China's stockmarket
Another great leap
Aug 27th 2009 HONG KONG
From The Economist print edition
Share prices in China are once again unhinged
EVEN critics of China’s stockmarket would be hard-pressed to call it dull. After losing almost three-quarters of their value between late 2007 and the end of 2008, shares have gone back on the rampage. They are up by more than 70% this year, and that encompasses a wrenching 15% decline since late July (see chart). Combined, China’s two mainland bourses in Shanghai and Shenzhen are second only to America’s, measured by the value of domestic listings. Activity is frenetic: the average share in China has changed hands three times so far this year.
Since foreigners are largely barred from investing in the mainland Chinese market, what goes on in Shanghai and Shenzhen used to be largely of interest only to local punters. But now China’s position as the only big economy reporting strong growth, and the general scepticism surrounding the accuracy of the government statistics underlying these reports, has transformed the role of its equity market into a potentially unique source of information. Jing Ulrich, a regional strategist for JPMorgan, was bombarded with questions about China’s market on recent overseas travels in the hope they could elicit clues about the future course of the economy. Anecdotally at least, global stockmarkets have become more sensitive to Chinese gyrations, on the premise that they reflect real shifts in the country’s prosperity which have repercussions everywhere.
Whether this reputation is deserved is an open question. The market’s remarkable rise comes with enough caveats to suggest it is priced as much by madness as by reason. On average, shares in China trade at 31 times trailing earnings, double the global average. Although this is less than half the stratospheric valuation that existed prior to the market’s crash last year, it can only be justified by remarkably strong and sustained earnings growth.
There is evidence that business conditions are improving in China, but only by going from abysmal to merely bad. According to JPMorgan’s calculations, the year-on-year decline in industrial profits has ebbed from a dreadful 37% in February to a still awful 21% in June. The same story holds for the profits of companies listed on China’s exchanges. Profits were down by 26% in the first quarter. About half of all companies have reported their figures for the second quarter; earnings declined, on average, by 18% year-on-year.
Share prices should reflect future, not past profits, hence the hope that the rally in China cleverly looks beyond today’s problems to better times. In support of this, the consensus estimates of Chinese security analysts are that earnings will rise by 9% this year and 22% in 2010. A big bounce is not unprecedented. Demand for housing, which uncharacteristically (for China) dried up earlier in the year, has rebounded sharply. Only in southern China, hit particularly hard by the collapse in exports, do prices remain below their prior peaks. Retail sales continue to be strong.
But even that sort of growth, if not followed by more of the same, does little to justify current prices and there are any number of reasons to be pessimistic. Exports, a core component of the Chinese economy, remain soft. Critical demand has come from a huge government stimulus plan that, by design, is transient.
Of even greater concern is that much of the market’s strength may be the result of the abundant money sloshing around China, rather than a fundamental change in profit expectations. This would help explain why companies with dual listings in Hong Kong and the mainland have seen disproportionately large rises in their mainland shares.
One source of this liquidity is individuals, usually responsible for about three-quarters of all share purchases in China. Capital restrictions limit investment options to bank deposits (at low, government-mandated, rates), property, or the stockmarket. That the vertiginous rise in mainland share prices accompanied a decline in the rate of growth for money in longer-term time deposits suggests small investors may have shifted from the safety of banks to riskier market punts.
More controversially, there is widespread speculation that the tidal wave of bank lending initiated by the government as part of its stimulus plan has made its way into the stockmarket. The proportion of loans going into shares is hotly debated. Executives at Chinese firms and the chastened survivors of other Asian stockmarket collapses worry that despite government restrictions lending trickles into the market indirectly.
Redirecting bank loans is typically a violation of credit agreements, but the main impact of such rules is likely to ensure any diversion is not reported. Recently rumours have circulated that the People’s Bank of China has initiated investigations to determine if these claims have merit—a move which, by itself, may have put a damper on the market.
Equally jarring, after an extraordinary lending binge, the country’s leading banks are abruptly pulling back on credit expansion, a move that could affect the funds available for investment in the stockmarket, and indirectly undermine the market by reducing the near-term prospects for growth. Rumours are rife that banks’ capital requirements are being tightened, as are the conditions for various kinds of loan. A decline in new lending in the second half of the year had been expected; the rate of decline has, for many, been a shock. As share prices rose earlier in the year, numerous private companies and their bankers began the lengthy process of preparing for public offerings. In June debt was abundant and there was every reason to expect equity would soon be as well. Such confidence is now frayed.
China’s mainland market has come a long way since its relaunch almost 20 years ago in an old hotel on the Bund in Shanghai. It is now the world’s second-largest on most measures, but a second speculative bubble in three years raises real questions about its credibility. The job of a stockmarket is to provide useful signals to help allocate capital. However thrilling, China’s market is a long way from doing that.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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