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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.