Making a Trading Decision in the Chinese Market - Research Paper Example

Making a Trading Decision in the Chinese Market Making a Trading Decision in the Chinese Market Part Assessing Economic Conditions The money market instruments are the ones that are used to obtain financial reserves for short term investment. The instruments have been usually known to have a maturity of less than one year (Mertellini, Priaulet, & Priaulet 2010). The instruments are ideal for application in the emergent markets which had been showing the sign of rapid fiscal growth. The rapid growth means that there are significant numbers of investment opportunities available for the investors (Ziemba & Ziemba, 2008). The interest rates are anticipated to increase and therefore, the corporate sector is going to experience a setback. The inventory levels are rising and sales had been predicted to swell as well in the near future. There are other instruments that can also be used in order to raise money. The common examples are bonds, swaps and debts and equity. The bonds are the instruments which are being used by governments and companies for obtaining funds from the public. These have the lowest return rate but with highest degree of safety and because of this reason, they are advisable for investors who are risk averse in nature. The bonds are also used by the companies for fund raising but this is taken and treated as a last resort as debtors will have to be paid regardless of the profitability situation of the company (Choudry 2010). The commonly used method for obtaining financial resources goes by the name equity. The companies offer shares to the investors and their returns will be paid in the form of dividends and this technique is preferred because dividend payouts are dependent on the profitability of the organization. The Chinese money market is becoming more and more suitable for the investors because Foreign Direct Investment is growing (Liu, Burridge, & Sinclair 2002). The growth is however, localized in the outsourced production facilities of the multinationals who are indigenous to America and other developed and advanced nations. The FDI levels are increasing because the country’s local currency is cheaper than those of advanced nations and therefore, the multinationals are more than happy to invest in the Chinese local market in order to attain notable and significant level of cost advantages. In the light of above argument, it can be established that the Chinese economy is slightly slowing down and it is speedily crossing the milestones in the journey of becoming a successful industrialized economy. The government is starting to invest in the educational institutions so that the intellectual basis of the nation can be strengthened (Fengzhen 2002). This step is needed to be taken because in few decades from now, the Chinese economy will require to transform into a knowledge based society. The Chinese government is establishing and powering its relations with India as it may require outsourcing of its production to its new ally in the economic world. The decision will be pushed as soon as overproduction and inflation will initiate to grow in the China’s local economy. The overproduction and inflation may cause the industrial operations to become unprofitable and therefore, relocation of industries to less expensive country such as India will be warranted in the near future. As if now, the Chinese local market is an ideal place for short term investment and that is why, this paper has chosen money market instruments as a tool of trading strategy. The Chinese national debt level is considered amongst one of the highest in the international monetary market as it is 12.62% of the nation’s GDP in the year of 2012 (Anon., n.d.). The Chinese government is following a relaxed monetary strategy and therefore, the interest rate is as low as 6.42%. The lower interest rate means that the government is committed to boost economic activity in the country. The China is the most populous country in the world and because of this reason; it has to expand its economy in order to feed the citizens. The borrowing trend remains stable because most of the debt burden is nullified by the strong financial position of the nation’s corporate sector. The government has decided to order a few industries those were producing off the scale merchandise levels but overall the borrowing trend of China is pretty much stable in the current times. The local government is looking to strict the borrowing terms but still, the economy is headed for expansion as there is room for improvement in the production capacity (Chen, Yang, Liu, & Li 2013). The Chinese fiscal outlook remained exemplary in the past few years but the economy is experiencing imbalance because the investment’s ratio in the local GDP is growing that can lead to overproduction and lower rates of return. The trend if not checked timely may lead to growth in inflationary pressures as well. The unused production capacity of the economy is believed to be 40% and the country’s economic growth is sluggish but the government is not taking any action. The government’s inaction in this regard means that the leaders are ready to slow down the growth in order to lower the investment levels in the country so that the returns and liquidation can be enhanced. The per capita income is also expected to grow as investment will lower. There are no significant inflationary pressures in the economy but they can rise dramatically, if investment levels will not drop soon enough. The interest rate is expected to rise as the country is looking to drive down the investment levels which can effectively be done by making the loans expensive. The bonds will become expensive in the local market as the interest rate will rise and therefore, the trading strategy proposed by this paper will include forward for buying bonds as a central tool. Part 2: Interest Rates in the Economy The discount in the interest rate market of the country is 6%. The interest rate is expected to be risen because the national management is looking to slow down the process of growth in order to balance and iron out the economic outlook of the Chinese society (Kwan 2013). The current investment will be converted into cash and level of disposable income shall rise. The debt instruments will become expensive and the companies will opt to issue shares but soon their price will decline as they will increase in terms of supply. The shareholders will not be able to gain capital advantage on their shares whereas; the companies may take quite a significant period of time in order to make a dividend payout. The abovementioned graph signifies that interest rates remained quite static over the past three years. However, it is anticipated to drop off because governmental plan for controlling the investment in the economy. Table 1. The Interest Rates in China Month Interest Rate (%) Apr 12 6.5 Jul 12 6.5 Oct 12 6 Jan 13 6 Apr 13 6 Jul 13 6 Oct 13 6 Jan 14 6 The degree of dividend will also remain unpredictable until and unless the financial statements come out. The bonds on the other hand, are a very safe bet because of their higher return rate while their payouts are much more predictable as compared to that of shares. The economy is slowing down and therefore, it will only be wise to focus of acquiring bonds as they will provide a shielding affect to one’s investment. The predictions say that the debt will get expensive but nothing certain can be said and established at this point in time. The uncertain nature of the market prompts the investors to enter into the forward contracts involving purchases of the bonds because in this way, they will have the option to withdraw their decision, if interest rate does not raise as a result change in the fiscal policy of the government. The forwards can be broken by paying a modest fee (Sundaresan, 2009) but the futures are more formal in nature and therefore, they are needed to be fulfilled, once they are formed. The unpredictable nature of the money market needs the investors to enter into the forwards because the debt offerings are still prevalent in the market (Bruce & Angel, 2011). The companies will halt offering bonds when the interest rate will rise in the near future. The governmental bonds can also be bought as they will most likely offer the rate of return that will be equal to the discounting ratio of the central bank but it should be a last resort because the companies are known to offer greater return rate than baseline in order to keep the investors interested (Cecchetti, 2006). The idea is to maximize the financial return so that the elementary assumption of economic rationality can be satisfied and contented. The bond yield spread on standard one year T-bill between US and China is 0.05 and therefore, it can be established that America is suffering with the higher level of inflation than the Chinese Republic. The forwards must include premium for the probability associated with other party’s incapacity or unwillingness to perform the contract and in case of governmental bonds, the chances of nonperformance are minimal and therefore, no fees for breaching the contract are usually ascertained. In case of companies, lenders often add monetary value of default risk to the interest and charge higher level of return for loans of longer tenure (Mishkin & Eakins, 2006), Given the current situation of Chinese market, the default risk is at a minimum level because the companies are enjoying higher level of asset strength and therefore, they are fully capable of paying back the loan with interest. The risks are skewed in the direction of companies as they will be sending a wrong message to the market by defaulting. The market will become very skeptical towards lending once the organizations will not payback. The companies are not going to be able to raise significant level of funds by issuing shares because the share prices will suffer due to higher supply of the instruments in the market. The companies will opt to get debt and then, they will fall into a situation where they have to issue preferred stock as well. The investment will also drop as propensity to save in the public will only increase in response to potential increase in the interest rate (Hull, 2008). The companies face a risk that people after entering into the forward may decide to back out in order to save their money in the bank (Fry 1990). The above discussion supported the presumption that the risk is tilted towards companies because they will not be in position to issue shares whereas, the public will have the option to save their money in the bank after increase in interest rate. Based on the previously presented argument, the companies will need to offer high rate of returns in order to keep the debtors interested in lending or otherwise they will keep the money in the bank and earn interest. The funding costs of bonds dropped from $85 billion to $75 billion in ending months of 2013. Additionally, the Chinese population have higher literacy rate and their financial sense is also stronger than major number of nations in the world. The higher level of business and economic sense must not be a surprise to the local companies. These attributes will only worsen the already troubling situation for the organizations (Boisot & Child 1996). The long term plan of the government is to get rid of the weak players from all of the industries so the level of investment can be driven down. The companies will go bankrupt and due to this reason, they will liquidate their assets in order to pay the debt. The payment of debt further lower investment in the society and higher interest rate will prevent from new investments to happen. These events will no doubt go a long way in terms of restoring balance in the Chinese economy. The inflationary pressures will also be contained because the supply of the money will reduce and it will force the powers of demand and supply to settle at a higher price level. The overall idea is to hinder the growth of the economy for a short interval of time sand once an appropriate balance between investment and saving can be found then, the country will move to use its slack capacity to experience more growth because industrialization is presently the best strategy for the giant economic system of the world. Finally, the country is in need to slow down the growth in order to strike an appropriate balance in the economy which is desperately required to avoid overproduction and lower rates of return. The inflationary pressures are also anticipated to kick in, if the government does not succeed in the efforts of controlling investment by raising the interest rate. Part 3: Trading Strategy The trade strategy is simple because it fundamentally entails entering into the forward contracts in order to acquire bonds. The bonds are preferred over common stock and even keeping the money in bank due to their higher rate of return that is the ultimate purpose and objective of doing trade after all. The companies tend to offer higher return rate as compared to that offered by banks so that they can attract debtors towards lending. The lending on the other hand is less vigorously regulated by the government and therefore, it will be less costly to issue bonds than offering common stock in the current market conditions of China. The reason of the abovementioned decision is again based on the principles of elementary economics as offering common stock will yield less level of monetary power for the organizations and they will not be able to raise substantial amount of money because of lowering new share prices in the market. The lowering of prices may occur due to unprecedented increase in the supply level of the instruments. Additionally, the investors will get lured into lending because of corporate sector’s good to excellent position with respect to capital and physical assets. Table 2 10 Years Bond Return in China Date 10 Year Bond Return (%) 30-11-11 3.75 28-9-12 3.5 31-7-13 3.60 Furthermore, the Chinese government has not yet decided to increase the interest rate in the local economy and therefore, it will be foolishness to enter into a future contract merely based on a rumor. Additionally, the inaction on the behalf of the investors may result in loss of the opportunity to lend their money on excellent terms. The whole idea is to hutch against the risk of investing in common stock by entering the forward contracts for buying the bonds so that the options of common stock and bonds remain alive as long as the final decision about the interest is taken and implemented by the government. The returns of 10 years bonds are rising in the country and therefore, it would be wise for the investors to buy debt instruments. The Chinese community is having a collective culture and the people like to benefit the whole rather than the individual. The imbalances caused by increased level of investment might guide the economy into the direction of overproduction and inflation. The whole will suffer and go through a pained life. The government is anticipated to increase the interest rate but again this decision may cause the production costs of foreign subsidiaries to grow which might compel them towards disinvesting. The government has to make a tradeoff and it is in the process of making this important decision and that is why, the tide can turn both ways. The condition has bred nothing but uncertainty in the external environment of the country. The global forces are holding their breath in order to get over this painful period of waiting. The organizations are floating their debt instruments because they are almost certain of the fact that interest rates will rise in a few months from now. The ten year bond yields are 2.65% and 4.47% in US and China respectively and the bond yield differential is -2.18 in the favor of China which means the Chinese economic system wants to increase the use of debt instrument as it is offering higher rate of return on the instrument. The Chinese government is finally approaching the decision of letting the interest rates act free for a while. Part 4: Monitoring Performance The initial target of the trade is blend in with the crowd because a lot of people will invest in debt instruments in order to gain a higher financial benefit. The share prices are turning down regarding their ability to pay regular and growing dividends whereas, the shares’ market prices are also dropping as investment is planned to decrease so bonds are the best bet. The news about interest rates will be of great interest to the investors using the suggested plan of action. The further increase in interest level will provide motive to the investors to grow their bond possession. The news that will make the investors think that the level of interest is going to decline will most probably make them reassess the plan of trading they have opted previously. Yes, it is quite possible for the investors to take the trade off in an economic condition where the share prices in the market will grow considerably and therefore, they are offering greater rate of return than the bonds. However, in the light of current economic and fiscal conditions of China, the investors are strongly recommended to hold their collection of bonds as they are the best paying instruments in the local market. The share market is in chaos right now and the prices are dropping as well. The investors who were following the idea of aggressive trading should sit back and relax because the situation does not allow them to do so. Conclusion The paper has reviewed and analyzed the economy of China in order decide the best course of action, when it comes to trading in the financial instruments in the country. The economy is no doubt high on the scale of uncertainty and therefore, the investors must look to seek security that is provided by bonds. Additionally, the actual decision of increasing the interest has not yet been taken and that is why, the investors must enter the forward contracts in order to keep both options of buying common stock in case the interest rates are not increased whereas, the forwards can be used to buy bonds, if the interest rates do Ultimately, it is not the end in itself because the investors have to keep an eye open so that they can sense the change in the environment and make appropriate modifications in their trading strategy. The main argument of this paper is simple because it states that Chinese financial market is favoring debt because it is getting expensive as interest rates are about to soar so it will be beneficial for the investors to purchase bonds   References China Government Debt to GDP. [Online] Available at: http://www.tradingeconomics.com/china/government-debt-to-gdp [Accessed 3 Feb 2014]. Boisot, M. & Child, J., 1996. From Fiefs to Clans and Network Capitalism: Explaining Chinas Emerging Economic Order. Administrative Science Quarterly Vol 41 no.4, pp. 600-628. Bruce, T. & Angel, S., 2011. Fixed Income Securities. 3rd ed. New Jersey: Wiley Finance. Cecchetti, S. G., 2006. Money, Banking and Financial Markets. 1st ed. London: McGraw Hill International. Chen, B., Yang, T., Liu, K. & Li, S., 2013. Capacity Linear Evaluation for Production Line Based on Production Course. International Asia Conference on Industrial Engineering and Management Innovation Proceedings, pp. 417-427. 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