The Outlook of the U.S. Stock Markets

My friends asked me if the U.S. stock markets will turn bearish and how far it will go up or down.


First of all, I said that I am not a prophet, so I am unable to confirm the direction of the stock markets accurately (as there are so many variable factors including the unpredictable psychological factor). However, I can offer my prediction based on my research and the history of the financial markets. Since the U.S. stock markets haven’t fallen for more than 20 percent from its peak, they are not in the bear market yet.


I think the U.S. stock markets are still under selling pressure, so further corrections will be extended to the third quarter. However, I don’t think the U.S. stock markets will crash like the one in China.   

According to Wall Street, it expects a 3.4 percent decline in earnings for the S&P 500 companies in the third quarter of 2015, led by steep declines in the energy and materials sectors. The decline in earnings is also affected by the strong dollar whose strength has hurt the competitiveness of U.S.-made products, lowering the export sales of the U.S. companies. Since about half of the earnings of these S&P 500 companies generates from overseas sales (because they are multinational corporations), the currency translation (i.e. from domestic currency such as euro and yen into U.S. dollar) would reduce their earnings, causing stock prices to fall. Meanwhile, the average P/E ratio of the S&P 500 stocks is about 15 times after the recent fall in the U.S. stock markets. The decline in earnings means a lower P/E ratio and stock price. Therefore, I feel the selling pressure for the U.S. stocks, and further corrections in the U.S. stock markets seem to be inevitable.


In addition, I expect the Chinese stock markets will go lower because of the sluggish economy. I think China’s economic slowdown will last for a period of time since there is no quick fix for their economic problems including the over-reliance on fixed investments, high levels of debt, declining exports, and insufficient domestic consumer spending, etc. A 2 to 3 percent devaluation of its currency is not enough to stimulate strong exports. Therefore, I think the Chinese government needs to devalue the RMB by a total 5% to 7% before the end of this year in order to spur export growth.


To support the Chinese stock markets and a falling currency, the Chinese government might have spent a total $400 billion USD, causing the foreign exchange reserves to drop from $4.1 trillion USD in 2014 to $3.6 trillion USD at the current level. Spending $200 billion USD to pop up the Chinese stock markets is very costly, so the Chinese government may stop doing it. If this is the case, I think there may be another crash, and then it would adversely affect the U.S. stock markets.  Now the major buyers are the “National Team”. If they stop intervene the stock markets, the demand for Chinese stocks will tumble. The retail investors, who make up 80% of the Chinese stock markets, have got seriously burned, so they would not return to the stock markets quickly. Instead, they are waiting for the chance to unload their stocks to recover or to minimize their losses. The stock market crash and currency devaluation have caused capital outflows, which would reduce the money supply of RMB (since the money supply of Chinese currency is based on the inflow of U.S. dollar), further depressing the Chinese economy. If the Chinese government stimulates the economy by increasing the money supply of RMB not based on the inflow of U.S. dollar, this will be inflationary.


I don’t think the U.S. stock markets will crash because the U.S. economy remains strong. The GDP rose at a 3.7 percent (annualized rate) in the second quarter of this year after a revision from a 2.3 percent growth. The GDP growth was mainly driven by strong business investment with an increase of 8.6% percent in spending on intellectual property, the largest since the last quarter of 2007. Consumer spending, which accounts for about 70% of the U.S. economy, grew at 3.1 percent (annualized rate). Government spending increased at a 2.6 percent annualized rate. The trade also contributed 0.3 percent to the GDP growth. The growth in spending on business, consumer and government is quite impressive. In addition, nonfarm payrolls increased 173,000 in August, so unemployment rate fell to 5.1 percent, which is close to the natural unemployment rate of 5%. The U.S. trade deficit also shrank 7.4 percent in July to $41.9 billion USD, the lowest in five months. Last week the Labor Department announced that the initial claims for state unemployment benefits were 282,000 for the week ended August 29 (Note: it was about 550,000 in 2009 when the U.S. economy entered into recession, so a weekly figure of 282,000 is a substantial improvement). Furthermore, falling gas prices has increased the U.S. consumer’s purchasing power, which is a windfall for Americans. Moreover, the U.S. construction spending increased 0.7 percent to $1.08 trillion USD in July, the highest level in more than seven years. All of these indicate that the U.S. economy is getting traction, so I don’t think the U.S. stock markets will crash because it has a strong economic fundamental.


On average, bull markets end after 4.5 years. Now the bull markets in the United States have lasted for almost 6.5 years since 2009, and they haven’t declined 10% for more than 40 months, so I am not surprising that there were corrections in the markets recently. Now I think the interest rate hike by the Fed and the Chinese stock markets are the two major factors determining the direction of the U.S. stock markets in the short term. Therefore, we need to pay particular attention to these two factors.


The U.S. National Debt Problem

If the US has massive debt, and the Chinese also have a growing debt, then who do we all owe money too? It seems to me like someone should be coming out ahead. Or is there more debt in the world market than there is currency to repay it with? It’s something that I’ve been wondering for some time now. How can we pay our national debts?

Here is my response:

I think the whole world is highly indebted, which was caused by the massive credit expansion in the last 30 years. The U.S. national debt problem is quite complex. I can write 30 to 50 pages about it in details. Therefore, I would try to explain to you in a concise way. Some liberal politicians and economists always say that the national debt problem does not matter. It is because they don’t want to deal with it and will pass the bucket to your generation to take care of the massive national debts. I think these liberal politicians and economists are very irresponsible. I am quite sure that the national debt problem really matters to every American. If the national debts continue to grow faster than the GDP, it will increase the chance of debt defaults (fortunately, the United State government has never defaulted its debts yet), leading to higher interest rates, deterioration in the confidence of U.S. dollar and our economy. This will weaken the dominance of the U.S. dollar in the global finance.

Before I try to explain to you the U.S. national debt problem and how we can tackle it, please take a look at the following table summarizing the amount of U.S. national debts and GDP in billions (USD), the national debt to GDP ratio and the federal budget surplus/deficits for the last twenty years.

(1)                    (2)                                (3)                   (4)                      (5)

U.S. National          U.S. GDP         Debt to               Surplus (+) or

Year      Debts (in billions)      (in billions)      GDP Ratio          Deficit (-)


2014            $17,794               $17,522             102%              – $   492

2013            $16,719               $16,728             100%              – $   680

2012            $16,050               $16,228               99%              – $1,100

2011            $14,764               $15,587               95%              – $1,299

2010            $13,529               $15,058               90%              – $1,171

2009            $11,876               $14,384               83%              – $1,413

2008            $  9,986               $14,843               67%              – $   248

2007            $  8,951               $14,570               61%              – $   161

2006            $  8,451               $13,909               61%              – $   248

2005            $  7,905               $13,205               60%              – $   318

2004            $  7,355               $12,368               59%              – $   413

2003            $  6,760               $11,625               58%              – $   378

2002            $  6,198               $11,037               56%              – $   159

2001            $  5,770               $10,640               54%              – $   127

2000            $  5,629               $10,357               54%              – $   236

1999            $  5,605               $  9,712               58%              +$   126

1998            $  5,478               $  9,147               60%              +$     69

1997            $  5,369               $  8,692               62%              – $     22

1996            $  5,181               $  8,159               64%              – $   107

1989            $  2,868               $  5,712               50%              – $   155

1982            $  1,137               $  3,367               34%              – $   128

1981            $     995               $  3,261               31%              – $     79

1974            $     484               $  1,563               31%              – $       6

1945            $     259               $     228             116%              – $     48

1929            $       17               $     105               16%                      N/A

Generally speaking, a national debt to GDP ratio of 60% or less is considered favorable that a country can manage its national debts. A national debt to GDP ratio of 25% or less is considered as a strong fiscal position. In 2014, the U.S. national debts to GDP ratio reached 102%, which is historically high. The last time this ratio exceeding 100% was in the year of 1945 after the WWII was over. In 1974, it was only 31% under Nixon Administration (even though President Nixon closed the gold window on August 15, 1973 to allow the U.S. dollar to float freely without gold backing). As indicated in the above table, the U.S. national debts to GDP ratios are less than 60% for most of the time since 1945. However, this ratio began to climb above 60% after 2005 (as the national debts increased because of the two wars with Iraq and Afghanistan after September 11th in 2011). The ratio further exceeded 80% in 2009 and became alarming to the public (because of the subprime loan crisis in 2008 leading to a bailout program of $700 billion USD by the Bush Administration). Then, the United States entered into a prolonged recession and suffered a huge budget deficit of $1.413 trillion in the fiscal year of 2019, the highest budget deficit in the U.S. history (note: the fiscal year of the U.S. federal government begins on October 1st and ends on September 30th of each year).


Meanwhile, the annual tax receipts (or the total revenues) of the U.S. federal government are about $2.5 trillion USD while the annual federal government spending is about $3 trillion USD. Therefore, we still have an annual federal budget deficit of $500 billion USD. Based on the annual tax receipts of about $2.5 trillion USD, there is no way that the U.S. government can pay off the national debts currently close to $18 trillion USD. That really sounds scary! In fact, the U.S. government does not need to pay off the whole national debts of approximately $18 trillion USD. This will be explained later.


The U.S. federal government annual budget consists of the revenues from tax receipts and spending. The tax revenues come from the individual income tax, payroll tax, corporation tax, excise tax, gift tax, estate tax and other taxes. The individual income tax is the major source of the tax receipts. The federal government spending includes social security payments, national defense, health care, interest on national debts, education, housing and social services, etc. For example, the federal budget deficit was $1.17 trillion in 2010. The total revenues (or tax receipts) were $2.381 trillion USD while the total government spending was $3.55 trillion USD. National defense and health care accounted for almost 19% and 21%, respectively in 2010.


To pay for the U.S. federal deficits, there are three ways: (1) raise the taxes (2) print the money (3) borrow money by issuing the government securities (i.e. the U.S. treasury securities issued by the U.S. Treasury Department including the long-term bonds, intermediate notes and short-term bills with different maturities from 90 days to 30 years). As you know, raising taxes is always unpopular and a political suicide. Massive money printing money would cause hyperinflation and destroy the currency and the economy. Therefore, it seems that the best way to finance the federal deficits is to issue the government securities. If the government securities are bought by the foreigners or the U.S. private sectors including individuals, corporations or institutions, etc. using their earned income or savings, no new money is created (since they are using funds that are already in existence). Therefore, this is not inflationary (since no new money is created), but it would increase the national debts. Meanwhile, the foreigners (mainly the foreign central banks and financial institutions) are holding about 45% of our national debts. China is currently holding about $1.27 trillion USD of the U.S. government debts. Japan is also holding about $1.2 trillion USD of our national debts. Now the Federal Reserve Bank (the Fed) is the biggest buyer of the U.S. national debts. The social security fund is also a big buyer of the U.S. national debts. In 2009 before the subprime loan crisis, the Fed had about $900 billion USD in U.S. treasury securities and its holding of U.S. treasury securities has expanded to $4.2 trillion USD in 2014 after four rounds of quantitative easing (QE).


Meanwhile, the U.S. government is playing a financial game to deal with the national debts. Here is the trick that you should remember. As long as the U.S. government has the ability to do the refunding for its national debts (refunding means replacing an old debt before its maturity by a new debt) at affordable interest rates and the total annual interest payments are less than 25% of the total tax receipts that the U.S. government can collect, we should not worry about our national debts at least for the time being. Meanwhile, the U.S. government has no trouble at all to refund its debts at historically low interest rates although its national debt to GDP ratio has exceeded 100%. Why?


First and foremost, it is because the U.S dollar is the world’s most important reserve currency, which accounts for about 63% of the foreign currency reserves kept by the foreign central banks. Since the commodities (such as crude oil, gold, silver, copper, aluminum and agriculture products, etc.) are priced and transacted in U.S. dollars, every country must maintain a large reserve of U.S. dollar in order to buy the commodities in the international markets. Moreover, 45% of all international transactions are currently settled in U.S. dollars. Therefore, foreign central banks need to buy the U.S. treasury securities as their foreign currency reserves for the purchase of commodities and for international transaction settlements, thus creating a huge demand for U.S. treasury securities. The higher the demand for the U.S. treasury securities, the higher the liquidity they can offer. The U.S. treasury securities (especially the short-term U.S. Treasury bills, which are called “risk-free” securities) are always the safe haven in time of crisis.


In addition, the United States has the biggest and the most liquid bond markets in the world (“liquidity” means that investors can sell the U.S. treasury bonds at any time without problem). Although our national debt to GDP ratio has exceeded 100%, now the total annual interest payments on the national debts account for less than 20% of the total annual tax receipts. It is partly because of the low interest rates set artificially by the Fed (by purchasing a massive amount of the U.S. treasury securities through QEs). Meanwhile, the yield to maturity (YTM) or the long-term interest rate on the 10-year U.S. Treasury bond is around 2%. In fact, the average YTM of a 10-year U.S. Treasury bond is about 7% since the 1960s. What really makes the United States different from Spain and Italy is that the U.S. government can finance her deficits by issuing long-term treasury bonds at 2% while Spain and Italy have to pay about 7% or even higher on their long-term bonds. That’s why they are in trouble.


In addition, the Fed returns all the interests earned (i.e. on the holding of U.S. treasury securities) after administrative costs to the U.S. Treasury Department. In 2014, the Federal Reserve (Fed) earned $115.9 billion in total interest payments from holding the U.S. Treasury securities and mortgage bonds, and returned $96.9 billion to the U.S. Treasury (after paying the administrative expenses and keeping a little profit).


The artificially low interest rates and the return of interests earned on the U.S. treasury securities have successfully helped to keep the total annual interest payments for less than 20% of the total annual tax receipts. Therefore, the U.S. government has no trouble paying the interest on the national debts, and the financial game keeps going. If the total annual interest payments exceed 50% of the total annual tax receipts, the country will bankrupt soon. There are many examples in the history. As you may not know that since the Bank of England, the world’s first central bank, was established in 1694, England has never paid off her national debts. It just keeps the national debt to GDP ratio at a manageable level and continues to do the refunding over and over. In the 1720s, Prime Minister Sir Robert Walpole’s introduced this funding “scheme” in England. Then, the British government debt never needed be repaid. For every retired bond sold, a new one was issued. Therefore, a national debt could be made perpetual. Isn’t it a smart way to deal with the national debts?


To tackle the national debt problems, I think the United States government should do the following:


  1. Balance the annual budget, so it would not increase the national debts.
  2. Make sure that the GDP grows faster than the national debts. Therefore, the national debts to GDP ratio will decline.
  3. Allow an inflation rate of 3% to 4% a year to reduce the value of the national debts (although it is not a good option, but it is an effective way to reduce national debts at the expense of the bondholders).
  4. Prevent deflation (which will increase the value of the national debts and decrease the GDP growth).
  5. Bring the national debt to GDP ratio back to a manageable level (i.e. below 70%). Note: once the ratio exceeds 100%, the economic growth will slow down because it is hard for the government to increase further debts to stimulate the economy. Too much debts would increase the chance of debt defaults and interest rates.
  6. Defend dollar hegemony, so that foreign central banks keep on buying U.S. treasury securities as their foreign currency reserves.


I think as long as the United States still controls the global finance through dollar hegemony, military might and taking the leadership of high technology invention, it will continue to lead the world. Therefore, I still believe in America at this point of time. In addition, the United States has rule of law, a democratic system for balance and check as well as a strong cultural influence in the world. The discovery of the huge reserves of natural gas is another plus. All of these give America a strong foundation and competitive edge. Although we have the leading edges and competitive advantages, we cannot abuse their use. Instead, we should spend our money wisely, keep our budget under control and reduce our national debts to a manageable level. Since the United States is the world’s largest economy (and also the world’s most diversified economy) and the U.S. dollar is the world’s most important reserve currency, I think a national debt to GDP ratio of 70% to 80% is still not a problem for the United States.


Now what worries me most for the U.S. national debts is that if the U.S. interest rates normalize, for example, the 10-year YTM returns to 7% (instead of 2% at present), the U.S. bond markets will collapse. The dramatic increase in interest rate from 2% to 7% would cause the bond prices to tumble sharply. If this happens, the U.S. government will have trouble in refunding its debts. In addition, the Fed will suffer huge losses from holding the U.S. treasury securities, wiping out a large portion of its equities. Of course, the Fed can print more money to make up for the losses, but it would cause inflation and jeopardize the U.S. dollar’s status as the world’s most important reserve currency. Now I think the U.S. Treasury bond market is a bubble, so we have to be careful about it.


The Possibility of a Rate Hike in September

I think the chance of a rate hike in September is slight (unless the unemployment rate falls below 5%, which is probably not going to happen by the end of August).
It is because a rate hike will make the U.S. dollar even stronger against other major currencies (especially the RMB which is under selling pressure due to a faltering economy and continues to devalue to stimulate exports) and also the currencies of the emerging economies (around 35% of their loans are denominated in U.S. dollar. A strong dollar will make them pay more on their loans. The worst case will be similar to the 1997 Asian financial crisis when Thailand was unable to pay the U.S. dollar-dominated loans when the Thai Baht devalued sharply against the U.S. dollars).
A strong U.S. dollar has already caused capital outflows from China and the emerging economies, hurting their financial markets and domestic economy. In addition, a strong U.S. dollar would exert further downward pressure on oil price and commodity prices, increasing the global deflationary pressure. Finally, there is no imminent threat of inflation in the United States. If the corrections of the U.S. stock markets extend to September, then I think the chance of a rate hike is almost impossible. Therefore, I don’t see strong reasons for the Fed to increase interest rate in September.
I do expect the Fed to raise interest rate before the 4th quarter of this year. However, the rate hike will be very mild and symbolic for 0.25% or 0.50% at most depending on the U.S. economy.

About U.S. Stock Markets and Oil Price

The stock market plunged in a way that beyond most people’s expectation the past couple days.  Now people began to talk about if this is a correction or in fact the beginning of a bear market or a market crash. What is your view?


You expressed your view in the email below that oil will rebound from the current level, and I tend to agree with your assessment.  However, given the continued decline of oil and market sell off the past couple days, a bigger concern starts to surface as people begin to worry about global deflation. If indeed people have been overly optimistic about the global economy and now the deleveraging process is underway,  will people readjust their expectation on the valuation as global demand for oil   continue to shrink.   Will this factor cause oil to fall below $30 to $20 a barrel as some analyst argued. If this view is not correct and will not happen, does oil at current level represent a buying opportunity for long term investors now?   What is your latest opinion on this subject given what had happened in the financial market the past couple days?


As regard to the U.S. stock market, today the Dow Jones Industrial Average dropped 3.21% (or 530.94 points) to close at 16,459.75 and the S+P 500 dropped 3.19% (or 64.84 points) to close at 1,970.89. The fall in U.S. stock prices are driven by the fears of a China-led global economic slowdown and further collapse of the Chinese stock markets. As I have mentioned before, the collapse of the Chinese stock markets would definitely affect the U.S. equities markets. Now you cannot ignore the world’s second largest economy. It would have impacts on the U.S. financial markets. In fact, I think the U.S. stock markets are due to correction. In my email “Is the U.S. Economy Expanding Again” on August 2, 2015, I predict that there may be a correction soon because the average P/E ratio of the S+P 500 stocks was about 21 as of July 31, 2015 (which was high in reference to company earnings) and earnings of some companies were not very encouraging. What worries me most is that the total of dividends paid and stock buybacks are less than the total operating earnings, which is the first time it happened since 2007 before the U.S. stock markets crashed. Therefore, the companies borrow from banks to pay for dividends and stock buybacks. This is very unhealthy. However, I don’t think we should be panic or overreact to today’s correction at this time. Instead, we need further observations. If the U.S. stock markets fall another 5 to 10% for correction, then we need to be more careful. As of now, I don’t think it is a bear market yet.


As I mentioned in my email “The Outlook of Oil Price” on August 9, 2015, I think the oil price will remain low in the near future due a number of unfavorable factors such as the strength of the U.S. dollar, the oversupply of oil by OPEC (about 800,000 to 1,000,000 barrels a day), global deflationary pressure, near-collapse commodity prices, the worry over China’s economy, extra supply of oil from Iran and the possibility of rate hike by the Fed. Therefore, I think the oil price, which is under heavy selling pressure, will stay between $40 to 50 a barrel in the short run due to these unfavorable factors and negative sentiment on oil price.


However, I don’t believe the oil price will fall below $30 or even $20 a barrel. Now the average production cost of oil is $55 per barrel. Saudi Arabia has the lowest production cost of oil. It is estimated to be $15 to $20 per barrel. I don’t think Saudi Arabia is willing to supply oil at its full capacity at the low price such as $20 to $30 a barrel for long. Oil is a scare resource, so its supply is limited. Meanwhile, Saudi Arabia is running a budget deficit. She can hardly provide extravagant social benefits to her citizen if the oil price stays at around $40 a barrel.


Even the oil price falls to near $30 a barrel for whatever reasons, it is only temporary and will not be sustainable for long. When the oil price stays at around $40 a barrel, the U.S. oil producers are forced to cut production to minimize losses and to slash the drilling for rigs, which will cause the supply of oil to fall in the future. I think the dramatic fall in oil price recently is caused by the short selling activities from the speculators (i.e. short selling the financial future contracts with the expectation that the oil price will fall to make profits). These speculators will close their short position to make profits soon by buying the contracts, which will generate demand for oil, causing oil price to rise. Therefore, I believe that the oil price will rebound to a price range between $50 and $60 per barrel. If this is the case, now it is definitely a good time to invest in oil company stocks and oil-related companies and hold the stocks for medium and long term.


The Devaluation of RMB

The devaluation of RMB is the main focus of economic news this week. I had received calls from my friends asking me the reasons for RMB’s devaluation, the impacts of the devaluation and the outlook of RMB.

RMB has risen against the U.S. dollar constantly for ten years since 2005. The value of RMB has been quite stable for a while. However, on Tuesday, August 11, 2015, the People’s Bank of China (PBOC) devalued 1.9 percent to $6.2298 RMB per dollar. The devaluation was the biggest one-day drop since a dramatic devaluation in 1994 when China aligned its official and market rates. The PBOC called it a “one-time devaluation” and said it was part of reforms intended to make its exchange rate more market-oriented, and the devaluation would make the Chinese currency more responsive to market forces. Unlike other major currencies such as U.S. dollar and the euro (which are freely traded), the exchange rate of RMB is under a “managed float” which allows the RMB to fluctuate within a band 2 percent above or below a point set by the People’s Bank of China based on the previous day’s trading. By keeping a tight control on the currency, it has helped protect China during times of market turmoil such as the Asia financial crisis and global financial crisis. This has also controlled the sudden fund outflows and inflows for financial security.

On Tuesday, August 12, 2015, the PBOC further devalued the RMB by another 1.62 percent to $6.3306 RMB per dollar from $6.2298 per dollar. This move took the devaluation to 3.5 percent within two days. On Wednesday, August 13, 2015, RMB devalued again to $6.4010 per dollar. The RMB fell for three consecutive days. Then, PBOC slowed the pace of RMB’s devaluation to the calm jittery in the financial markets. On Friday, August 14, 2015, the PBOC raised the value of the RMB against the U.S. dollar by 0.05 percent. Therefore, the total currency devaluation was 4.4 percent in a week, which was the biggest devaluation in two decades. On Thursday, the PBOC said it would not allow the RMB to plunge 10 percent. The devaluation scared the global markets and induced an angry reaction on Washington, with politicians on both parties criticizing China of returning to its old policy of artificially manipulating its currency in order to boost its declining exports and economy.

The 4.4 percent devaluation of RMB has caused jittery on the financial markets and other economies. First of all, the devaluation of RMB has sent global stocks lower as traders worry about weakness in the world’s second-largest economy. Therefore, the Dow Jones industrial average lost 193 points, or 1.1 percent, to 17,212 as of 9:35 a.m. Eastern time Wednesday. The Standard & Poor’s 500 index fell 19 points, or 1 percent, to 2,064. The Nasdaq composite declined 58 points, or 1.2 percent, to 4,977.

Stock prices at Europe and Asian markets also fell. Germany’s DAX dropped 2.4 percent to 11,025.72 and Britain’s FTSE 100 lost 1.2 percent to 6,588.08.Japan’s Nikkei 225 fell 1.6 percent to 20,392.77 and Hong Kong’s Hang Seng dropped 2.4 percent to 23,902.51. The Shanghai Composite Index fell 1.06 percent to 3,886.32, and shares in Southeast Asia were also lower. In addition, oil price fell to $44.13 a barrel on Tuesday after China devalued its currency. The devaluation of RMB also hurt the Australian and New Zealand dollars and the Korean won.

Although the PBOC emphasized that the currency devaluation was intended to make the exchange rate more market-oriented and more responsive to market forces, so that it can enhance the chance for the RMB to be accepted in the SDR currency basket in October this year. This would establish RMB as a reserve currency. In fact, I think the real reason behind the devaluation is that China’s economy is deteriorating fast. The health of the Chinese economy is probably much worse than what the official data suggests.

For example, exports fell 8.3 percent and manufacturing output collapsed and consumer confidence fell for a fifth consecutive month in July. The three pillars of China’s economy are fixed investments, exports and consumer spending. However, fixed investments are hard to increase dramatically to boost economic growth because debts are mounting. In addition, the collapse in both stock market and housing market has devastated the wealth effects, which in turn hurt people’s purchasing power. Therefore, the only way to expand the economy is to stimulate exports.

The currency devaluation also indicates a reversal of the strong-yuan policy that is aimed to boost domestic consumption in order to reduce the reliance on fixed investments and low-end manufacturing. It is because a strong RMB can increase the purchasing power to move China toward more on domestic consumption. Now the world needs more demand from China, but not more supply of inexpensive products to flood the global market.

What are the impacts of RMB’s devaluation on China and other countries? First of all, a cheaper RMB will make Chinese-made products less expensive, potentially increasing exports to boost the economy and to create jobs. However, the Chinese currency devaluation will add global deflationary pressure, as the inexpensive Chinese-made products will flood the world market, exerting further downward pressure on prices.

The devaluation of RMB would hurt the exports of other Asian countries. In response, they will probably devalue their currencies in order to remain price competitive to boost exports. The worst case may trigger a currency war, pushing the world into a recession.

Global commodity prices have been declining since the devaluation of RMB. The weakness in commodity prices (partly because of a weakness in China’s economy) would hurt the economies of Australia, Brazil and Chile (which rely on exports of commodities), enhancing the chance of a global recession.

A weaker RMB also means that the purchasing power of RMB declines. Therefore, it is more expensive for Chinese consumers to buy foreign goods such as German cars, Swiss watches and French handbags. This would hurt the domestic consumer spending. In addition, Chinese tourists would cut back on their overseas visits because of a weaker currency, cutting the global economic growth.

Now it is hard to play carry trade in which investors borrow cheaply offshore (such as from Hong Kong) and use the borrowed funds to earn a higher interest rate in China to make profits from the interest rate differential. However, a declining RMB would kill the carry trade.

The devaluation of RMB may cloud the picture of an interest rate hike by the Fed. It is because the U.S. dollar will appreciate in value if the Fed increases the interest rate. A strong dollar will attract capitals from other economies, especially the emerging economies and make them more difficult to repay the loans denominated in U.S. dollar. The devaluation of RMB will also cause capital outflows from China. Last year China had $4.1 trillion USD in foreign currency reserves, now it declined to $3.8 trillion USD.

So, what is the outlook of RMB? I think the RMB will further devalue if China’s economy keeps on deteriorating. In order to stimulate exports, a devaluation of 4.4 percent (a total devaluation last week) is not enough. Therefore, I expect another devaluation of 4 to 5 percent or even more before the end of 2015 if China’s economy continues to deteriorate. However, a stronger currency is more favorable for China’s acceptance into the SDR currency basket. Therefore, we can’t be too bearish on RMB in the short run.

The Outlook of Oil Price

The Outlook of Oil Price


This week I had a discussion with my friends if the crude oil price will slide further since it has fallen more than 25% from the peak in May 2015 (when the crude oil was about $60 per barrel). I think the oil price will remain low in the near future due to a number of unfavorable factors (which will be explained as below). However, I think the oil price at $40 to $45 per barrel is not sustainable for a long period of time as these unfavorable factors will change.


On Friday the crude oil plunged further to $44.31 per barrel due to the dollar’s continuous strength after a solid U.S. job report showing that the unemployment rate remained at 5.3 percent for the month of July with a creation of 215,000 new jobs. The U.S. robust economy and strong employment may increase the chance of a rate hike in September by the Fed. The rate hike will further strengthen the value of the dollar, making it more expensive for oil importing countries using U.S. dollars to buy oil (remember that oil is priced in U.S. dollars). The dollar has been up about 14 percent against other global currencies last year. Besides the strong U.S. dollar, there are other reasons to trigger the recent plunge in the oil price.


First of all, although the global demand of oil has increased by about 1.6 million barrels a day over last year’s average according to a report from Morgan Stanley in July (the rising demand is due to a lower oil price), the global supply still exceeds the rising demand. In fact, the recent oil price weakness is due to an oversupply. According to the International Energy Agency (IEA), the average global oil production was 96.39 million barrels a day in the second quarter of this year, creating an oversupply of 800,000 barrels a day. OPEC, which produces one third of the global oil, has openly announced that it will not cut oil production in the near future. Meanwhile, OPEC is producing 30 million barrels of oil daily. In addition, it is widely expected that Iran will further increase the global supply of oil if the U.S. Congress approves a nuclear deal with Iran, which is having the world’s third largest oil reserve and was supplying more than 40 percent of European oil before the economic sanctions by the United States. When Iran resumes oil production, it will definitely put downward pressure on oil price.


The reserves for finished oil products also keep rising. According to a report from the U.S. Energy Information Administration (EIA), it indicated that the gasoline inventories increased by 8.11 million barrels for the week ending July 31, 2015. Furthermore, a report from American Petroleum Institute (API), an industry group, showed that the inventory level reached 462 million barrels in July, compared with 383 million barrels at the beginning of this year, further confirming the extent of oversupply of oil.


In addition, economic slowdown in China and financial concerns in Greece has painted a bleak picture for oil demand, depressing oil price further. China’s exports fell 8.3 percent in July, which is their biggest drop in four months and far worse than expected. Imports also fell 8.1 percent after a 6.1 percent decline in June. The decrease in exports may diminish China’s hopes for an economic turnaround in the second half of this year. China’s manufacturing also had no growth at all in July as indicated by the purchasing managers’ index standing at 50. I think the Greece crisis is far from over. When Greece’s stock market reopened on August 3, 2015, it plunged over 22 percent. Manufacturing output collapsed and consumer confidence fell for a fifth consecutive month in July. Greece’s bailout deal with the international creditors for up to 86 billion euros ($94 billion) in new loans has not been concluded yet. There are still a lot of uncertainties over Greece’s economy and future prospect.


Moreover, decline in commodity prices have also caused oil price to plunge. It is because commodity mining would consume a lot of energy. The dwindling mining activities (due to the near-collapse commodity prices) mean less consumption for energy, causing the demand of oil to fall. The decline in commodity prices, which is also affected by the recent strength in the dollar and the economic slowdown in China, has added deflationary pressure on prices, enhancing the chance of a global recession (if the decline in commodity prices continues). Meanwhile, China accounts for 12.8 percent of all global commodity imports. The increased deflationary pressure would also put the Fed in a dilemma for a rate hike this year to normalize the interest rates.


The lower oil price has also caused some other oil exporting countries such as Russia and Venezuela in financial troubles. Oil price is one of the major factors that will determine the ruble’s strength. The situation in Venezuela is precarious. The country is on the verge of bankruptcy. It can only survive when the oil price is $80 per barrel. Therefore, these oil exporting countries have a strong tendency to step up oil production to make up for the loss of income from a lower oil price.


Based on the above unfavorable factors, it is no doubt that there is tremendous downward pressure on oil price for the time being and in the near future. However, I think the oil price at $40 to $45 per barrel is not sustainable for a long period of time and it will rebound. First of all, the strong dollar has already hurt the U.S. exports and widened the trade deficit. In June the U.S. trade deficit increased 7.1 percent to $43.8 billion USD. The strong dollar has also hurt the earnings of the S+P 500 corporations, of which half of them have 50% of their revenues generated from overseas sales. Therefore, to reduce the trade imbalance and to stimulate exports (to create jobs), the value of U.S. dollar should go down. The depreciation of dollar will boost up the oil price.


Although Saudi Arabia, the largest oil producer in OPEC, can currently produce 10 million barrels of oil a day, it has only a spare production capacity of 1.6 million barrels a day. Therefore, it can hardly increase oil production for more than 20 percent. Once Saudi Arabia has reached its full potential production capacity, oil production will fall, causing oil price to go up. In fact, I think a lower oil price does not serve its best interest. As you may know, Saudi Arabia provides extravagant social benefits to her citizens (such as no income tax, low electricity cost and very inexpensive gasoline price, etc.). However, to keep the fiscal spending for these social benefits, the oil price should be around $100 per barrel. Therefore, now Saudi Arabia has to use her foreign currency reserves and even borrow money from local banks to pay for the extravagant social benefits. Saudi Arabia is expected to be running a 20% budget deficit in 2015 due to lower oil price. Therefore, I think Saudi Arabia also wants the oil price to rise. Oil is a scare resource, so the supply is limited. It doesn’t make sense to sell the oil at low prices to exhaust the reserves.


According to OPEC, Iran can produce only 3.1 million barrels of oil a day, which is about 3% of the global oil production. Due to the economic sanctions, Iran’s production abilities have declined over time. Iran has huge reserve of oil, but it will take some time to step up the production. Increasing oil production capability can be a slow process. It requires investments from $50 to $100 billion USD in the expensive equipment and building infrastructure for oil drilling and production. Some experts estimate that it will take Iran a full year to increase 500,000 barrels of oil a day from its current production. Therefore, I don’t think Iran will be able to flood the oil to market immediately to drive the oil price lower.


In addition, I think the future supply of oil will get tight because of a drastic cutback at energy companies (due to the slump in oil price). The drastic cut in capital expenditures has caused the number of rigs actively drilling for new oil to decline by 42 percent since October last year. So far oil companies have trimmed about $129 billion USD in capital expenditures, causing more than 70,000 oil workers to lose their jobs. Now the U.S. shale gas companies have another problem. At the beginning of this year, the earnings of the shale gas companies were well protected against oil price decline from the hedging contracts, which helped them lock in the prices ahead of time to maintain the profits. Therefore, many of them could secure high prices by hedging before the oil price tumbled. However, unlike the beginning of this year, now the shale gas companies are unable to hedge their oil production at $80 to $90 a barrel. Therefore, they will expose to lower oil prices and their earnings will decline. Some shale gas companies may even go belly up if the oil price stays at $45 per barrel. If this happens, it will cut the oil production since some shale gas companies will be out of business. Eventually the oil price will go up because of a decrease in production. Therefore, I am not too bearish about the oil price.


In conclusion, now low oil price seems to become a new norm. With spare capacity for oil production from Saudi Arabia and declining rigs for oil drilling, I think the supply of oil will be under pressure in the future. The world may be struggling to meet rising oil demand, causing oil price to rise again. Therefore, I think the low oil price at $40 to $45 a barrel is not sustainable for a long period of time. Oil price should return to a price range between $50 and $60 a barrel and stay at this price range for quite a while until the picture of supply and demand will change again.

Is the U.S. Economy Expanding Again?

Is the U.S. Economy Expanding Again?


On Thursday the U.S. Commerce Department released the first estimate of the gross domestic product (GDP) for the second quarter of this year, which grew at a 2.3 percent annual rate, the best gain since a 4.3 percent increase in the third quarter of last year. The 2.3 percent rise in GDP matched my prediction of a GDP growth of 2 to 3 percent for the second quarter, which I mentioned in my email “Is the U.S. Economy Shrinking” on May 2, 2015. The GDP for the first quarter of this year was also revised to GDP 0.6 percent instead of shrinking at a 0.2 percent pace.


My friends asked me the reasons for the GDP rebound in the second quarter. Here is my response. First of all, the adverse factors in the first quarter (such as the harsh weather affecting consumer spending and labor disputes in the West Coast port delaying the custom clearance for imported products) affecting the GDP disappeared in the second quarter. In fact, the GDP growth in the second quarter attributed to the rise in consumer spending, improving international trades, a surge in housing construction and an increase in government spending.


Consumer spending, which accounts for 70 percent of the GDP, increased at an annual rate 2.9 percent in the second quarter, a sizable increase from the 1.8 percent growth in the first quarter.


International trade gave a small boost to overall economic growth. It added 0.1 percentage point to growth after subtracting nearly 2 percentage points in the first quarter due to a rebound in export sales (which had fallen in the first quarter), and a slowdown in imports.


Housing construction grew 6.6 percent, which was just slightly slower than in the first quarter. The government spending surged 0.8 percent as the state and local governments stepped up their spending to offset a drop at the budget cut by the federal government.


However, business investment, which has been hurt by a sharp cutback at energy companies in response to falling oil prices, fell at an annual rate of 0.6 percent in the first quarter. In addition, businesses increased their stockpiles at a slower pace in the second quarter, leading to a 0.1 percentage point drag on economic growth, otherwise, the GDP might grow at 3 percent.


Besides a rebound of GDP in the second quarter of 2015, other economic indicators such as durable goods orders, initial claims for state unemployment benefits, unemployment rate and consumer sentiment index also look very strong.


Durable goods orders jumped 3.4 percent in June after falling 2.1 percent in May. The increase was the best result since March because of a rise in demand for commercial aircraft. The non-defense capital goods orders, which are considered as a proxy for business investment plans, increased 0.9 percent in June. The surge in factory goods orders gives a temporary relief for U.S. manufacturers since they have struggled this year from the effects of a strong dollar and a plunge in energy prices.


Initial claims for state unemployment benefits declined to 225,000 for the week ended July 18, the lowest level since November 1973. In June payroll increased 223,000 after rising 254,000 in May. Therefore, unemployment rate fell to 5.3 percent in June, which is very close to what the Fed considers as full employment. That tightening of the labor market may cause wages to rise, helping build up consumer confidence over the past eight months.


Although the University of Michigan’s consumer sentiment index slipped to 93.1 in July from 96.1 in June, the index was still up 13.8 percent compared to July of last year. Households expected their incomes to rise over the next two years.


All of these indicate that the U.S. economy is gaining traction. Therefore, my friend also asked him if the Federal Reserve Bank will increase interest rate in September.


I think there is only a slight chance that the Fed will increase interest rate in September because of the deflationary pressure and a slow increase in labor costs (which will be discussed in the following paragraphs). However, we need to keep an eye on the unemployment figure which will be released next week. If payrolls add another 250,000 in July, causing the unemployment rate to drop to 5.1 percent, then it will enhance the chance of a rate hike in September by the Fed. I always believe that there may be a couple of interest rate hikes before the end of the year. However, the interest rate hikes should be symbolic and very light not to kill the economic recovery and end the bull of the stock markets. In fact, on Wednesday the Fed announced in its latest policy meeting that it would continue to keep interest at a record low. The Fed said it still needs to see further gains in the job market. Fed Chair Janet Yellen has often cited wage gains as a key criterion that will help the Fed determine the direction of interest rate.


Despite the fact that GDP rebounded and employment was picking up fast, labor costs recorded their smallest increase in 33 years in the second quarter. According to the U.S. Labor Department, the Employment Cost Index (ECI), which is the broadest measure of labor costs for cash compensation and employer-paid benefits, inched up only 0.2 percent in the second quarter, the smallest increase on record since the series started in the second quarter of 1982. The weakness in compensation was concentrated in occupations (such as sales, information and wholesale trade) where workers are likely to receive incentive pay such as commission and bonuses. This actually worries me because slow increase in wages may affect the consumers’ purchasing power in the second half of the year. In fact, I believe that the labor costs are gradually climbing up, as big retail chains such as Walmart are increasing hourly pay well above the minimum wage for their works.


Furthermore, deflationary pressure continues to mount as indicated in price weakness of commodities such as oil, copper and gold, etc. Oil price recently fell to their lowest levels due to the concern over a global oversupply, so it is expected to further head south for a while. The price of crude oil closed at $46.82 per barrel on Friday. On Thursday OPEC Secretary-General Abdullah El-Badri said the Organization of the Petroleum Exporting Countries (OPEC) is not planning to cut production despite the fall in crude prices over recent months and concerns about the possible addition of Iranian oil in the market.


Meanwhile, OPEC is producing one third of global oil (at 30 million barrels a day) and is currently pumping around 3 million barrels per day of oil more than daily demand in the second quarter, compared with around 2 million barrels per day in the first three months of the year. Therefore, the return of oil production from Iran would definitely worsen a global supply glut, forcing oil price to depress further.


In conclusion, I think the U.S. economy will continue to grow in the second half of this year as long as interest rate remains low and strong employment stays afloat, leading to increase in consumer spending. As regard to the U.S. stock markets, I think there may be a correction soon because the average P/E ratio of the S+P 500 stocks is about 21 as of July 31, 2015, and earnings of some companies are not very encouraging either. In addition, what worries me most for the equity markets is that the total of dividends paid and stock buybacks exceeded the operating earnings in the second quarter of 2015 (meaning that companies need to borrow to pay dividends to shareholders and to buyback company stocks to boost stock prices because operating earnings are not enough), the first time since 2007 before the U.S. stock markets crashed. The U.S. stock markets may also be affected by the spillover effects of further plunge in the Chinese stock markets. Therefore, please be careful about the correction in the U.S. stock markets.

Is Gold Still a Good Investment?

Is Gold Still a Good Investment?


Last week I had a lot of discussions with my friends regarding the direction of the gold price. Now I would like to share with you my thoughts.


Gold price began to fall after China released her gold reserves on July 17, 2015. On Friday, gold price rose only 0.37% to close at 1,098.20 an ounce. The analysts at Morgan Stanley led by Tom Price predicted the gold price could plunge as low as $800 an ounce if there will be an interest rate hike in the U.S., another correction in China’s stock market and further selling of gold reserve by central banks. Therefore, is gold still a good investment and a safe haven?


Since gold price reached its peak at near $1,900 an ounce in 2011, it has fallen about 43 percent (against the U.S. dollar since gold is priced in U.S. dollar). On the morning of July 20, 2015, gold prices plunged as much as 4 percent to their lowest since March 2010 at $1,088.05 an ounce and closed at 1,097.70 an ounce because close to 5 tons of gold was sold on the Shanghai Gold Exchange (SGE) in a two-minute window just prior to 9:30 a.m. Normally, the volume is about 25 tons in a whole day.


According to the data released from People’s Bank of China on July 17, 2015, China increased her gold reserves to 1,658 metric tons, up 57 percent from 1,054 tons in 2009, which is dramatically lower than market expectations. Before the announcement of her gold reserves, it is widely predicted that China has accumulated at least 3,500 metric tons of gold (since China is now the world’s largest gold producer and has been actively buying golds in the markets). Meanwhile, the U.S. has the largest gold reserves of 8,133.5 metric tons, according to the World Gold Council show. Germany, the second largest holder of gold reserves, is currently holding about 3,384.2 metric tons. Since China’s gold reserves were lower than many market participants had expected, gold price plunged 1% when China announced her gold reserves of 1,658 metric tons on July 17, 2015. It is because China’s demand for gold was not as high as what the market participants had expected.


However, Jim Rickards, the author of “Currency Wars” and “The Death of Money,” said China still has far more gold than it admits in his latest update for Strategic Intelligence members. China should have more than 1,658 metric tons of gold on hand because she can hold gold with the State Administration of Foreign Exchange (SAFE) and the China Investment Corporation (CIC), so China does not report as part of official central bank reserves. China can then move some of that gold to the central bank, the People’s Bank of China, as and when it wants to report a higher figure. I think there are two reasons for China to underreport her gold reserves (1) A large gold reserve would make RMB strong, which would hurt China’s faltering export (2) a large gold reserve will drive up the gold price, so that China has to pay a higher price to acquire gold.


Shanghai Gold Exchange (SGE), which was opened in 2014 to challenge the West to control over the pricing of gold, announced on June 25, 2015 that they are planning to establish a new “physical” gold price mechanism in Chinese currency by the end of this year, so that it will compete with London and the U.S. Comex, which transacts gold in paper future contracts and derivatives without physical delivery. Since the transactions are done in London and U.S. Comex by derivatives, it is easier to manipulate the gold prices by the West. Meanwhile, the West still dominates the world’s gold reserves. Since the RMB is not a fully convertible currency, I think it is hard for China to take over London (which has been dominated the world’s gold market for 200 years), but it may be a challenge to dollar’s hegemony. The success also depends on the participation of foreign banks, which may be reluctant to join because of internal compliance issues.


Besides the lower than expected gold reserves of China, there are also some reasons for gold price to fall. First of all, it is widely predicted that the Federal Reserve Bank will raise interest rate this year. Federal Reserve Chair Janet Yellen confirmed on July 15, 2015 that the central bank would likely raise interest rates this year if the U.S. economy continues to expand. In addition, the U.S. dollar hit a three-month high against a basket of currencies, making dollar-priced gold more expensive for holders of other currencies. Encouraging data from home-building statistics to consumer prices has also confirmed expectations that the U.S. Federal Reserve will raise short-term interest rates later this year.


Furthermore, China’s slowing growth means she will consume less of all commodities, including gold. Deflationary pressure is building up. Oil price, which is closed at $47.51 per barrel today, continued to fall because the supply of new oil may continue to increase as sanctions against Iran dissolve. Meanwhile, gold, which is always a good hedge against inflation, is under tremendous selling pressure as commodity prices are weak.


Gold, which is also considered as a safe haven, has failed to gain traction from continued turmoil in Greece before the referendum on July 5, 2015 because investors generally believed that the crisis in Greece would not threaten the global financial system and Greece would accept the bailout terms in order to remain in the euro zone. Gold price also failed to rise when China’s stock markets crashed. It seems that gold has lost its historical status as a safe haven, at least for the time being.


This is what Warren Buffet thought about the gold.


“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all – not some – all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”


Warren Buffet doesn’t care about gold. He thinks only the greatest fool would buy gold since it cannot produce cash flow (such as interest and dividend). The value of gold is mainly based on supply and demand (depending on how people perceive its value). Since it cannot produce cash flow, we are unable to use the discounted cash flow (DCF) model to calculate its intrinsic value. In fact, Warren Buffet has accumulated gold secretly.


In my opinion, based on both economic and psychological factors, gold price may continue to fall in the short run due to speculations. However, I will not overlook the importance of gold since it has a very high monetary value in human history, limited in supply (the U.S. Geological Society estimates that just 51,000 tons of global gold reserves remain in the ground), durable and easily be divided into smaller monetary units for transaction purposes. Gold’s value is fully reflected during financial crises and wars (governments would print massive amount of paper money to finance the wars) when people lose confidence on paper currencies. There are numerous examples in the human history.


Therefore, I always recommend my friends to hold at least 5% of gold in their investment portfolio. If gold price falls to $800 an ounce (as predicted by Morgan Stanley), I think it is a definitely good buy. It is because central banks will step up the purchases of gold to diversify their foreign exchange reserves and consumers will also buy more gold for investment. Meanwhile, the average production cost of gold is about $1,000 per ounce, so if gold price falls to $800 an ounce, it is mainly because of short selling by derivatives. It can’t hold the price at $800 an ounce for long.

Is China cooking the GDP figure?

Is China cooking the GDP figure?


On Wednesday China’s National Bureau of Statistics (NBS) released the GDP figure for the second quarter of 2015. China’s GDP expanded 7 percent year-on-year (YoY), down from 7.5% in the same quarter of 2014. This figure was in line with the new “normal” growth rate that was defined by President Xi Jinping. It goes without saying that a 7 percent growth rate in GDP is very impressive. Premier Li Keqiang said that China’s economy was regaining its strength, while the NBS also announced that the worst was over. However, I think China was cooking her GDP figure. It should be less than 7 percent.


When Li Keqiang was a provincial official in 2007, he told an American ambassador that China’s GDP figures are man-made and not reliable. Therefore, China’s GDP figures and other economic data can only be used as a reference. He preferred looking at electricity consumption, railway freight volume and bank loans to measure China’s real economic growth.


Here is how the 7 percent GDP growth picture looks like in the second quarter of 2015. Industrial output increased only 6.8 percent YoY. Fixed asset investment expanded 11.4 percent YoY and retail sales increased 10.6 percent YoY. Export has grown only 2.8 percent. Much of the boost came from the tertiary sector, which grew at 8.4 percent after an increase of 7.9 percent in the first quarter. In addition, personal consumption is weak as indicated by the sales of automobiles, which have been growing just 0.5 percent year-on-year, down from 9 percent in the previous quarter. Based on these figures, we know that China’s economy is actually shrinking, as export and personal consumption are still weak. The only growth is the fixed asset investment.


In 2013, President Xi announced that he wanted to deepen the economic reforms by allowing the markets to have more freedom and a bigger role, so that the allocation of resources and production are determined by the force of supply and demand. Unfortunately, now the Chinese government is still the boss to direct the country’s economy. As we can see that China still relies heavily on fixed asset investment such as building infrastructures and factory plants, etc. to boost economy in the second quarter of 2015. In addition, China’s economy is still dominated by the state-owned enterprises. Now it is the Chinese government’s top priority to keep the economy growing at 7 percent. President Xi is still putting economic growth ahead of deepening economic reforms. A good example is the active intervention in the stock markets recently by the Chinese government after a 30 percent correction in stock prices. It is quite obvious that that the Chinese government lacks the confidence to allow markets to rise and fall by their own mechanism. In contrast, Premier Zhu Rongji was very bold in late 1990s to slash 40 million jobs from state-owned enterprises when he introduced economic reform. Now deepening economic reforms by President Xi seem to be another empty talk.


In an interview with CNBC on May 11, 2015, Hank Paulson, former U.S. Treasury Secretary (2006 – 2009) and also former Chairman of Goldman Sachs (1999 – 2006), said “China’s economy faces enormous challenges” and warned that exaggerating the country’s economic strength was a mistake.


“They have an economic model that’s run out of steam. I think investors should really be looking at what are the sources of that growth. Are they (China) taking the reform steps they need so they’re much more reliant on the private sector and opening up markets to competition? Are they taking steps to rein in their over-investment in infrastructure?” Paulson said.


“China is facing some real structural issues with regard to its economy. They’ve been much too reliant not only on exports but on municipal investment and infrastructure which has led to a very rapid increase in municipal debt and that’s not sustainable.” Paulson warned.


I think Paulson is right. He has visited China many times while he was the Chairman of Goldman Sachs and the U.S. Treasury Secretary. He really understands China’s economy and its problems. Rebalancing the economy by placing more emphasis on domestic spending from fixed investment and export is definitely needed. However, it is not easy for China to rebalance her economy because she has addicted to its old economic model for three decades and there are strong opposition by the interested groups. Therefore, Premier Li Keqiang once said that rebalancing China’s economy will be as painful as “taking a knife to one’s own flesh.”


Meanwhile, the Chinese government has a significant influence on the economy because the allocation of most resources is still controlled by her. To achieve a 7 percent economic growth a year, the Chinese government relies heavily on the huge white elephant projects in regardless of whether these projects have high economic values or not. In the process of approving these big-ticket projects, it gives Chinese government officials the opportunities of rent seeking, which allows an individual to use his or her resources to obtain an economic gain from others without returning any benefits back to society through wealth creation. As a result, corruption (a hidden cost to the society) becomes rampant in China.


When the economy is shrinking, the Chinese government fabricated a bull stock market, hoping that it can help the state-owned enterprises raise equity capitals through IPOs and offering new stocks to pay off or reduce a significant portion of their existing debts (when stock prices fly high) and to create wealth effect to stimulate consumer spending. Now the Chinese government has stopped all IPOs when the stock markets are in deep turmoil. The Chinese government even forced the major shareholders to buy back company stocks to boost stock prices and has increased the money supply to support her stock markets. These actions have seriously violated the game rules of a free market economy and would certainly make the economy even worse. Now power struggle intensifies at the top of the Communist Party and opposing parties are finger pointing at each other. There are no consensus as regard to some major economic issues and reforms. Therefore, I think rebalancing the economy and deepening reforms are quite bumpy.

Can China’s Drastic Measures Save its Stock Markets?

Can China’s Drastic Measures Save its Stock Markets?


As I have mentioned in my email on April 7, 2015, the stock market crash in China is inevitable unless proper measures are done by the Chinese government in a timely manner, otherwise; it is just a matter of time. Unfortunately, my prediction is correct. I am pretty sure that the crash will happen because this stock market rise is driven primarily by liquidity (through expansive money supply and high leverage by margin borrowing) and government propaganda instead of the strong economic fundamentals. Zhou Xiaochuan, the governor of People’s Bank of China (PBOC), said early this year that investing in stocks means investing in the real economy. A state-owned media even described this stock market as a “Reform Bull” because the economy will fly high as China deepens its economic reforms.


After a total of 30% correction in the A-Share Market from its recent height of 5,180 on June 12, 2015, more than $3.2 trillion USD (an amount more than 10 times the size of the entire Greek economy) of market value has been evaporated in about three weeks. Therefore, the Chinese government has tried all its strenuous efforts to do whatever it takes to boost the stock markets and restore investors’ confidence. It is because the stock market crash would cause serious economic losses to investors (with 85% are retail investors), leading to social unrest and instability. The market crash is now a major threat to the rule of the Communist Party in China. Therefore, to distract the public’s attention, the Chinese government tried to blame on hostile foreign forces for short selling stocks and market manipulations. I think this is totally ridiculous.


To induce a stock rally, besides cutting interest rates and the reserve requirement ratio (RRR) on bank deposits, the Chinese government has taken the following measures in the last two weeks.


    1. The China Securities Regulatory Commission (CSRC) has announced plans to increase the capital base of China Securities Finance Corp. (which is owned by the CSRC) from $24 billion RMB (or $3.9 billion USD) to $100 billion RMB ($16.1 billion), so it can provide credit to brokerage firms.
    2. Central Huijin, China’s sovereign fund, has recently buying exchange-traded funds (ETFs) and will continue to do so.
    3. Initial public offerings were suspended to reduce the supply of shares in the markets. Therefore, twenty-eight companies which CSRC had approved to list shares in the markets were suspended.
    4. Around 1,350 companies have been suspended from trading, representing half of the companies listed on China’s two major exchanges.
    5. Companies’ major shareholders – those with more than 5 percent of a company’s shares, as well as executives and board members – were prohibited from selling shares for six months. In addition, the Chinese government ordered publicly-held companies to choose one of the five following options. I think this is outrageous.
      • Major shareholders increase their stock holdings.
      • Major shareholders lend money to top executives to increase stock holdings.
      • Board members increase their stock holdings.
      • Stock repurchase by the company.
      • Increase cash dividends or stock dividends.
    6. Insurance companies are allowed to buy more blue chip stocks. On Thursday, six insurance companies purchased $15 billion RMB ($2.43 billion) worth of stocks and stock funds.
    7. Make malicious short selling as a crime. CSRC is now probing investors who have used stock index futures to short sell shares. Police are also planning a nationwide campaign to crack down on illegal operations for securities trading.
    8. More importantly, PBOC has provided more liquidity to the China Securities Finance Corp., so it can provide credit to brokerage firms to finance stock trading. So far the China Securities Finance Corp. has provided $260 billion RMB ($41.8 billion USD) to 21 brokerages, which in turn would collectively buy at least $120 billion RMB ($19.3 billion USD) of the largest company shares listed in the index to help stabilize the market and pledge not to sell the stock holdings as long as the Shanghai Composite Index is below 4,500.

Now the Chinese government is expanding the money supply to buy shares through the “National Team” (all the major government agencies and state-owned enterprises) to stabilize the stock market and it becomes the biggest stock dealer ever in the human history. This is a complete violation of a free market economy which President Xi Jinping encourages for deepening China’s economic reforms.

Can these drastic measures save China’s stock markets? I think “Yes” in the short-run. It is because the Chinese stock markets are quite close-end. Meanwhile, foreign investors hold only 2% of the all Chinese stocks and they can invest in the Chinese stock markets only through the QFII and Shanghai-Hong Kong Stock Link. China is a totalitarian state ruled by the Communist Party, which controls people’s every aspect of life and the country’s resources. The Chinese government can muster all necessary resources to support the stock markets. It can use administrative powers to prohibit short selling activities and print massive amount of money to buy shares to reach target prices. Therefore, I expect stock rallies will continue to come (due to government’s active interventions and returning to an average P/E ratio of around 14 to 15 for A-Share Market). However, each stock rally may be a Sucker’s Rally since it is not backed by strong economic fundamentals. After a 30% correction, the Chinese stock markets are actually in a bear market. I think investors should take advantage of each rally to unload stocks. Investors may also buy shares after each correction and sell them at the next rally to make short-term profits. Now I become more conservative after entering into a bear market.

In the long run, I think all these drastic measures are futile and doomed to fail because they violate the game rules of a free market economy which an efficient stock market should obey. In addition, the effects of these measures could be short-lived if investors are still negative and don’t trust the government anymore. Now investors, especially those who got burned recently, are waiting for a chance to recover losses when stock prices rebound. Each time when there is stock rally, they will sell their stocks to recover or cut losses. This would put further downward pressure on stock prices. I think the massive money printing to boost stock prices could produce short-term results, but it would jeopardize China’s financial system, eventually causing runaway inflation and massive capital outflows. If the government dictates stock prices and controls trading activities, then who will be interested in investing in the stock market? In addition, if investors know that the government would rescue the stock markets after a crash, they will take more risks because their future losses are insured by the government. In addition, Chinese business owners, executives and investors will spend more time on predicting what the government thinks, and less time on making their companies productive and innovative and evaluating the intrinsic value of a stock. These are the bad consequences of manipulating stock markets by the Chinese government. In fact, China needs a functioning stock market which allows business enterprises to raise capitals and provides liquidity for equities investment. One of the reasons why Chinese government wants to generate a bull market is that it would allow Chinese enterprises to raise equity capitals to reduce their existing debts (since they are highly in debts) and direct idle savings in the banks to fund efficient business enterprises. A stock market manipulated by the government would defeat the purpose. Now I start worrying about China’s real estate market. The stock market crash appears to be spilling over into the real estate market because some investors are under pressure to sell their properties to pay off the margin loans or abandon plans to buy new homes, reducing demand for properties and further depressing house prices. There were renewed hopes in March and April this year that some investors would buy new homes after taking profits from their stocks. Now it is the other way around that people want to sell their properties. The stock market crash is a major setback for China. In October this year IMF will decide if Renminbi will be included in SDR, making it one of the world’s reserve currencies. As I have mentioned in my email on June 8, 2015, it has a pretty good chance this time since it was denied by IMF five years ago. However, now IMF (especially the United States who operates behind the scene) has a good excuse to deny China, yet again for another five years because of the unstable nature of China’s capital markets and violating the free market operation. If this is the case, the U.S. dollar remains the world’s most important reserve currency without any challenges in the next five years.