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China on a razor's edge

Investors are pouring money back into China's stock markets, helping to reverse a plunge of more than 27% this year, on signs that the government's efforts to cool the economy are having their effect and on the hope that policy tightening measures may thus be relaxed.

The benchmark Shanghai Stock Exchange Composite (SSEC) is up more than 8% in two weeks and as of mid-afternoon local time Thursday it had climbed to 2,555 on its fourth consecutive advancing day.

The pace of China's tearaway economic growth declined in the second quarter to 10.3% year on year, from 11.9% in the first three months, and inflation dropped to 2.9% in June from 3.1% in May. Leading economic indexes separately calculated by the Conference Board and the Organization for Economic Cooperation and Development both look for a continuing deceleration of economic activity through the end of the year.

Even so, Deutsche Bank economist Jun Ma warns that the current advance in stocks might stall because the expected policy relaxation might be put off until the fourth quarter. Industrial production declined more than expected in June, but the government could prefer to wait for a few months of economic data before moving on the policy front, Business Week quoted Ma as saying.

The still high level of inflation could also make policy makers hesitate about re-tightening policies lest they react too strongly and too swiftly.

The first real test for the SSEC will be the 50-day moving average, which today is at 2,573, less than 20 points up from today's index. After that, there is short-term resistance at 2,600, and then some hard going up to 2,680, where both short-term and medium-term resistance come into play, and which already, in late spring, has been unsuccessfully challenged.

Ma, who believes there will be "safer entry points" into Chinese equities later in the third quarter, points to "short covering and high cash positions of many investors" as creating a "self-fulfilling" short-term uptrend that "does not require much support from improvement in macro fundamentals".

It is possible the short-term low earlier this month just below 2,400 will be re-tested. This would be an especially significant move because the support there relies upon a mid-February 2009 local maximum, below which the next supports are in the 2,000-2,100 range followed by the November 2008 crash low just above 1,700.

Macro fundamentals certainly offer little support. Steel companies have helped lead the recent advance but copper imports, an index of industrial activity, are well below last year's level. This puts world commodity prices at potential risk if demand from other countries does not increase so as to pick up the slack. International equities markets watch the world price of copper and sometimes overreact to its swings, especially in the new environment of heightened global share-price volatility.

There are other reasons to question the new market optimism. Chinese fuel imports have been strong, but this is mainly due to the imperative to keep the country's expanded refining capacity busy. The construction of new national strategic oil reserves may also account for part of demand.

New national pricing policies introduced last year also favor refineries, while an imperfect domestic price mechanism for natural gas has resulted in reduced imports of this fuel, leading to some regional shortages.

According to the International Energy Agency (IEA) in Paris, China in 2009 became the world's largest energy consumer, overtaking the US, where the economic slowdown has diminished consumption. A Chinese official later rejected the IEA report.

Still, even if economic growth finishes the year "only" in the 8-9% range, Sun Mingchan of Nomura Holdings notes that the infrastructure projects announced in November 2008 as part of the China's 4 trillion yuan (US$565 billion) economic stimulus should continue to undergird the economy's expansion.

And despite his reservations about the present gains, Ma expects Chinese stocks to rise over the next 12 months by over a quarter (a conservative estimate in comparison with other analysts).

The unspoken fear is of a real estate crash. Property developers have been to the fore in the recent short-term rise, and any future tightening by the government could cast darker clouds over the earnings outlook. A property collapse would affect the nascent middle class, some of whom have made speculative investments in real estate. This is the social stratum that gives political stability to the regime, and the government is loath to see them end up in the financial mess of their American counterparts.

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URL:  http://www.robertcutler.org/blog/2010/07/china_on_a_razors_edge.html
First published in Asia Times Online, 22 July 2010.

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