PINR: China's stock market bubble
efore closing for the week-long Chinese New Year holiday, the composite index for the Shanghai Stock Exchange briefly broke through the 3,000-point mark for the first time in history. On February 16, the index closed slightly below the psychologically important mark, but the unprecedented rise in Shanghai's exchange is increasingly becoming a cause for concern for the Chinese government.
After rising 130 percent in 2006, the Chinese stock market has continued its bull run into 2007 (it is up more than 12 percent since the start of January), causing Chinese officials to warn that the market is overheating. Cheng Siwei, vice chairman of the Standing Committee of the National People's Congress, told the Financial Times in a January 30 interview, "There is a bubble going on. Investors should be concerned about the risks." When other officials supported his warning, the Shanghai market slumped 11 percent before beginning its recovery on February 6.
Since then, the Shanghai and Shenzhen markets have surpassed previous record highs and are expected to continue the bull run when they reopen on February 26.
One reason for China's current stock market boom is that it follows a five-year slump from 2001. Also, following a strong performance last year, corporate profits should be up by 20 percent this year, according to Jing Ulrich, chairman of China equities at JP Morgan, in an interview with The Economist.
However, other factors imply that the current run has less to do with the underlying profitability of Chinese companies and more to do with an increase in the demand among mainland Chinese for equities. Record numbers of individual brokerage accounts have been opened in recent months, reaching 80 million accounts in January, a ten percent increase over the previous year. Retail investors control 60 percent of the shares on the Shanghai market, a level that also appears to be increasing.
The reasons for the increase in retail investing are complex; the basic components, however, are easily identifiable. China's middle class is expanding rapidly, but the state continues to provide negligible health and pension benefits for the elderly, which leads to high savings rates within the middle class. For various reasons, Chinese interest rates remain low, and will likely remain low for the near term. Thus, Chinese investors are encouraged to seek higher rates outside of traditional savings accounts and have easy access to credit. Also, there are limitations on foreign investments, making it difficult for individual investors to enter stock markets outside of China. As China's markets expanded in 2006, more individuals pushed their savings into stocks, causing the current cycle.
The sustainability of the bull market is questionable, and it will almost certainly have to retreat in the coming months. Siwei and others warn that up to 70 percent of the listed companies on the Chinese exchanges are worthless and should be delisted. Among companies listed in both Shanghai and Hong Kong, the spread in valuations has increased widely since 2005. The Price/Earnings (P/E) ratio for companies listed on the Hong Kong market is close to 18, but the P/E ratio for the same companies in Shanghai is 33. A similar gap between the markets preceded the 2001 collapse of the Shanghai market.
Beijing is wary of the expanding equity bubble for a number of reasons, but mainly it is concerned that a sharp deflation could cause a backlash from middle class retail investors. Political protests are on the rise in the inland provinces, but the booming economies on the coast have been more stable. A large-scale backlash from China's investing class could threaten political stability in China's most prosperous regions. [See: "Domestic Threats to China's Rise"]
The basic problem comes down to an imbalance between the supply of shares and the demand for such shares from retail investors. Beijing has begun tackling the problem from both fronts.
On the demand side, it has attempted to warn against investor euphoria through statements such as Siwei's. Secondly, it has asked banks to tighten their lending practices, preventing retail investors from borrowing money to invest in the markets. On the supply front, the government has encouraged the listing of more companies by loosening regulations on Initial Public Offerings (I.P.O.) and share structures. Price Waterhouse Coopers estimates that Shanghai could see 200 billion yuan in I.P.O.s this year, outstripping the level in Hong Kong.
Still, these policies, so far, do not seem to be letting the air out of the Chinese markets. As such, further restrictions on lending or taxes on capital gains could be in the offing. As investors discuss stock tips and trading strategies over the holiday, however, most market analysts expect that the bull market will continue for the near term.
When China's markets reopen on February 26, the bubble is likely to inflate further. The government has limited powers to reverse this trend, but it must prevent the bubble from growing too large, otherwise a backlash might occur if the investor frenzy ends with a burst. More restrictions are likely to be placed on bank lending practices, possibly including increasing minim reserve ratios. Officials might try to set up a joint trading mechanism for those companies listed in Shanghai and Hong Kong to prevent further spreads in valuation. A further loosening of the restrictions on stock listings also seems inevitable, although such a move might only further increase the problem of quality listings on the domestic markets.
In the end, none of these measures are likely to be enough, and Beijing will have to deal with a bursting of the Chinese stock markets. If the bubble pops before the 17th National Congress scheduled for this fall, it could weaken President Hu Jintao's ability to appoint the successor government he would like. If the burst does not come before the fall, it will likely be a dramatic plunge and could wipe out the savings of many within China's new middle class. If this occurs, then Hu's government would have larger problems to deal with.
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