Houston Community News >> China's Market Myths

3/3/2007 BEIJING and TORONTO — A few hundred small-time traders in ski jackets and baseball caps are crowded into a shabby hall in central Beijing, puffing on cigarettes and noisily kibitzing. The stock tickers and computer screens are modern, but the air is smoky, the paint is peeling, and the walls are lined with red Communist propaganda banners.

In the corner, men are playing cards and Chinese chess, while a stream of housewives and elderly pensioners, some dressed in Mao suits, casually wander in from the street. They look innocent enough – certainly, it's difficult to believe this group helped to incite a global market panic this week, one that erased hundreds of billions of dollars worth of value from the world's stock exchanges in a single day.

“It's even worse than a casino,” complained Li Daqing, one of the investors at this trading hall, who has been investing in the Chinese market since 1996. “At least a casino has some rules. The Chinese stock market has no rules. I hate this market. It's controlled by the government. It can't be a fair game if the referee is also one of the players.”

Chinese stock pickers like Mr. Li have reason to be a little surly. The Shanghai Stock Exchange, which more than doubled in value over the past year, suddenly faltered on Tuesday, losing 9 per cent of its $1.3-trillion market capitalization in a single day – and, for the first time, acting as a catalyst for a selloff on established exchanges around the world.

The Shanghai meltdown should hardly come as a surprise. Playing the stock markets has become China's favourite form of institutionalized gambling, attracting droves of novice investors looking for a way to cash in on the country's economic promise.

The problem is, the markets are still riven by corruption, lax governance practices, and deeply troubled companies. Fundamentals are largely ignored in favour of rumours and wild speculation – so much so that investors have been known to bid up the price of a company's stock when it reports bad news.

All of which begs the question: If China's markets are such a fickle bellwether of the country's fortunes, why did stock exchanges from New York to Toronto get so easily spooked, staging their own gut-wrenching nosedives? On the face of it, at least, it looks as though sophisticated North American investors failed to grasp what Mr. Li and his compatriots have known for some time: Chinese markets function more like casinos than economic indicators.

“It's a purely speculative market,” Michael Pettis, a finance professor at Peking University and a former investment banker, said of China's stock exchange.

“It's driven by speculation about the government's intentions. If you want to invest in Chinese stocks, don't waste time figuring out what companies will be profitable or what sectors of the economy will grow. Just figure out what the government wants and what the government will do.”

The Chinese stock market is barely 15 years old, and analysts say it has not been around nearly long enough to develop the safeguards that it needs. Many believe it will take several years – perhaps decades – before investors are suitably educated and companies are adequately reformed.

Liang Jing, the nom-de-plume of a Chinese economist who is a frequent commentator in the country's media, said the volatility of the past few weeks is a symptom of an irrational market dominated by speculators, hot money and corrupt officials.

“The stock market will carry on with its craziness, whether it collapses, oscillates, or both at the same time – collapsing in crazy oscillations,” he wrote, reflecting a prevailing sentiment about the company's unpredictable equities exchange.

If there is any doubt about the tenuous correlation between the exchange and the underlying economy, consider the period between 2004 and 2005. Both those years witnessed stock market declines, yet GDP growth was surging ahead at a double-digit clip. If North American stock markets weren't rising on the back of Shanghai's breath-taking run up last year, why should they sink with it now?

They shouldn't – at least not in rational terms, say most economists familiar with the Chinese markets. Yet the story of China's rise has attained quasi-mythic proportions, and not just for its burgeoning investor class. Many countries have come to see their own prosperity as inextricably intertwined with China's transformation into a global financial power, one with an insatiable appetite for resources, professional expertise, and consumer goods.

Ed Legzdins, the president and chief executive officer of BMO Investments Inc., which has a substantial mutual fund presence in China, said he wasn't entirely surprised that the problems in China caused panic in other parts of the world – not because the fear was warranted, but because foreign investors still don't have a strong grasp of how Chinese stock markets work.

He suggested that macro decisions like government policy tend to drive the markets much more than company-level decisions. Indeed, there were ill-founded rumours this week that Beijing was planning to introduce a capital gains tax, something that observers blamed for triggering the wave of selling on the country's markets.

“I don't think even institutional investors understand China's capital markets all that well,” Mr. Legzdins said.

North American investors, for instance, view the Toronto Stock Exchange or the New York Stock Exchange as an indicator of growth, and of future economic prospects. But this can be a dangerous assumption to make about China, where the markets are in their infancy, and investors are notoriously unsophisticated.

“Too many outsiders are naive and uninformed about how the markets there work and are drawing conclusions about stocks in New York or Toronto from what happens in Shanghai and Shenzen, [which] they shouldn't,” said Donald Straszheim, vice-chairman of Roth Capital Partners in California, and formerly a chief economist at Merrill Lynch.

For one thing, he said, the state-owned enterprises that dominate China's economy don't need to visit the markets to raise money. In other words, a dip in the benchmark index doesn't mean there will be mass layoffs or corporate downsizings, which would have an effect on retail spending.

Mr. Straszheim also played down fears that a negative turn in the markets could hurt Canadian commodities players who have come to view China as one of their most important customers. The stocks of many domestic resource companies, particularly in mining, were badly bruised this week by the market turmoil.

“[China] still has to have the raw materials for the goods that they produce that you and I go buy at Wal-Mart,” he said, adding that these decisions are made by managers in state-controlled companies who don't pay much heed to what the Chinese stock markets are doing.

“Equities at the moment don't bear much relation to the economy in China,” he acknowledged. “At some point I hope they will, but they don't now.”

To be fair, there are some investors who are mindful of the Asian financial crisis of 1998, and worry that sudden weakness in the Chinese market could prefigure a similar outcome.

But that fear is misplaced, given how small a role the Chinese stock market plays in the country, said economist Carl Weinberg of High Frequency Economics in Valhalla, N.Y. Of the 1.3 billion people in China, an overwhelming majority of those live on farms and rural areas and don't own shares.

“It's an enclave of people living in Shanghai and other cities who are affected by this, but that's not the real China,” he said. “There is more free-floating anxiety than factual knowledge.”

It's also important to remember that the Chinese market remains dominated by lumbering state-owned companies – not the private sector enterprises that are the real engine of economic growth, or many of the global companies that dominate exports.

Although the official market capitalization is $1.3-trillion, most of this amount is in shares that cannot legally be traded until 2008 or 2009 because of rules imposed when they were converted to A-shares, explained Arthur Kroeber, director of Dragonomics Research in Beijing.

Only about $400-billion worth of shares can be legally traded now, he said, and of this amount, only about $160-billion are held by retail or institutional investors.

This means that 60 per cent of tradable shares are controlled by state corporations, government agencies, the police, the army, or large private investors with dubious legal status.

Despite the reforms of recent years, the Chinese market is still riddled with manipulation and insider trading, and it will take at least another 10 years before it reaches any level of maturity, Mr. Kroeber predicted.

“The market prices aren't set by any transparent process,” he said. “The prices of the stocks are unrelated to their value. Nobody really knows who owns the stocks. This is basically the same old casino that it always was.”

Mr. Li recalls that only two or three years ago, economists were warning Chinese investors to stay away from the stock market because it resembled a casino. Today, nobody seems to listen.

“Now look at these old men and women, struggling to pour into the market,” he said, nodding at the people around him in the cramped trading hall. “Did they forget all those warnings? The stock market is like a lion that eats meat, and I believe that most of the newcomers and old people will become meat.”

(Contributed by Globe and Mail)