The Chinese Stock Market is a Bubble

China Finance and marketThe figures and stories on China’s stock market keep getting higher and crazier. The Shanghai index is now up over 140% in the past year, while the Shenzhen Index is up 185%! Among the slightly more than 1,700 stocks on the Shenzhen Index, only a mere five have declined this year; and individual stock rallies of more than 500% “are not unusual.”

IPOs in China are so hot that recently a company seeking $2 billion attracted bids totaling $273 billion, virtually equivalent to the entire economic output of Hong Kong. Further, shares of the 144 firms that went public this year have averaged a return of 539% so far.

Valuations are looking frothy as the Shenzhen index now trades at approximately 44 times projected earnings, compared to the Nasdaq’s current 23 and the MSCI World Index of 17. The entire market capitalization of the Shenzhen index is now $4.7 trillion, surpassing the U.K.’s entire stock market value.

What’s driving the index to these nosebleed levels? It doesn’t appear to be fundamentals or an improving Chinese economy; rather, it is individual investors opening new brokerage accounts and trading on margin.

Newly opened brokerage accounts have spiked in recent months, while margin financing (borrowing money to trade) has also gone parabolic. A recent Bloomberg story recounted a 28-year old office worker in northern China who travelled 1,000 miles to set up an account in Hong Kong in order to get cheaper trade commissions and lower margin finance charges saying, “I can make more money if I can borrow more.”

Perhaps Chinese citizens have just gotten stock market fever and are getting caught up in the euphoria. Alternatively, it also appears the Chinese government actually had a direct role in creating this hysteria. Last August the state-run media started urging the Chinese public to put their savings into stocks, “espousing the wisdom and patriotism of owning equities.” The government has also reduced fees and now allows individuals to open 20 accounts instead of only one.

But that begs the next question, namely, why does the government want its citizens in the stock market so bad? According to Anne Stevenson-Yang of J Capital Research, a Beijing-based research group, there are two main reasons. First, a bull market will allow heavily indebted firms, many of them state-owned, to swap out debt for equity which they won’t have to pay back.

The second is to provide an alternative to the sagging Chinese property market. It wasn’t too long ago that Chinese savers and investors were stashing their wealth into empty apartment buildings, trying to earn a return or at least keep their principal safe as they didn’t trust the banking system. But the real estate bull market has run its course and now they are turning to the stock market as an alternative.

This is the unfortunate outcome of a country that continually tries to centrally plan economic growth and inflate its economic statistics. Instead of allowing real wealth producing activities to take place, which is messy and takes time and hard work from entrepreneurs, the Chinese government bounces from inflating one asset to the next in order to juice GDP numbers. Chinese citizens are then forced to play the same game in an attempt to preserve their wealth and earn a return on their money.

Chris Kuiper, CFA is currently a student and researcher at George Mason University pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.

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