China's Bubble May Not Spell Trouble for Global Investors

No repeat of February trouble expected

Despite a recent government decision allowing investment in markets outside of the mainland, China's indexes still continue to close higher, fueling renewed speculation in some quarters that the markets are inflated and ready to pop. But Alec Young, international market strategist at Standard & Poor's, says American investors should not be too concerned.

While Young thinks the China market may be a bubble and could correct, since Americans cannot currently invest in that market, they are unlikely to be hurt by any sell-off. Furthermore, Young thinks it's unlikely there will be repeat of what happened in February (when the China plunge caused world markets to swoon). He points out the February sell-off was short-lived and then everything started going up again.

In China earlier today, in what Young termed "a conciliatory gesture" ahead of U.S. Treasury Secretary Hank Paulson's upcoming visit, the Chinese government increased the amount its currency can fluctuate, raised interest rates, and curbed bank loans yet again in an effort to tame a red hot economy and ease trade tensions with the West.

The latest to characterize the mainland's stock market valuations as a bubble is the man considered Asia's richest, who said that prices are likely to decline. "As a Chinese, I'm worried about the stock market in China," Li Ka-shing, 78, told reporters on Thursday. The chairman of two Hong Kong companies that trade in the city-state, joins China's central bank governor in saying the mainland's stock prices are excessive. On Wednesday, China's Premier Wen Jiabao warned of "problems" for the economy.

S&P Equity Research's opinion on China's "A" shares, those that are available only for investment by local investors and qualified institutional foreign investors remains underweight. Representative exchange-traded funds include: iShares MSCI Pacific ex-Japan Index Fund and iShares S&P Global Utilities (JXI NR). Mutual funds concentrated in Asian equities outside of Japan include: Fidelity Southeast Asia (FSEAX) and T-Rowe Price New Asia Fund (PRASX).

Concerned that its markets have overheated, China this week let banks buy shares overseas for the first time ever, diverting some 35 trillion yuan ($4.6 trillion) from the local stock market where trading has surged sevenfold. But the move has done nothing to dampen enthusiasm for Chinese shares.

Commercial banks can invest as much as 50% of funds in the qualified domestic institutional investors program (QDII) in overseas stock markets, the China Banking Regulatory Commission (CRBC) said. Retail investors need at least 300,000 yuan or about $40,000 to buy such financial products and capped at 50% of their total equity portfolio, the regulator said. It's been widely reported that the growing Chinese middle class have been buying stocks of Chinese companies on margin, pledging their homes as collateral for personal loans, currently valued at about $180 million in Beijing alone.

The Chinese regulator's action is not a surprise to Standard & Poor's Equity Strategy, which has been awaiting actions that will help to cool the mainland's markets. Alec Young, S&P's international equity strategist, says the move by regulators is welcome since the traditional means of slowing growth (raising interest rates and bank reserve requirements) haven't worked. "By giving Chinese citizens greater equity investment alternatives, this action may help moderate the pace of the local market's ascent, making it more sustainable," he explains.

S&P's Asia Strategist Lorraine Tan says, "Smart money may start to diversify." In a note published earlier this week, Tan wrote, "Recently, a Xian-based newspaper (Sanqin Daily) reported that a monk has opened a share trading account in China. While his intention is to make profits for charities, the news is undoubtedly a potential indicator of how bubbly things are in China's domestic stock markets. While the clarification on individual participation in the QDII scheme was indeed a positive development, we believe that the market is running ahead of fundamentals. This may continue for a while, however."

China wants more money to be invested abroad to slow the growth in the country's $1.2 trillion in currency reserves, which are flooding the domestic market with cash, according to Bloomberg. Local investors have traditionally shunned QDII because they had been limited to lower yielding fixed-income and money-market products. Alternatives for the retail investor include savings accounts yielding under 3%, for example.

Collectively, China's Shanghai and Shenzhen markets surpassed Hong Kong's capitalization in March, as investors sought higher returns than the 2.79% one-year savings rate at banks. The Shanghai A-shares market has risen more than 45% so far this year through May 16 after a 130% increase in 2006, while Shenzhen A-shares have more than doubled year to date after nearly doubling - rising 96% -- in 2006. Both the Shanghai and the Shenzhen Composite Indexes have set new records in the last week. China's CSI 300 Index has surged about 80% this year, after more than doubling in 2006. The surge has prompted officials including People's Bank of China Governor Zhou Xiaochuan to warn of a stock market bubble.

However, S&P's Young points out that although a near-term decline in China's local market is likely, he does not believe it will lead to a repeat of February's global stock market rout because China's economy is likely to remain strong through the 2008 Olympics next summer. "February's lesson was that there is a disconnect between movements in China's insulated and illiquid local stock market and the momentum of the real economy. In Young's view, "As long as China's real economy remains strong, U.S., European and Asian companies will continue to profit from Chinese growth allowing global markets to largely shrug off local profit taking in China."

Last month, Chinese regulators declared that companies raising money through the stock market must get approval from shareholders if they want to re-invest it in other companies' shares. It was an attempt to curb the amounts of money flowing into Chinese stock markets. In a recent survey of 20,000 households conducted by the Peoples Bank of China, 30.3% said they intend to invest in stocks and funds. With banks offering at best 3 percent on savings, for them the choice is an easy one - for China's Government it's a frightening trend.

Now, with the new rule, the government has granted a total of $13.4 billion in QDII quotas to 15 commercial banks. Hong Kong's stock market may be the biggest beneficiary, China International Capital's Chief Economist Ha Jiming told Bloomberg News, "Hong Kong is the most natural starting point as the QDIIs are most familiar with the Hong Kong market, especially the Chinese companies listed there,'" he said.

China is leading the world in IPO volumes and new share offerings are often doubling in value on the first day of listing, a trend that is seeing shareholder accounts burgeoning by millions each month. The CRBC's new regulations still prohibit banks from investing in hedge funds, commodity derivatives and securities rated below investment grade, the banking regulator said. Individuals will still be barred from investing directly overseas.

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