For the steady stream of new investors rushing into the stock market, will all the excitement end like the Titanic's fateful voyage? China's highest policy-making authorities are asking just this question.
The EO has learned that on April 26, the State Council and other political leaders invited six prestigious economists to discuss China's stock market. Sources say that a vice-secretary-general of the State Council attended this conference. Ha Jiming, Ba Shusong, and the four other scholars all came from major securities institutions and government research agencies.
The conference revolved around the question of whether or not the market is overvalued, whether it's already in a bubble, and whether or not a capital gains tax should be levied. One attendee tells the EO that the debate was slightly intense, with opinion being split between two camps.
Over the past few years, the State Council leaders had convened meetings with economists from various fields several times to discuss the economy's track, but this is the first time that scholars were consulted over asset pricing.
Today, the stock market's value stands at more than 70 percent of the nation's GDP.
One Issue- Is the Market Overvalued?
Of the six scholars present, four believed that the current market value was acceptable. Two believed that the market was showing serious signs of being in a bubble.
Just-released data shows that recently, the A share market's PE ratio was just 31. For a rapidly maturing market, this is still considered safe, because the financial performance of listed companies has improved.
But this was a main point of contention between the two groups. In 2006, listed companies net profit growth was 45.81 percent year-on-year. First-quarter figures from this year indicate that that number may soon exceed 70 percent.
Zhong Wei, director of Beijing Normal University's Financial Research Center, agrees with this. He believes that from a financial angle, the market's foundation is relatively stable given that profits are rapidly growing and the yuan is appreciating 5-7 percent a year. Thus, the A share market does not have to be seen as a bubble.
Scholars that support this believe that if profits are on the rise, then the market value is justified. Because listed companies are seeing ballooning profits, the PE ratio is decreasing.
In spite of this growth, bubble theorists have varying opinions. They believe that much of these profits are stemming from gains made by firms who hold overlapping shares. Profit here does not stem from improved business performance and is hard to maintain.
Take CITIC Securities as an example. China Life, Youngor, and Liangmianzhen-- all listed companies-- have shares in it. As a whole, the value of these shares makes up approximately 20 percent of CITIC Securities. When CITIC Securities stock share goes up, it makes 27 billion yuan for them. In 2006, listed companies made a total profit of 360 billion yuan. Recently, listed companies have announced that income derived from investments as a proportion of net profit reached 7 percent, up from below 3 percent in 2005. According to Cheng Weiqing, a strategy analyst for CITIC Securities, they already looking into how overlapping stock ownership is affecting listed companies' profits. He believes the stock market is valued rationally, if at the higher end of the spectrum.
Stephen Green, a senior economist for Standard Chartered Bank, says that if no policy comes out, it's possible that the Shanghai index will break 5,000 points within a month. At that point, he says, the market would be clearly overvalued.
Issue Two- The Liquidity Surplus
When a liquidity surplus co-exists with market exuberance, it will exaggerate the overvaluing.
On May 7, UBS released a report saying that the stock market's self-adjustment cannot completely eliminate overvaluing.
For economist Wang Xiaoguang, both the economy, and the market, are overheating. He has been a consistent proponent of the increasing of interest rate in order to cool off capital markets. After Labor Day, the market surged because an interest rate bump had been expected, but ultimately did not materialize.
To solve the liquidity surplus, monetary policy still does not have suitable measures. On April 18, a meeting held by the State Council used the words, "quickly address [the surplus]".
A source close to senior officials involved in monetary policy says that the Central Bank of China cannot fundamentally solve the liquidity surplus, as it can only make structural economic adjustments in order to buy time. This is because the liquidity surplus is based on a structural trade surplus.
On May 10, the Central Bank of China's first-quarter monetary policy report pointed out that while trying to advance liquidity management, monetary policy should be better coordinated with fiscal and trade policy. By focusing on policy to strengthen domestic demand before focusing on exchange rate controls, the balance of international payments can achieve equilibrium.
The report goes on to say that although structural policy is unlikely to produce visible results in the short term, it is vital that they are implemented now. One source close to senior policymakers says, the CSRC's view is that it's hard to avoid an overvaluing of the stock market, and thus, it is likely to eventually encounter a fierce readjustment. This, however, won't affect the positive long-term prospects for the market.
Third Issue: The Herd Mentality
Zhong Wei says that A share investors have taken a new shape. He notes that shareholders coming to the market these past two years are fresh sheep, and because they have no memories of big losses, they invest more radically. Furthermore, this group of investors is growing at a rate unprecedented in history.
Statistics from the China Securities Depository and Clearing Corporation Limited (CSDCCL) show that on the first trading day after the May break there was 368,000 new A share accounts-- a record. Before now, the one-day record was 311,000 on April 24.
The six experts worried that most of these investors lacked basic investing knowledge.
Of course, not everyone is crazy.
Data just released by the Shenzhen Exchange shows that by the end of March, there were 11.2 million individuals who owned Shenzhen A shares. Approximately 3.4 million shareholders have cashed out their A shares this year or have not traded in the new quarter.
As far as the debate over the bubble, professor Zhao Xiao of the Beijing University of Science and Technology's Management Institute believes that both non-bubble and bubble forces are at play. The problem lies in settling on a suitable time to use economic measures in order to readjust the market, and that now is that time. The bubble is still nascent, and if it gets too big, attempts to control it will be fruitless.
For one official from the Ministry of Finance, where the market is going, the actual size of the bubble, are both still too difficult to discern. But he is still worried that stock prices and their intrinsic value are out of touch with each other.
No Turning Back?
In just two days following the May holiday, the Shanghai Index grew 5 percent, leaving it at 4,000 points.
UBS chief Asia economist Jonathan Anderson believes that this increases the chance of policy coming out. Standard Chartered Bank's Stephen Green also believes that if the index breaks 5,000 points, the chance of a policy move will increase dramatically.
"A lot of our clients are concerned about when the Central Bank will raise interest rates and whether or not it will try to clamp down on liquidity." But Anderson maintains that these questions are misleading. To him, low interest rates and tightening measures by the Central Bank are not the basic driving forces of the market. "We should really be keeping a close watch on the CSRC," he says.
In the May 10 report, Anderson pointed out three possible policy outcomes: first, measures dealing with the supervision of market inflows from new funds; two, more aggressive anti-leveraging measures; and three, taxes on capital gains for equity investment instruments and short-term trading.
The EO has learned that many supporters of a stock market readjustment look favorably on a capital gains tax, and at the April 26 meeting the issue led to intense debate.
Is a capital gains tax a good idea? According to Mr. Green, China's institutional investors by and large oppose it, believing that it would be a deathblow to the market. He says that even in the US, the capital gains tax is hotly debated.
Xu Sitao, chief China representative for the Economist Group, believes that a capital gains tax is unacceptable. He says that fundamentally, solutions must be found to speed up the reform of capital items. But he also says that there can be buffers-- for example, floating yuan-denominated bonds in Hong Kong, opening up more QDII, and raising the reserve ratio or interest rates.
On the other side of the fence, BNU's Zhong Wei believes that capital gains are a necessity. China is becoming wealthier and wealthier, and income derived from real estate, stocks, and other investments should all be taxed.
In controlling an overheating market, what role will the Central Bank play? When Central Bank president Zhou Xiaochuan participated in the Bank for International Settlements' 10th central bankers' conference, he admitted that the bubble was making regulators anxious, and that the Bank is closely monitoring capital prices.
Xu Sitao of the Economist Group says that the world actually has no definite standard to judge overheating markets by. Today, the Federal Reserve mulls over whether or not to consider stock prices when fixing monetary policy, an issue that has been debated for decades without consensus. And after all is said and done, the Central Bank is not omnipotent.
The above-mentioned source at the Ministry of Finance says that the stock market clearly is in a bubble, but he believes that the government will not personally administer adjustments. It can only choose economic means to indirectly influence the market.
Although Mr. Green agrees that the government should persist in its role as an umpire of the market, he doesn't oppose it stepping over the line to control a bubble. He stresses that China's interest and exchange rates are not decided by the markets, that capital markets still have not been fully developed; and as a result, there is still much disconnect between the China's macro-economy and capital market prices.
Economists suggest that simply relying on the Central Bank to readjust the market is insufficient. They say that Central Bank's greatest talent is at controlling liquidity, as well as interest rates, but that even so these can't reign in the pace of China's charging markets.
Mr. Green predicts that the Central Bank will likely raise interest rates two or more times by 27 base points, but in spite of this, the market won't be influenced much.
Policymakers are gearing up for war. But exactly what kind of weapons they will ultimately use are still anyone's guess.
