China Trouble?

Why does the market have to fall when I'm not in the office?

I think there is a conspiracy against my taking a vacation.

Though I'm at Disneyland with my three year old, I've been able to surf the net and find some interesting perspectives on current market activity. Here is one of the most worthwhile perspectives on the China stock market that sparked yesterdays decline.

I would like to point out that volatility in the Chinese equity markets is not unexpected. A quick review of U.S. economic history shows how volatile our economy was in its early stages with multiple booms and busts. We always remember the Great Depression but that is nothing compared to some of the early depressions this country suffered as it became an industrialized nation. China may learn from some of our mistakes but they will make their own. Tremendous growth precipitates increased volatility. The road for China's stock market will be rough with many potholes. Many investors got complacent and took their eyes off the road.

Enjoy! And have a supercalfragilisticexbealladousious day!!!

The Financial Pragmatist

Libby Mihalka

China Trouble?

From the desk of Edmund Harriss, portfolio manager of the Guinness Atkinson
China & Hong Kong Fund and Guinness Atkinson Asia Focus Fund

Chinese domestic stock markets fell heavily overnight with the Shanghai Stock
Exchange Composite Index down 8.84% and the Shenzhen Stock Exchange
Composite down 8.54%.

While these moves may seem dramatic they should be seen in the context of a rise in
Shanghai of 135.54% in 2006 and a rise of 100.39% in Shenzhen in 2006. The chart
below shows the performance of these two markets since the end of 1997. This shows
the strong run up from the end of 2005 which followed four years of falling markets
during which time annualized return for Shanghai were -9.68% a year and -14.73% for
Shenzhen.

However, if investors were looking for some indication of the direction of the Chinese
economy, never mind the global economy, the Chinese domestic stock markets are
the last place one should look, in our opinion.

The Chinese stock markets are in reality very thin in terms of market participants. In
spite of the huge numbers of brokerage accounts a small number of funds, companies
and high net worth individuals dominate the market. And they invest on the basis of
Technical Analysis (i.e. price patterns) and News Flow, not on Valuations.

The markets are also ring fenced by China’s closed capital account that means there is
no general freedom to move money in and out of the Yuan or in and out of the
country. Foreign investors are allowed into the domestic market but on highly
restrictive terms and local investors are not allowed to go outside except on highly
restrictive terms.

So local investors don’t really have a choice. Or they do, but not a very attractive one.
They can invest their money in bank deposits which will pay 2.52% for a one year
deposit; or they can buy a 2.5% guaranteed return product from an insurance
company; or they might invest in government bonds that currently yield under 2.65%
for the ten-year, if they can get them. No wonder that when they see a hot thing they
are on to it.

But this means that Chinese stock markets do not adequately reflect local economic
conditions, in our opinion and therefore should not be used to predict global ones.
High volatility and high valuations are part and parcel of inadequately functioning
stock markets. Investors had been buying as though it was a one way bet (see chart
above) and for twelve months they were not wrong. Now we have hit some
turbulence in news flow coupled with the (larger) Shanghai market passing through
3,000 points – you will note from the chart it checked briefly at 2,000 and again at
2,500 points.

What is really going on and what conclusions can we draw?

Firstly, it is clear that the government is concerned by the vertiginous rise in the equity
markets and view it as unhealthy. These markets were closed as a source of funds for
four years between 2001 and 2005, and they certainly do not want them closed for
another four after a massive crash. So they want to try and squeeze out excess and
one way to do that is to attack illegal trading and market abuse, of which there is sure
to be some.

Secondly, there is no desire to clamp down on liquidity. China is suffering an excess of
liquidity with its massive trade surplus and through leakages in the ‘closed’ capital
account whereby players look to exploit the rising Yuan and equity markets. Moves to
mop up the excess either through increasing banks’ statutory reserve requirement
now at 10%, or through the possible creation of a Government Investment Company
to sweep up liquidity and invest overseas are all designed to cope with excess, not to
implement a tightening.

Thirdly, China’s economy is looking comparatively benign or to the sceptics, certainly
no worse than it has been for the past five years. Growth is continuing at 9%, loan
growth and investment growth have moderated and the housing market has come
back in the previously overheated areas of Shanghai and Beijing. Certainly there are
no grounds for assuming an imminent downturn in Chinese demand for commodities,
capital or investment.

The consumer too is looking well. Retail sales growth just breached 14% compared to
the same period last year. And it should also be remembered that households overall
are not exposed to the stock markets (and neither is the industrial economy) in the
same way as in developed markets. Of household financial assets it is estimated that
76% are held in bank deposits, 7% in insurance products, 9% in bonds and 8% in
equities. So no consumer crisis is looming as a result of this.

In Conclusion

We believe this to be a long overdue break in China’s heady equity markets and a
useful reminder that the stock market is not a one way bet. It will act to curb a
speculative market that showed signs of running out of control.

We do not believe it should have more than a temporary effect on overall Chinese
share prices because those that trade in Hong Kong or in the US are traded on the
basis of more fundamental valuation measures. Chinese shares traded in Hong Kong,
known as H shares are trading on a forward Price Earnings multiple of 17.33 times
estimated earnings, according to Bloomberg. This compares with 28.96 times for
Shanghai and 36.99 times for Shenzhen.

We do believe that Chinese shares will continue to move ahead once the political
news flow becomes clearer after the Party Congress ends in March; and also once we
start to see bullish company earnings reports for the year ended December 2006.
And global markets?

We reiterate the point that we do not believe Chinese stock markets adequately reflect
their own country’s economic prospects. We see no sign from China that demand is
slowing.

Of far greater import for stock market prospects is the outlook for the US inflation and
growth. For that, Chinese equity markets are no guide.
Edmund Harriss
February 27 2007

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