There’s certainly much scope for catch-up. China’s economy and stock market spent much of this decade running in different directions. While China has been emerging as a leading manufacturing power faster than anyone expected, the mainland market based in Shanghai has been stagnant, even as rivals from Moscow to Mumbai boomed. Today, while China constitutes 5 percent of the world economy, it accounts for a mere 1 percent of global equity-market investment. For cynics, the lagging stocks symbolized all that’s wrong with China’s development model: its companies, largely state-owned, showed little care for profitability and got away it, thanks to generous funding by huge, inefficient state banks. The result: low productivity growth, narrow profit margins and opaque bookkeeping. For years, many investors have been resigned to the notion that in China, the growth you see in the economy is not what you get from China stocks.
That’s still the prevailing view of the global financial commentariat, which is why many of its members have pronounced the current China bull market a bubble. That word has been put to rather liberal use since the tech bubble burst in 2000. However, it has more often than not turned out to be just a lazy way of dismissing a new fundamental shift. This could well be the case with China today.
Many investors still picture the Chinese market the way it was in 2000, when it was truly in a bubble. The average price-to-earnings ratio on the Shanghai exchange was above 50, and the rising prices of its star companies had no clear relationship to the growing economy. In fact, the only companies that even came to the market for capital were those denied it by the otherwise liberal banking system. Foreign investors dubbed most of the 1,300 listed entities “zombie companies,” given their morbid growth and financial statements that amounted to a vacant stare.
But that view is out of date. Today the Shanghai Stock Exchange is a much more accurate reflection of the real economy, following a wave of reforms. The most important development has been the listing of China’s largest banks, which had been the Achilles’ heel of the country’s development model. Policymakers are bringing in strategic foreign partners, cleaning up balance sheets and then listing the banks in the hope that market discipline will force them not to return to their old, reckless lending ways. It’s hard to say political interference will cease in a banking system ultimately controlled by the state. But at least the slate has been wiped clean and these banks can make a new start.
That is not the only critical change. The authorities embarked on a plan to reform the domestic market in May 2005, undertaking to align the interests of minority and majority shareholders. The details are complex, but the result of the reform is simple: managers of big companies now have much more incentive to focus on profit, rather than collecting assets. That’s good for stock prices.
Policymakers are also encouraging greater participation in the domestic share market by institutional players, including insurance companies. This should bring some semblance of stability to a market often driven by trigger-happy traders. Blue-chip Chinese companies, which long considered Hong Kong more prestigious, are now keen to list on the Shanghai market.
The result of these dramatic changes is that domestic confidence in equities is rising rapidly and money is flooding in. This is hardly surprising, as the ratio of China’s bank deposits to market capitalization is about 300 percent, among the highest in the world, and the low yield on deposits doesn’t even compensate for inflation. With confidence building, the fledgling mutual-fund industry is recording inflows on a scale possible only in China. In December, a new mutual-fund offering collected $5 billion on the day of its launch. Retail investors are opening 50,000 new accounts daily as they try to get a piece of the action. All of a sudden, Chinese authorities are worrying how to keep these animal spirits in control.
Of course, these spiking numbers only fuel the critics eager to dismiss China as a bubble. But Chinese equities are now trading at an average price-to-earnings ratio of around 20 (based on one-year forward earnings), way down from the highs of 2000. That’s hardly bubble territory, especially if odds are that analysts are once again underestimating the earnings growth of Chinese companies. Over the past three years, annual earnings growth has come in at more than double the level projected by research analysts at the start of each year. The sharp increase in return on equity, from 4 percent at the end of 2000 to 16 percent currently for China’s top 200 companies, reflects a major improvement in productivity, with capacity utilization and capital-efficiency levels rising significantly. This helps explain why inflation has remained remarkably well behaved in China even as growth has accelerated and input costs have risen.
That’s also the main point of the Chinese stock-market story: the systems in place are still far from perfect and there’s ample room for misallocation of capital, with 80 percent of listed companies still owned by the state. However, what’s underappreciated is that several fundamental changes have taken place, which could make the stock market better capture the economic miracle.
The situation is analogous to that of the U.S. stock market of the 1920s in many ways. During its heady growth phase in the early years of the 20th century, U.S. equities were disconnected from the economic boom. Then, following reforms that put the stock market on a foundation that was more solid (but not quite solid enough), stock prices took off in 1921, to make for a roaring decade. It all ended in tears, but not before there was one rocking party.
