Stock Market and Economic Analysis

The global economy is on a recovery path aided by Government stimulus. The OECD leading economic indicators point to a strong recovery in all major economies and potential expansion in the economies of Italy and France. A survey of economist also shows that the U.S. economy might have expanded at the fastest pace in the last two years in the third quarter of 2009.

A strong recovery in U.S. as well as China is an important factor in restoring the global confidence and also for spurring up global trade activity. This article looks into the key economic indicators of China and what kind of recovery do they point towards.

Monitoring Signals of Macro-Economic Climate Index

The above chart gives the trend of key economic indicators for China for the last one year. On a cumulative basis, the Business Cycle signal index has gone up for five months on a trot and is now in a stable region after six consecutive months of decline. So, on a overall basis, one can say that the Chinese economy is on a sustainable and stable recovery path.

The chart also shows that the investment in fixed assets has been increasing for the last six months. In my opinion, this is good, as long as it is directed towards local spending and consumption. China already has a overcapacity with regards to its exports.

The same trend of fixed investment increases is observed in the chart below which gives the year-on-year increase in urban fixed investment in China.

Urban Fixed Investment in China (Chart Source: Bloomberg)

Fixed Asset Investment, China Investment

As the chart shows, the urban fixed investment growth in China is the highest it has been for the last five years.

The index of industrial production has also been in a stable region according to the monitoring signals of the macro economic climate.

The increase in economic activity is also indicated by the logistics index, which has recovered sharply in the last few months. The logistics index is an indicator which involves no element of speculation in it. Thus, would give the real picture of economic recovery.

China's Logistics Index

Source: National Bureau of Statistics of China

The Area of Concern

While industrial production trend and fixed asset investment trend look robust, the biggest area of concern, which is clearly visible in the Chart is the financial institutions loans. For six months in a row, the indicator is showing overheating signs for financial institution loans.

This issue was talked about a few months back and the Chinese markets fell almost 20% on concerns of overvaluation and that lending standards might be tightened. However, the Chinese central bank promised easy avaliability of funds and things were back to normal.

But, the increase in money supply at such a rapid pace is a cause of concern.

The chart below gives the year on year increase in M2 in China for the last five years. These figures are not seasonally adjusted. M2 includes M1 and quasi money. M1 includes M0 and demand deposits. M0 is money in circulation.

Money Supply (M2) growth in China (Chart Source: Bloomberg)

This record increase in money supply (as indicated above) has been aided by low interest rates coupled with very easy lending standards. For the month of August 2009, the money supply in the system increased by 29.3% as compared to prior year period. In the first nine months of 2009, 8.67 trillion yuan in new loaans were extended to various business organizations and individuals.

In the near term, this might not be so much of a concern. Easy lending standards give market participants some easy money to speculate in various asset classes. Moreover, the CPI for August 2009 (y-o-y growth) was at -1.2%. So there is no immediate need for the Central Bank to raise rates.

However, this rapid increase in money in the system can lead to significant problems in the long term. One of the major issues will be inflation. As the economy recovers, inflation is bound to increase on the back of strong commodity prices (aided by excessive money supply). At that point of time, the Central Bank has to tighten interest rates.

When this happens or even when speculators get a hint of the same, there will be massive selling across all assets where speculative money is being invested or traded. This might include stock markets and real estate.

In my opinion, if the lending standards are not tightened in the near future China might be faced with the following issues:

Bubbles across various Asset classes

High Inflation

Rise in non performing assets in the Banking sector

Decline in the Capital Adequacy Ratios of banks in China

Increase in loan loss provisions in the future. This will impact lending significantly in future even to business which are in good shape and need funds for expansion.

Thus, one needs to look at China's recovery with some degree of caution. Moreover, as China has a big sentimental impact on the rest of Asia, any massive fall in Chinese stock markets might impact the Asian equities in a significant way.

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