By tripling the tax on brokerage transactions, the Chinese government succeeded, at least temporarily, in restraining the surging Chinese stock market. But my expectation is that the correction will be short-lived. It’s not that the Chinese stock market is not a bubble, as it clearly is, only that more air will likely inflate it further before it finally bursts.
While Chinese concerns over a potentially bursting bubble are legitimate, their attempts to discourage further speculation can be compared to the captain of a sinking ship who dispenses teaspoons to his crew instead of fixing the gaping hole in the hull. The giant hole in the Chinese economy is the currency peg to the dollar. In order to maintain it, China must pursue a highly inflationary monetary policy which fuels the stock bubble. As long as they continue this policy, dispensing teaspoons will have little effect.
The effects of inflation are not limited to stock prices. Pork prices in China, the primary meat in the Chinese diet, rose over 30% in May alone (live hog prices actually rose over 70%)! In order to hedge against such persistent price increases, Chinese savers are being forced into the stock market. The alternative is to watch the value of their savings erode as the government debases the yuan to prevent the U.S. dollar from collapsing.
Initially, a dollar peg brought stability to China. When the dollar was sound, discipline was required to keep a pegged currency from falling. Now that the dollar is weak, inflation is required to keep it from rising. It’s analogous to tethering your monetary ship to the Titanic. Failure to cast off the line will inevitably sink the pegged currency along with the dollar.
Recently two Arab nations have done just that. Within the last three weeks, both Syria and Kuwait de-linked their currencies to the dollar. Other Gulf States will likely follow suit, with The United Arab Emirates looking like the next domino. The most logical progression would be for these nations to no longer price crude oil in dollars.
Perhaps these actions will cause the Chinese to begin abandoning their defense of the dollar in much the same way the U.S. did with the British pound in 1929. When that happens China’s stock market bubble will burst, but its economy will be on much firmer ground as a result. Though nominal stock prices will decline, the value of the yuan will soar, mitigating the real extent of the losses. Despite some short-term pain, China will not experience anything like our Great Depression (as long as they do not make the same mistakes that Hoover and Roosevelt made).
America however will not be so lucky. Our stock market and economy will fare much worse, as a collapsing dollar will exacerbate the real value of the declines.