China’s share markets:
A bubble for local not foreign investors
This document is intended for the general information of financial advisers only. Fidelity does not authorise distribution to retail investors.
January 2008
In January 2007, Cheng Siwei, the vice-chairman of China’s National People’s Congress, described China’s share market’s surge as a “bubble”.1 Then things really boomed.
The CSI 300 Index, which tracks the movements of the 300 most representative of the yuan-denominated stocks listed on China’s two domestic exchanges, jumped 162% in 2007. That came on top of a gain of 121% in 2006.
The boom is even more impressive in that it defied government attempts to smother it. Throughout the year, China’s government raised interest rates six times, boosted reserve requirements for lenders 10 times, launched crackdowns on speculation and eased restrictions on Chinese nationals buying Hong Kong shares, all to no avail. The forces propelling share markets were too strong.
In some ways, the jump in China’s stocks can be explained in simple supply and demand terms. China’s impressive economic growth over the past 25 years of 9% p.a.2 has created wealth that needs to be invested.
But there are few investment options for Chinese nationals. It is estimated that US$4 trillion of savings is sitting in mainland bank accounts that only offer about 2.5% p.a. in interest. Chinese nationals can only turn to property or the Shenzhen or Shanghai stock markets to earn a higher investment return.
And they sure have pursued the stocks option. Chinese nationals, for example, opened 4.79 million new Shenzhen and Shanghai trading accounts in April 2007, 853,500 more than the combined total for the previous two years, according to the China Securities Depository and Clearing Corp.3
Anecdotal reports showed how crazy the share frenzy became. People even fought for time on trading computers in share-trading rooms.4 A flood of initial public offers in recent years and converting the vast amount of non-tradable, government-owned majority share holdings in many listed companies into tradable shares barely met the hunger for stocks.
Thoughts of a boom, though, generally raise concerns about a bust later on. And the last time Chinese valuations reached extreme levels, China’s share markets stagnated for five years. In 2001, the average price-earnings ratio (P/E) on China’s two domestic share markets in stocks available for domestic investors exceeded 60 times, compared with about 45 times at the end of 2007. They fell below 20 times in 2005 during the idle days on China’s share markets.
Source: Bloomberg. A-shares benchmark is Shanghai SE A Share Price Index.
Outsiders interested in investing in China need to recognise that there are really three Chinese share markets - Shenzhen, Shanghai and Hong Kong - and the bubble is generally only regarded to be on the mainland share markets.
China’s path from socialism to capitalism since the late 1970s led to the creation of five different share classes because authorities wanted to do two things simultaneously; take advantage of free-wheeling Hong Kong’s sophisticated and deep capital markets while controlling mainlanders.
A-shares are the ones Chinese nationals buy when they invest in Chinese companies. They are shares issued by Chinese companies listed and traded on the Shanghai and Shenzhen Stock Exchanges, denominated in yuan and originally designated for domestic investors only. Since 2003, qualified foreign institutional investors have been able to purchase these securities.
B-shares were originally designated for foreign investors and are traded on the Shanghai and Shenzhen Stock Exchanges. The underlying securities are denominated in yuan but paid out in US or Hong Kong dollars.
H-shares are shares issued by mainland Chinese state-owned enterprises that are listed on the Hong Kong Stock Exchange and available only to foreign investors. These securities are denominated in Hong Kong dollars. The companies are incorporated in mainland China.
Red chips are shares in overseas-incorporated mainland Chinese companies that are listed in Hong Kong and available only to foreign investors. These companies have substantial mainland interests and are controlled by affiliates or bureaus of the Chinese government.
“P(rivate) chips are shares in Chinese companies listed in Hong Kong that have substantial mainland interests but are not controlled by affiliates or bureaus of the Chinese government. They were formerly known as “other Hong Kong-listed” shares.
Most China share funds sold in Australia use the MSCI China Index as their benchmark. On the 31 December 2007, the MSCI China Index comprised 112 stocks, none of which were A shares and only eight of which were B shares. On that day, the remaining stocks in the MSCI China Index were 58 H-share stocks, 29 red chips and 17 P share companies. The market cap breakdown of the index this day was B shares 1%, H shares 46%, P-chips 8% and red chips 45%.5
H-shares, as measured by the Hang Seng China Enterprises Index, which tracks 43 H-shares issued by Chinese companies, gained 39% in 2007. They were driven by optimism about the earnings outlook for Chinese companies plus the government’s decision to allow Chinese nationals to invest in Hong Kong stocks. The MSCI China Index in Australian dollars rose 49.2% in 2007.
More fairly valued H-shares
Given that A-shares rose four times more than H-shares in 2007, it’s no surprise that at the end of December 2007 H-shares were more reasonably valued than their mainland counterparts. H-shares were trading on a P/E of 27 in December 2007.
Source: Bloomberg, DataStream. H-shares benchmark is the Hang Seng China Enterprises Index. A-shares benchmark is Shanghai SE A Share Price Index. January 2008
And it may well be the case that A-share valuations are out of skew.
UBS Investment Research predicts the A-share market boom will fizzle out because a dramatic portfolio reallocation has largely been completed in China.6 In developed economies, overall equity holdings normally account for around 25% to 30% of liquid financial assets (including stocks, bonds and bank deposits). In emerging Asian markets, where bond markets are relatively underdeveloped, the equity share has been closer to 40%.
In China, by contrast, UBS says, the entire domestic stock market capitalisation accounted for only 7% of financial assets in mid-2005. In the investment bank’s view, the real story of the past two years has been one of savers trying to redress an enormous and long-standing underweight position by jumping into what was suddenly a viable market.
As at the end of October 2007, following strong valuation gains and a virtual flood of new paper entering the market, total A-share capitalisation reached 45% of financial assets. In other words, according to UBS, China has now reached a more mature portfolio weight by international standards.
UBS says two factors will prevent the boom persisting for too much longer. The first is authorities will take the steps needed to calm investor enthusiasm. The second is that Chinese investors can’t borrow to invest, so the prevailing asset allocation will stand.
Hong Kong has a better short-term future, in terms of more potential to rise, although UBS says the favourable news is largely priced in. Chinese domestic savings are unlikely to flood the market as initially thought. Chinese authorities are acting to slow the so-called “through train” scheme, which would have let Chinese retail money flow directly into Hong Kong shares on an individual investor basis. The scheme has been delayed indefinitely due to concerns about the overheated market.
Solid economic outlook
Most people are optimistic about the outlook for China’s US$2.7 trillion economy, which grew at an annual rate of 11.5% in the third quarter and is on course for a fifth consecutive year of double-digit growth. Investment, exports and consumption are well placed to drive the economy for years to come.
Investment in China’s roads, factories and other fixed assets has grown at an annual pace of 30% in recent years, driven to a large extent by industrialisation and urbanisation, as about 1% of the population shift from the countryside to cities each year.7 (Authorities will have to invest in infrastructure and housing to accommodate the population shift while companies will have to invest in plants and equipment to meet changed consumption and service demands.)
China’s exports are growing about 40% a year because Chinese goods keep gaining world market share because of the low cost and good quality of production in China. Consumption is set to be a big driver of China’s economy. China's high savings rate, rising incomes per capita and the rise of a middle class point to strong future consumption.
Even though Chinese authorities are trying to calm the stock market frenzy and cool economic growth to more sustainable levels, an economic crunch is unlikely because consumer price inflation is not a major concern. Even at 2007’s peak of 6.5%, it is nowhere near the highs reached in 1988 and 1994, when it rose above 25%.
Growing public concern about the rising cost of living may see authorities take other measures to contain inflation. Beijing has already imposed a freeze on a wide range of government-controlled prices such as those on oil and electricity. Wages growth is no great threat to inflation and money supply growth is moderate.
China is not without risk of course. A slowdown in the US may curb export growth and boost tensions with the US over China’s huge trade surplus to the extent that the US imposes restrictions on Chinese goods. There is the long-term political risk of how much a communist government will free the economy without releasing its grip on power. China’s rapid industrialisation has created social tension because the income disparity between rural and urban areas has widened. Questions remain about the health of China’s financial sector. Steps to limit the environmental problems arising from China’s rapid growth could curtail future growth.
But the biggest risk for investors from 2001 to 2005 was that China’s impressive economic performance was not translating into faster earnings growth and improved stock performance. The events of 2006 and 2007 have turned around these concerns. While there may be short-term volatility as valuations are reassessed, China has embarked on an industrial revolution that shows no sign of slowing. Amid this growth, many companies are emerging in China that are worthy investments. Of course there are risks so investors need to take a long-term view when investing in China.
All market and economic statistics come from Bloomberg unless otherwise stated.
1 Source: Financial Times, 30 January 2007
2 Source: IMF. World Economic Outlook. October 2007
3 Source: China Daily. Chinadaily.com. “Stock buying fever grips China”. 11 May 2007
4 Source: The Australian Financial Review. “Demand persists for mainland shares.” 11 July 2007. Page 20
5 Source: MSCI
6 Source: UBS Investment Research. Paper “It was really nice”. 7 November 2007
7 Sources: World Population Prospects, United Nations Secretariat, CLSA, June 2005
