Editor's note: China's strong economic indicators suggest that the Chinese economy might be roaring back to life, but concern is growing that record lending rates, the backbone of the recovery, are feeding a speculation bubble.

As economists and analysts debate whether the government will use monetary policy to prick those bubbles, Jerry Lou, the Hong Kong-based China strategist for Morgan Stanley, told reporters at a recent media briefing that bubbles have already formed and that the government will not do much about it before the economic recovery is in full swing.

While the US and other Western economies have faced a credit crunch, there is a credit feeding frenzy happening in China. China's state banks have loaned nearly 7.4 trillion yuan in the first half of the year - far exceeding the country's initial full-year target of 5 trillion yuan in loans.

The record lending spree - equal to one-quarter of the nation's total economic output in 2008 - is helping China's economy grow close to 8 percent in the second quarter.

Based on his observation of the government's reaction to economic bubbles in the past 20 years, Lou believes China's central bank remains focused on economic recovery.

"For the moment, if it were to choose between managing the asset bubble and consolidating economic recovery, the government would definitely choose the latter one while making compromises with the bubbles," Lou said.

Lou believes the government will not officially opt for a tight monetary policy, despite a series of micro-tightening efforts, before the second half of 2010. "We assume there would be two rate increases in the second half of 2010," he said.

However, Lou warned that China might pay for the consequences of asset bubbles in the medium and long run. "It might not be able to bring on an economic downturn in the second half of this year, but we are not sure if it would come in 2010 or 2011," Lou said.

China's failure to complete industrial restructuring during the economic recession might also lead to an economic downturn in the near future, he added.

As for the capital markets, Lou predicted that bubbles would form in the local stock market later this year. The Hang Seng China Enterprise Index (HSCEI), which tracks the H shares of mainland companies listed in Hong Kong, might rise by 40 percent by the end of the year, while the indices measuring the domestic A share market are likely to rise by higher margins, Lou said.

China recently overtook Japan as the world's second-largest stock market by value for the first time in 18 months, after government stimulus spending and record bank lending boosted share prices this year.

The benchmark Shanghai Composite Index has gained more than 70 percent this year, becoming the best-performing major market in the world.

"The best way to profit from this bullish economic outlook, in our view, is through the consumer and industrial sectors," Lou said.

"We expect consumer demand and industrial production, the less exciting sectors so far, to take over from the policy-sensitive sectors and serve as stable and organic growth engines as the economy moves into the next stage of growth after policy-induced recovery," Lou said. These are also the sectors least exposed to policy uncertainty with any policy exit still pending.

The strategy is to avoid sectors sensitive to monetary and fiscal policy, such as banks, property and materials, because they are too close to the "policy exit". These sectors, according to Lou, were also the early beneficiaries of the stimulus-driven economic recovery.

The following is an excerpt of the Q&A session at the press briefing.

Q: A record amount of speculative capital, or hot money, has entered the Chinese market in recent months. Why is hot money favoring China?

A: Hot money is now fleeing the US because the interest rates it offers are too low, and the interest-rate gap between China and the US is widening. Another reason is that the economic recession in the US might have bottomed, but it has not shown signs of recovery.

For the moment, the United States is not threatened by future risks and is not in need of capital to fund industrial upgrading and infrastructure construction. That is the reason why the Federal Reserve did not dare to withdraw liquidity.

The Federal Reserve will continue pumping money into the banking system for fear that it might otherwise hurt US consumers by selling its bulk of mortgage and real estate assets.

In this case, we believe the US will maintain relative liquidity in the second half of this year to avoid financial distress. It will not switch to an exit strategy of policy tightening, as pulling back too soon could hurt the recovery.

The growth-rate gap between the economic output of Europe, the US and Japan and that of the emerging markets is expanding. Signs of an economic rebound in the emerging markets such as China are very obvious.

Under such circumstances, we believe the hot money influx in China will speed up in the second half as a result of wider gaps in economic output growth, the interest rate gap and a weaker US dollar.

We assume that the hot money coming into China in the second quarter might have exceeded $100 billion. This hot money will turn into currency supply and will add to the pressure on China's foreign exchange regulator.

Q: What can the Chinese government do to stop the inflow of hot money?

A: I think China could borrow the experience in 2007 when its massive trade surplus had caused excess liquidity. (In August 2007, China's currency regulator announced the launch of a pilot program in Tianjin's Binhai New Area on a trial basis to allow citizens to buy hard currency to invest in overseas securities.)

It was one of the ways to provide some cooling to the local market, because so much liquidity had been trapped within the system with no outlet.

Back then, the pilot program was announced out of chaotic circumstances. But now if the government tries to direct the capital to the offshore market, it will do it in an orderly fashion.

First, it will widen the scope of investment under the QDII scheme. (China allowed select banks and brokerages to start investing overseas starting in 2006 under a so-called Qualified Domestic Institutional Investor, or QDII, program.)

Second, China can have more varieties of investment products such as long/short funds and index funds.

Third, China can relax the rules for individuals to invest in overseas markets.

Personally, I believe it is not likely that the government will switch to a tight monetary policy. The most effective way to deal with excess hot money for the time being is to give the liquidity an outlet such as the Hong Kong market.

Time is mature for the reform of our foreign exchange reserves management system. But the ultimate solution is policy tightening.

Q: The last time international hot money flooded China was with great anticipation of the appreciation of the renminbi. For this hot money influx, are investors trying to profit from rising asset prices?

A: Yes, absolutely. In the first half of this year, the expected appreciation of the renminbi provided a strong incentive for "hot money" flows into China.

People thought trade then might go well in China, but they were soon proven wrong.

There are many ways to achieve capital appreciation. If the exchange rate remains unchanged, we can still profit from gaps between different countries' interest rates and economic expansion.

Even if China's economy expands at a rate of 9 percent, there would still be capital influx, because the interest rate in the US is negative.

Hot money will only flow to strong economies when the economy of the rest of the world remains lackluster.

If the economies of Europe, the United States and Japan pose a strong rebound in the next year, the hot money will flow to them.

The flight of hot money will affect the Chinese market but we wouldn't worry too much, as our trade will recover by then.

Q: How would you evaluate the prospects of China's A share stock market in the second half of the year, especially that of the financial sector?

A: Unlike the mainstream opinions, we are not optimistic about China's banking sector.

The growing interest rate gap and rising profitability should support a stronger banking sector, but we should be aware of the possibility of rising bad debts, which might rise by several times.

China's banks could withstand the risks of rising bad debts, because the government will bail them out, but not the effect on their share prices.

Asset problems will arise during the interest rate hikes. Once bad debt appears, share prices of banks will begin to fluctuate. Such things have happened in the past.

On the other hand, we think the insurance sector will have a good performance. The insurance sector will benefit from asset bubbles, as well as interest rate hikes. And it is not exposed to the hazards of bad debts.

There is no doubt that property will be the driving force of China's economy, even in the coming year, but this sector is too close to the "policy exit."

The government might switch to a tighter monetary policy next year or probably later this year, when the economy is overheated in some regions. By then, the property sector will be the first to be regulated.

(China Daily 08/10/2009 page2)