Stock-market bubbles are always different and yet always the same. That may not yet be a Chinese proverb, but it ought to be, given the recent activity on the Shanghai exchange. Once again, a combination of speculative euphoria and easy money has resulted in soaring stock prices and stretched valuations.
The aftermaths of great financial bubbles also follow a common course—investor disappointment often gives way to recriminations and a political backlash. That may explain why the Chinese authorities are so keen to dampen the current mania before it goes too far.
China bulls point to the country’s extraordinary recent growth. The economy expanded by around 10% last year. Exports grew even faster, at an annualized 29% in the second half of 2006. Furthermore, the quality of the businesses listed on the mainland stock markets is improving, as evidenced by the floatation of the Industrial and Commercial Bank of China, which after its IPO last year was briefly the world’s second-largest bank by market value.
Fraser Howie, the Singapore-based author of several books on China’s stock markets, was sceptical of such claims last March, when the Shanghai Composite Index was at 1,300. He has remained sceptical as the market soared to nearly 3,000 in January 2007.
For a start, valuations are out of whack. Chinese banks, which constitute a third of Shanghai’s capitalization, have been trading recently at between four and six times their book value—that’s roughly twice the valuation accorded to the best-managed foreign banks, like HSBC. Last May, Ernst & Young estimated that the country’s banks still carried nearly $1 trillion (Rs44 lakh crore) of non-performing loans. (The accountancy firm later retracted the report under pressure from the Chinese authorities).
Chinese stocks have recently been trading at an average of 33 times earnings—roughly the level of the S&P 500 at the peak of the technology bubble in 2000. Late last year, the aggregate market value of Chinese companies exceeded the country’s gross domestic product (GDP). Some might think that China’s whirlwind entry into the global economy, and its huge population, justify a premium valuation.
But accounting is suspect and the ability of Chinese companies to earn profits is doubtful. Investment has been running at around 40% of GDP and growing rapidly.
Dr Jim Walker, China economist at broker CLSA in Hong Kong, fears what he calls a “malinvestment crisis” (a term borrowed from the Austrian economist F.A. Hayek). Recent investment, claims Walker, is producing excessive competition among businesses, while blistering growth has pushed up labour costs. That suggests Chinese companies face a profits squeeze and the prospect of low returns on capital.
Despite recent reforms, the state still dominates the Chinese stock markets. The bubble commenced after the state social security fund started buying up stocks in 2005. State-owned enterprises, local governments and Communist-Party bigwigs are widely believed to be deploying funds in the stock market.
Aside from owning the majority stake in most companies and acting as a major acquirer of stocks, the government also controls the country’s brokers. “The state in its many roles is so involved at every level of the market, it is difficult to see where anyone else fits in,” writes Howie.
The state, in the guise of the People’s Bank of China, is also responsible for excess liquidity, which has inflated this bubble. To pave the way for the currency revaluation in 2005, the authorities endorsed a loose monetary policy, says Walker.
As a rule of thumb, interest rates should roughly equal a country’s growth rate. But Chinese short-term rates at 6% are some 12 percentage points below the country’s nominal growth rate. If you accept Lombard Street Research’s estimate for inflation at 7% in the last quarter, then real interest rates are currently negative. Households can choose to deposit their savings at a bank that will earn them 2%, which won’t cover the cost of inflation. Or they can play the stock market, which returned 130% in 2006.
As the People’s Bank acquires export dollars to prevent the yuan from appreciating, it creates more reserves in the Chinese banking system. True, much of this foreign currency intervention is sterilized and the authorities have recently pushed up the domestic banks’ reserve requirements. However, the banking system has been recapitalized and the large banks are flush with the proceeds of their IPOs.
Bank lending has been expanding rapidly. Although margin loans are illegal in China, many of these loans are believed to be directly or indirectly financing share purchases. At some stage, the business sector must face the consequences of over-investment and rising costs. The export-oriented economy is also acutely vulnerable to behaviour of the US consumers. If the downturn in the US housing market makes American households sneeze, China will catch a cold.
Given the likelihood of a profits crisis in the near future and the current excessive valuations, it’s not difficult to imagine the Shanghai market giving up all last year’s gains and some more. That would create a problem for the authorities. There are now some five million shareholders in the country. Some 3,00,000 new mutual fund accounts were opened in a single day this January. Many speculators, who have recently piled into the market, are destined to lose their shirts. A collapse of the Chinese stock market could well coincide with a recession and the reappearance of bad debts in the banking system. After all, that’s what happened after the Japanese bubble economy ended in 1990 and the Tiger economies ground to a halt later in the decade.
The prospect of millions of disgruntled stock-market investors could become a nightmare for Beijing. No wonder government officials have been talking down the market in recent days. They are probably satisfied that the Shanghai market is down around 10% from its peak in recent days.
A stock-market correction, they can probably handle. A crash, however, would create a different order of problems.