Commentary

China’s Bubble Trouble

CHINA’S BUBBLE TROUBLE

Look out below! It seemed as if the sky was falling
for China’s new breed of stock market investors last
week. The Shanghai Composite Index, similar in
importance to Chinese market speculators as its
cousin, the New York Stock Exchange is to gamblers
(or if you prefer, shareholders) in America, lost nearly 9
percent last Tuesday.

The Chinese stock market has been on a tear over the
past year, gaining 130 percent. To put this enormous
gain into perspective, the S &P 500, a broad index of
America’s largest publicly traded companies, tacked
on a meager 13.6 percent- just slightly above its 10-12
percent historical range.

Almost a month ago, the Shanghai market fell almost 5
percent after a senior official, Cheng Siwei, vice chair-
man of the National People’s Congress, cautioned
against the speculative mania that was sweeping
China’s newly-minted investors. He feared that stock
market speculators were acting “relatively irrationally.”

Tuesday’s meltdown was blamed on fears that Chinese
authorities would attempt to rein in the speculative
juices that have powered the market to dizzying new
heights. Before the panic set in, the Shanghai Composite
was up 14 percent since the start of 2007-quite a gain
for a two month period.

The rumor surrounding the imposition of a capital gains
tax in order to rein in the new, over-eager investment
class was not confirmed by government officials, and
no resignations from the office of security regulation
materialized as a result of the market turmoil.

After the week’s volatile trading came to an end, the
Shanghai index was off 6 percent. As for the year, it is
still up 6 percent, so this could be seen as just a
dusting-off of speculative excesses.

One item worthy of consideration is the fact that the
Shanghai market for “A” shares is largely off-limits to
foreigners, and is the primary destination for domestic
savings. This results in making these shares more
susceptible to bubble formation than stocks traded
in better developed markets.

Even after last weeks meltdown, Chinese shares are
still a lot more expensive than those traded in neighboring
countries, the US, and Europe. The most common
valuation metric, the price/earnings ratio, shows that
Chinese shares trade at 37 times earning, versus 18 for
Hong Kong, and approximately 17 for American shares.

Granted, economic growth is higher in China than
elsewhere, meaning a premium is justified. But, share
prices can easily outstrip underlying economic
fundamentals- and apparently Chinese shares have
done just that.

The problem is that China’ s markets, and investors are
new to the game, and have only seen a market that
rises over the past few years. In addition, many Chinese
speculators have been borrowing heavily in order to reap
the maximum amount from the stratospheric rise in stock
prices.

The situation in China today resembles the late 1990’s in
America. During the final leg of the greatest bull market
in history, the Nasdaq market, where the largest technology
firms are traded, nearly doubled in 1999. That market
peaked in March 2000, and seven years later it is over 50
percent BELOW its all-time high.

China is experiencing enormous economic growth, and
with it has come a transformation of it’s society.
Tremendous amounts of wealth is now concentrated in the
hands of the few. The coastal regions are benefiting the
most, and the rural inland provinces are wasting away,
abandoned by the intense industrialization that has
transformed the land closest to the water.

Unrest is growing with the increasing divide between rich
and poor. The last thing that China needs is a stock market
crash that wipes out the savings of its emerging middle
class. The hope is that Chinese regulators can ease the air
out of the bubble over time; the fear is that if prices
resume their rapid descent, margin loans will be called
in, and small investors who borrowed to buy shares will
be decimated.

The nightmare scenario described above played itself
out in America during the bear market of 2001-02.
Millions of investors, introduced to the stocks during the
bull market of the late 1990s, were caught off-guard when
the bottom fell out. Many lost sizable amounts of their
retirement nest eggs, and a significant number are still
wary of investing in the market.

The United States has more sophisticated markets, a
better regulatory framework, and safety nets in the form of
social security and unemployment insurance. China is
only now constructing a net, as it attempts to find
employment for hundreds of millions of rural inhabitants.

A stock market collapse would ripple through the economy,
taking with it personal savings, and confidence in
government authority, and the market-based economic
system. For China, much more is at stake than for other
nations, their embrace of capitalism is new and intense,
and the negative consequences of such a rapid adoption
could be much more disruptive than anywhere else on
the planet.

Greg Strid

© 2007 Splendid Marbles.