COMMENT: Goldilocks burns her tongue

By bne IntelliNews March 5, 2007

Roland Nash of Renaissance Capital -

Don't panic, but be warned: We believe the recent sell-off in China is not of itself a reason to be concerned about valuations in emerging markets in general or Russia in particular. As many have pointed out, the integration of the Chinese equity market into the rest of the Chinese economy is limited and unlikely to impact Chinese demand. This demand has been behind so much of the recent global economic boom, including the bull market in commodities which is behind much of the superb performance of Russian equities in recent years. However, as a warning signal of the potential misperception of risk globally, and of the sustainability of global asset price appreciation without interruption, it should be heeded. Bottom line - it is unlikely to be enough on its own to stop the emerging market party. But it would be equally unwise to ignore the warning signal.

Medium term: China's downward move is a warning signal that the global imbalances that currently exist must eventually work themselves out, a process which will prove painful for many asset classes, including emerging markets. We are living in a period of the unprecedented availability of liquidity, driven in large part by two interrelated global factors:

1) the generation of extraordinary new value in China and Southeast Asia, an unusually large proportion of which is being saved;

2) the willingness and ability of international capital markets to borrow those savings and redeploy them to keep demand rolling.

If either China slows and the net savings decrease, or international capital markets question the efficiency with which they are able to reprocess those savings, then the world could, in the worst case scenario, slip from unprecedented growth towards a significant slowdown. On top of the growth outlook, the liquidity, which has been generated has inevitably led to the mis-pricing of various asset classes. Simultaneously, therefore, a decline in liquidity can impact valuations both because:

1) lower growth rates are discounted (or higher volatility is assumed;

2) over-valued asset classes are exposed.

The risk that China is choosing to press on the brakes, signaled by the recent increases in interest rates, was highlighted by the 10% fall in the Chinese equity market. The collapse in the subprime lending market in the US highlights the mis-pricing of various asset classes caused by the unprecedented availability of liquidity. The recent sell-off should very much be seen as a warning signal. It is quite easy to see the situation in a year’s time when people point to the moves this week as the first major sign that the global party is drawing to a close.

Short-term: In the short-term, this is unlikely to prove more than a warning signal, in our view. We believe any end to the liquidity driven boom is very unlikely to happen suddenly. Generally speaking, markets need either a more dramatic event than what we have seen so far, or a greater accumulation of evidence. Chances are that the market will get over-sold and then rebound. As has been noted everywhere, the Chinese equity market has very little inter-relation with the rest of the Chinese economy, and will not on its own cause the economy to slow. From a Russian perspective, the oil price is stable to up, and Russia’s macro looks very good, as does Gazprom below $10. The market was under-weight Russian hydrocarbons before the sell-off. It will now be very underweight, particularly as Gazprom is a proxy for emerging markets more widely, and therefore, will likely have been sold for non-fundamental reasons.

Economics: Historically, there have been several longish periods when for different temporally specific reasons, the world has been able to generate extraordinary rates of growth. Pre-1914, global trade, credit and the economic hegemony of the US was one such period. Another was the post-World War II reintegration of Japan and Germany. Over the last 10 years, the unlimited quantity of cheap labour available in China and India has fuelled another such period.

One factor specific to the most recent period of high growth has been the very high propensity of the Chinese to save rather than spend. This would have been problematic for China unless there was an entity capable of borrowing the savings and reinvesting it. The massive expansion of international finance at the same time as the Chinese growth allowed the rest of the world to act as the borrower (particularly the US). Thus capital was cheap globally, and excess demand for all other factors of production (in particular natural resources) pushed up their price relative to capital. A perfect combination of events for natural resource producing emerging markets, like Russia.

In the very long term, global trade and the integration of China and India should mean that high rates of economic growth will be sustainable - in that sense the Kondratiev super-cycle is intact. However, to assume that the current coordination of global economies will continue uninterrupted is ambitious. There are two major ways in which the benign situation can deteriorate. The first is that China is unable to sustain such high growth rates. Markets have to be unrealistically efficient to be able to absorb the labour available in China without any signs of strain elsewhere in the economy. Attempts to slow the economy in reaction to what are deemed to be distortions by, for instance, raising interest rates, creates the fear that available liquidity could dry up, raising global risk rates and causing a sell-off in assets. The second is that international capital markets are unable to allocate the capital efficiently, resulting in valuations that are deemed to be not supported by fundamentals. Examples abound currently, from sub-prime lending in the US to London property markets to Chinese equity. Asset price distortions must eventually unwind.

The danger currently is that we are seeing an unfortunate coincidence of both of these possibilities. China is putting its foot on the monetary brake and capital markets are questioning the efficiency of previous capital allocation decisions. At its absolute worst, this combination could be highly destabilising. If risk perception rises globally, capital markets may be unwilling to reinvest liquidity, causing a decrease in global demand which will itself lead to increasing risk perception.

As stated earlier, we believe it is highly unlikely that the recent sell-off is the start of something so potentially destabilising.

However, very low interest rates, an almost certain over-valuation of at least some asset classes, the twin dependence on the sustainability of high growth in China and on international capital markets to continue to recycle capital and the historically low level of risk perception provide for a dangerously unusual situation, in our view. Don’t panic - but be warned.

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