China Risks Outside of China

With investors flocking to Chinese markets, experts warn that a bust from beyond its borders could bring the hot economy down

Most traders who checked their investments on January 2 weren't disappointed. Stock markets in Hong Kong and Shanghai jumped to record levels, other markets in Asia also rose, while European stocks showed significant climbs. Just about every market - with the notable exception of those in the US - gained.

It was a good way to start the year and a marked difference from the day, just two weeks prior, when every market in the region dropped after authorities in Thailand announced new regulations curbing foreign capital inflows.

Hit by the news that 30% of all overseas money entering the country would be locked up in non-interest bearing accounts with the central bank, shares in the Thai exchange dropped 15% on December 19, the biggest drop since 1990. Hong Kong, a stronger market, fell about 1%.

Cowed by the backlash, the Thai authorities ditched the policy the next day.

The lesson, perhaps one that should have been learned during the 1997 Asian financial crisis, is that markets are much more interlinked than they have ever been (See: Worst Case Scenario).

These are good days for investors in Asia. China, in particular, saw record profits in 2006 on the back of a 130% rise in the stock market, and fund managers are positive about the outlook for 2007.

"The attraction of the China/HK shares is related to the relative economic growth in this region. As long as other regional economies are benefiting from healthy Asian growth, I believe the markets will also be pulled up," said Lorraine Tan, head of equity research at Standard and Poor's.

While the links between markets are growing and certainly helping prop each other up, this interdependency could also work the other way, a drop in one market torpedoing the rest.

"China is now Japan's largest trading partner, superseding the US. China is also one of the world's largest consumers of commodities, which buoys the Australian market. Hence, a sharp downturn in China's growth does have a negative risks to Asia-Pacific," Tan said.

In the same way, some unexpected bad news in a market with close ties to China could have a detrimental effect on share prices in Shanghai. Behind all the bullish sentiment about China's financial outlook, it is this risk of potential downturns elsewhere that represents one of the biggest risks of doing business in the country.

In a more complicated financial environment, investors - everywhere - have to look at the whole board.

BEHIND THE BOOMA Goldman Sachs 2007 outlook report says China's growth is likely to hit 10% driven by significant productivity gains. But "?if the US economy hard lands, and demand in the rest of the world unravels, China's export growth would be seriously bruised."

Reports from just about every investment bank share Goldman Sachs's positive stance on China. Similarly, domestic investors, once bitten and twice shy about dipping a toe into equities, are diversifying from bank deposits toward stocks. In Hong Kong, it is hard to find anybody who invests who is not counting on healthy returns for the year. The Christmas shopping season, for example, was the best in history.

"A lot of money is coming into this part of the world with nowhere else to go," said Steve Vickers, president and CEO of International Risk.

But, he warns, it would not take much to send it all tumbling down. Regional markets slipped in December in response to Thailand's capital inflow rules; another tremor was felt in early January, triggered by a Wall Street slump after Motorola announced weaker than expected returns.

Vickers' nightmare scenario is more cataclysmic: for example, an earthquake hitting Tokyo, the focal point of the second largest economy in the world and the strongest market in the region. Such an event could bring every market in the region tumbling down, he said.

To unpredictable natural disasters can be added barely predictable regional politics: India and Pakistan, terrorism in Thailand, attacks in Malaysia - there is no shortage of risk. China's own proclivities towards unilateral decisions have shored up its stock markets in the last year but decisions tend to be autocratic and one bad move could hurt.

"It is normally something we haven't planned for," said Vickers. "At times of high volatility and high froth it doesn't take much."

The likelihood of a major man-made disaster, like an attack or wave of investor panic, is lower than it was a decade ago but, with so much money floating around the region, it is a risk worth considering.

"You got taxi drivers in this town trading on margin," said Vickers. "It's a herd mentality."

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