China Stocks: Tick, Tick, Kaboom?

The speculative mania sweeping Chinese stock markets is getting frothyBeijing will need a smart policy mix (and fast) to settle things down

By any reasonable measure, China's domestic stock markets have moved into Alice in Wonderland territory. The Shanghai Stock Exchange composite index has shot up 50% this year, following a 130% gain in 2006. Even though the so-called "A-share" mainland companies are now trading at rich multiples of about 30 times projected 2007 earnings, Chinese investors continue to shovel more of their savings into stocks, betting this party is anything but over.

Few doubt that the frenetic speculation in Shanghai—and at the smaller Shenzhen Stock Exchange (its benchmark index is up 100%-plus in 2007)—is at big risk of ending in tears if the government doesn't do something soon and effectively. If not, Chinese domestic markets will be in for a major-league blowout, some argue. "We believe it's now critical for the government to take action and prevent the excess from building up further," Goldman Sachs (GS) equity strategist Thomas Deng warned in a note to clients on May 10.

To really have an impact, Chinese President Hu Jintao's government has to send a strong message to investors that shows it is deadly serious about cooling things off. It then needs to follow through with a mixture of tighter monetary policy, perhaps the introduction of a capital gains tax, and an acceleration of state-owned company share sales, more initial public offerings, and secondary stock sales to increase share supply.

Too Many Investors

Further out, the introduction of a vibrant futures market—in which investors could make money shorting stocks ripe for a fall—would add more stability. Though Shanghai expects to introduce index futures sometime this year, market watchers say regulators are reluctant to launch them during such frothy times. The key thing, though, is for Beijing officialdom to understand the risk—a market crash would annihilate the finances of millions of Chinese households with big exposure to equities.

"The government should actively state that there is a bubble in China and the wording should come from senior Chinese Communist Party leaders," says Shaun Rein, managing director of the Shanghai-based China Market Research Group (CMR). "There are too many new investors coming into the market with glossy eyes expecting to make fortunes." In fact, some 368,000 brokerage accounts were opened on May 8 alone, according to the China Securities Depository and Clearing Corp.

While China's economic fundamentals are incredibly robust—first-quarter gross domestic product advanced by 11.1% and mainland companies are enjoying explosive earnings growth—the rally this year has taken on a life of its own. A sizable chunk of China's $2.2 trillion in household savings has shifted to equities. Money inflows are driving market gains, which in turn attract more cash, and so on.

Beyond Expectations?

Even so, the closely watched Shanghai benchmark index could rise another 14% or so (to 4,600 from the May 10 record close of 4,049) this year, according to UBS (UBS) equity strategist Henry Ho. Standard Chartered economist Stephen Green thinks 5,000 is conceivable in a month if the government doesn't get involved. If so, it would be tick, tick, tick time, most analysts contend.

Though estimated earnings for A-share stocks traded on the Shanghai-Shenzhen 300 index (recently renamed the CSI 300 Index) should grow at a torrid 40% clip this year, it would be hard to justify those kind of valuations even in an economy as high-speed as China's. At 4,600 or so, the stocks on the Shanghai stock exchange would be trading at a staggering 42 times estimated 2007 earnings, Ho figures.

What makes all this particularly tough for regulators is the fact that traditional monetary tools probably won't have much impact on investor psychology, at least short term. Back in March, the People's Bank of China increased a key benchmark, the one-year interest rate, by 27 basis points, to 6.39% and the one-year deposit rate was nudged up by the same amount, to 2.79%. It was the third such interest-rate hike in the past 12 months—and one or two more credit tightening moves are likely in 2007. Stock investors merely yawned—with good reason.

Longer Wait, Bigger Risk

Even if deposit rates doubled, Chinese savers would still have a hard time swallowing such low returns when the domestic exchanges are on fire. China doesn't have a deep corporate bond market that might offer more competitive returns. A capital gains tax is another possibility, economists say, but that would take time to set and likely be highly unpopular. Cutting bank lending to mutual funds and stock speculators is probably more doable short-term.

Still, the longer Beijing waits—and some think China won't act forcefully until after the 2008 Summer Olympics—the bigger the risk of a painful blowout. Right now, China's market is worth about 70% of the country's total $2.6 trillion in annual economic output, compared to 150% in the U.S. So the mainland's macro-economy wouldn't suffer a Japanese-sized shock if the market collapsed, optimists point out.

But for a developing economy like China with such vast employment and social spending needs, even a minor setback would hurt. "Move slowly now and the risks of a much bigger, more painful correction later in the year increase," notes Standard Chartered Bank's Green in a May 10 report on market conditions.

The regime in Beijing has had some success cooling off the high-end property markets in some major urban markets and so far has successfully kept the broader economy from overheating, though worries abound. Yet when it comes to China's turbocharged markets, studied inaction could be a very perilous strategy.

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