Hopes that China’s stock markets have finally shed their multi-year losing streak may have been dashed again. Since February 6, just before China’s New Year holiday the Shanghai Composite Index has slumped 5.6 percent. This followed an encouraging 20% rise in the couple months since the market reached a dismal four-year-low last December.
What’s drives China’s stock market? Individual retail investors make up 80% of the driving force. Additionally, the role of policy pronouncement or downright speculation has a significant impact on the Chinese markets. However, as we said in class, the Chinese market is a bit like gambling. The retail investors are new to the market and do not look at fundamentals like institutional investors do.
Qinwei Wang, China economist at Capital Economics, believes, “the trigger for the declines appears to have been a move by the government to tighten implementation of property controls, along with hints that monetary policy is shifting towards tightening, amid concerns about rapid credit growth.”
Even with the fears of real estate clampdown (the property sector makes up one-quarter of all investment in China), some are optimistic that long-term trends will be good news for China. With an increase in China’s middle class, more personal assets may be placed into investments rather than savings accounts.
What do you think will happen to China’s stock market in the future?
The Chinese stock market is still dominated by individual retail investors. And in turn, the investment decision and sentiment of Chinese individual retail investors are mostly subject to Chinese government’s fickle public policies. The Shanghai Stock Exchange Composite Index reached its record high (around 6000) in Oct 2007 and has been stagnant at around 2000 for over 6 years. The market once traded at P/E ratio over 50s and now it is at around 10s. From that we can conclude the extreme volatility in the Chinese market.
While the mainland China investors might find the market out of flavor, foreign investors would find the market rather cheap. Recently, the new government has put up more effort to liberalize the Chinese market. The efforts I am talking about here are the RFQII and QFII, RMB Qualified Foreign Institutional Investors and Qualified Foreign Institutional Investors respectively. These two schemes are essentially allowing foreign investors to participate in the onshore market at some degree. Before, only the subsidiaries of Chinese financial institutions in Hong Kong were allowed to participate, the quotas were very small and bond was the main type of investment allowed. Recently, not only does the Chinese government qualify the local Hong Kong Banks, stock brokers, and major insurance companies to participate, but it also increases the quotas and the types of investment they are allowed to buy. QFII quota rose from $30 billion to $80 billion and RQFII quote were lifted twice since Dec 2011, now at $43 billion. Before, institutional investors can only buy up to 20% of stocks in their portfolios, the other 80% being bonds. Now, they can buy up to 100% of stocks in their portfolios. Despite of these, the impacts on the Chinese market are still expected to be insignificant considering the size of total capitalization of the market.
But I do see Chinese government is moving towards the direction of opening Chinese stock markets to more sophisticated institutional investors who do look at fundamentals and the potential growth in China. And hopefully with less fickle public policies being announced, the market will become more stable. With an average growth rate of 10% in GDP, Chinese stock markets should certainly be trading at a higher multiple, at least from the perspective of fundamentally-based investors.
The appropriate price ought to depend on (i) core profitability and (ii) payout ratios in light of (iii) interest rates. As we noted, deposit rates available to ordinary consumers are negative in real terms. That makes the promise of even a meager gain playing the stock market seem attractive. However, (i) is unclear because of poor accounting and (ii) is subject to whether stockholders matter to management. The answer to the latter is “no”, that insiders (the managers who control the company) matter and shareholders (including, for state owned enterprises, the government) don’t. Now optimists see things improving on the first two dimensions. But over what time frame? And will it match the returns on “real” assets such as a condo in Shanghai? The past 6 years say no, the low P/E says … maybe.