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The China Syndrome--Financial Meltdown   (March 28, 2007)

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The 1979 film The China Syndrome took its name from the darkly humorous notion that a nuclear reactor meltdown in the U.S. would burn straight through the Earth to China.
(wikipedia entry on The China Syndrome)

Nowadays, the idea that a consumer-spending meltdown in the U.S. could trigger a subsequent slowdown in China's red-hot economy is a given. But perhaps "The China Syndrome" works both ways, and a meltdown of China's speculative financial bubble will trigger a meltdown in the U.S.'s debt-driven speculative bubbles.

To give you a taste of just how frenzied the Chinese stock market has become, consider this Bloomberg story sent in by frequent contributor U. Doran:

March 21 – Bloomberg (Luo Jun / Simon Pritchard):

“Deng Yijun, a cargo freight agency manager in Shanghai, faced a dilemma last December. ‘I needed a car, but I didn’t want to use up my savings as the stock market was booming,’ she says. ‘So I used credit cards.’ Deng, 32, was eyeing a Ford Focus that cost about 200,000 yuan ($25,815), roughly equal to her savings. Maxing out three cards, she put 140,000 yuan on plastic and gained 56 days of interest-free credit….. Most of her remaining cash went into stocks… Deng is typical of Chinese who are using easy credit to fuel a stocks boom only briefly deflated last month by government threats to crack down on illegal lending. The willingness of banks to break the law to finance stock trades shows the blunt tools regulators wield as they try to manage China’s markets."
( source link-Prudent Bear)
This chart illustrates the stupendous (and recent) rise of the Chinese stock market. It also poses three questions.

1. Is this sustainable?

2. How soon will it drop?

3. What effect will a sharp decline have on global financial markets?

Question Three is easy to answer, for the late February swoon in the Chinese markets immediately sent global markets tumbling.

As for Question One, here's an article submitted by frequent contributor Albert T.:
Hong Kong's stock market romance turns sour:

"We like to buy shares, but when the nanny starts to give out investment tips, you know things have got a bit irrational," said Allan Chan, who like many Hong Kong residents likes to dabble in the market.

Signs of Hong Kong's feverish romance with stocks and shares abound, with an upsurge of small punters enrolling in investment workshops.

The abrupt turn in the markets last week was triggered by a 9% drop on the Shanghai stock market, its biggest fall in a decade. It should have been an insignificant event as Shanghai is a tiny, illiquid market, accounting for a mere 2% of global markets.

But the Chinese sneeze was contagious. Wall Street lost more than 500 points, the FTSE fell more than 300 points and Japan's Nikkei surrendered all the gains it had made since the turn of the year, falling back below 17,000 today.

Analysts said the fall in Shanghai had to be put into perspective of a 107% rise in the last 12 months and expressed surprise at its impact on the rest of the world.

"China's stock market right now is relatively small and not very globalised. So it's not possible for it to have such an impact," said Shang Fulin, chairman of the China Securities Regulatory Commission (CSRC).
Oh really? This statement is a laughably absurd denial of reality, for February's drop amply proved that China's markets can and will influence global markets. The reason is not the size of the Shanghai market or any technical reason; it's simply that the entire world knows that China has been the engine of global growth, sucking up vast quantities of raw materials, machine tools, consumer goods and capital. It has also been (along with Japan and the OPEC countries) the primary supporters of debt-loving American consumers' 6-year buying spree via the purchase of hundreds of billions of dollars of U.S. Treasury bonds, which has kept U.S. interest rates low and kept the dollar from plummeting even lower than it already has.

If the party stops in China, it stops everywhere.

All the strident babble in the media and in Congress about the dollar-yuan exchange rates fails to consider how deeply intertwined the U.S. and Chinese economies have become. It is nonsensical to think that an adjustment in the exchange rate is going to change much of anything; that would be the equivalent of moving a pawn one square forward on a 3-D chess board.

While American politicos have focused on the trade imbalance to score easy points with confused constituents, they seem to have forgotten that the Chinese central bank owns at least $600 billion in U.S. Treasuries as well as other U.S. debt--including residential mortgage-backed securities: China's money woe: Where to park it all:

go to source document
Most central banks have invested them in U.S. securities, mostly Treasury bonds, but sometimes mortgage-backed securities as well. In recent years, these giant purchases have helped hold down interest rates that American home buyers pay for mortgages and the U.S. government pays to finance its budget deficits.

If central banks move out of such securities, U.S. interest rates could rise. But moving into equities, which tend to earn higher returns over the long term, poses risks to stock markets.

Chinese Communist Party officials have insisted that central bank officials be paid only civil-service wages, with the result that even fairly senior officials earn as little as $500 a month with minimal benefits.

(Albert interjects: I do not really know how wise it is to underpay people who have control over billions of dollars or any other currency. Wouldn't they sooner or later just rig trades so that could get paid some other way?)

"By contrast, the China Securities Regulatory Commission, the China Banking Regulatory Commission and the big state-owned banks are all permitted to pay wages that are competitive with the private sector, with salary and benefits totaling at least $1,000 a month and sometimes as high as $3,000. This has allowed them to lure managers from the central bank, as well as Chinese citizens returning from overseas with doctorate degrees in economics."

The People's Bank of China has now been given permission to pay wages closer to market levels, but the rest of the central bank still struggles to hire China's best and brightest, said Victor Shih, a China banking specialist at Northwestern University in Evanston, Illinois.
Albert T. also sent over this link to a story on China's slowing economy:

Pace of Chinese growth 'to slow'

The pieces are in place for a meltdown of China's speculative market. A speculative bubble in which people are betting credit card debt on a market which has jumped 200% in less than two years is clearly vulnerable to reversal.

Underneath the speculative bubble, the real economy is slowing as officials seek to restrain risky lending and inflation.

As China has expanded its U.S. debt holdings to include mortgage-backed securities, it has unwittingly exposed those holdings to the meltdown currently underway in the U.S. housing and mortgage-backed securities markets. Its vast horde of U.S. dollar-denominated Treasuries further exposes it to a decline in the dollar. And the entire $1.3 trillion portfolio is managed by woefully underpaid civil servants.

On the U.S. side, our speculative markets are vulnerable to the slightest tremors in the Chinese markets, and to any re-shuffling of their dollar and Treasury holdings. It may come down to whose speculative financial "reactor" melts down first. The idea that one country's debts and bubbles can melt down without effecting the other is wishful thinking.

As for question Two, How soon will the Chinese market drop? Consider this chart of an eerily similar bubble--the NASDAQ circa the dot-com era.

If this had any value to you. . .
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