FYI | Feb 28 2007
The Chinese share market was an accident waiting to happen. In hindsight, that is an easy conclusion to draw.
As we know from pre-February 27 warnings by central bankers and economists, the Chinese economy is flush with cash thanks to, among many things, a too cheaply priced Chinese currency and a massive trading surplus with the US. Add foreign investors who cannot wait to secure their piece of the Chinese growth potential and what you get is a brewing cocktail of aggressive liquidity streams, all looking for a destination.
In 2006 part of this liquidity found its way into the Chinese share market. From that moment on shares of local Chinese businesses (the so-called ‘A’ shares can only be bought by Chinese citizens) seemed unstoppable as a similar theme started sweeping through the market that has also been repeatedly mentioned in relation to the Australian share market: too much money chasing too few available shares.
In China this situation was exacerbated by the fact that many companies are still majority owned by the government and only a small amount of their capital is freely available through the stockmarket.
The result was a huge bubble and as is always the case with bubbles, everybody knows it is going to end in tears at some stage, but when? Foreign experts have been watching from the sidelines for a while. They may have shaken their heads, on occasion. However, few would have picked February 27 as the day the Chinese house of cards would come tumbling down.
The latter is a fairly safe assumption as nothing really happened on the day itself. Well, nothing outside Chinese shares recording their biggest losses since the death of Mao Zedong was publicly acknowledged by the ruling Communist party.
Things have moved very rapidly in China over the past twelve months. Macquarie analysts in the country looked into the matter a few times over the period. Their assessment was always the same: yes, this is a humungous bubble building, but we think this can go further still – much, much further.
Others were not so confident. Imagine the China research team at Credit Suisse. Last September, when China’s domestic market capitalisation stood at circa US$632bn, they forecast it would reach US$1,876bn by 2010.
Only six months later the team had to capitulate: “It seems that we were hopelessly
wrong”. The Chinese market had already exploded to a market cap of US$1,457bn over the period.
Foreign experts have identified the pillars under the Chinese equity market craze: it’s a story about abundant liquidity in combination with a low free-float for listed shares, a steadfastly appreciation of the yuan while the country is enjoying a prolonged period of high growth and low inflation.
Sounds familiar? It’s Japan before the big bubble burst at the end of the eighties.
Not surprisingly, the rapid appreciation of Chinese equities had already led to stories about factory workers and farmers taking out loans to invest in the local share market, while property owners would bet their house on share prices reaching higher.
Soon after they had to revise their growth predictions for Chinese equities, Credit Suisse analysts switched to the Macquarie side, acknowledging it was truly possible China could be swept off its feet by a huge stock market bubble. Not surprisingly, comparisons with Japan three decades earlier were made: “For example”, Credit Suisse wrote, “if the market cap-to-GDP ratio reached 100% or 150% (like in Japan in 1989), the China A-share market cap could reach US$4,518bn, or US$6,777bn, respectively.”
To some commentators, yesterday’s event which triggered a global sell down of shares, marks the beginning of a new era: one wherein China and no longer the US will dominate the direction of global equity markets.
While that era is likely to come, it has to be noted that the Chinese share market correction came at a time when most market commentators were expecting somewhat of a correction anyway. Technical chartists and quantitative specialists have been pointing at red lights flashing for some time now. It also happens that the Chinese melt down occurred on the same day that ex-Fed governor Alan Greenspan uncharacteristically warned of a potential severe economic slowdown later this year.
Note, for instance, that Chinese H shares, listed in Hong Kong and available to foreigners as well as to Chinese investors, only fell by 3.1% compared to more than 8% for the local markets in China.
Based upon the information available at this stage, it would seem that yesterday’s sell off in Shanghai and Shenzhen (down 8.8% and 8.5%, respectively) was caused by an announcement on the website of the China Securities Regulatory Commission. The announcement said a co-ordination group had been formed to monitor, control, and regulate “illegal securities markets activities”.
Foreign commentators state the precise role of this new controlling authority is still vague, but it is seen as a clear sign that the Chinese government is genuinely concerned about the risks that come with an inflating stock market bubble. Taking from that perspective, the market has simply drawn its conclusions and is now expecting further government measures to clamp down on the “irrational exuberance” that once characterised the US markets.
It is has yet to seen whether the Chinese government is willing to risk spoiling the pre-Olympics euphoria. It probably won’t, but more restrictive measures are likely to be put in place, say foreign experts.
These new measurements are likely to revolve around the following themes:
1) A much tighter monetary policy involving a much higher level of exchange rate and a higher cost of capital in the form of higher interest rates;
2) A significant increase in the free-float in the stock market, which would allow a more genuine market value to be reflected in the prices of Chinese shares.
Until these matters have been dealt with in a genuine and effective manner, yesterday’s sell-off will simply prove a small dip in the biggest bubble of all times, made in China.
Till next week!
Your editor,
Rudi Filapek-Vandyck
(Supported by the Fab Team: Chris, Greg and Terry)