Page 1 of 2 Short success an ill omen for China
By Richard Komaiko
China's economy grew 11% last quarter, its stock market is up almost 300% this
year and the country now boasts five of the world's 10 largest corporations.
Just when you thought things couldn't possibly get any better, you realize
things could, possibly, get a lot worse. New developments in the finance
industry, combined with the growing structural problems of the Chinese economy,
present cause for great concern.
The fastest-growing type of financial instrument today is called an
Electronically Traded Fund (ETF), which tracks a basket of stocks or bonds. An
ETF is a lot like a mutual fund in that it allows investors to put money into
an entire industry, sector or country. However, unlike a mutual fund, an ETF
can be traded electronically 24 hours per day, just like shares of stock. There
are at present about 500 ETFs on the American market.
On November 8, Proshares launched an ETF called the Ultrashort FTSE/Xinhua
China 25 Index (FXP). The FXP is based on an index of the 25 largest
corporations in China, and it is an inverse fund. This means is that when those
25 corporations decrease in value, the FXP increases in value. Also, the FXP is
a leveraged fund. So for every 1% decrease in the value of those corporations,
the FXP will gain 2% in value. The FXP effectively enables international
investors to hedge against the growth of the Chinese market and make a two-fold
profit in doing so.
"Proshares is definitely the industry leader in inverse and leveraged
products," according to Lawrence Rosenberg, Neal Weintraub and Andrew Hyman,
co-authors of ETF Strategies and Tactics: How to Hedge Your Portfolio in a
Changing Market, which will be released in March. "The FXP has created
new opportunities for investors where none existed before," said Rosenberg, the
former chairman of the Chicago Mercantile Exchange.
Almost US$100 million has been invested in the FXP since it launched two weeks
ago. "On opening day, FXP had almost a million shares traded, which is unheard
of for an ETF," said Proshares managing director Steve Cohen. "I believe China
may be in for a bubble, like the tech bubble of the '90s, and we at Proshares
want to provide a tool for investors to deal with that situation. I have my
personal opinion, and we at Proshares have our opinion, but that doesn't really
matter. All that matters is how investors feel about the market. Right now, the
investors are really nervous."
The launch of FXP, in context, must be taken as a serious omen. To appreciate
this omen, let us review the problems facing the Chinese economy, the
authoritative commentaries on these problems, and the economic theory that
provides their grounding.
One of the most pressing problems facing the Chinese economy is inflation.
Officially, inflation in the third quarter was 6.2%, which is already an
uncomfortably high rate. Multiple analyses have indicated that after adjusting
for price controls, the real rate of inflation may be closer to 10%. This rate
is simply unsustainable. Moreover, all of the government's traditional policy
instruments for controlling inflation have been rendered ineffective by the
frenzy of the market.
This assessment can be confirmed very easily by considering investment growth.
Despite the government's most sincere efforts to tame investment - this year
the central bank has raised interest rates and reserve requirements five and
nine times, respectively - investment in the first three quarters of the year
still grew by 25.7%.
With the traditional tools rendered useless, astute observers have developed a
sense of unease at the realization that nobody is at the helm. "Recently, some
prominent Chinese economists, including some members of the NPC standing
committee, have publicly voiced their dissatisfaction over the government's
obvious failure to slow down the economy." [1]
Another serious problem facing the Chinese economy is the asset bubble. This
can be seen in the real estate market and in the equities market. In the third
quarter, nationwide average housing prices increased by 8.2%. In large cities
the increase was dramatically higher. Many politicians have expressed concern
that large cohorts of urban dwellers have now been totally priced out of the
housing market.
In the equities market, the bubble is even worse. The A-share market is up
almost 300% for the year. On average, stocks are trading at 65 times earnings.
However, because the Chinese market is dominated by a handful of national
champions, the average is not a good representation of the severity of the
bubble. A better representation would be to consider the price-to-earning (P/E)
ratios of the national champions, like PetroChina, Baidu, and Alibaba. For such
firms, a P/E ratio above 200 is not uncommon.
This absurd price level has been supported by millions of first-time investors
indiscriminately flooding the market with capital. For certain months this
year, the average number of new brokerage accounts created each day was
200,000. As hordes of new investors have brought their money to the market,
they have created a situation where the price of stock no longer has any
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