China’s Economy Is at a Critical Point

News on China’s economy is always popular. In recent days, reports about China’s economy are catching eyes particularly. “China Regulator Urges Investor Awareness of Stock Market Risks”, “China's Inflation Probably Broke Central Bank Target”, “China Money Supply Rises 17.1%, Exceeding Target” and etc. (Headlines from Bloomberg.com) Those headlines are delivering the same message: China’s economy is at a critical point.

Then what is the clue for these problems? One bold guess is the unexpected inflation. It seems reasonable that since the inflation is 3.1% (an estimated number from Bloomberg. com), the negative real interest rate has forced citizens to give up saving at banks as a traditional way of investment and to turn to other financial assets, stocks in particular. In the first quarter this year, 8.58 million new accounts have been opened at brokerages. In contrast, the number for last whole year was only 5.38 million. And the investment of stocks also explains the breaking of the China’s money supply target partially. Many people even try to borrow money to buy stocks which increases the M1 greatly.

Where does the inflation come from? It may result from undervalued RMB. When RMB is undervalued, we can see great trade surplus and higher demand for RMB. To stable the exchange rate of RMB, China’s government purchases a lot US Treasury bond to create demand for US dollar artificially. This method may not give US economy a great impact as I mentioned in “A Brief Overview on RMB and the US Dollar” (May 8th), but it may have great side-effect on Chinese domestic market. One effect is mainly caused by the constant payment of Chinese Yuan, which may lead to the excess printing of RMB and cause an excess money supply. The ending of the circle is a higher inflation rate.

Whatever the reason is, it is a critical point of China’s economy. The flood of new shareholders is not from the elites or at least people with financial know-how. However, they are those who have little understanding of the risks of financial investment. The once popular saying, “there are risks in the stock market, and you should be careful when you enter it” does not prevent the irrational growth of shareholders. If the increase in stock investment could not be contained immediately, an economic bubble would be easily forming at a quick pace, especially for China, such a large and immature economy.

It is reasonable to predict that the government will try to tight its monetary policy (to raise the interest rate) seriously, as the former changes in policies do not work effectively.