For 2,000 years, foreigners have seen China as the golden dream. Time after time, they have learned to their regret that it is a gilded illusion; and it is happening again.
During 2006, foreign investors tripled their investments in the Chinese equity markets. Even with that, foreign capital constitutes only 10% of the Shanghai (SSE) and Chenzhen (CSE) stock exchanges market value; and they have absorbed the $12 billion with scarcely a ripple.
The minor role of foreign investors is not for a lack of interest. Half of the funds that went into emerging markets were directed to China. Likely far more would have been invested, but Chinese regulators restrict foreign participation in a futile effort to maintain an orderly market.
The Chinese equity markets began trading on 19 December 1990. During the early period, the SSE and the CSE could not have handled the potential tidal wave of hot money that could have destabilized a thin immature market.
Scarcely more than 16 years later, the Chinese markets have surpassed one trillion dollars in market value. Without any assistance from the foreigners, the Chinese have managed well in creating an unstable market that underwent a major sell off on 27 February.
No one should have been surprised by the 9% fall in one day. All of the warning signals were flashing danger. At the beginning of February, the markets fell 8.6% during the week, but few noticed.
On 13 January, Cheng Siwei, vice-chairman of the standing committee of the National People’s Congress said at an international conference in Dubai, “Only 30% of companies listed on the Shanghai Stock Exchange are good to invest in by Western standards, and investors in the remaining 70% will probably lose money.” Simply put, 70% of the companies listed came under the category of junk issues.
Whether blue chips or junk, the gamblers in the Shanghai Casino are buying and selling whatever is available. They drove up the SSE by 46% in the fourth quarter of 2006, but a quarter of trades are focused in 26 warrants. About $250 billion dollars drive the 26 warrants up and down to the delight or horror of the army of day-traders, who have appeared over night in China.
The trading craze has reached a level beyond even that of the dot com period. During December, accounts were being opened at the rate of fifty thousand per day. Market regulators require the brokerage houses to confirm the identity of each account to be sure that traders do not use multiple accounts and instruct the banks not to make loans for trading. In spite of the regulators efforts to curb the rush of new gamblers, the number of accounts continues to escalate.
There is a degree of desperation that sends people into the markets in search of profits. The sudden surge of prosperity has enabled millions of Chinese to accumulate $2 trillion in savings. The system, however, gives the savers few places to invest their capital. Ten-year bonds pay a meager 3%, while the cost of living is rising at 2.2%. The result is a near zero return on capital and little chance of achieving the riches that the new freedom offers.
Only the stock market makes possible a better return on capital for the average person, and it is this average person without any previous experience and with scant knowledge of the markets who is plunging it into chaos; and often with borrowed funds. They form a horde of inexperienced immature gamblers that react to every shift in the wind. At the time of the February sell off, rumors were circulating that a capital gains tax was going to be imposed on profits and that further restrictions would be put on trading.
Perhaps, these had some effect. What also was facing the horde was the intent of the government to dump 4.4 billion shares into the market during March.
The same government that was threatening to curb the trading activities and warning the public about the junk quality of many of the traded issues is selling off its holdings in some of the unprofitable state enterprises that are being privatized.
The market was stumbling already under the weight of several major IPO’s. Suddenly, it faced a tidal wave of new shares that it would have great difficulty absorbing. The result is predictable.
What are less predictable are the longer term consequences. Well managed corporations that trade in Shanghai as the restricted “A shares” also trade as “H shares” in the more stable Hong Kong Exchange and as ADRs in the U.S.
They too are being smeared by the same brush. It could lead to a general rejection of future Chinese issues to the detriment of the development of the economy.
In respect to the outside world, the only serious impact is to those who had the golden dream and tried to turn that dream into profits through Exchange Traded Funds (ETFs) and emerging market funds with their emphasis upon China. The losses may send them elsewhere in search of more moderate gains, but it is likely that the domestic gamblers in the Shanghai Casino will stay at the table to try again. The imposed limitation upon investment possibilities gives them few other choices.
by Felix Imonti
Photo credit: Thomas Hawk via Visualhunt / CC BY-NC
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