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  Playing the Market in the People's Republic: Chinese Investors Fear Burst of Stock Bubble

Playing the Market in the People's Republic Chinese Investors Fear Burst of Stock Bubble

By Wieland Wagner in Shanghai

Part 2: Learning the Rules of the Capitalist Game

The fact that stock prices can fall as well as rise is a truism that many of China's small investors are now learning the hard way. Many investors new to the market couldn't have cared less whether the market actually reflected the value of listed companies. This is reflected in the difference between price-earnings ratios in Hong Kong and in the rest of China: In Hong Kong they are only about half as high as on the mainland.

Despite repeated warnings, the boom continued unabated for a long time. The government vainly attempted to convince investors to let reason prevail. Others also expressed their concerns. "This must be a bubble," said Hong Kong tycoon Li Kashing. And Alan Greenspan, the legendary former head of the US Federal Reserve, even predicted a "dramatic contraction" for the Chinese market.

But China's shareholders, who felt that they had spent too long waiting for the boom, were not about to allow anyone to spoil their shopping spree. The market had slid deeper and deeper into the doldrums between 2001 and mid-2005. A lack of investor confidence was at fault for the malaise. Fearing the consequences of the famous Chinese passion for gambling -- in other words, out of concern for calm and stability -- the party had forced the stock market into a rigid system of bureaucratic rules and regulations.

For example, foreign investors in China were long barred from buying class A shares, the most popular form of stocks, but instead were only permitted to trade in so-called B shares. That rule has since changed somewhat, so that selected foreign financial institutions can now trade in the Chinese market, but their trading is subject to a fixed upper limit.

For these reasons, many large Chinese corporations preferred to raise capital on the Hong Kong Stock Exchange, where they issued so-called Class H shares, or in New York, where their shares are known as Class N shares. By comparison, the two mainland Chinese stock markets, one in Shanghai and the other in Shenzhen, deteriorated into little more than casinos for insider trading. The securities traded on these exchanges were primarily issued by state-owned companies, only a small portion of which are publicly traded. Ordinary investors were constantly petrified that corporate executives could decide one day to flood the market with vast numbers of non-tradable stocks.

Two years ago, Beijing finally addressed the long-overdue reform of China's stock markets. As a first step, many state-owned companies were prohibited from putting their non-tradable securities onto the market. As an alternative, the government convinced attractive companies like insurance company Ping An or Citic, a major bank, to also offer their shares on the stock exchange in Shanghai, in addition to Hong Kong.

The communist market overseers deliberately stoked the country's stock fever. They insisted that companies keep their issue prices extremely low -- to ensure that prices would ultimately rise even more dramatically.

Ironically, when the market practically exploded, it was because the People's Republic is still far from being a functioning market economy. For example, China ties its currency, the yuan, to the dollar, and in doing so keeps its exports artificially cheap. To defend the so-called "peg" against foreign currency speculators, Beijing must keep domestic interest rates extremely low. In fact, interest rates even go into negative figures when adjusted for inflation.

Bracing Themselves for the Crash

All this means that China is virtually swimming in money. The economy is already booming, and companies are rolling in record earnings. For companies and ordinary investors, there is only one place in which to invest all this money: the domestic stock market. Because of restrictions on the flow of capital, few Chinese have the option of investing their assets abroad.

But for China's communist planners, the stock bubble, which they themselves had energetically helped inflate, has recently become a matter of increasing concern. When the Chinese Communist Party holds its 17th congress in Beijing this fall, partly to confirm the leadership of President Hu Jintao for another five years, the last thing it wants is a market crash to spoil the festive mood.

But Beijing is less concerned about the possible negative consequences for the economy. China, the world's factory, was even booming during the recent market slump in mid-2005, and it continues to boom today. In the first quarter of this year, China's gross domestic product (GDP) rose by more than 11 percent compare to the same quarter last year.

For this reason, a stock market crash will hardly slow down growth within the Chinese economy, at least not directly. China's industry generally uses profits, not the domestic stock market, to finance necessary investments. It borrows the rest from banks.

But China's one-sided dependency on exports has its own risks, which is why Beijing plans to increase its efforts to stimulate private consumption. However, this plan could be delayed by four or five years if the market crashes and an army of small investors lose their savings, says economist Zhang Jun in Shanghai.

But the greatest concern of Beijing's leaders is over the social and political chaos a market upheaval could trigger. Using lead articles in the state-owned press, they beseeched investors last week not to embark on any panic sales. At the same time, they gave their fellow Chinese a lesson on the rules of the capitalist game. "Bull markets need consolidation, and prosperity requires rationality," wrote Zhongguo Zhengquanbao, a financial newspaper.

The communist leadership has always feared the stock market as a potential source of unrest. Party officials remember the year 1992 with a shudder. At the time, 1.2 million Chinese in Shenzhen stormed 302 retail locations where the government was handing out lottery tickets for buying stock. So many wanted to buy shares that the crush of people resulted in several deaths.

In a market economy, an independent central bank could control speculation fever using its monetary policy instruments. But this is difficult in China. And as long as the country fails to come up with a better solution to the contradictions between a planned economy and a free market, the market remains a bumpy environment for investors.

Besides, China does not allow a free press which could shine a critical eye on publicly traded companies. Insider trading cases rarely come to the fore. In late May, the Chinese central bank announced that the country needs laws as quickly as possible to increase the transparency of financial transactions.

How quickly a market panic in China can infect markets in other countries became clear in late February. At the time, a sharp drop in prices in Shanghai triggered panic selling from New York to Frankfurt am Main. This time the global markets responded in a more relaxed way. But will they continue to do so if Chinese stocks enter a free fall?

China's investors hope that they will be spared such a debacle, and they place their bets on the government planners in Beijing. "Our government manipulates the market from start to finish," says shareholder Huang in Shanghai. "Now it has to ensure that we are compensated for our losses."

Translated from the German by Christopher Sultan