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Taming the Roaring Chinese Stock Market

Lynic Wang wants to have a home of his own, but property in Shanghai, where Wang lives and works, is very expensive. The two-bedroom apartment he dreams of costs between 1 million and 1.2 million yuan (about $156,453). That's far from affordable for the average Chinese professional who takes home roughly 180,000 yuan (US$23,468) a year and that's if you work for a multinational corporation. Local firms pay less. Wang's solution – invest in the stock market.

Wang, a natural resources specialist, who is invested in companies like Shanghai Pudong Development Bank, entered the market in 2004, back when few imagined the Shanghai Composite Index could breach the 2,000 level. In early May 2007, the SCI crossed over the 4,000-mark. 

"Yes, I've earned some money," Wang says, but adds that he will be selling his holdings within the next two weeks. The Shanghai market is sizzling hot right now and Wang is afraid of all the new investors pouring into the market, speculating on shares. "I have seen the market go from 2,000 to 900 points, and from 900 to 4,000. It's going up too fast," he says. 

He's right about the numbers of new investors. Last month, according to the China Securities Depository and Clearing Corp., 4.8 million new A-share trading accounts were opened. That's 853,500 more than the combined total accounts for 2005 and 2006 and more than the entire population of Singapore. On May 8, the first trading session after the May Day holidays, almost 370,000 A-share accounts were added. As of May 14, there were 96.7 million A and B share trading accounts -- approximately a third of which are actively traded.

According to a Goldman Sachs research note, household financial assets – which are mostly cash and bank deposits – stand at $2.5 trillion or 88% of gross domestic product. But with an inflation rate of 3%, and after-tax returns on bank deposits of below 3%, Chinese are flocking in droves to put their money in the red-hot A-share market. In April alone, household yuan deposits fell by 167.4 billion yuan, or $21.8 billion.

"There’s massive liquidity in China," says Vincent Kwan, director and general manager of HSI Services Ltd. "Money supply in China is increasing at a rate of 16% – 17% per year and with the economy growing around 11% and inflation at 3%, the excess money supply is huge."

So, put together a country awash in cash, millions of residents with limited investment options and a limited supply of shares and it is easy to see how the Shanghai Composite Index -- and its 800-plus listed companies -- has soared. Year to date, the SCI is up 50%, and up 247% since 2006.

The roaring stock market -- like the economy -- is a concern for Chinese authorities. The central bank -- The People's Bank of China -- has raised interest rates four times in just over a year and increased bank reserve requirements eight times since last June. The most recent measures took place just this past Friday, when the central bank not only hiked interest rates and raised bank reserve ratios again, but also increased the yuan's trading band against the U.S. dollar from 0.3% to 0.5%.

Earlier this month, Beijing announced it would allow qualified domestic institutional investors (QDII) to purchase overseas stocks.  Analysts say the measures will help in the long run but are unlikely to cool off the current market.

"Chinese residents believe that there is more to be made in Shanghai, plus the appreciating yuan supports this," says Kwan. "I think this is a positive development for the Hong Kong and China markets in the long run. All along we’ve advocated that China needs to take care of its internal disparity."

"By relaxing the QDII, China is doing the right thing allowing Chinese residents to invest overseas. This is a long-term strategy in the right direction," Kwan adds.

Rob Lutts
Rob Lutts

"The QDII is the first step in the move away from restrictions, towards an open market," says Robert Lutts, president and chief investment officer of Cabot Investment Advisers. "I think this will happen in maybe three to five years or so. The Chinese government has controlled every aspect of the economy, but as the economy matures, they are going to have to let go of controls. The A and H share differentials is one good example of why the market needs to be free."

Lutts is referring to the price differentials of Chinese companies listed in both China (A shares) and Hong Kong (H shares). Dual-listed H shares trade at an average of 43% discount to A shares. According to Morgan Stanley, that's up 33% since the start of the year. 

(There are three classes of Chinese stocks: "A" shares in Chinese companies denominated in yuan listed on the Shanghai and Shenzhen exchanges and generally available only to Chinese residents; "B" shares in Chinese companies denominated in foreign currencies, generally available only to foreign investors; and "H" shares, which are for Chinese companies listed and traded on the Hong Kong Stock Exchange and available to foreign investors).

China's Retail Boom
China's Retail Boom

"I believe we're in the early phase of the China phenomenon," says Lutts. "You can't wait for the opportunity, you have to grab on today. If this lasts another seven years, the share performance will peak in about five years. The urgency is to get in today."

Lutts advises international investors to take initial positions in the H shares, because the A-share market is due for a correction.

Most analysts agree. Pullbacks of as much as 20% are quite possible at any given time in these indices, they say. In February 2007, for instance, the SCI shed 9% in a single session. However, the liquidity story and the limited supply of shares remain. Those factors will likely continue to drive the market for a while.

Lutts thinks that the A-share market will be very volatile and for some time to come. He firmly believes that this is not a market for amateurs. "The A-share markets are a closed economic system, with limited supply, and a ton of money chasing the same assets today," he said. "This is not going to stay this way forever."

And that is what more than 30 million Chinese investors including Lynic Wang are betting on – that they can ride the wave up and cash out before the downturn.