China's Wall of Money

"There's a saying in the United States that the customer is king. But in Japan the customer is God."

Tak Kimoto, Sumitronics Inc.

Flashback to mid-July 2007: global equity markets all appeared headed into a collective selling abyss. Such was the "fear" initiated by the Subprime Syndrome and investor aversion to risky assets. Surely the emerging markets like China would also be affected? After all, don't Chinese banks hold oceans of U.S. bonds and other assets including those infamous toxic AAA rated CDOs that had exposure to subprime assets?

So while European, U.S., Australian and Japanese bank stocks and broader equity indices took a beating China and Hong Kong actually stood relatively firm. In fact, global stock market performance dispersion has been wide and notable. For example in the month since July 16, 2007 the DJIA returned -7.92%, the S&P 500 returned -8.92%, TOPIX returned -12.12%, the FTSE 100 returned -12.52% and the CAC 40 returned -14.40%.

Over the same period the Hang Seng returned -9.94% while China's A-Share Shanghai and A-Share Szechzen Indices returned 24.75% and 30.21% respectively. This is hardly the earth-shattering collapse hinted at even by illustrious circuit-speakers like former Fed-Chairman Alan Greenspan not too many moons ago. And by the way, looking at August alone the Hang Seng recovered to be up 3.52% month-to-date. What happened and why the apparent decoupling with the rest of the subprime infected financial world?

The Wizard of Oz in this story happens to be the Chinese government. Kudos for pulling off what they did when they did! Co-incidence? I do not think so.

Every indication suggests that Chinese bank exposure to the subprime mess has been substantial - just how much of it is brought out in the open is up for debate. And it should be too. The Bank of China said that it had minimal exposure of US$8.965 billion in U.S. sub-prime mortgage-backed loans by the end of June; Industrial and Commerical Bank of China held US$1.22 billion and China Construction Bank held US$1.06 billion.

That said, it was strangely good timing that just when the finger was about to be pointed in all sorts of directions with hedge fund short-sellers primed to go after China's banks the rules of the game suddenly changed.

The Chinese authorities suddenly relaxed a previous restriction placed on mainland Chinese to invest in the Hong Kong markets. This led to a wall of money suddenly chasing Hong Kong-listed Chinese stocks as the long-discussed arbitrage between "A" and "H" stocks suddenly became a reality. So, not only has this money inflow supported and lifted the Hang Seng but the one condition that the authorities also included in this incredible relaxation in investment strategy was that Chinese residents are now allowed to buy Hong Kong shares only if they leave investable sums with a bank approved by the Bank of China. What an inventive way to "direct" deposit inflows and at the same time keep the markets supported.

The Subprime Syndrome has clouded the masses in the U.S. and Europe with regards to this masterful act which was under-reported when it took place a little over a week ago.

What it did do, was to ensure that aside from a recession risk, Chinese equity markets are likely be decoupled from any renewed Subprime revelations in the U.S. and Europe.

Expect the record breaking markets there to roll on favoring local hedge fund managers anxious for a piece of the momentum driven market. Investors might be wise to look again at BRIC-oriented ETFs if they seek a low-cost piece of this action which should continue for quite a while. International hedge fund managers take note.
Mahalo.