The first trading day after the Asia-wide three-day holiday, and following the weekend announcements of Lehman Brothers Chapter 11 filing and the buyout of Merrill Lynch, China’s stock markets dropped in tandem with Asian and world markets.

China Supertrends has been following the financial implications of the sub-prime crisis for a while now and will comment on this latest development and the state of China’s stock markets in a separate post. Today, Tuesday, September 16, was yet another blood-bath in the markets, but at a time like this it is worth remembering that China’s underlying economic fundamentals remain very strong.

In fact, China just came off yet another strong month of growth. If this is true, what causes the apparent contradiction of one of the world’s best performing economies having one of the worst-performing stock markets?

In brief answer to this complex question, let’s just say that the theory of decoupling - the idea that China and other developing countries are mature enough to continue to develop on their own during an economic decline in the US and elsewhere - is increasingly discredited.  We wrote as much in Supertrends: We are living in an inter-connected world, and nothing, not even neo-Mercantilist policies, a protected currency, nor the world’s largest foreign reserves, can resist the forces that are sweeping our world.  As John Donne famously said, no man is an island. This financial crisis calls to all governments to act.

China, with its strong economic performance in August and year-to-date, may appear to be in the eye of the storm, an island of calm and prosperity. Last week was the Mid-Autumn Festival, and the economists at China’s National Bureau of Statistics were producing new data faster than mooncakes at Wang Jia Sha. Virtually everything seems according to plan.

Starting with the drivers of the economy, consumption continued to show signs of strength, with retail sales maintaining a 23.2 percent pace of growth in August, only slightly lower than July’s 23.3 percent, the fastest rate since 1996, according to the Shanghai Daily.

The level of retail sales growth is far above the most recent inflation levels, meaning retail sales growth is not just about price increases, there is real growth there.  In fact, CPI - the consumer price index, or basic inflation - decreased to 4.9 percent in August, continuing the downward trend, but worrisome PPI - the prices producers are paying for raw materials and commodities - continued to climb, to 10.1 percent in August. PPI increases will, at some point, either result in decreased margins and profits as companies absorb the increases, or get passed on to consumers as price increases, so China is not out of inflationary woods yet.

Many were regarding the fight on inflation to be one of China’s core economic policies of 2008, but in a surprise move today the People’s Bank of China decided to cut interest rates by about a quarter percent, down from 7.47 percent to 7.2 percent and, in perhaps the most surprising move of all, cut the reserve ratio by a full one percent after having just increased it by one percent in June.  Now that the Olympics are over, micromanagement of the economy seems back in style.

But the message, that the economy is ready for a rate cut and wants to increase money supply, could be evidence that the PBOC overshot the mark and caused money supply to shrink too quickly, contributing to some of the summer’s abysmal stock and real estate performance.  Growth in M2, the money supply, decreased to 16 percent in August, down from 17.4 percent in June.  It is important to point out here that we are still talking about an increase of 16 percent, just that the rate of speed it was growing simply slowed down a little.

Is the PBOC acting wisely or foolishly? Time will tell if they are cutting too soon, a knee-jerk reaction to the latest sub-prime casualties, trying to prop up the falling stock and property markets, or if they are presciently avoiding a much harder crash in the wake of Fannie/Freddie/Lehman fallout and other factors yet to come.

While some of this data could be construed as negative, China had a lot of other positive economic results in August. For example, the trade surplus is up by 25.7 percent year-to-date, compared with Jan - Aug 2007 figures.

In August, with industrial output growth the lowest in 18 months, a mere 12.8 percent increase, exports decreased to 21.1 percent from 26.9 percent in July. Imports were down more dramatically, from 33.7 to 23.1 percent, mostly because of commodity import price decreases  (i.e. oil), so the trade surplus actually still got bigger. 

Though slowing its rate of increase slightly, clearly China’s export prowess is not affected significantly by the world-wide financial crises, and despite the 2008 increase in  the strength of the RMB exporters seem to have adapted. The sky, it woud seem, is not falling, though its perhaps a paler shade of grey. Ecnomists, analysts, and the Chinese media make a lot of dire proclamations about how the Chinese economy is in decline but this is better thought of as healthier, sustainable growth.

I could go on. FDI and other investments - still strong. Foreign reserve size- still troubling, but thanks to the Fannie Mae / Freddie Mac bailout, the 20 percent of reserves held in US mortgage debt appears safe.

So the question originally posed, why is there a contradiction? China’s strong economy (with all the usual provisos and assumptions about the data, of course) on the one hand, and its weak stock and property markets on the other. What gives?

Is this a sign that global markets cannot decouple and are doomed to falter together, or is it a sign that somebody needs to act more decisively?  Just as China became a stabilizing force in the Asian Financial Crisis of 1997, is there are way it could use its economic and financial strength to do so again?

No country is an island in our globalized world.  Everybody has a stake.  With the alarm bells sounding, can China passively wait for the U.S. to get through its bailouts, and hope that the world financial system remains intact?  Or does this bell ring for another?  Whom does the bell toll for?  China, it tolls for thee.

Categories: Affluencing, China Supertrends, Consumption, Drivers of the Drivers, Foreign Direct Investment, Globalization, Trade