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Stock Market – The Chinese Puzzle

The stock crisis in China blew up on 27th February 2007 and was duly named ‘Black Tuesday’. Financial commentators have a convention: they are not happy unless a crisis is given a name! Indeed the developments appeared a puzzle shrouded in mystery and hence the suitability of another term “Stock market – The Chinese puzzle” to describe the crisis. The entire financial press has been awash with different and conflicting interpretations of the phenomenon and it will be useful to draw on some of those studies. The main focus should however be on narrating the developments leading to the crisis and ending with a larger question: Is stock market capitalism suited to the economic development of all countries, especially emerging economies?

Except for the uninitiated, the developments in Shanghai/Shenzhen stock markets were worrisome. By the end of 2006, it was evident that the Chinese stock markets were gripped with a financial frenzy not seen since the late 1990s. The Shanghai> exchange soared 130% in 2006. Between Christmas and New Year’s eve, shares in some leading blue chip companies jumped as much as 30%. The Shanghai> benchmark index touched a new high and the combined market capitalization of stocks traded in domestic Chinese markets broke the $1 trillion mark for the first time. Shanghai Index had an 11.5% average weekly index over a six and a half week period. From 5th to 24th February 2007, it went up 1060 points or 20.97% in 19 days.

The Chinamania had gripped those in other markets such as the U.S.and the U.K. Investors began throwing money into Chinastocks. Reports suggested how quotations for companies investing in Chinaimproved in the U.S.even when the companies were not performing in the U.S.At another level, the valuation of Chinese stocks was out of line with their prospects. Stocks of Chinese banks that had gone public less than a year earlier traded at massive premium vis-à-vis older and reputed banks like Citibank or Bank of America. China’s newcomer ICBC overtook Bank of America as the world’s second largest bank in terms of market capitalization. It was trading at a P/E of over 60.

As one analyst described, “Asking whether Chinese blue chips that are trading in Shanghai> are overvalued today is like asking whether the Pope is Catholic.” Reputed economists with leading investment banks began to issue warnings about the sustainability of Chinese values. Chinese authorities began to express concern over the behaviour of stock markets. As the Wall Street Journal (January 31, 2007) wrote how the stock frenzy in Chinastoked official concern. “As China’s stock market continues its record-breaking rally, regulators are increasingly expressing concern that the country’s growing ranks of investors are doing everything from mortgaging their homes to borrowing against their credit cards to get in on the action.” “Online trading is spreading rapidly, and in recent weeks individuals have been opening stock-trading accounts at the rate of about 90,000 per day, 35 times of a year earlier”

‘Financial Times’ (January 30,2007)carried the warning of Cheng Siwei, Vice Chairman of the National People’s Congress, on how the Chinese stock market is developing into a “bubble” and investors are in danger of behaving irrationally.

‘Los Angeles Times’ (February 16, 2007) carried a report early in February of the bull market in China. As it reported, “Millions of Chinese have entered the trading frenzy in the last year amid the strongest bull market in the nation’s capitalist history. The Shanghai> composite stock index has doubled since August after four years of dismal performance.”

Chinaprohibits banks from giving home equity loans to play in the stock market. So many people took loans from pawn shop dealers who typically front borrowers as much as 60% of the value of their homes but charge an annual interest rate of 36%. These loans were taken against their hope that they could repay them through stock market returns.

For Beijing> the collapse of the stock market would have serious political backlash. It would create social unrest among the impoverished. More importantly, Beijing> had put through stock market reforms in the hope that a well performing stock market gives its citizens and pension funds a platform to invest for the long term.

Unlike many developing countries, Chinawas not subject to conditionalities of the Fund/Bank and had the freedom to devise its own developmental strategies. It was not subject to “shock” therapies and, under Deng’s vision, it adopted a policy of gradualism and moving towards market socialism or “crossing the river by feeling the stones under the feet.”

The early years were devoted to agricultural transformation and industrial reconstruction. After reaching progress in those fronts, Chinabegan its financial reforms in the early 1990s. Early years of development and investment in infrastructure were entirely based on bank funding and channelling national savings.

Development of a capital market was secondary and was taken up in the early nineties. Initially the idea was to allow stock markets to function for smaller, non-state firms. Noting the enthusiasm of the public stock investment and the interest of SOEs to tap funds, the Shanghai> and Shenzhen stock markets were established.

In 1992 a new device was created to create a segmentation called the “B-Share Market.” It is a market where domestic companies issue stock denominated in foreign exchanges (US or Hong dollar) and investors were limited to non-residents and foreign exchange holders. In 2001 the market became open to domestic residents, but the qualification of FX holders remained. In 2004 a “second board” was established in Shenzhen for small and medium-sized enterprises that are also high-tech and fast growing.

Notwithstanding these changes, China’s stock markets remained discretionary and discriminatory between state and non-state owned entities. It was observed that from around 2001, the stock markets began to languish. By 2005, the market was said to have lost about half the value from its peak in 2001 and the market tanked below the psychologically important point of 1000. It was felt that the segmented ownership of shares was the key factor weakening the stock market.

In April 2005, the China Securities Regulatory Commission (CSRC) issued a new plan for state share reform. The reform plan was aimed at making all non-tradable state shares to become tradable on the market. In the early years two-thirds of the stocks listed were state owned shares and only one-third was freely tradable. By removing the restriction, the expectation was that SOEs would become more efficient, accountable and transparent.

Many western analysts looked upon the reforms as radical in nature. Chinaalso seems to have viewed it as a necessary complement to its program of gradual privatization of SOEs. It was hoped that the institution of qualified Foreign Institutional Investors (QFII) who were earlier allowed to invest only in tradable in B-Shares would get access to A-Shares and became critical foreign investors. It was not a coincidence that the surge in stock market rise commenced after these reforms and nearly opened up the floodgates. Add to this the native mania described earlier. Chinese, it is alleged, are compulsive gamblers and stock market provides a channel. Indiaalso witnessed small investors running after investments in chit fund companies, teak plantations and many other fly by night operators offering high returns.

As it happened, the doomsayers had their day and Shanghai stock market collapsed by 9% on 27th February 2007. Over the course of five days, the principal stock exchanges of Europe lost an average of 6.9%. The Ibex 35 was the worst hit and lost 7.5%, resulting in lost capitalization of 37 billion euros. In the U.S., the Dow Jones dropped 4.6% and the S&P 500 dropped 5.19%. These are slight compared with the losses met with in the exchanges of emerging markets. Buenos Aires> lost 12.58%; Brazildropped by 10.88% and Mexicoby 8.05 %. In Asia, Japanled the falls with Nikkei going down by 700 points at one stage. Malaysiamet with the biggest loss in six years. Singaporewas lower and Seoul> shares went lower than their level since June 2004. India’s BSE lost 400 points.

All these did suggest that there was “contagion” referring to the spread of stock market falls and the chain reaction. It reminded many of the Asian crises of June 1997. More recently, it reminded them of the Thai crisis of November 2006.

‘Financial Times’ would call it “the beating of a butterfly’s wings.” Economist would go further and add, that it was more than that and “A snort from a dragon’s nostrils.”

There are many others who dismiss the importance of Chinain the global stock markets. Prof. Jeremy Seigal of Wharton School of Management says, “But the Shanghai drop did not justify in or by itself a world sell-off of many times the entire value of the Chinese market – if we look at the drop in the values around the world.” What added piquancy to the developments was that within a couple of days the markets seemed to have turned normal!

By the same argument, some economists seem to look upon the crisis as local to China. They blame it on the phenomenon called “momentum investing” where individual investors without any background or specialization rush to the market to make a quick buck. This trend was facilitated by the radical reforms undertaken in 2005 detailed earlier. The hope is that when a new class of institutional investors with the requisite expertise take over, the market’s behaviour would be better. How long will it take to expect this transformation? There is no answer.

There is one factor, which has been described by Prof. Nouriel Roubini of Stern School of Management, New York University. He traces the asset price inflation in the stock market to the exchange rate policy; adopted by the Chinese authorities. The fixed exchange rate necessitates sterilization of foreign exchange inflows. He assesses that there is laxity in controlling inward flows and only about 70% of the flows are sterilized and the balance moves into assets. Real asset was indeed an earlier attraction and restrictive measures taken by the government to curb real estate dealings have shown some result. However, they have driven a lot of money into the stock market.

These explanations are indeed correct – but only partially. They fail to take into account the larger role of foreign investors in China’s stock market as a result of the reforms undertaken in 2005. These reforms changed the character of the market and brought about a new surge in investments. Local investors joined the fray and hoped to reap high returns.

Further, it fails to factor in the changes in stock flows and the operations of global investors who have access to huge amounts through hedge funds, private capital and, especially carry trade. Every major company is dealing with international markets. With the decline in the earnings in OECD countries, the markets in emerging economies have become more attractive. Pension funds, mutual funds, etc were looking for better returns in these markets.

Even by the middle of 2006, the market turned uneasy over investment in emerging markets. The tremors in May 2006 were clearly indicative. As one investment analyst explained, “These markets are smaller and the weight of foreign money in them is greater.”

The relative weight of foreign investment in local stock markets would have its own toll. The market was wired with those in advanced countries. There are more or less the same players in the world market. They are instantaneously connected through communications. They talk to each other about the market sentiment and this produces “group think.” “Emotions, fear, greed, optimism, pessimism are travelling at the speed of light throughout the markets.”

So when Shanghai plunges by 9% on a fateful day, the markets elsewhere follow suit – though in differing degrees.

The crisis in Shanghai had its own causes. It may seem to be a coincidence that it got linked to the developments in the U.S.such as decline in durable demand, warning by Alan Greenspan about the “possibility of recession”, the collapse or the souring of housing loans, etc.

Many of these explanations were given to assuage the markets in the west and to avert a major crisis. Opinion is divided in the developed countries: there are those who are highly optimistic about the current state of the financial markets; there are others who are pessimistic and feel that the market could unwind any time.

For developing countries like Chinaor India, the prospects seem dim, especially if there is over dependence on stock markets to raise capital. Developments in the west could exacerbate the global imbalances by reversing the flows, driving Asian surpluses away from dollar assets, upsetting balance sheets, pricking housing bubble, lowering U.S.consumption levels and slowing growth and hurting Asian exports. To many these concerns may seem irrational, but the worm has entered the apple.

The moral of the story is that the Anglo-Saxon model of stock market capitalism is not applicable to all countries. Even within the OECD, it has not developed deep in countries other than the U.S.and the U.K.The model cannot be replicated in other countries and efforts to foist them on emerging economies have ended in failures. The stock markets do not develop unless other financial institutions such as banks, investment banks, mutual funds, etc support them. Sadly, the freedom, which the developing countries had in earlier years – that is prior to global financial integration – to regulate and promote these markets has been lost. Any attempt to regulate them or tax them results in massive outflows threatening the economies. Many reports suggested that Chinawas planning to tax capital gains and this move was the instant trigger and led to steep decline. In Indiaalso we have had similar experience.

(The writer, Mr. K.Subramanian, is former Joint Secretary, Ministry of Finance, Government of India. The article is based on his keynote address on the subject at the Chennai Centre for China Studies- University of Madras joint “China Colloquium”, held at Chennai>, India, on March 14,2007)

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