Talking Investors Down From China High

Beijing officials have issued stern warnings and domestic stock markets could be in for a nasty correction. Will Chinese investors listen?

Chinese financial authorities have stated as bluntly as possible in recent days that the mainland's hyperactive stock markets are clearly in Alice in Wonderland territory when it comes to valuations and sustainability. And sure enough, some sort of pause, or possibly the beginning of a much-needed correction, may be under way.

Comments by National People's Congress Vice-Chairman Cheng Siwei that both the Shanghai and Shenzhen stock exchanges were in the midst of a "bubble" have had an impact, as have suggestions by other officials that they are prepared to clamp down on bank funding to domestic mutual funds and possibly raise reserve requirements on banks.

The Shanghai and Shenzhen 300 Index that tracks local currency-denominated mainland stocks fell 6.5% on Jan. 31, and while that index finished up slightly on the first trading day of February, few doubt this market is in for some adjustments on the down side. In fact, analysts have been sounding the alarm since late last year about the rapid runup of mainland stocks and exchange-traded funds heavily exposed to China, such as the iShares FTSE/Xinhua China 25 Index Fund (FXI) that is designed to mimic the index it is named after (see, 1/8/07, "Stocks: The Chinese Correction?").

Not Over Yet

At the mainland exchanges in China, "The valuations for some of the stocks have become quite stretched, and clearly officials are worried about a bubble," says Jing Ulrich, head of China equity markets at JP Morgan (JPM) in Hong Kong. Ulrich has pointed out that big mainland banks have been trading at richer price-to-book value multiples than Citigroup (C) and HSBC Holdings (HBC). "A 15% to 20% correction isn't out of the question."

But don't bet on a massive retreat from mainland stocks from panicky Chinese investors. In fact, plenty of analysts, including Ulrich and Lorraine Tan, vice-president of S&P Equity Research for Asia Pacific based in Singapore, think the A-share market could easily deliver double-digit gains this year. Tan is actually forecasting a 25% gain in 2007. S&P, like BusinessWeek, is a unit of The McGraw-Hill Cos. (MHP).

In fact, right now there is something of a tug of war between government officials and rich Chinese investors. Beijing is trying to shout down stock prices to more reasonable levels without resorting to drastic measures, while the investors see earnings-per-share growth rising by 20%, and have precious few other investment options to choose from that can deliver that kind of growth.

Investors Rush In

Shaun Rein, founder of China Market Research Group, says that moves to make mortgage down payments higher last year, coupled with ultra-low bank interest paid on savings, is driving a lot of cash into the stock market. The government mandates time deposit interest rates of around 2%—but that is not keeping up with inflation that in December clocked 2.8% year-on-year growth (see, 1/25/07, "China Growth Blows Past Growth Forecasts").

"The result is that the Chinese are blindly pouring money into Chinese stocks because they have no other choice to see their money grow," says Rein. "We have interviewed housewives who are now running to invest money because they do not want to get left out of the action."

Also, no one can really make a case against Chinese economic growth that is bearish enough to persuade ordinary investors that it's time to stuff yuan notes under the mattresses. On Jan. 25, China blew away consensus forecasts and reported that its economy grew 10.7% in 2006, vs. 10.4% in 2005. Its total economic output in dollar terms is now about $2.69 trillion.

China is expected to grow again in the near-10% range in 2007, and will certainly overtake Germany as the world's No. 3 economy by the end of next year. China's latest GDP data, "…makes 2006 the fastest year of economic growth in a decade," Minggao Shen, a Beijing Citigroup economist, wrote in a note to clients on Jan. 25 after the numbers came out.

Hoping for Soft Landings

Last year, the Shanghai and Shenzhen 300 Index delivered returns of about 130% to investors. Earlier this year, the index touched a new high and the combined market capitalization of stocks traded in Shanghai and Shenzhen broke the $1 trillion market for the first time. For investors, it's hard to resist all this momentum and take a pass on possibly robust gains in 2007.

Still, Standard Chartered Senior Economist Stephen Greene thinks Beijing, if need be, is ready to basically cut off bank financing to the markets by ratcheting up bank reserve requirements or maybe even raising interest rates. "They would be happy with a stable and rising market, but the sheer violence" of the recent rally has rattled government officials, says Green.

Song Guoqing, an economist at Beijing University, thinks the government probably won't have to resort to blunt tools and will engineer a soft landing in share prices by verbal warnings. "I don't think the government will take serious action to cool the stock market," he says. "They just want the growth to slow down a little bit."

That's true, but China's swelling investor class doesn't have a lot of options. There will certainly be some net selling if the current market declines are sustained, but it is likely folks will be back in full force later in the year. Once you're hooked on stellar and sudden market returns, it's hard to go cold turkey, regardless of what the government says.

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