China’s inflation problem

To be honest, we are stunned, and that doesn’t happen often after watching the markets for several decades. Our Chinese supply chain management (SCM) software producer eFuture (EFUT) came out with good results and upped it’s guidance for the year, but the stock price is tanking.

Since these shares are cheap, the growth story of the company (50-100%) in tact and hardly priced in, and the market opportunity and the position of EFUT in it very well, we have to look for explanations elsewhere. It’s the markets, stupid!

We’ve hinted at this before. The problem is the Chinese overall market. There is just no other explanation, unless there is something going on behind the screen that we’re not aware off at the company, but considering its healthy financial position, we don’t think so.

What’s wrong with the Chinese markets? In one word: inflation. That threatens the whole Chinese economy. The authorities face an awkward dilemma. To stop inflation in it’s tracks before it’s too late (and it really is five to twelve), they have to embark on deflationary policies.

What can these be? They could let interest rates and/or the currency rise, hike some taxes, cut spending, and the like. Deflationary policies bring significant risk in an economy still largely driven by investment. If they are successful, demand will decrease, suddenly exposing a lot of bare capacity and dud investment.

Business investment itself will suffer as a result, and some industries will have to go through a cleansing process getting rid of excess capacity (a Chinese real estate crisis, anyone?) and the most optimistic investment projects. This will reduce demand further.

The Chinese jobs machine will come to a halt, and this could very well have dreaded political consequences, it’s widely perceived that the legitimacy of the political class derives largely from its ability to deliver economic growth and a smooth transition from an agrarian to an industrial and knowledge based economy.

Also, the authorities have embarked on a policy of boosting domestic demand (in stead of relying mainly on exports), and this has led to rapid wage rises, further boosting inflation, which is not caused by the commodities and energy boom alone. To take that away just at a time when expectations are rising would further endanger political stability.

These problems are the main reasons why the Chinese authorities are not keen, to say the least, to tackle this problem head on. Real (inflation adjusted) interest rates are negative, they need to be a lot higher.

Chinese shares, which already went through a heavy correction the last half year, are feeling the brunt of these awkward policy dilemma’s and the danger that inflation will spiral out of control.

No matter how good our company (EFUT) performs, it can’t escape these realities for the time being.