China‘s stock market has rocketed upward for much of the last two years, and that had some commentators at the recent 2007 Wharton Asia Business Conference wondering aloud about a bubble and when it might burst.
The country’s economic fundamentals — low wages, a huge population and substantial investments in infrastructure — position it for strong long-term growth, said Michael Dee, former managing director and CEO, Morgan Stanley Asia, and one of the participants on a panel titled, “Capital Markets: Is the Asian Market Really Attractive?” But for the moment, he noted, the soaring stock market is outpacing that potential.
Consider PetroChina, a leading Chinese oil company, Dee said. Its A-shares have recently had a market capitalization of more than $1 trillion. “That’s equal to four Gazproms [a leading Russian oil-and-gas driller], which has more natural gas reserves than almost any country in the world. That’s four times Australia. Can one company be worth that?”
Investors, in their enthusiasm for China’s future, may be overlooking worrisome signs in the present, Dee noted. Chinese corporate earnings, which in theory should drive stock prices, aren’t subject to the same sort of financial oversight as those of developed-world firms. “There are some real companies in China, but I’m very skeptical of the earnings numbers,” he said. “If Enron can occur under U.S. GAAP [Generally Accepted Accounting Principles], tell me what a Chinese company can get away with.”
Dee isn’t the only person who has speculated that the Chinese stock market may have reached an unsustainable level. Experts such as Alan Greenspan, former chair of the U.S. Federal Reserve Board, and billionaire investor Warren Buffett have voiced similar concerns. And within the last several months, two major U.S. investment banks — Goldman Sachs and Morgan Stanley — have published reports suggesting that the Chinese market is due for, as it’s euphemistically termed on Wall Street, a “correction.” In a report released earlier this month, Goldman predicted that China’s Shanghai Exchange would peak next year and that its shares, on average, would see a negative return for the year.
Since the beginning of 2006, the Shanghai Composite Index has risen more than 300%. Though its shares have slumped slightly since mid-October, the average price-earnings ratio for the exchange’s A-shares remains about 60 times 2006 earnings. The average PE for the stocks in the S&P 500, in contrast, was about 18 at the end of October.
Shades of 1929
One of Dee’s fellow panelists, Richard Wise, chief risk officer for institutional equities at JP Morgan, noted an historical parallel in China’s recent stock market performance, pointing out that emerging economies often rollercoaster as they fight to establish themselves. Back in the 1920s, he said, the United Kingdom dominated world commerce, and the United States was trying to shoulder its way into preeminence. Just as China has, the U.S. kept its currency undervalued, and its interest rates stayed lower than they should have been. “That was overly stimulative to the economy, and then came the 1929 crash.”
China appears to be following a similar path, he suggested. To keep demand for its exports high, the country keeps its currency artificially low. “Every single day, the Ministry of Finance in Beijing buys billions of capital inflows,” he noted. “There’s too much liquidity in the system, and that’s inflationary. It’s not sustainable and will end in the way that all irrational periods end — in a crash.”
While government policy is playing a big role, Chinese retail investors are also contributing to the Chinese market’s surge, said Raymond Wong, senior managing director for fixed income securities at Bear Stearns (Japan). Many of them are seeing their first opportunity to buy stocks, and they are seizing it. “It’s the first time that Chinese retail people can look at alternatives to buying real estate,” he noted.
Their enthusiasm is being fueled partly by the lack of viable options. Chinese interest rates, factoring in inflation, are negative, making bank deposits unattractive. People, therefore, are pulling their money out of savings accounts and plunking it into stocks. “Last year, bank deposits [dropped] by $43 billion,” he pointed out. “You have to assume that money is going into the market…. This is a learning process for the market, and there will be a correction. But the economic fundamentals are very strong.”
Dee, for his part, noted that among China’s emerging entrepreneurial class, stock investing has become the sort of frenzied pastime that day-trading was during America’s dot-com bubble. “Your friends are doing it,” he said. “Everybody’s making money. It’s a feel-good thing.”
Those investors are chasing a relatively small pool of shares, and that, in turn, redoubles the upward pressure on prices, he argued. Chinese companies typically sell only a small portion of their shares to the public, so their so-called “free float” is relatively small. “When you look at the free float of a PetroChina, there’s only a small amount of the securities available to be owned. One of the ways you could deflate this thing is to bring these shares onto the market. The Chinese government can release more shares. They can, to some extent, bring the market down to a more realistic level.”
Loaded with Bad Loans
Another source of concern is the health of China’s banking sector. Chinese banks historically made loans based not on borrowers’ creditworthiness, but on government mandates, Dee pointed out. “When you travel around China, you will see these little village enterprises,” he said. “There will be a big farm and, sitting in the middle, is a fiber-optic plant. The number one issue for the Chinese government is social stability, which means jobs and prosperity. The local communist party guy decides that there’s not enough [demand] and that he needs to build some other kind of plant. So he goes to the bank. The local head of the Bank of China branch: Do you think he’s doing a credit check? No way. It’s a policy loan. It’s like a government handout.”
The result is that the books of China’s banks are loaded with bad loans. If the market drops sharply and the economy slows markedly, the amount of those loans could spike, Wise pointed out. “The potential for [nonperforming loans], should there be a correction, could dwarf what you saw in Japan. There, it took a decade of deflation to resolve the situation.”
Of course, Chinese lenders aren’t the only ones looking less-than-sharp-eyed lately. The United States is mired in a mortgage crisis, with numerous subprime borrowers falling behind on their mortgage payments and many filing for foreclosure. In a globalized economy, that economic trauma might soon ripple to China, too, the panelists said. “As the Ministry of Commerce in Beijing recently said, ‘If there’s a slowdown in the U.S., that will be devastating for China’s economy,’” Wise noted. “The world is still heavily dependent on the U.S. as the consumer of last resort, and the U.S. consumer is highly leveraged.”
During the U.S. mortgage boom, many borrowers took adjustable-rate loans with low teaser rates. Now many of those mortgages are coming due, and consumers are finding themselves strapped as they refinance into higher-rate loans. If these sorts of problems spread to other consumer financial sectors like credit cards, “you are going to see the consumer collapse in America,” Dee predicted. “Asia is an option on U.S. growth. If the U.S. consumer goes down, Asia is going down with him.”
A step that Chinese policymakers might take that could give the U.S. economy a boost is revaluing their currency, thus increasing the comparative appeal of U.S. exports. “Yes, their products will cost more in the foreign markets,” Dee conceded. “But Wal-Mart is going to have to eat that in their profit margin. Wal-Mart is still going to buy their stuff because there’s no one else to buy that stuff from.”
In addition, pushing the value of the currency higher would give China more buying power as it scours the world for oil and other natural resources that it lacks. “That giant sucking sound around the world is China buying natural resources,” Dee said. “They’re in every dictatorship that the U.S. won’t deal with, buying oil and doing natural resources deals.”
China’s thorniest dilemma may ultimately be a political, not economic, one, Wise noted. “The big challenge that China is going to face, when you have this tremendous growth of wealth, is polarization. You have these extremely rich people, but far more are living below the poverty line. The challenge will be the politics around wealth distribution.”
An audience member asked the panelists to handicap the economic competition between China and India, as both vie to be economic leaders. Dee said that he believed that both could succeed and pointed out that they had chosen different paths.
“India has terrible physical infrastructure,” he noted. “The roads are bad. The ports are bad. The airports are terrible. They can’t get their act together on a government level. China, on the other hand, made massive, well-targeted physical infrastructure investments. But India has better intellectual capital. It has the great legacy of a British system – democracy and a legal infrastructure. And they speak English, which helps with globalization. What you have is China making things and India thinking up [capabilities] like outsourcing, consulting and programming.”