In the late-1980s, the financial world created Asia Ex-Japan, a new category of investment to deal with what was then the world's second-biggest economy. The idea was that Tokyo's market was so big, and its valuations had diverged so widely from its peers, that Japan and the rest of the region each warranted its own asset class.
Today, China is following in Japan's footsteps, having grown so large as a financial market that investors can no longer plausibly group it together with its neighbors. Asia Ex-Japan has been reduced to an anachronism. But China's newfound financial status will likely prove a mixed blessing.
China is fast rewriting Asia's pecking order, more so than Japan ever did. Its economy is almost twice the size of Japan's, as is the market capitalization of its equity arenas. And China's price-to-earnings-ratio profile is in an orbit all its own. Shenzhen shares are trading at prices 73 times above expected earnings, compared with 17 in Seoul and 14 in Taipei. In Shanghai, meanwhile, 94 percent of stocks are trading at higher valuations than the market's index.
"China is the big elephant in the room, dominating Asia Ex-Japan metrices to the point where they've become meaningless," says economist Frederic Neumann of HSBC in Hong Kong. "This is not to say that China doesn't set the pace for the region overall. But when looking at Asia, the two heavy-weights of China and Japan are best left out of regional averages for analytical purposes."
For China, there's both good news and bad in achieving status as an independent asset class. The good news is that it confirms the financial clout Beijing covets. The bad news is it might encourage policy makers to lose sight of the country's economic fundamentals.
In Japan's case, it triggered the country's economic decline. The rise of Japan Ex-Asia indices furthered the boom in Japanese stock markets, driving the Nikkei to an all-time high of 38,916 in 1989. It was a brilliant marketing tool, but it allowed the country to ignore necessary economic reforms. Even today, Tokyo is struggling to adhere to international corporate governance standards.
Chinese authorities have been lobbying for their stock markets' inclusion on global indices in order to lay the groundwork for making the yuan an international currency. But Beijing has been putting the cart before the horse. If China wants to win over international financial markets, and convince global fund managers to make its shares a cornerstone of their portfolios, it should do so organically, by steadily pursuing a program of bold economic reforms. Instead, Beijing has been doing the opposite, fueling a credit rally of Shenzhen shares that has produced an impossible 173 percent boom in 12 months even as broader economic growth has slowed.
MSCI's decision last week to defer adding Chinese shares to its indices was entirely prudent given China's fragile financial health. Although its GDP has surpassed Japan's, China still needs to improve its deficits in financial transparency and market access. It should also rethink the mechanics of its system of investor quotas; the last thing its stock markets need is an artificial inducement to add more shares.
There's no denying that China, like Japan decades ago, is outgrowing its Asian peers. China's vast and still growing scale has already made it problematic for economic observers to take weighted averages in Asia. But wise investors will also recognize there's still considerable convergence in the region. As Tim Craighead of Bloomberg Intelligence points out, China's "increasing integration with Asia makes a pan-Asia investment strategy a fundamentally intriguing complete-supply-chain investment thesis." HSBC economist Frederic Neumann adds: "There is still a remarkable correlation between China's growth and that of other Asian emerging markets."
That's not to suggest investors shouldn't separate out China where needed in their economic analyses. But they'd be wise to do so cautiously. Although the country is flying high now, it may only be a matter of time until it again falls in line with its Asian neighbors.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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