A Rough Day for China Stocks

A 9% tumble in the Shanghai-Shenzhen index, sparked by a Beijing move to damp liquidity, could signal the onset of a much-heralded correction

Chinese stocks in 2007 have had all the stability of the quake-prone San Andreas fault. Market swings up and down in the 3% range have been the norm at the extremely overheated Chinese domestic stock exchanges in Shanghai and Shenzhen. That kind of volatility, not to mention sky-high valuations and 130%-plus gains last year, had stock analysts and Chinese government officials warning feverishly that all signs pointed to a nasty correction down the road.

The big one, or at least one heck of a temblor, came with surprising intensity on Feb. 27 when the Shanghai and Shenzhen 300 Index that tracks local, currency-denominated mainland stocks fell more than 9%, the most dramatic one-day decline in a decade. The drop vaporized more than $100 billion in market value from stocks traded on most exchanges, and spread to bourses in Europe and the U.S. The Dow Jones industrials plunged 416 points, or 3.2%, while the S&P 500 index was off 3.5%. Bourses in the UK, France, and Germany on Feb. 27 also tumbled, down 2.3%, 3%, and 2.9%, respectively.

A contributing factor to today's market upheaval was the action late yesterday by the People's Bank of China to raise—for the fifth time in eight months—the required cash reserves that lenders must park with the nation's central bank. These moves are aimed at draining liquidity from the banking system and taming the growth in lending, which grew 16% year-on-year in January.

Time for a Break

As a result, among the hardest hit stocks today in Shanghai were bank stocks such as Bank of China, China Merchants Bank, and China Minsheng Bank. That's not entirely surprising given that a number of mainland banks earlier this year were trading at richer price-to-book value multiples than Citigroup (C) and HSBC Holdings (HBC), Jing Ulrich, head of China equity markets at JP Morgan (JPM) in Hong Kong, pointed out in an interview last month.

Ulrich and plenty of others had warned that bloated valuations across the board suggested a correction of 15% to 20% was definitely in the cards. And in that sense, an orderly retreat from recent market highs wouldn't be a bad thing at all. "It is about the time market takes a breather," says Nicholas Yeo, an investment manager with Aberdeen Asset Management, based in Singapore.

He adds that price-to-earnings ratios in both Shanghai and Shenzhen have been hovering between 35 and 40, more than double the levels in other Asia markets excluding Japan and South Korea. While the long-term prospects for China stocks are golden given the mainland's high-speed economy, "we could see some more consolidation," according to Yeo. Still, share prices on both Chinese bourses remain in positive territory for the year and the Shanghai and Shenzhen 300 Index actually touched a record high of 2707.68 on Feb. 26.

Bubbling Over

Today's market blowout, though painful for some, will be welcomed by financial authorities in Beijing who have been sounding the alarm about runaway valuations at both exchanges. In fact, worries that the government will take further action to cool off domestic stock markets at next month's National People's Congress probably influenced some investors to sell, says Yeo.

In late January, comments by Cheng Siwei. standing committee vice-chairman of the National People's Congress, to the effect that both the Shanghai and Shenzhen stock exchanges were in the midst of a "bubble" contributed to a sharp 6.5% decline in the Shanghai and Shenzhen 300 Index that tracks local currency-denominated mainland stocks (see BusinessWeek.com, 2/1/07, "Talking Investors Down from China High").

It has taken awhile but a shift to a more cautious stance among mainland investors, by far the biggest source of demand for so-called A-shares traded on the domestic exchanges, may be at hand, according to Michael Chang, an analyst with ABN Amro based in Hong Kong. "People are taking money out of the market after the [just completed] Chinese New Year's holidays," he says. "They realize they have had a good run."

No Revision Needed

Though the months ahead are likely to be choppy as the markets find a more sustainable trading level, few expect the Chinese bourses to spin completely out of control. Many analysts, including JP Morgan's 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).

Nor can anyone reasonably make the case that China's economic growth story needs a major revision. 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 gross domestic product 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 (see BusinessWeek.com, 1/25/07, "China Blows Past Forecasts").

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