China learns hard lessons about markets, while Taiwan prepares for a boom

Tumbling markets and rising inflation are hurting the Chinese economy, not helped by incessant governmental meddling. Taiwan, however, is Asia’s best-performing market this year.

More misery for China's investors. With markets across Asia under pressure amid fears that combating rising inflation will crimp economic and earnings growth, China's domestic market has cratered. With Chinese producer-price inflation at over 8% year-on-year for the last three months and consumer price inflation at 7.7%, the authorities last week increased the required reserve ratio for banks by 1%.

The unexpectedly steep increase marked the fifth time this year the government has forced banks to keep more of their money in reserve rather than lend it out. Along with global market weakness, it wiped another 14% off the Shanghai Composite index last week. It has fallen below 3,000, marking a fall of over 50% from its peak.

The fundamentals point to further falls. Tighter monetary policy threatens growth, while earnings forecasts have been scaled back as rising commodities prices are squeezing profit margins and exports are slowing as the global economy cools. Real Chinese export growth in April was 10%, compared to 15% in December and 25% in December 2006, notes Lex in the FT. It also hardly helps the earnings picture that "companies were among the most avid punters in each other's shares when prices were soaring".

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But the main issue here isn't fundamentals, but government meddling. Beijing has raised share-trading tax to temper the boom, then cut it again to lift spirits once the bubble had burst. It has also imposed limits on new share issuance and told fund managers not to sell holdings too quickly. In short, investors have been concentrating on anticipating government moves rather than the economic backdrop, says The Wall Street Journal, which has compounded herd behaviour and volatility. Now that the government has failed to keep the market above the psychologically significant 3,000, investors might lose faith totally, exacerbating the slump.

There's certainly scant room for manoeuvre now: raising interest rates seems likely to entice even more foreign capital into an economy already awash with it. Clamping down further on share issuance would hold back the development of the market in the long term. The market's slide, says Capital Economics, simply highlights "how ineffectual government intervention has become over the medium term".

While China is learning that tinkering with markets is easier said than done, it has at least helped Taiwan become Asia's best-performing market this year, with a 2.5% climb in dollar terms. The new Taiwanese president is keen to strengthen links with mainland China, and fully opening the economy to the Chinese should spark a boom, as CLSA's Peter Sutton said earlier this year.

The story is likely to be one of "incremental progress on the economic front, not a definitive one-off deal ending the 60-year dispute" between mainland China and Taiwan, says CLSA's Christopher Wood. The first direct flights between China and Taiwan are now on the cards, while the limits on Taiwanese firms' investments in mainland China should soon be addressed. Taiwan's economy may be highly exposed to exports and domestic demand weakening, but with the region's markets jittery due to higher food and energy prices and concern over US consumers, at least Taiwan has the "promise of progress" on links with China to look forward to this year.