The Bear Comes to China

pandaIn November, 2007, the stock market bear, all too familiar to international capital markets, made one of its infrequent visits to China. In Shanghai, the market ended the month the way it began–in negative territory. Opening within a hair of 6000 at the beginning of November, shares on the Shanghai Stock Exchange tumbled on the first day of trading, and the index fell by 1 percent to 5914. It was all downhill from there. By the time the dust settled on November 30, the Shanghai Index had fallen by almost 19 percent to 4872, the largest monthly decline since February 1995. In 14 of the 22 trading sessions during the month shares ended lower, and on last Friday alone, the last trading day of the month, the market declined by 2.6 percent.

Why was November such a difficult month for the China stock market? There certainly are enough potential trouble spots out there for the market to worry about. Inflation in China is now running at an annual rate of 6.5 percent, after being largely dormant for almost 10 years. Raw material prices continue to increase, and oil, the lifeblood of China’s industrial economy, keeps flirting with the US$100 per barrel price level. China’s economy is still growing at a blistering rate, but senior Chinese government officials met last week to discuss measures to cool it down and slow growth. Finally, there is growing speculation that the United States, China’s biggest customer and the largest market for its exports, may experience a recession in 2008.

While the man on the street in China may fully comprehend these broad economic issues, I’m not sure that these issues are what are actually driving the market. The fact is that China’s stock markets, whether in Shanghai or Shenzhen, are being driven by a unique set of supply and demand factors which exists in China today and which lend an added dimension to market behavior.

On the one hand, China’s explosive economic growth has created a great deal of wealth in the country and an enormous appetite for investment opportunities. On the other hand, ordinary Chinese citizens and institutions are limited in how and where they can invest their money. Investment opportunities for most Chinese citizens are limited to depositing money in Chinese banks at rates of interest which are now below the rate of inflation; investing in apartments and other real estate investments in China that are already at speculation pricing levels; and buying shares on the Shanghai or Shenzhen stock exchanges. The option to put money into banks in Hong Kong, Europe or the United States does not exist; nor is it possible to buy shares on the Hong Kong, London or New York Stock Exchanges.

That is why shares of PetroChina, which were listed on the Shanghai Stock Exchange during November, trade in Shanghai at a price which values the company at approximately $1 trillion, while the company’s shares which trade outside China are at price levels that value it at less than one-half the amount. Both valuations can’t be right. If China had a fully convertible currency, and if Chinese citizens and institutions could freely invest their money anywhere in the world, such valuation differences would quickly disappear.

The lofty valuation given PetroChina may prove to be the best thing to have happened to the China stock market. Warren Buffet’s investment acumen is well regarded everywhere, including in China, and it wasn’t lost on Chinese investors that Buffet sold his position in PetroChina at much lower valuations, and, in well publicized statements, said that shares of Chinese companies were more than fully valued. Since almost tripling on their first day of trading in Shanghai, PetroChina shares have slumped 34 percent from their high.

In addition to Warren Buffett, Alan Greenspan, the former chairman of the U.S. Federal Reserve, and Li Ka-Shing, the savvy Hong Kong tycoon, have joined the chorus of voices casting doubts on the sustainability of the Chinese stock market. The Chinese government is on record saying that it is concerned about bubbles in all assets classes, including stocks and real estate, and will take action to dampen speculation. Articles in the media have urged individual investors to use caution when investing in the stock market. And late last week, China Life, the largest life insurance company in China, said that it will trim its stock portfolio.

With international investors, the Chinese government, the media, and now the country’s largest financial institutions all saying the same thing, China’s army of individual investors may be finally getting the message. Compared to losing 20 percent in one month, interest rates on bank deposits, no matter how meager, are a bargain.

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