Is China's B-Shares' Bubble Near Bursting?

With Beijing's blessing, money pours into the shaky shares

Li Hehua enjoys spending time at his neighborhood brokerage in Shanghai, monitoring stock prices. No wonder. This year alone, the value of Li's portfolio has doubled. Among the group of 20 or so regulars in the Haitong Securities office, the 68-year-old retired researcher is known as "the professional." He has made $100,000 since 1998 buying and selling China's B-shares, the U.S. and Hong Kong dollar-denominated stocks of 113 Chinese companies.

In fact, all the regulars--including a night-school teacher, a laid-off factory worker, and a retired chemical engineer--have been feeling pretty flush. This market, which mostly trades shares of state-controlled companies, exploded this year. The B-share markets in Shanghai and Shenzhen rose 157% and 186%, respectively, through June 6, making them the world's most spectacular gainers. Analysts estimate that B-shares trade at 87 times 2000 earnings for Shanghai listings and 41 times for Shenzhen's. Many companies, of course, have no earnings at all.

The game is getting dangerous, though. On June 1, Chinese authorities lifted the last restrictions on mainland citizens' B-share investments, which until February were only open to foreigners. That was supposed to unleash a new buying binge. Instead, the Shanghai B market fell 8% between June 1 and June 5. Shenzhen lost 11.8%. Uh-oh. Is the bubble about to burst? "We don't believe everything will collapse," says Henry Ho, China strategist for Morgan Stanley in Hong Kong. "The government won't allow it."

Li and his friends sincerely hope so. But government intervention won't stop this market if it goes into free fall. There's little fundamental reason to buy B-shares. Nor is there an Alan Greenspan to warn off investors. In fact, Beijing created the B-share boom and has prolonged it to pull idle hard-currency savings into the economy. "It's ridiculous," worries one senior Chinese banker. "I'm very concerned."

The B-share market opened in 1992 to let foreigners invest in Chinese companies; local yuan holders were confined to the A-share market (which has also seen substantial gains). When the best companies started listing in Hong Kong, B-shares became a backwater, with a mere $7.7 billion market cap at the end of last year. Then, on Feb. 19, the government let mainland Chinese--who hold some $80 billion in foreign currency from overseas relatives and business interests--invest in B-shares. China also has H-shares, the so-called red-chip Chinese companies listed in Hong Kong.

The move opened the candy jar. Shenzhen's B-list market cap almost tripled from mid-February through early June. Shanghai's B-share valuation hit $10.1 billion on June 5, up from $3.7 billion on Feb. 19. The downturn after the government opened the market to anyone with foreign currency on June 1 only damped enthusiasm slightly.

OBLIVIOUS. None of this is about corporate fundamentals. Take Shanghai Automation Instrumentation Co., which makes auto industry equipment. On the verge of delisting after two years of losses, its stock rose 192% between Feb. 19 and June 4. Across the markets, manipulation and insider trading are rampant. Reporting is spotty at best. After the China Securities Regulatory Commission rejected an earnings report from A-listed chemical company Sisha Co., it took months for Sisha to restate them.

Beijing has made a show of its desire to improve the market. Still, it seems oblivious to the dangers of feeding the bubble. Any number of events could trigger a rout: Rising interest rates, a massive swindle, or conflict with Taiwan. Li and his fellow B-share investors say they know they're gambling. But they trust that Beijing will protect them. "We can make a lot of money in the stock market," says Li. That's what Beijing wants him to keep believing.

By Alysha Webb in Shanghai with Mark L. Clifford in Hong Kong

— With assistance by Mark L Clifford

    Before it's here, it's on the Bloomberg Terminal.