I don’t read the Economist much. I think of it as a Time Magazine for the mid-brow transnational elite: a crystallization of conventional wisdom, and therefore a powerful contrary indicator.
But sometimes, they are right. Their latest article on China, “Flashing Red,” is an excellent layman’s summary of why investing in China is so insane.
THE scene on the trading floor of the Shanghai Stock Exchange appears to be strikingly out of character for a market that is on fire. Situated in an iconic square building at the heart of Shanghai’s costly new financial district, it has a vast trading floor filled with orderly rows of obsolete, box-like terminals. Clustered in one corner are a dozen clerks, heads resting on desks, dozing peacefully.
On a purely objective level, the lack of activity on the exchange is the result of trading becoming fully electronic. But why, then, does the trading floor exist at all? A rather more worrying interpretation of the Potemkin village set-up is that it does speak of something more than merely a shift to electronic trading. The Shanghai market itself is a kind of façade—not really a market, at least in the Western sense where prices are set by broad forces of supply and demand, but rather a place where China’s government can provide the appearance of a modern economy, complete with a signature statement of modern finance and business: an equity exchange.
The result is an odd trading venue where companies are tied to shares but the shares do not carry genuine ownership rights, such as the authority to determine management (often directly controlled by the central government) or dividends. And, perhaps most importantly, it is not a trading venue where people believe shares are as likely to go down as to go up. Currently, they believe they can only go up.
This confidence has its roots in a spate of initial public offerings of government-controlled companies, each of which was deliberately priced to leap on opening day. Wealth made from flipping offerings proved to be contagious, particularly given the lack of alternatives. With few exceptions, China bans its citizens from investing abroad. At home, the choice is between savings accounts paying less than inflation or real estate with uncertain property rights.
The flood of money into shares has pushed stock prices so high that even China’s remarkable growth cannot justify them: 65 times trailing earnings on the Shanghai exchange in October 2007, and 75 times earnings on the exchange in Shenzhen, which caters to smaller companies. The valuations are even more jarring because earnings are often inflated by corporate investment in the stockmarket, a circular logic that can just as easily come unwound. Similar distortions are also rife throughout the balance sheets of public Chinese companies as a result of recently adopted accounting rules that require assets to be revalued at prevailing prices, though the markets to set prices, for example in real-estate holdings and exotic securities, often do not exist.
In a normal stockmarket, speculators can deflate bubbles by shorting shares. That is illegal in China. In a normal stockmarket, investors can reap large rewards by having their investments bought in a heavily fought acquisition. In China, an acquisition must survive central planning (and often doesn’t). Most of all, in normal markets, share prices are based on how a substantial amount of the shares in a company trade. In China, shares in many of the benchmark companies are held by the company or the government and do not trade. Prices are determined by just a few shares being batted back and forth.
If only a few shares are determining the overall valuation, it means only a few people need change their opinions for the market to unwind. Normally, a counter-balancing force for a sudden panic comes from contrarian-minded investors who believe an objective understanding of information provides a reason to buy shares as their prices become more reasonable. Put simply, crashing prices are an opportunity, not just a problem. But finding objectivity in the Chinese market is no easy task because information disclosure is wretched. Companies, and the investment banks that coddle them, distribute information to favoured investors but not to the market at large. For its part, the Chinese government broadly abets this process, granting selective permission to favoured foreigners wanting to invest.
These insiders are comforting friends for China to have, but they are insidious forces for a genuine market. Instead, China needs disinterested outsiders—and insiders—free to do research, free to buy and free to sell. Yet the market in China has become an example of moral hazard gone wild. Historically, this is not uncommon. Markets work in nasty ways and countries frequently try to control them. Critics are faulted for misunderstanding the local “culture” or for missing the crucial fact that this time, really, is different. And then, inevitably, there is a crash.
Couldn’t have said it better myself.
The point about the government owning most companies on the Exchanges is crucial. I can’t remember how many times I read that PetroChina was a “$1 trillion company,” “double the size of ExxonMobil.” 2 percent of PetroChina shares were capitalized at $20 billion on the day of the IPO; that doesn’t mean that the other 98 percent, which is locked up in one form or another by the government, is or was ever worth 49 * 20bn = $980 billion.
But I guess that would have gotten in the way of a lot of “great” headlines.