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The Chinese Stock Market

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by Arthur Waldron, Ph.D
Published on May 13th, 2007

How will the Chinese stock market rally end? The answer is important not only for investors there, but for ordinary Chinese farmers who have never laid eyes on a stock certificate.

Last Wednesday, 9 May, the value of stocks traded on Chinese markets overtook, for the first time in history, the value of turnover on all other markets of Asia combined, Japan included. The Chinese stock market index, which was a bit over 1,000 a year ago broke through 4,000, and talk is that 5,000 is in sight. Price to earnings ratios are in the 50 range; this for securities lacking track records, of companies having the most dubious management and accounting, in a country where property law and bankruptcy law, not to mention securities law or for that matter law in general, is not yet in place.

True, announced growth rates for China and Chinese enterprises are high. But they were just the same six months ago, when daily trading volume was $5 billion. Now it is $50 billion. What is going on and where will it lead?

First, remember that if you have money in China, you have very few choices about how to use it. You cannot convert it into foreign money. You cannot use it to buy land, because land is all government owned. You can buy an apartment, but how firm your ownership may be is questionable: the Party can turf you out and regularly does so, with little more than the promise of a replacement miles away and yet to be built, or derisory compensation.

You cannot start your own private company, or perhaps more accurately if you do, and if you succeed, you will most likely be penalized or lose it. Many speak of the private sector in China as being perhaps 60% of the economy. This is not so. If one looks at government revenues, considerably less than 20% are from genuinely private entities. This is still a state owned economy, albeit with layers of shell state companies obscuring that fact, and neither the state nor the party want—for obvious reasons-a vigorous and competitive private sector.

So if you have money in China you have little choice but to deposit it in a state bank. Chinese save as much as 40% of their incomes, so deposits are huge. But they are very low yielding, in the order of 2%.

Much of China’s recent growth has been powered not by productivity gains or demand increases, but rather by low cost state mandated loans, that take these savings and assign them to state owned businesses that may or may not invest them wisely.

The money that ordinary Chinese make is, in other words, trapped. It cannot be used in the ways that it could be in India or Japan or Belgium.

In particular, no avenue exists for Chinese to put money to work for the long term. You cannot buy and own for sure real property. Starting your own business is risky, you cannot diversify. You cannot even give to a charity, with the confidence the money will be properly used, not to mention still at work in a century.

Planting trees is often the metaphor for the long term. I am in late middle age yet I and my wife still plant oaks and hickories and other such slow growing trees on our acre place west of Philadelphia. We will not live to see the trees mature. But someone will, perhaps our children or grandchildren, or someone else’s, and the value of the land is enhanced and the environment improved.

A Chinese cannot plant a tree on his ancestral soil—where his clan has lived for perhaps a thousand years—because the government, not the clan, owns that land. Neither we nor they paint other people’s houses, nor do we spend hundreds of dollars on trees for land that may be paved over or covered with new buildings tomorrow.

Or in economic language, long term investment doesn’t really exist in China. The axiom among the money men is three years and out.

Or to sum it up, the money made by ordinary Chinese is trapped. It can go only to state owned banks whence in turn it is loaned not to market favored investments but to those favored by government. The vast savings of the Chinese people are in effect an immense slush fund from which bureaucrats can fund what they fancy: new roads, office towers, luxury villas, immense statues . . . whatever they like for interest rate tests do not exist.

One tiny escape seems to exist from this bank deposit trap, however: the stock market. That brings us to our second point. Ordinary Chinese can set up accounts and invest, if that is the right word, in companies most of which are still state owned, with vast overhangs of state stock holdings.

But at least money is being made. The rate of inflation at about 3% is much higher now than the interest paid on bank deposits and government bonds. Other avenues of investment are closed. So the rush for exits from negative yielding assets leads right into the stock market. As long as it keeps going up, as it will as more and more people buy into it, those savvy enough to know when to sell will end up with a lot more cash than they would have had they stuck to banks.

The rich and corrupt will buy their Mercedes and villa and put the rest into the market. Others will mortgage their real estate to pull out value for speculation. The poor will dig deep and borrow.

But how far will the market go up?

The current stock market boom is not about blue chip gilt edged widows’ and orphans’ investments that can be relied upon to grow in value and dividends over the decades.

Fifty is an insane price to earnings ratio. Seventy, pretty much the historical high, is beyond belief. No tree grows to the sky. No company will have a rate of growth discounted to the present that will justify paying that much. The late Benjamin Graham thought seven was more like the P/E (price earnings) ratio one should seek.

Yet chances are that the current stock market frenzy in China will continue for some time. The reason is that it is not only psychological, it is also structural. Pressure to seek higher yielding investments is created by inflation. Yet the Chinese economy has been intentionally given a structure that prevents individuals from making their own choices, starting their own businesses, etc. instead reserving savings to be used at the discretion of the Party. The money and the desire to invest have been imprisoned—save for one tiny, unintentional pinhole: the stock market.

Now the high pressure steam is pouring out through that pinhole, creating a demand for stocks that is exaggerated because of the intentional lack of alternatives, which means that as long as there is pressure and demand, the market will rise higher and higher.

But how much is it worth? Try dividing two trillion of total market capitalization by fifty, the price to earnings ratio, which will get you average earnings per share. Then multiply that by seven, and you will have a very, very rough and crude idea of how much the underlying companies may really be worth. Remembering, of course, that the government maintains very large holdings in most companies, outside the market, which makes this calculation even more crude.

Prices have broken their tethers and floated up miles beyond any accurate valuation either of the companies being traded, or of their earnings prospects.

Which brings us to the inexorable conclusion that one of these days the Chinese markets will undergo a correction, which is to say, they will unexpectedly crash. Total capitalization is half Japan’s, but on the order of two trillion dollars.

When the market crashes, those who have long positions will be wiped out. Those who have sold will have piles of cash. We have already seen the problems associated with having piles of cash, which is that no good investment opportunities present themselves. This may explain all the money leaving China by dubious routes ostensibly in pursuit or resources, and so forth. It is a way of exiting the cash trap

But what about the losers, the people whose assets vanish? They are unlikely to be farmers or day laborers or rural migrants—though some such people will be included.

No. The losers will come from the urban middle classes, in places like Shanghai and Tianjin and Guangzhou, who have been doing rather well cooperating with the government, to the point where they identify their interests with the government. But if they are wiped out, how will they feel about that government?

Suddenly and unexpectedly they will fall back into the great mass of the Chinese who are poor, even desperately poor. They will be saddled with mortgages they cannot pay; styles of life they cannot sustain. No more Mercedes and designer wardrobes. They will feel angry—and betrayed, for they have known all along that the game in which they have staked their savings is not and never was, on the level.

And what will the government do? Markets cannot be revived by diktat. Printing money to save the indebted will ruin the winners. No good options will exist.

The great Chinese novelist Mao Dun describes in Midnight the horror and despair that sweeps over crowds in 1920s bourses as they watch their assets disappear, owing to political warfare. Those people had been loyal to the government of the day. But they switched to the insurgent Kuomintang. Likewise, after inflation had destroyed assets in the 1940s, the urban middle classes decided it was time to let the Communists have a try at running China.

The numbers are clear. Chinese stocks are grossly overvalued. But a buying frenzy is driving them higher—a frenzy that reflects the fundamental irrationality of a system that now lets people earn money but closes off almost all avenues for investing it—except a swelling stock market bubble.

We know the bubble will burst. When it does, the fundamental bargain between the repressive Chinese government and its people—you let us rule and we will make you rich—may burst too. With unfathomable, but no doubt very serious, consequences.

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