Fireworks Ahead

May 2007 Rosalia Tan

Over the last year, the Shanghai Composite index has taken off like a rocket. From a level of just over 1180 at the start of 2006, the index ended April 2007 at 3841, a gain of about 225 percent (after a plunge of 9 percent in February that sent shock waves through the Western markets). Clearly, there are some fundamentals underpinning this impressive rise. From a flow of funds perspective, in an economy that has been enjoying robust, double-digit growth despite a five-year bear market that ended in mid 2005, individual investors, whose average savings rate is about 40 percent, are keen to find opportunities to increase their returns. In the current low-interest-rate environment where real estate prices have been softening, the public has been flocking into the stock market in a big way (domestic debt markets, although expanding rapidly, suffer from the low number of listings on the exchanges) and there is every indication they are continuing to pour savings into equities in spite of a number of warning signs.

Historically, the Chinese stock market has been characterized by low credibility and lack of investor confidence. Many investors lost faith in the past due to the questionable integrity of state-owned enterprises and their high quantity of non-tradable shares, fraudulent disclosures, corruption scandals, and lack of adequate information. An inefficient banking system — with limited controls on business lending and credit — also added to the risks that the public had to face when investing in corporations. Conditions have improved somewhat and some regulatory progress has been made to make the market friendlier to investors. Today, China’s capital market structure has tighter regulations in place while still containing various restrictions with regard to domestic and foreign investing. China has two stock exchanges, one in Shanghai and the other in Shenzhen, with banks and insurance companies dominating the main Shanghai exchange. The shares traded on both are divided into two components, A shares and B shares. The A shares are quoted in renminbi, and only mainland Chinese investors and certain foreign investors are allowed to trade in this market. Most foreigners are restricted to the foreign-currency-quoted B-share market. However, since March of 2001, mainland investors are permitted to own these shares as well. Problems still remain, however, as some forms of deceptive practices persist, such as preferential treatment for state-owned enterprises (although many of these companies have begun to clear up their non-tradable shares and have been forming joint ventures with private enterprises in order to alleviate governmental control). Tighter oversight by the Chinese authorities has improved as well, and public corporations have started to use newly-raised capital for proper business growth and development in order to increase profits and shareholder equity. There is promise for the future, but the market is still an uneasy alliance between 21st century capitalism and a state-controlled economy.

Given the 44 percent rise in Chinese equities since January this year, monetary controls were recently established by the People’s Bank of China in order to curb the dramatic acceleration of the stock market. An interest-rate hike was introduced on March 17, and four reserve ratio hikes were also established this year to help control investments and excess liquidity, although evidence suggests these controls did not seem to factor into the prices of equities: Chinese investors still remain highly bullish, trading in and out of stocks for quick profit, despite frequent discussions on the overheated stock market and the attempts of the authorities to deflate the bubble before it bursts.

To get a sense of what a phenomenon the market has become, one need only to look at the demographics of the investing public. Retail investors make up over half of trading on the Shanghai stock exchange, and this number seems to be increasing continuously. There were 60 million brokerage accounts before the five-year slump in 2001. Today, there are well over 91 million, which represents a 50-percent increase in the number of established brokerage clients within the past six years. Although only around 5 percent (or about 65 million) of China’s individuals own equities (the ratio is 1 in 3 in the US), it appears that more and more are entering the market each day, many of whom are first time investors. According to the China Securities Regulatory Commission, 3.42 million accounts were opened in January alone and 1.27 million in February, which comes to a combined 4.7 million new, registered accounts in the first two months of 2007. At this time of writing, the total has reached about 10 million new investors for this year alone, almost double the number of account openings for all of 2006. In fact, according to The Economist, the record number of new brokerage accounts registered in one day was 310,000 on April 24. With an account opening rate reaching an average of 200,000 per day, it is perhaps not surprising to see CITIC SECURITIES, China’s leading securities dealer, increasing its net profit by 1,200 percent in its first quarter this year, and the nation’s securities dealer industry earning a total of $2.25 billion in commission income the first three months of 2007. However, with all of this investment rage, or perhaps specifically because of it, financial institutions have progressively begun to tighten their regulations on trading and the exchanges.

With an average monthly salary of $260 US, it is understandable that individuals would be eager to enhance their income by investing in the high-growth investment environment that has cut across all strata of society. Blue- and white-collar workers, housewives, and retired seniors are among those succumbing to the craze. Day trading, by all available information, is quite popular, with many using their computers at home to take advantage of the increasing liquidity in the speculative market. Although some investors are reportedly disciplined enough to conduct fundamental research on their security purchases, many enthusiasts have come to believe that profits in a stock market inevitably go up. As a result, it is evident that many retail investors have begun placing the majority — or all — of their savings into stocks, even selling their cars and homes, and borrowing on margin in order to raise capital. In short, stock investing has disrupted the daily lifestyle, living and working habits of citizens across the nation to such an extent that some larger companies impose fines on their employees if caught trading at work. Even college students have become caught up in this frenzy, gluing themselves to their laptops at classroom breaks. Allow me to illustrate with a personal observation.

I myself am Chinese, and in chatting with my aunt (who lives in China) on the telephone the other night, she informed me: “Everyday when I go to the office, all I hear about from my colleagues is how much money they have been making from trading stocks. Everyone is giving everyone else some form of advice on which companies to pick, and I don’t think this is going to stop anytime soon, at least not until next year.” Perhaps, but viewed from the perspective of an outsider, this contagious optimism is starting to look like a serious game of mahjong, with most of the participants believing they are going to come out a winner. What is clear is that the potential risks of investing are not completely understood by the mass of the population, as the present lack of transparency in the stock market does not permit individuals to make fully-educated decisions. An irrational market exuberance has become the key in continuing to push stock prices and P/E ratios sky-high, at the same time that many veteran speculators have chosen to extract their capital. As a result, the majority of today’s Chinese retail participants are probably unaware of the magnitude of their potential losses, given their asymmetrical risk and return profile. A new generation of investors is likely to suffer some hard lessons.

Wanting the party to go on will not necessarily make it so. The People’s Bank of China has already raised interest rates once this year on March 17, with the one-year benchmark deposit rate rising 27 basis points to 2.79 percent and the loan rate to 6.39 percent. The central bank had hoped that the first interest rate hike of 2007 would help curb the overheated investment and lending market and keep price stability in check. Nevertheless, it seemed that Chinese investors barely reacted to the hike, given that the Shanghai Composite rose another 84 points the following business day. The year-on-year inflation figure also accelerated to 3.3 percent in March, which means that individuals are unable to earn a real return since inflation is now 51 basis points higher than the benchmark deposit rate. Therefore, it is no surprise that investors are continuing to withdraw funds from their savings accounts and to invest heavily in equities, which they see as the only game in town. The government itself appears to be in a tight position, as it may not want to upset its own A share citizens (note that A shares are owned by domestic investors and that the A share market has substantially outperformed the B share, foreign-investor, market). A collapse in the over-extended A share market would not be cushioned by foreigners’ participation in the losses or by their ability to buy to help stem a decline.

What is apparent to sophisticated investors is that with such incredible growth in stock investing in China over the past year, the ensuing pain could be sharp and widespread when a genuine sell-off finally occurs, especially for inexperienced investors without a steady stream of income, such as students and retirees. The outcome is not in doubt. Only the timing is a matter for conjecture. Monetary tightening, such as interest rate and reserve ratio hikes, are likely to occur at least once more in the near term, but given that the Beijing Olympics are due to take place next summer, the government may wish to keep its citizens in high spirits at least until then to maintain its credibility. Furthermore, as long as the real deposit rate continues to remain in the negative-to-zero area even with a few more rate hikes on the horizon, investors may not be quick to abandon the stock market, ignoring the often-repeated lessons of participating too long in a bubble market. After all, even Chinese rockets have to return to earth.