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World in love with China: unpredictability ahead!

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China_flag1(Oct. 21, 2009 - Erwan Mahe) This title even fits me, since I am looking for a Chinese teacher for my two young boys at home. That is what I call a free option (aside from the price of the classes), because at their age (7 and 8), either they find the classes fun and they learn or they don’t and, tough luck.

I was talking with a friend a few days ago who is creating a private equity fund in Hong Kong whose focus will be investments on the Chinese mainland. He said that he is hiring only those graduates of the most prestigious US and European universities who speak Chinese! If current trends continue, these lessons should give my kids a nice edge up in the next 10 to 15 years.

However, when I speak of the world’s love affair with China, I am referring to the incredible energy spent by observers throughout the planet to determine if the Middle Kingdom’s current growth is sustainable....

...or if it is not simply the result of the avalanche of credit on the country in the first nine months of the year, accounting for 50% of GDP, which has fuelled a 33.20% hike in fixed asset investments.

We thus anticipate that Q3 GDP, set for release tomorrow, will show an annual hike of +9.1%, following +6.1% in Q1 and +7.9% in Q2.

Here is a fresh illustration of this trend:

Guangzhou Baiyun International Airport Co. said its September cargo throughput grew 64.6% year-on-year to 101,000 tons, continuing an upward trend that began in May.

The consequences of this frenetic growth in China is making itself felt in all asset classes, as the Shanghai exchange is being scrutinised by investors for emerging market stocks, themselves monitored by equity investors in G5 countries, but it is also affecting commodity prices (record iron ore imports at 64.6 M tonnes in September and +23% in copper), interest rates and currencies …

As such, Thailand’s foreign trade stats, just released this morning, are directly impacted by its big Asian neighbour: its exports grew again in September, this time by 12%, bringing the rebound since the low point in April 2009 to 42%, and not far from the record monthly hike attained in July 2008.

In the meantime, the country’s imports logically grew but at a slower pace, given the average trade surplus of $1.2bn in 2009 compared to a deficit of $360m in 2008.

Volkswagen just announced that it sold 150,000 vehicles in China during September, which is a new record, representing 37% growth on the first nine months of the year!

Keep in mind, however, that the government had stimulated this sector by cutting in half taxes on auto sales and by subsidising purchases in rural areas.

Since during all this time, the yuan remained pegged to the dollar, which is undergoing a period of “benign neglect”, the euro continues to appreciate, but it is not the only currency to do so.

It is easy to understand the reasons for Brazil imposing a 2% tax on incoming financial flows, given the real’s 50% appreciation in the past 10 months!

I remain as sceptical as ever about the medium-term consequences of this flood of credit in China, whose structural risks to the domestic financial system we highlight on a regular basis On the Chinese Minsky Ladder, again…), and I am clearly not alone.

The CRBC, the body in charge of monitoring the banking sector, has been sounding the alarm regularly in recent weeks:

"Credit risks are accumulating after the surge in new lending this year,"

Liu, CRBC director, urged banks to improve liquidity risk management systems and "always maintain ample liquidity levels", to strictly follow government credit policies and strengthen risk control.

And the government itself seems to greater importance to the consequences of this liquidity wave:

The State Council meeting, which was chaired by Premier Wen Jiabao, concluded that "adjusting the economic structure and managing inflation expectations are the focus of macroeconomic controls,"

However, at the same time, Mr Yin (deputy-director of the Finance and Economic Committee under the National People's Congress), declared:

New lending for next year should be no less than CNY8 trillion to maintain fixed-asset investment growth.

(CNY8.67 T on first nine months).

I must admit that I am more than a little perplexed at the thought that the world economy and its main financial markets have become dependent on the behaviour of a few decision-makers in Beijing whose experience in dealing with such a “financiarised” macroeconomic cycle is very limited.

As such, I have decided to sideline the time being my usual investment focus, leaving only some option positions which we find attractive in terms of risk/reward.

Have a good day.


Erwan Mahé - Asset allocation and option strategy

22, rue des Capucines - 75002 Paris

TEL : + 33 1 53 05 57 20



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