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Can a Big Bull Run Without Stumbling?

"Everyone from Hong Kong billionaire deal-maker Li Ka-shing to former US Federal Reserve Chairman Alan Greenspan and People's Bank of China Governor Zhou Xiaochuan have been warning for weeks that the results of the wild bull run in China's domestic bourses in Shanghai and Shenzhen would not be pretty.

With even ayis (babysitters / housekeepers) and college students getting into the investor fray, observers say the signs of a stock market bubble are readily apparent.

Defying financial gravity, and perhaps even commonsense, the Chinese market rally has seen the benchmark CSI 300 Index,which monitors 300 of China's biggest companies listed on the Shanghai and Shenzhen stock exchanges, nearly double this year. This has inspired millions of new investors (some say gamblers) to open up trading accounts, but this trend may have encountered its turning point. On May 30, the CSI 300 tumbled 6.8 percent. That was the most precipitous fall since a 9 percent-plus blowout on February 26, 2007, that rattled markets worldwide.

The decline was triggered by a Chinese Government decision to increase its stock-trading tax (stamp tax) to 0.3 percent starting on May 30 from 0.1 percent to cool the nation's overheated stock market. The hike in the stamp duty was announced at midnight by the Ministry of Finance via Xinhua, the State news agency. The hike in the tax, which is based on transaction turnover and is levied on both sellers and buyers, came after regulators warned of stock trading risks and ordered brokerages to help educate investors about the risks inherent to stock trading.

The unusual move underlined the government's deep concern about a 62 percent increase in a key stock index, the Shanghai composite index, in 2007 and repeated record highs experienced in May. The big gain in the index followed a 130 percent jump in 2006.

“An official with the ministry said the tax increase, which was approved by the State Council, or the Chinese cabinet, is intended to help promote the healthy development of the securities markets,” reported.

The tax increase marked the seventh adjustment in the stamp duty. The country cut it to 0.3 percent in 1991 from 0.6 percent for the first time.

According to the People's Bank of China, the country's securities stamp tax revenue totaled 12.2 billion yuan (US$1.6 billion) in the first quarter of 2007, an increase of 515.9 percent from the same period in 2006, testifying to a huge increase in stock transactions.

In April, the Shanghai Stock Exchange and the Shenzhen Stock Exchange added 4.79 million new yuan-denominated A-share trading accounts. This exceeded the number of new stock accounts opened in the past two years and brought the total number of stock trading accounts on the two bourses to 993.95 million.

China cut the stamp tax to 0.1 percent in 2005 to help boost what was then a sluggish stock market. The stamp tax is a form of taxation on certain transactions, including investments, by means of a validating stamp.

The absolute effect off the tax hike is hardly likely to dampen investor enthusiasm for markets that have been on a tear for the past two years, but the hike does signal that the government is serious about guiding the market downward, perhaps with even stronger measures if needed.

On May 18—in the biggest effort to cool the market before May 30's duty increase— China's central bank announced a slew of cooling steps: an interest rate hike, an increase in the bank reserve ratios and a widening of the yuan's trading band. But the market continued to hit record highs. The Shanghai stock market again closed at a record high. It has gained more than 55 percent since the start of 2007. The meteoric rise of Chinese stocks has fuelled concern that a severe correction, which might also affect global markets, is in the works.

"This policy change reveals the government's concern about a possible stock market bubble," said Citigroup economist Shen Minggao, quoted in an Associated Press story. Shen described the tax hike as Beijing's first formal move to cool the boom. “The market didn't know what the government was thinking until now.” 

The stamp tax increase “is an early move, so that even if the markets correct soon, they still have time to stabilize or even improve before the Party meeting [the 17th National Congress of the Communist Party of China] in the fall," Shen said.

The World Bank, in a May 30 report, raised its forecast of China's economic growth this year to 10.4 percent, up from 9.6 percent, and said China’s current account surplus could reach US$340 billion.

China's stock markets are soaring, with more than 70 billion yuan (US$9.1 billion) being transferred from savings accounts in Shanghai to stock trading accounts in the first four months of this year, the Shanghai branch of the People's Bank of China estimated.

After a five-year slump, China's US$2.6 trillion economy 2006 has reportedly been showing signs of overheating for months.

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 gains have been fueled by strong corporate profits and a flood of fresh money from millions of new investors sinking their savings into the stock market amid a scarcity of other investment options. 

There are now about 100 million Chinese stock trading accounts, with tens of thousands of new ones being opened every day. The press has reported on first-time investors mortgaging their homes or dipping into retirement savings to play the market.

As the benchmark Shanghai Composite Index broke the psychologically important barrier of 4,000 points on May 23, less than two months after surpassing the 3,000-point mark, college students, yuppies, retirees and others were reported buying individual shares or investing in China's swelling mutual funds. 

Stock investing has so gripped the public that it has caused labour disruptions. About 10 percent of the ayis in Shanghai have resigned because they make more money trading shares, the government-run Eastday Web site reported on April 24, citing a local employment agency. A Shanghai training company has set aside half an hour twice a day for employees to play the market, the Oriental Morning Post reported on May 17, without identifying the company.

The first-quarter reports from 941 of the Shanghai and Shenzhen listed A-share companies show profits of up to 100 percent if compared with a year ago. These figures are driving the fast development of the Chinese stock market and reassuring investor confidence.

In sharp contrast with investor confidence in the stock market, the Chinese central bank is being extremely cautious about the volatile market and excessive liquidity. The government is working to cool down the bubbly national real estate market have made stocks a logical place for Chinese investors to park their money.

The People’s Bank of China, the central bank, reported that household deposits in April decreased sharply by 167.4 billion yuan, compared with an increase of 60.6 billion yuan in April 2006. Meanwhile, household loans increased by 123.6 billion yuan in April, a year-on-year increase of 63 billion yuan, according to the bank. The dramatic change signals a new era for the Chinese people. In the past, they would rather put their life savings into the bank in hopes of eventually gaining interest returns.

The People’s Bank of China, the central bank on May 18 raised the benchmark one-year interest rate by 0.27 percentage points to 3.06 percent, and one-year lending rate by 0.18 percentage points to 6.57 percent. It also ordered commercial banks to set side 11.5 percent of the value of their assets as reserve, up from 11 percent. That marked the first simultaneous use of two monetary tools in a decade, the eighth increase in the reserve requirement ratio since last July and a fourth interest rate hike since last April. The government also allowed China's banks to buy stocks overseas for the first time, easing a ban that's contributed to high valuations by limiting investment options. 

Hong Kong’s Li Ka-shing, an entrepreneur and philanthropist and Asia's richest person, said that China's stock valuations “must be a bubble” and that prices were likely to decline. “As a Chinese, I'm worried about the stock market in China,” Li was quoted saying by Financial Times. Li echoed Zhou Xiaochuan in saying China's stock prices are excessive, speaking a day after Prime Minister Wen Jiabao warned of “problems” for the economy.

Government officials and financial analysts have expressed concern that some novices are making risky investments, creating a possible bubble in prices.

Addressing a meeting in Madrid via teleconference, Greenspan said the recent boom in Chinese stocks could not last, but he added that the global economy may be able to shrug off a drop in asset prices.

“It is clearly unsustainable,” he was quoted saying by Businessweek. “There's going to be a dramatic contraction at some point.”

Greenspan also said a correction could cause problems for Chinese personal wealth. Some analysts have speculated that the Chinese Government could be tempted to dip into its reserves to bail out any stung investors to avoid social unrest.

But China's individual investors, who have ignored Li and Zhou’s warnings, gave Greenspan short shrift, too. The CSI 300 fell less than half a percentage point after Greenspan warned that the gains were unsustainable and that the market may contract. 

The Chinese Government on May 24 urged skilled investors and securities brokerages to raise the level of “investor education” and advised new investors especially to consider the risks of stock speculation.

China's education watchdog expressed concern on May 27 about college students investing in stocks in hopes of cashing in on the country's booming stock market.

Wang Xuming, spokesman with the Ministry of Education, said the ministry does not encourage college undergraduates to enter the stock market. The students can hardly absorb losses as they have no fixed incomes and most of their capital comes from their parents, Wang said. The education ministry has noticed college students' enthusiasm for the stock market in recent months. 

In a related development, following the most recent session of the China–US Strategic Economic Dialogue, China has agreed to triple the quota of QFIIs (qualified foreign institutional investors) from the current US$10 billion to US$30 billion and will remove a bar on new securities firms.

China will resume licensing securities companies and allow foreign securities firms to expand their operations in China to include brokerages.

“We have found a great deal of interest in gaining QFII status and quota among our clients though QFII money tends to concentrate in the top 100 or so stocks and many QFIIs have taken a defensive positions in recent days in anticipation of a correction,” said Stephen Green, a senior economist at Standard Chartered, in a quote in the Financial Times.

The reality is that the rest of the world will have to tolerate some large trade numbers during the rest of this decade and at the same time persuade Chinese leaders to stay on a course of phased-in reform of currency policy, full interest-rate liberalization, and the lifting of capital controls. Beijing also has to shore up its social welfare programmes so ordinary Chinese can feel more secure about their retirement and health care and perhaps spend more.

“The government should actively state that there is a bubble in China and the wording should come from senior Chinese Communist Party leaders,” said Shaun Rein, managing director of the Shanghai-based China Market Research Group (CMR). “There are too many new investors coming into the market with glossy eyes expecting to make fortunes.”

Financial experts say there's a way China could create greater stability: stock index futures. Sophisticated traders in developed markets use these wagers on the direction of shares to cushion themselves against massive losses if the market falls. Futures also theoretically dampen volatility as more pricing information is factored into investment decisions. China currently has no equity derivatives such as stock options and futures, and short-selling stocks—betting that the price will go down—is banned. That means people can make money only in a bull market, and have no choice but to cut their losses when prices tumble. And if everyone rushes for the exits, shares go into a tailspin.

Chinese market regulators understand this and originally hoped to introduce index futures in spring 2007 to open the country's markets wider. Now the launch has been delayed until at least September this 2007. The reason: While futures might eventually create more stability, in the short term investors who don't fully understand the concept might get spooked and start selling their shares.

Fan Fuchun, vice-chairman of the China Securities Regulatory Commission (CSRC), made the announcement in a meeting of the annual top legislative body and to broad-based national advisory organization sessions in March.

Market watchers believe the introduction of such derivatives could provide institutions with a much-needed tool to hedge risks, but may also spur speculation and widen volatility. The China Financial Futures Exchange, the country's first financial derivatives exchange, was inaugurated on September 8, 2006.

There's a second fear. To work well, futures markets require transparency, ample safeguards against insider trading, and a sophisticated investor base, all of which are glaringly absent in China. While futures can smooth out the bumps in the market, they also let traders leverage their bets, increasing their potential profits—but also the risk of bigger losses if they get it wrong. “Futures won't achieve what the government is trying to do,” said Carl Walter, managing director at JPMorgan in Beijing. “They may even cause more volatility.”

Previous Chinese experiments with financial futures haven't been particularly auspicious. In the early 1990s, China introduced bond futures but abruptly halted trading in 1995 after a securities company, acting on bogus insider information, lost billions of dollars on futures, driving itself into bankruptcy and landing its CEO in jail. Since then, trading in most derivatives has been banned, though futures contracts for commodities such as copper, soybeans, and corn are traded on three exchanges.