China Calling

First, you had that stupid scare on rumours of a possible capital gains tax which started a markets' diarrhoea. Now that was proven to be untrue. However at the recent very big pow-wow (National People's Congress) a few major decisions were made.

a) China will allow a new agency to manage a portion of its US$1 trillion in foreign reserves, prompting fears that China may not be as aggressive in holding USD in the future. Yes, baby steps initially, but nothing much for the Fed to worry about initially. This may herald the start of the soon to be infamous long term decline of the USD. Just imagine how this decision will affect other central banks or the oil barons. Holding USD is definitely no longer fashionable. Anyway, back to the issue, it looks like China wants to put a part of the reserves to be managed similar to Temasek, and hence will be modeled after Temasek to do direct equity investments. The new company will be called Lianhui and will start with 250bn yuan (US$32bn).

b) China also raised rates by 0.27% thereby pushing the bank lending rate to 6.39%, the third hike in the last 12 months. The hike was more to rein in lending and the property market. Nonetheless, it would put a wet blanket on China stocks as well because the mood from the top dogs is that they want to be more aggressive this year to curb excessive lending and to tame the wild property market. While that might be the case, the actual deposit rate is only giving 2.79%, which is not highly attractive compared to the highly volatile and exciting China stocks.

Bearing in mind the rate increase came right after the recent raising of the banks' reserve requirement ratio. The bureaucrats are really trying hard to send a message that they are really not happy with the current very liquid conditions. I would say that there will be more tightening from China in rapid succession until Chinese stock markets and property side can feel the noose around their necks. I would strongly advise to sell China stocks and stay sidelined for now, and just collect the very attractive interest rate in yuan currency. Yuan will be allowed to appreciate more for the rest of the year. What a good investment option.

c) Premier Wen Jiabao made the following speech, quite unbelievable really. You'd think a hardline Democrat or Al Gore was making the speech and not a communist leader. “China's investment growth is too high, lending growth too fast, liquidity excessive and trade and international payments very imbalanced. Energy efficiency and environmental protection issues haven't been properly resolved." Wow! Cool and highly responsible. These statements should not be taken as baseless regurgitations by a politician but rather the "new platform" where all major decisions and strategies for the rest of the year will be plotted on. Be afraid, be very afraid. It is highly likely that there will be a lot more unpopular and restrictive policies that will tighten liquidity considerably. Again, get out of stocks and property for now in China.

d) Now China don't need FDI so much. Also from the recent pow-wow, foreign companies will no longer be given preferential treatment. Chinese enterprises had long pushed for a unified tax policy, complaining that overseas firms enjoyed an unfair advantage over them. Foreign companies have been paying an income tax rate of 15%, while domestic firms were taxed as much as 33%. A single corporate tax rate of 25% is to take effect next year.

As China moves into its 10th year of uninterrupted growth, the lawmakers are now getting really serious about a lot of things. The bulging trade surpluses is very unhealthy. The slowly appreciating yuan will not do the trick. Unifying corporate tax may be more effective than at first perceived. The bulk of the trade surpluses are actually generated by foreign companies manufacturing in China and exporting back the goods rather than domestic Chinese companies' exports. This move will remove a good portion of the incentives, and will at least slow down the rate of FDIs.

d) China will raise its 2007 defense spending by 17.8% to 350bn yuan or US$45bn. Naturally Japan and the US voiced concerns. Bear in mind that at US$45bn, it is just 10% of US defense spending while China has a few times more people than the US. Bear in mind that despite the economic successes, you still have to protect the 1 billion over residents with some form military might. No matter how peaceful you claim to be, you never can know, the geopolitical military equation has to be balanced. You cannot seriously expect China to maintain a flat defense budget!!??

All the tightening moves could emanate from a possible US proposal to implement a 27.5% tariff on goods imported from China. Some nitwit senator probably is proposing that, and Paulson would have to set things straight and not allow that to get to the floor. Bear in mind that the majority of the trade surplus is by foreign companies based in China who are exporting goods. This is a little known fact as they are all shrouded in jvs. Bumpy road ahead in China.