China Syndrome: How Scary?

By Maria Bartiromo

When stock markets in China took a major hit on Feb. 27, I rang up Don Straszheim, vice-chairman of investment bank Roth Capital Partners in Los Angeles, for some answers. Straszheim was chief economist at Merrill Lynch (MER ) for a dozen years and is an expert on investment in China.

Why was China so important to this week's market volatility?

For the first time, an event in China's equity markets triggered a reaction around the world. In the last two years, China has gone from being interesting to being important to being top of mind among investors. So when China's equities collapsed, investors around the world concluded, "Oh-oh, this means maybe something important to China's economy. And it may mean something important to equity markets around the world." This wasn't the case five years ago.

Should we be worried that China's economy could crack and set off a ripple effect?

I don't think so. Equities in China are not really important to economic growth. Equity financing is still a small part of raising capital. Far more important than paper gains or losses for Chinese investors is growth in real jobs and income for workers. That's what drives the economy.

China had a huge rally before this week's sell-off. Were the gains warranted?

From 2001 till summer, 2005, China's markets went down about 70%. This was because more people came to realize that China's equity markets were still quite immature...and just stayed away or bailed out. Beijing, in the summer and fall of 2005, decided...we've got to accelerate the reforms we're making in the equity markets. When those reforms were initiated, investors in China concluded this is the start of something big. And so equities rose 130% in 2006 and up another 10% to 30% in early 2007. As enthusiasm got ever greater, it became a mania. No other word to describe it. And for whatever reason, investors in China a couple of days ago concluded, "This is getting increasingly worrisome. We've made fantastic gains, let's take some money off the table." So when you look at this 9% decline, it's a big number in a day, but it's a small number in terms of the magnitude of the rally over the last 18 months.

How sound are the underlying values of the Chinese shares?

I'm a skeptic about many of the equities on the Shanghai and Shenzhen markets. First, about two-thirds of those companies remain state-owned. And those markets are dominated by retail investors, not institutional investors—exactly the opposite of the States, Europe, Japan, and other developed economies. Return on equity, price-earnings ratio, book value—these concepts have not yet entered the consciousness of the average Chinese equity investor. The Shanghai and the Shenzhen markets are still highly vulnerable, with enormous inherent risk to Western investors.

Does the market still have room to go down? Beijing analysts say it could safely drop 10% more.

This is now really a matter of investor psychology. The decline may be over, or there could be another 25% or 40% drop.

Do you think the banking crisis could derail China's economy?

China's financial sector is clearly its weakest link. The banks are state-owned, and loans are made more on the basis of nonmarket considerations. The result is that China doesn't have effective tools to carefully manage its economy.

What do you tell U.S. investors who lost money this week?

To me, it is more of a buying opportunity than a time to bail out and run for cover.

Alan Greenspan just suggested a recession could happen. Do you think the U.S. will fall into recession this year?

No. I think the economy is going to continue to grow at a reasonable pace, something in the 3% range. Most of the damage in housing is over. Almost anybody in this country who has any job skills can find a job. And earnings have been rising rapidly for the last four or five years. Inflation remains under control, and rates are not at levels that suggest the economy is approaching a danger point. We had a 10-year recovery from 1991 to 2001, followed by a modest recession. We're now in the sixth year of the current expansion, and I think it has many more years to run.

Maria Bartiromo is the anchor of CNBC's Closing Bell.

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