Galileo Blogs has left a new comment on your post "Froth in the Chinese Stock Market":

The froth is evident. My hypothesis is that both the froth and its very likely correction will be largely the result of monetary actions by the Chinese and U.S. governments.*

Rapid growth rates in the money supplies in both China and to a lesser degree in the U.S. have boosted the froth. Now, we see Chinese bank regulators trying to tamp down bank lending and growth in the money supply. They have raised bank reserve requirements several times and have cracked down on bank financing of stock purchases.

If they do this aggressively enough, it will trigger a bank lending contraction, which will drain money from the stock market. Without bank capital backing up the margin purchases, the stock market will contract. Then, as stock prices contract, margin loans will be called, triggering further stock sales. All of this will spill over into the physical economy, causing a recession or slow-down in economic growth, unless the Chinese central bank then turns around and quickly re-inflates the money supply. Of course, that could just stoke inflation.

The Chinese economy, as fast-growing as it is, is still much smaller than the U.S. economy, so I am not sure what it all means for our economy here. However, the U.S. Fed has also been expanding the money supply at a moderately fast rate, and the U.S. Dollar and Chinese Yuan are linked through a semi-fixed exchange rate.

The other factor for the U.S. is the increasingly likely faster revaluation of the Yuan, which is the same thing as a faster devaluation of the dollar (versus the Yuan). Of course, this would be on top of the long ongoing fall in the value of the dollar, which has lost value generally against nearly all world currencies.

All of it is quite interesting. If the U.S. dollar devalues further, it suggests staying long foreign securities versus American securities. Of course, if both the U.S. and Chinese market are likely to pull back, then it is time to get more bearish on equities in general. I invest in U.S.-based utilities primarily, and these stocks had quite a sell-off on Thursday. I'm not sure if the greater risk of a new round of dollar devaluation had anything to do with it.

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*A qualification on my comment in the first paragraph. Monetary policy undoubtedly has contributed to the froth, but a certain proportion of the Chinese stock market gains has a solid base in genuine, rapid improvement in China's economy. Often, though, this is the pattern of a boom/bust. A legitimate boom caused by a major economic improvement is then artificially stimulated further by overly accommodative monetary policy. Then, central bank officials get nervous about the risk of inflation and artificially curtail the money supply, thereby causing a recession or depression.

Such needlessly exacerbated booms-busts are caused by government manipulation of the money supply, which should be provided only by private banks (and most likely based on gold or some other monetary asset).

I suspect I am preaching to the converted on this issue, though!

Posted by Galileo Blogs to Thrutch at 5:17 AM