NEWS / Foreign Exchange

What is the Chinese Translation of ???Asset Bubble????

To say that the Shanghai Stock Exchange has been a bumpy ride over the past few months would be an understatement. Over the past six months there have been eleven sessions where the index has changed by over 4% in one day (five gains and six losses). Before 2007, it took 28 months to accumulate 11 days of 4%+ changes. And incidentally, since mid-2006 the market has absolutely exploded, having grown by 173.3% since June 2006 and by a staggering 91.4% in 2007 alone. Not too bad for an index that was on a steady decline from 2001 to 2005.

When any stock market gets this ???exuberant???, it is only natural that people start debating whether or not it qualifies as a stock market bubble, what the repercussions of a correction could be, and who would be impacted the most by a sudden, sharp decline in value. There are the masses of defenders of the Chinese miracle who insist that this market is justified by economic fundamentals. These analysts are willing to say things like ???the market is unique,??? and other fine quotables that are disturbingly similar to comments made about the NASDAQ prior to its spectacular collapse in 2000. The skeptics and naysayers are a small minority, but occasionally someone points out that the Shanghai market is at about 44 times last year??™s earnings. While this ratio is not as high as the run-ups witnessed in the NASDAQ in late 1999 and the Nikkei of the late 1980s, it is getting closer every week.

Our concern is not specifically about what the supposed fair value of Chinese stocks should be or how long such gains can be sustained, but what possible scenarios could unfold when, not if, the bubble bursts. We believe that a correction is inevitable not just because of the P/E ratios (which in and of itself would seem like a valid reason), but because of the rising market volatility that resembles a market driven more by speculation than by fundamentals. Looking back at the rise and fall of the NASDAQ in the span between 1994 and end-2000, the behavior is similar. In 1994, the average weekly change in the NASDAQ Composite was a mere 0.05%, with a standard deviation of 1.71. Using the standard deviation as a representation of volatility, it suggests that 1994 was not a particularly exciting year for that index. However, by the end of 1999 ??“ shortly before disaster struck ??“ the weekly average change was up to 1.25%, and the standard deviation was 3.32. The NASDAQ was very excited, very turbulent, and doomed to fall. Comparatively, the Shanghai index had a weekly average change in 2001 of 0.57% with a deviation of 2.03, and these had increased to 1.84% and 3.48, respectively, by the end of last week.

To understand the repercussions of a prolonged dive in the Shanghai index, the makeup of its investors should be understood. The Shanghai market, which is for domestic investors, is estimated to have a capitalization of about $2 trillion, with $1.2 trillion held by individual investors who are believed to account for 80% of market turnover on particularly active trading days. These people and their families, representing as much as 170 million people, are mostly members of the growing middle class that has developed over the past 15 years of profound growth. China does not have the broad exposure that the US had to the NASDAQ due to retirement plans and stock options, but the rapid increase in individual investors is similar to what the US experienced in the late 1990s. Furthermore, while exact figures are virtually impossible to collect, there is a growing body of anecdotal evidence suggesting these individuals are taking out debt through various means in order to make a few extra yuan on the domestic stock markets.

While it is nice to see the Chinese people learning about the joys of leveraging, the lessons of wealth destruction and negative net worth would be painful for these people to endure.

With all of this risk exposure and potential for significant wealth destruction, there is little doubt that the Beijing government is fully aware of the potential for social unrest if the market takes a significant dive over any extended period of time. It is understood that the government is willing to take measures to ease any prolonged decline in share prices, such as tightening the limit on one-day share price falls. However, it is not clear what steps Beijing will take to cool off the market. A wealth of possibilities exist, including a further increase in transaction fees, limits on speculative investments or perhaps even a capital gains tax. The risk that Beijing faces is trying to implement such regulations without also triggering a panic. Last week??™s increase in the share-trading stamp tax from 0.1% to 0.3% triggered a one-day fall of 8.3%, but the market recovered most of those losses over the remainder of the week as traders returned to their exuberant ways. We believe that the government will only take small steps to keep a lid on the local market while it rises. However, once the bubble bursts we expect Beijing to be behind the curve in its responses, and there will be some short-term social unrest at the very minimum.

The impact on Chinese consumption patterns could be significant, and would be in direct proportion to the amount that the market falls. Of more significance, however, will be the effect on neighboring countries with close ties to the Chinese economy ??“ particularly India. Throughout South and Southeastern Asia, local economies have provided plenty of the goods and services that feed into China??™s rapid rates of growth, and exporters have benefited substantially. If a crisis in the Shanghai markets lasted for more than a couple of days, or was even perceived as having a significant impact on China??™s outlook for the next year or two, the repercussions would be felt from India to Korea. Most every exporting economy in the region depends on Chinese consumption as a significant market for goods, and weaker demand would weigh heavily on their near-term outlooks. Furthermore, a significant bump in the road now will likely dampen the confidence of foreign investors looking to enter Southeastern Asia in general and China in particular, which would have an impact on investment inflows for this year and next.

There will always be those who try and justify a rise in asset prices with reasoning based on the economy??™s ???unique nature???, a ???new paradigm??? of development or a particular set of circumstances that sets this case off from the rest. While this may be true, we say that this ???new economy??? looks a lot like the last ???new economy??? that formed the NASDAQ bubble of 2000 ??“ and the results were neither new nor unique.