China’s Stock Markets Aren’t Insane

Chinese stock valuations are not at all as fancy as they may appear

Chinese exceptionalism

is often cited as a reason why things can happen in China that cannot

happen anywhere else in the world. Generally speaking these

exceptions are rather hard to justify but when it comes to China’s

stock markets there are valid grounds for suggesting that they may be

able to defy gravity and sustain levels of growth that are simply

unsustainable elsewhere.

The enormous inflation

of Chinese share prices has produced valuations that make Chinese

banks, life insurance companies and oil producers the largest in the

world. In reality none of these companies are world class by

practically any standard, nor are their shares trading in an

environment that is as transparent or accountable as that of peer

companies elsewhere in the world.

After three years of

stellar growth which saw the Shanghai Composite Index quintuple in

value between 2005 and 2007, Chinese shares are now on the retreat

but hardly in a manner that suggests that the boom is to be followed

by a bust. In the first month of this year the Shanghai index only

fell back by just over 10 percent, a figure that would give rise to

concern in other markets but barely makes a dent in the spectacular

inflation of Chinese share values. At the time of writing the market

continues on a volatile path but is not seriously out of line with

movements on other Asian markets.

And although the

meteoric rise in Chinese share prices looks record-breaking, it pales

in comparison to the 2,000 percent rise in Taiwanese shares seen

between 1982 and 1990. Moving closer to the present, it is often

overlooked that the Chinese stock markets have risen to a more

limited extent than those of the other so-called BRIC economies –

Brazil, India, Russia and China. All the other three, led by Brazil,

have seen their markets rise faster and more impressively than the

Chinese market since 2003, although the pace of increase has

accelerated in China since 2005.

The net result however

has left China with the lowest level of market capitalization

relative to gross domestic product (GDP) among these four nations –

India leads the pack here, followed by Russia and Brazil with China

seriously trailing even Brazil. Market capitalization in China

accounts for almost 80 percent of GDP, but, and this is the crucial

number, the value of tradable shares represents only 25 percent of

GDP. But even this percentage may be exaggerated because included

among the tradable shares are some equity holdings of the government

and state agencies. So China, which is now home to one of the world’s

biggest stock markets, still lags very far behind other nations with

major markets, like the US, whose market size is equivalent to150

percent of GDP. Indeed other three-digit numbers are common in most

leading markets.

All this suggests

considerable scope for growth in Chinese market size and there are

constant reports of the speed at which new trading accounts are being

opened. China’s Securities Association estimated that 32.7

million new stock trading accounts were opened last year, 10 times

the level of new account openings in the previous year, bringing

China’s investor population up to a figure of 136 million. Like

all figures concerning China’s population this is impressive

but it still only equates to around 10 percent of the total

population, which is modest in comparison to other nations, such as

the United States where half the population holds stock market

portfolios. And this influx of new Chinese investors raises other

questions that will be discussed later.

Despite all this

enthusiasm for shares there are indications which strongly suggest

that the Chinese stock bubble should be ready to burst were

conditions in China similar to those in other major markets. For

example, in historic terms Chinese shares appear to be trading on

price-earnings ratios that are unsustainable. The B Shanghai Index in

Shanghai, representing shares that can be purchased by non-domestic

investors, is trading in historic terms on a price earnings ratio

(PER) of around 50, about the same level as that for the A shares

that are exclusively reserved for domestic Chinese investors. (Over

the past decade the PER average has been more modest at 37). This

compares with a PER of around 19 for the stock market in neighboring

Hong Kong.

However closer

examination shows that Chinese stock valuations are not at all as

fancy as they may appear. A report by Edmond Huang from the

securities division of UBS suggests that the forward PE ratio stands

at about 33.

But even this figure

might not sufficiently take account of Chinese companies’

earnings potential. Michael Pettis, a professor of finance at Peking

University, who writes an interesting China finance blog, has done

some number crunching which shows that in reality Chinese stocks are

not trading on even vaguely demanding forward looking price earnings

ratios. He argues that if Chinese corporate profits are growing at

1.5 times the rate of US corporate profits in the next 30 years, then

a forward PER of 19-22 would arise. Even if Chinese corporate profit

growth is more modest at 1.2 times the US rate, this still leaves

PERs in the range of 25-28.

Given that China’s

GDP growth will double that of the US for the foreseeable future,

these projections are not outlandish. And even though many will

question the quality of Chinese corporate earnings, few question the

scope for growth. Indeed last year A-share listed companies notched

up average earnings increases of around 80 percent, a level far

higher than Professor Pettis’ projections.

But then again it is

quite possible to argue that the Chinese stock markets have become

detached from economic reality and are little more than casinos

attracting the surplus wealth of an increasingly affluent population

seeking returns higher than the modest offerings they have attained

from traditional bank deposits.

These stock markets

most certainly do not perform the role for which stock exchanges were

established, that is to raise new capital for companies. On the

contrary only about 10 percent of private sector investment in China

is derived from the stock markets, compared to about 60 percent which

comes from internal company resources.

New share issues are

made in the name of privatization of state companies and march under

the banner of reorganization and greater commercialization of

previously state-controlled industries. Some of this happens but on

the way a great many politically well-connected people make fortunes

and the stock market becomes a cash cow for taking money out of

businesses rather than putting it in.

Many of the players in

this game are novice investors who now account for almost half the

trading on Chinese stock markets and, according to the Securities

Association survey cited above, 10 percent of them believe that it is

impossible to lose money by trading shares. But just because they are

inexperienced and many are dangerously ignorant about how their

investments works does not mean that there are not more new investors

lining up to buy shares and this tremendous demand will have an

effect on prices regardless of the underlying economic reality.

Moreover because state

entities control at the very least 75 percent of the equity in the

stock markets they have the ability to prevent prices from falling

even if they lack the same ability to make them rise. The Chinese

government is determined to keep the nation free of bad news ahead of

this year’s Olympic Games in Beijing. Some things, like the

current disastrous cold snap, are beyond their control but the stock

market is not and it seems highly unlikely that the government will

allow anything approaching a crash to occur in this period.

Fortunately the state coffers are sufficiently full to ensure that

this determination can be realized.

The Chinese stock

markets may look ready to plunge, and may even fall quite

considerably but a crash seems unlikely. Indeed, for those who take

notice of this sort of thing, there is still enthusiasm among stock

analysts who believe that Chinese stocks remain on the way up. A

Reuters snap shot poll of eight analysts at securities houses in

Shanghai found them expecting the market to rise by 5- 10 percent

this year. Clearly this represents a dramatic slowdown in growth but

very few people expect a crash and in stock markets expectation often

help create reality.