it demonstrates exactly what the Chinese government is thinking when it comes to the next great step in that nation's financial growth.
Let's talk about the Chinese economy first.
Many investors are concerned that the bubble has burst, that all the profit opportunities are gone, and that somehow China is headed for a meltdown. Indeed, the real conspiracy theorists believe China has temporarily propped up the stock market in such a way that once the curtain comes down on the summer Olympics in Beijing next year, it'll be "curtains" for Chinese shares, as stocks prices there implode.
They couldn't be more wrong.
The interest rate hike is the ninth such increase this year alone. It's an important step, a move intended to restrict the money flowing into the Chinese economy to curb what the People's Bank of China refers to as "excessive credit growth."
Strip away the bureaucratic-speak that's a common manifestation of central bankers the world over and what you're left with is this: What China's central bank is actually saying is that the nation's economy is on fire.
According to the latest figures, in fact, China's economy is surging at an annual rate of 11.9%, putting the country on track for a fifth-straight year of double-digit growth.
That's impressive enough, but consider that this five-year surge follows 25 years of growth that averaged nearly 10% annually. The U.S., by comparison, advances at a 3% to 4% clip in a good year, and the average is probably half that, so we're talking about growth rates in China that are four, five or even six times higher than our own.
If you consider that China is still primarily a cash-driven economy, and you compare what's happening there to better-developed regional economies like Japan and Taiwan, the "official" growth rates are probably low … way low. In fact, it's not crazy to believe that China's real economy – the cash-based one that can't be accurately measured on an official basis – is growing 15%-20% a year.
By increasing the reserve requirement, China's central bank wants to encourage commercial banks to hold onto a greater percentage of their deposits, rather than recycling them as loans into the broader economy. Theoretically, this will curb the flood of capital that's driving growth as everyone from normal China citizens to Western capitalists tries to profit from the "China Growth Miracle."
I'll tell you right now that this rate increase by the central bank – like the increases that preceded it – will fail miserably.
Lending volumes have nearly doubled this year already and money-supply growth is actually accelerating. What's more, the yuan is arguably undervalued by as much as 40%, and China's stock markets are on a tear – even if you factor in the recent pullback.
And that brings me to what's next in the Chinese financial markets.
With the way China's markets have whipsawed investors in recent days, many people assume that the party's over. [For an illustration, click here to track a month's worth of closing prices on the closely watched iShares FTSE/Xinhua China 25 Index (FXI) exchange-traded fund (ETF)].
Walking away now would be a mistake.
Indeed, when it comes to China, we're still in the opening frames of what you can expect will be an exciting extra-inning ballgame. There will be many more volatile stretches like the current one. But each time – the present included – Chinese stocks will shrug off the fears and resume their march toward higher ground.
- First, as we noted earlier, the economy is on fire. Hundreds of millions of people are trading stocks. It's inevitable that most middle-class China consumers will want a piece of prosperity, meaning there's still big blocks of cash that hasn't yet entered the stock market.
- Second, you could argue the recent stock-price declines are, not surprisingly, being orchestrated by Beijing, although the country's leaders would never admit it. Without boring you with the details, China's getting ready to launch a stock-index futures market, so it's entirely conceivable the government is making a concerted effort to knock share prices back to more-reasonable valuation levels before an even-bigger flood of capital hits the markets and pushes share prices far higher. Interest-rate increases are part of that effort to suppress stock prices. So are the instructions the central bank has issued to state-run pension funds, in which the fund managers are ordered to cut back on their holdings of China shares. That's yet another source of potential downward pressure on stock prices.
- And third, this will result in an evening-out process that we here at Money Morning identified months ago when we suggested that investors avoid the China-based highfliers in favor of seemingly staid-and-boring companies that are actually superbly positioned to benefit "because of" the growth in China.
Case-in-point, consider some of China's banks and insurance companies, which have been largely ignored in favor of sexier technology and industrial firms. These denizens of China's financial-services sector have actually stabilized and even risen in value on several of the bigger down days recently. Part of that is associated with a record yuan parity rate of 7.4162 to the U.S. dollar.
That's unlikely to change in the near future and the sector should see above-average returns in the next 12 to 24 months.
But investors will have to move with caution to make certain they don't get burned in the interim. Beijing is notoriously secretive when it comes to many things, and protecting the yuan – as well as the future viability of the stock market – by pushing down near-term stock prices certainly qualifies.
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About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.