A series of news items (see here and here and here and here among hundreds of other ones) have been recently written on the Chinese stock market “bubble” and investors' "frenzy" (a 130% surge in 2006 and more upward pressure in January), on its risks and on the concerns of the Chinese authorities about such a "bubble" getting out of hand and then bursting. 

The key issue is why we observe such a stock market “bubble” and investors' "frenzy" in China now? In my view the main explanation, one that has not been discussed so far and that I find the most likely one, is that such a bubble is indirectly related to the Chinese policy of effectively fixing its exchange rate to the US dollar (the rate of upward crawl of the RMB is at such a snail’s pace that we have an effective peg on China).

This policy has led to forex intervention of the order of about $250 billion a year in 2005 and 2006 (see the recent work by Brad Setser Casson Rosenblatt on this). Since only 70 to 80% of such intervention was sterilized (according to sources close to the PBoC) this intervention led to a sharp increase in 2006 of base money and credit. The Chinese authorities tried to control such monetary and credit growth via administrative controls on credit and by tightening reserve requirements on the banks while, at the same time, maintaining very low deposit rates and very low interest rates on the sterilization bonds. But monetary, liquidity and credit growth have been substantial in spite of these controls. 

One would have expected that such large monetary growth would lead to goods price inflation. But in China a series of factors (elastic labor supply and slow real wage growth, administrative controls on prices, bumper crops) have kept goods inflation low. Instead, as in many other countries, the excess liquidity created by the forex policy has led to asset inflation. This asset inflation took first the form of a housing bubble; but with some credit controls being binding the existing housing bubble seems to show some signs of cooling off. Also, with deposit rates so low and capital controls, the 50% of  GDP savings of the Chinese needs to go somewhere. And increasingly, the liquidity created by the fixed exchange rate is now going into the stock market.

So the fixed rate regime is an indirect cause, through liquidity and credit creation, of the equity market frenzy and bubble. And with deposits rates and sterilization bond rates being so low, increasingly the hot money - that is flowing into China  because of the leaky capital controls on inflows - is going directly into the stock market, thus feeding the bubble frenzy. This also implies that, as long as China maintains a fixed peg, it will not be able to regain monetary policy autonomy and credit policy independence and will not be able to control the bubble in the stock market.

I have recently written a paper on why China should move to a more flexible exchange rate regime (available here for RGE Premium subscribers; see here a brief summary of this paper). The paper clearly discusses how the Chinese exchange rate policy has led to a loss of control of monetary and credit policy and has fed the investment, credit and asset bubbles – including now the stock market bubble – that are overheating the Chinese economy.

As the Chinese authorities correctly worry now, the bursting of this bubble could lead to a financial and real hard landing. What they do not seem to grasp yet is that such bubbles are direct consequences of their exchange rate policy. Unless they move away from their effective peg towards a more flexible exchange rate, these asset bubbles will fester and the risk of a hard landing will increase. Administrative actions to control this stock market bubble will be as ineffective as the mostly failing administrative controls on credit and investment. What China needs to do to control its stock market bubble is a more flexible exchange rate regime.