Whither China's Stock Market Bubble?

Consulting Fellow, RIETI

(July 31, 2007)

After dropping below 1,000 in June 2005, the Shanghai Stock Exchange Composite Index began to climb, reaching a record high of 4,440 as of July 30, 2007. Given the price earning (P/E) ratios at which Chinese stocks are trading in the Shanghai market, the current level of stock prices is already in a bubble state. Indeed, as symbolized by a sharp rise in the number of stock trading accounts, now in excess of 100 million, the Chinese stock market has fallen into a state of "euphoria," as termed by John Kenneth Galbraith, author of A Short History of Financial Euphoria.

Soaring Stock Prices in China and their Future Course - Preventing a stock bubble

Factors behind surging stock prices

Factors behind the ongoing rally in Chinese stock prices include excess liquidity resulting from a growing surplus in the balance of payments and expectations for improvement in corporate governance accompanying stock market reform, along with rising corporate performance amid the booming economy and the planned cut in corporate income tax.

First, in terms of macroeconomic factors, China has been achieving accelerated economic growth in the wake of its accession to the World Trade Organization in 2001 and maintaining double-digit growth since 2003. Also, as part of the major tax reform, the standard rate of corporate income tax applicable to domestic companies will be reduced from the current 33% to 25%, effective January 2008, resulting in higher after-tax income. These factors are pushing up the share prices of Chinese companies.

Concerning liquidity factors, China has generated a huge surplus in the current account - primarily in trade balance - as well as in the capital account which is primarily comprised of direct investments. The renminbi, reflecting these factors, has become subject to upward pressure. In a bid to suppress the renminbi's rise against the U.S. dollar, the Chinese monetary authority has been actively intervening in the foreign exchange market; selling renminbi and buying U.S. dollars. As a result, the supply of renminbi has been increasing along with China's foreign reserves. Part of the excess liquidity thus generated is flowing into the stock market in pursuit of higher rates of return than from bank deposits.

Although such excess liquidity has already been cited as a cause for rising real estate prices since 2002, stock prices only began to surge roughly three years later. The time lag is attributable to an institutional deficiency of the Chinese stock market with a majority of shares held by the government; the "non-tradable share reform" launched in April 2005, at long last, paved the way for solving this problem. Before that, state-owned shares and legal person shares cross-held by state-owned companies, collectively accounted for two-thirds of outstanding shares and were not tradable on the market. Thus, only the remaining one-third remains available for trade and in circulation among general investors. Under this system, general investors holding tradable shares had no choice but to settle for the status of "minority shareholder" and were therefore unable to monitor the management appointed by the government as a controlling shareholder or to discipline this management's conduct. Consequently, despite the Chinese economy's high growth, the profitability of listed companies for a long time remained poor and stock prices stagnant.

Non-tradable share reform has created a mechanism for releasing enormous volumes of government-held shares orderly into the market. This will be a gradual release and ownership of the shares will be passed to private-sector investors. The overall ratio of private-sector shareholding will resultantly increase, eventually paving the way for the privatization of state-owned companies. Continually rising stock prices reflect the improvement in corporate governance and growing corporate earnings expected to result from this process.

Warning of a stock market bubble

However, these factors alone cannot fully explain the current high level of stock prices. The P/E ratio of shares traded in the Shanghai market is now reaching 40, far higher than around 20 in the New York and Tokyo markets, demonstrating that Shanghai shares are being overvalued relative to corporate earnings.

Some Chinese companies are listed on both the Hong Kong and mainland stock exchanges, but the prices of their "A-shares" (shares listed on a mainland stock exchange) are on average about twice those of their of "H-shares" (listed in Hong Kong). Even in the case of the Bank of China, a blue chip corporation, A-shares are priced about 35% higher than of H-shares (as of July 30, 2007). In principle, the market prices of shares should the same, if they carry the same rights, such as dividend and voting rights. However, due to government-imposed capital controls, the mainland market is separated from the Hong Kong market, resulting in the two sets of share prices reflecting different views between investors in the two markets. The fact that mainland share prices are substantially exceed those on the Hong Kong market, which is accessible to overseas investors, suggests that the mainland prices are proportionately overvalued according to overseas investment criteria.

Be prepared for the bursting of the bubble

Mainland share prices may rise further over the short term, bolstered by the inflow of capital from individual investors. However, since the current level of share prices deviates substantially from underlying economic fundamentals such as corporate earnings, it is necessary to be aware of the risk of price falls.

A sudden plunge in stock prices would hit hardest the small investors who have only recently bought overvalued shares. The result could be social instability, such as deteriorating public security and a rising suicide rate, with public anger and frustration potentially directed toward the government that failed to prevent the plunge.

Also, should stock prices plummet, the amount of funds that flows into the stock market would diminish. In such a situation, the stock market cannot perform its function - which has been restored with much effort through non-tradable share reform - as a vehicle for fund procurement and facilitating the privatization of state-owned companies.

Furthermore, as suggested by Japan's experience, a portion of bank loans would become uncollectible following the bubble's bursting and the resulting rise in bad debt ratios would cause a credit crunch. In the aftermath of the 1997 Asian economic crisis, China spent an enormous amount of public funds on disposing of nonperforming loans held by state-owned commercial banks. Now that these banks have, one after another, received major equity investments from foreign financial institutions, it will become all the more politically difficult to bail them out with public funds again.

The 8.8% drop in the Shanghai stock market on February 27 this year that sparked a sell-off in markets around the world is still fresh in memory, and there is no guarantee that such an event will not happen again. Should it be repeated, it would impair the image of China as a country pursuing a "peaceful rise."

More often than not, the presence of a bubble can be recognized only when it bursts. And as shown in repeated formations of bubbles in many countries, people do not learn from history (particularly from other countries' histories). If formation of a bubble cannot be prevented, measures should at least be prepared to cope with post-bubble problems.

July 31, 2007

July 31, 2007