Enzio's Clock

Background

1. Sub-prime

In yesterday's South China Morning Post (SCMP), p. B1, we read that "Sub-prime losses seen for H-shares". Key points in said article are that -

• total losses of Hong Kong-listed mainland banks amount to RMB 4.9bn
• Here are the SCMP guesstimates of potential sub-prime-related losses
  
• Bank of China: RMB 3.85bn, representing 4.5% of its estimated pre-tax profit this year;
• China Construction Bank: RMB0.576 bn
• Bank of Communications: 0.252 bn
• Industrial and Commercial Bank of China: RMB 0.120 bn
• China Merchants Bank: RMB 0.103 bn, and
  
• China Citic Bank: RMB 0.019 bn

Even if these figures are low - what about China's onshore mortgage problems? They must dwarf their offshore sub-prime mess, and this makes us nervous.

2. Pork

We already have discussed "porkflation" at length elsewhere and would only re-iterate that -

• in July, food prices (mainly in pork and grain) rose an annual 15.4%, while non-food prices rose a mere 0.9% over the year, and
• that the Central Bank, by raising rates as well as reserve requirements, cannot fight food inflation
• Yes, there is a nascent view that food price inflation will feed into other forms of inflation, but we doubt this: the excess supply of goods being produced in China dis-allows price hikes.

3. Political, pre-Party Congress fuss, then?

Yes, we view current Central Bank statements about imminent tightening more as political manouvres in order to strengthen the position presumably of the conservatives, those people backing Jiang, in the forthcoming leadership re-shuffle. Anything that they can do - including the introduction of tightening measures that are as powerful as a paper tiger - to undermine Hu's and Wen's modernisation, will serve their power interests. All the more so ahead of next August's Olympics.

4. A- Shares at a 74% premium to H-shares

in today's SCMP we also read that the A Shares trade at a 74% premium to their 74 H share dual-listed cousins here in Hong Kong. According to journalist Enoch Yiu, the reasons are that

• "the yuan is not yet freely convertible, and that
• mainland markets are not totally open to foreign investors."

The Hong Kong government wants to organise an arbitrage mechanism whereby China Depository Receipts are issued. Through these, both share classes' prices can be brought into line.

But Beijing is opposed to this. Enoch writes further that "If such arbitrage systems were in place, it is likely investors would sell A shares and buy the H shares - a move that may caus a crash in mainland markets...More importantly...arbitrage activities may caus mainland markets to be more affected by global market liquidity....Should an arbitrage system exist, mainland markets would also be in the firing line. With national leadership changes in October and the Olympics next year, the Beijing bosses are not likely to risk a mainland market crash."

5. So why are A-shares so over-valued relative to H-shares?

Tom Holland wrote a useful piece in the SCMP of 9th August 2007, p. 9:

1. If the economy is growing at 12%, how can mainland corporate earnings be rising by 83%?
2. The answer is: by speculating on the stock market.
   
3. Tom writes that "There are some signs that this is happening. A number of mainland companies have recently booked big profits by marking their stock investments to market...It is likely that this is just the tip of the iceberg. Some observers warn that many of the 25 million individual share-trading accounts ... are fronts for covert stock speculation by companies funded with bank loans.
   

6. So is the A-share market "safe"? NO!

So the China A share market is "closed" - i.e. it cannot be buffetted about by hungry foreign investors who own only about two percent of that market.

Besides, the local government owns about 67% and the Central Government owns about 13% of the stock market - so the government owns about 80% of the market! Private firms own another 9% by individuals and 3% by foreigners. These are guesses based on a 2001 report by the China Securites and Regulatory Commission.

However, it is not impervious to domestic issues such as people borrowing money to speculate on the market. Gosh, is this not precisely what is happening in America, albeit in a different form?

Remember that two thirds of the Chinese stock market is owned by LOCAL governments - and they are not really under the control of the Centre, as we keep re-iterating. So they, along with corporates, could well be playing the speculation game...

Here is what Tom notes about the hidden dangers. onces that could get the mainland market to crash:

"If the market tumbles, perhaps following an interest rate rise to cool inflation, corporate speculators will lose money and default on their loans. In a research report last month, Morgan Stanley economist Qing Wang pointed out that even careful banks could be at risk. If a company borrows from a bank to invest in new plant while speculating with retained earnings, the bank still has an exposure to the company's stock position. If the stock market bubble bursts, Mr. Wang estimates that as much as 30% of all new loans extended by mainland banks over the past 12 months could turn bad: enough to wipe out more than 50% of the banking system's tier one capital and trigger a severed credit crunch."

How to Save Money Off This Idea

1. Stay out of H-shares here in Hong Kong. You won't need more US jitters to get people to unload. As foreign exposure to China's A-Share market is 2% of total market cap, "gweilos" hardly can shake China. But, by getting out of H Shares here you are dealing in a liquid, functioning market and saving yourself money.
   

How (Later) to Make Money Off This Idea

1. Remember that when we do signal that it's time to get back in, our favoured China play will be all of these H shares that are 74% undervalued to their A-share mainland cousins
2. Potential buyers are not just foreigners punting Hong Kong. In today's South China Morning Post we also read that with immediate effect, domestic enterprises in China no longer will be required to to convert forex equivalent to 20% of their previous year's revenues and 50% of their spending. This means that such companies do not from now on have to convert all of their forex into RMB, thus they pump up the RMB money supply a little less.
3. What does this have to do with our H share play? Everything.These domestic companies, now very long of forex, have even more foreign currency to pump into cheap H shares once they feel the time is right.
4. Buy Hong Kong banks. With more illegal Chinese funds coming into our market, mainlanders will seek to hide their moneys in their "Switzerland of the East". This means that Hong Kong banks are flush with cash and thus can lend more money...