Blindfolded on a cliff edge
By Robert M Cutler

MONTREAL - If the Chinese stock market is still an indicator of global investor appetite for risk, as analysts viewed it a few months ago, then that appetite has lately diminished. Perhaps they are finally absorbing some of the revelations about statistical manipulations.

They may also be reacting to more recent revelations warning of bank fraud in China. In one case, the Royal Bank of Scotland is reportedly investigating suspected fraud in its China unit. Client losses could be worth up to US$3 million, the Financial Times has reported, citing local media.

Whatever the reason, neither Chinese nor global stock markets responded favorably last week to the news that Chinese exports fell "only" 1.2% in November from the same period last year. The year-on-year figure for October had been down 13.7%.

Government statements in September that the stimulus would not be rolled back pushed stock averages higher at the time, but these have stagnated over the past month despite the appearance of a continued up-trend. The news that the 8 trillion yuan (US$1.17 trillion) centrally established lending target for 2010 was less than the 2009 figure had no effect; that figure is still twice the level from 2008.

has strongly encouraged speculation and the . These sectors are already in bubble mode, and the government fears bursting them. The advance of the Shanghai Stock Exchange Composite (SSEC) average to the mid-3,400s in late July and early August was entirely driven by hot money following government spending in support of domestic consumption and production by small and medium-sized enterprises.

Hong Kong , a news and publicity organ of the former colony's Trade Development Council, quotes Morgan Stanley Asia's chairman Stephen Roach as estimating that the stimulus accounts for 95% of China's economic growth through the first nine months of 2009. He voices a widespread skepticism over whether foreign demand will drive the export sector after the current domestic investment kick tapers off in the second half of next year.

The danger is that, for internal political and economic reasons, China may respond to that absence of foreign demand with another domestic investment stimulus. It is a danger because there is only so much the domestic economy can take: Shanghai has a nearly 50% commercial space vacancy rate, yet skyscrapers continue to go up there to provide employment and income for consumer spending.

At some point, domestic Chinese overcapacity, still worsening as utilization rates stagnate and capital spending continues, risks beginning to drive down world prices for export goods. That would lead to factory closures overseas in countries unable to compete, followed by unemployment there and social unrest - precisely the phenomena that Beijing is seeking to avoid at home.

Central economists in China recognize the overcapacity dangers but even as they named various industrial sectors that will be excluded from further capital investment and construction, they do not control all the spending. That is because local and provincial governments have incentives to promote such projects without reference to national policy goals, indeed to prevent implementation of national policies unfriendly to their regions.

Retaliation against China by political leaders of affected countries, through tariff and non-tariff barriers, then becomes an expedient riposte. Such retaliation could easily unleash the danger that protectionist policies are then generally adopted. The Financial Times suggested last month that such conflicts may be inevitable and recommended reforms that would decrease corporate revenues in favor of consumer income.

That will not happen overnight, and any resulting self-reinforcing spiral would bring about still further declines in overall world production, leading to further global job layoffs in a vicious circle.

To the degree that Chinese trade is driven by import of components for domestic assembly and re-export, the fall-off of foreign consumer demand would take even more air out of Chinese economic activity, increasing domestic unemployment and resultant increased potential for political unrest that Chinese leaders are seeking to avoid.

None of this is a barrier to further advances by the Chinese equity markets in the medium term, although exhaustion looks to be setting in for the time being. On the basis of its own dynamics alone, the SSEC should not have exceeded 3,300 in summer, although its breakout up through the ceiling of its earlier 2,850-3,000 trading range was a good sign.

The SSEC has not yet challenged the medium-term high of 3,471 and has failed so far to keep its head above water at the 3,264 level. There is, however, another support at 3,140 before the old trading range comes again into view.

Any further advance by the index above medium-term highs risks being followed by a significant decline into stagnation inside a new trading range. The relative strength of the yuan puts China at an advantage over its major trading partners, yet any move towards its upward re-evaluation would put further downward pressure on in the country.

Dr Robert M Cutler (, educated at the and The , has researched and taught at universities in the United States, Canada, France, Switzerland, and Russia. Now senior research fellow in the Institute of European, Russian and Eurasian Studies, Carleton University, Canada, he also consults privately in a variety of fields.

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