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Beijing Reforms Raise Hopes for Rally

Could this be the week China shares finally escaped a prolonged bear market?

A local investor watches the share-prices index display at a stock brokerage in Shanghai.
Liu Jin | AFP | Getty Images
A local investor watches the share-prices index display at a stock brokerage in Shanghai.

Having fallen 65 percent since its bubble-era peak in 2007, the Shanghai Composite bounced 5 per cent this week after the Chinese premier and the head of its securities regulator sought to boost confidence in equities and pledged to enact a fresh round of reforms.

“The pace of financial reform is picking up noticeably,” says Joyce Poon, analyst at research house Gavekal. “The result could be a substantial and permanent re-rating of Chinese stocks over the next six months.”

Investors have also been emboldened by speculation that Beijing will allow money and credit growth to accelerate in the coming months, giving rise to a wave of liquidity that could affect the stock market.

Caution is warranted, however.

The Shanghai Composite has been the worst performer of the 10 biggest stock markets in the past two years. Its relentless decline has defied the predictions of many analysts who had been dazzled by China’s rapid economic growth.

Indeed, the booms and busts of China equities have less to do with economic fundamentals and more with the vagaries of government policy and speculation by retail investors who chase trends with little regard for stock valuations.

This week, investors latched on to two proclamations. Speaking at the conclusion of the National Financial Work Conference on Saturday, Wen Jiabao, premier, called for more measures to boost confidence in the stock market, a sign that even the highest echelons of the party are concerned that equities have fallen to three-year lows.

Then on Monday, Guo Shuqing, new head of the China Securities Regulatory Commission, announced his intent to advance reforms in 2012. One of his plans is to improve the mechanism for initial public offerings, which has long been a source of corruption and an obstacle to private companies listing. He has also created an “investor protection bureau” to bolster confidence in a market that has been rife with manipulation and insider trading.

The latest moves by Mr Guo, former chairman of China Construction Bank, come only weeks after he said he would broaden the range of investors who are allowed to invest in Chinese stocks. Foreign fund managers, for example, are bracing for a big increase in the amount of investment quotas they are allotted by Beijing.

“With Guo Shuqing as chairman, we’re getting much more positive signs out of the regulator than we’ve had in years,” says Fraser Howie, co-author of Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise .

The prospect of strong market reforms with easier monetary policy, says Mr Howie, could “easily” cause the Shanghai Composite to rally 20 or 30 per cent in the coming months. However, the outlook for monetary policy, the process by which the People’s Bank of China controls the supply of money and credit, is far from clear.

Historically, China share prices have correlated strongly with changes in money supply, so any sign of policy loosening would be bullish for Shanghai equities. Bulls point to the fact that new lending and money supply for December rose at the fastest pace in months, exceeding analyst estimates. However, official rhetoric is that monetary policy is still “prudent”, and no one expects a large stimulus as in 2009 and 2010.

“The policy will probably stay in more of a holding pattern for the first half of this year,” says Mark Matthews, head of research for Asia at Julius Baer. “From all the sound bites I can gather, the authorities are still comfortable with the economic growth.”

Whatever happens to Chinese money supply, Mr Matthews believes Shanghai stocks may still get a boost from a counterintuitive source: the falling property market. People have virtually nowhere to invest besides bank deposits, stocks and property. Since the equity bubble burst in 2007, investors have shunned stocks and poured funds into property. But now that property prices have started to fall, Mr Matthews argues, investors may choose to switch back to equities with gusto.

There is a caveat. If, as some analysts warn, the China property market is very large bubble, the economic damage consequent upon its bursting would not leave equities unscathed.

Using standard valuation metrics, China shares are already cheap. The Shanghai Composite index is trading at a one-year forward price-to-earnings ratio of about 9.3, a whisker above its record low.

To the bulls, this means the downside for China stocks is limited, while the upside is potentially large.

However, more cautious investors note that mainland investors have never paid much heed to valuation metrics in the past, so there is little reason why the index could not fall further.

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