Chinese Stock Market Continues Rise

Oxford Analytica 05.18.07, 6:00 AM ET

The Shanghai Composite Index has surged to above 4,000, closing at 4,048.29 today.

Price movements are being driven by speculative sentiment as to whether liquidity will continue entering the market, thus facilitating further capital gains. This raises serious questions about the sustainability of this year's stock market surge and the implications of a downturn.

After rising by 130% last year, the Shanghai Composite Index has risen a further 50% this year. Prices in Shanghai and Shenzhen are now trading at close to 50 times 2006 earnings, compared with 16 times in Hong Kong. Stronger than expected earnings growth reduces prices to around 35 times 2007 earnings, but this still leaves the market looking decidedly overvalued. Morgan Stanley's MSCI China index, which tracks Chinese firms listed overseas, has a forward price-to-earnings (P/E) ratio of around 16 times.

The deterioration in fundamental value has already led some institutional investors, notably the National Social Security Fund, to trim their exposure, but interest from retail investors has remained strong. Last month alone, a total of 4.79 million new share-trading accounts were opened, nearly 1 million more than the combined total for the previous two years.

The rising market can be attributed to four demand- and supply-side factors:

• Former nontradeable share categories have been abolished, but the newly converted tradeable shares are subject to lock-up periods that will remain in force this year. Accordingly, only around 40% of total shares are available for trading.
• Many large Chinese companies continue to maintain a sole listing overseas, usually in Hong Kong.
• The steady stream of high-profile initial public offerings in the domestic markets has continued.
• Liquidity continues to enter the markets.

The authorities have implemented changes aimed at cooling the markets, although the overall policy stance remains moderate. In March, for the third time in a year, the People's Bank of China raised lending rates, the one-year lending rate now standing at 6.39%. And last month, for the fourth time this year, the People's Bank announced an increase in the reserve requirement for banks, to 11%, effective May 15.

There are other policy options. A more flexible exchange rate could be adopted. However, this is a blunt instrument for the problem at hand, and would only assist in moderating the creation of new liquidity without having any effect on the existing stock.

A capital gains tax could be introduced. Rumors that such a tax was about to be introduced triggered the sharp sell-off in Shanghai on Feb. 27. The Ministry of Finance and the State Administration of Taxation quickly squashed these rumors, a response making a policy turnaround unlikely, at least in the short term.

The stock markets have become highly sensitive to events that can have an impact on the volume of liquidity coming in. With no aggressive government policy changes foreseeable in the short term, an expectation that domestic growth will remain strong and external accounts in a large surplus, the scope for further price increases remains. However, any sharp fall would have a dampening effect on investment and consumption, although this might be limited as well as uneven.