China Downsizes The Monetary Dragon

At the height of Its fiscal / monetary stimulus push in 2009, China's broad money growth (M-2)
reached a staggering 29% measured yr/yr. That dubious milestone nearly co-incided with the
post bubble peak of its stock market.

If we hold money velocity flat, nearly 30% money growth in a 10% real growth economy equates
to inflation potential of nearly 20% per annum. Through successive tightenings of monetary and
credit policies, the Chinese have winnowed the growth of M-2 down to 20% yr/yr through year
end 2010. That still leaves inflation potential of 10%. In practice, as China has re-accelerated its
real growth from the 2008 lull, the velocity of money has declined, with the excess liquidity going
primarily into inflating its real estate market. China is running a CPI of 5%, with many observers
claiming the CPI is underreported and is really more like 7.5%.

I think it is likely China will have to continue to tighten  until its broad money supply declines to
15% yr/yr and inflation potential is brought down to 5% or less. So, at some point, since the
demands of the real economy eclipses money flow into the property and capital markets, China
could well experience price contraction in its property and capital markets, with the bloated
real estate sector the likely big loser. China money growth chart.

China's stock market has basically gone nowhere since the spring of 2009. There has been money
flow rotation into the real estate markets, and the strong earnings generated by corporate China
has been offset by a p/e ratio contraction stemming from rising inflation and interest rates which
push up the hurdle rate for new flows into equities. (Shanghai Composite)

Since 2012 is a year in which the top China leadership exits and the new guys come on board,
one could, if one used US politics as a guide, argue that Hu and Wen will want to go out strong
and leave the remaing mess for the new dudes to clean up. However, I am guessing that The
Party might take a dim view of such proceedings, and that Hu and Wen may be left to soldier
on by further bringing money and credit under reasonable control so that the fresh guys do not
face an immediate fire drill (no puns intended). 

So, I come out the door saying that the stock market may well be strong next year, and that
a good entry point may come later this year. The MACD intermediate term trend on the chart
link above suggests the market may be rolling down into a somewhat deeper short term correction.
If such occurs, the situation could get interesting down the road.