No Stopping Chinese Stocks

The CSI 300 index blasted through 5000 on Aug. 22 in spite of an interest-rate hike and market swoons elsewhere

by Frederik Balfour

Seems like nothing can cool Chinese investors' ardor for local stocks. Despite market meltdowns in the rest of the world and moves by Beijing to dampen demand for equities, China's stock markets are at a record high. On Aug. 22, China's benchmark CSI 300 stock index blasted through the all-important 5000 level, shrugging off an interest-rate hike by the central government announced the previous day, to close up 78.98 points, to 5051.69. The index, which tracks the 300 most important companies listed in Shanghai and Shenzhen, has jumped 147% this year.

While most of the world's financial markets are grappling with a short-term liquidity crisis, swooning stock markets, and fears that more bad news about the mortgage business is lurking on the horizon, China has the opposite problem: There is simply too much money sluicing through the economy, helping push the stock market to new highs day after day and adding to inflationary pressure. Inflation in July jumped to 5.6% year over year, its highest rate in over a decade.

The central bank is trying to fight back. The People's Bank of China on Aug. 21 hiked lending rates by 18 basis points, to 7.02%, its fourth increase this year. Deposit rates, which, like lending rates, are regulated by the central bank, increased by 27 basis points, bringing the yield to savers on one-year time deposits to 3.6%, up from 3.33%.

Opening the Door to Hong Kong Investing

The move by the People's Bank came one day after another step by the government to deflate China's stock bubble. On Aug. 20, the State Administration for Foreign Exchange unveiled a landmark decision to allow Chinese citizens to invest directly in Hong Kong stocks. The move is widely regarded as an attempt to siphon off some of the liquidity that has been driving equities on the Shanghai and Shenzhen exchanges steadily higher.

The decision to allow the Chinese to invest in Hong Kong represents an important step toward full liberalization of China's capital markets. Previously, individuals were restricted to purchasing $50,000 per year in foreign exchange. That ceiling will be lifted entirely provided the forex is placed into a securities account. Initially at least, all Hong Kong equity-related foreign exchange purchases will be conducted at the Tianjin Branch of the Bank of China. Tianjin has been earmarked by Beijing as China's second financial center after Shanghai.

However, the expected capital outflow is unlikely to be enough to ease the pressure on China's exchange rate. With the country expected to record a trade surplus of $300 billion or more this year, China's foreign reserves, which now stand at $1.33 billion, will continue growing. "It's one small step in a long road," says Stephen Green, chief China economist at ~~ in Shanghai.

Stocks Defy Rationality

Though both measures should have caused some weakness in Chinese markets—higher deposit rates make leaving money in the bank relatively more attractive, and giving investors an alternative to local investments ought to create some selling pressure—the stock market continues to climb.

That's puzzled some analysts. Jun Ma, China economist at Deutsche Bank in Hong Kong, says he has been surprised by the market's resilience. "It was supposed to come off," says Ma. "There's nothing concrete to convince me that this reaction is rational."

Of course, rationality is not the first word that comes to mind when describing China's emerging investor class, which is growing at an average rate of 200,000 new retail accounts per day.

Hong Kong's Hang Seng On a Roll

The reaction in Hong Kong was euphoric. The benchmark Hang Seng index climbed nearly 6% on Aug. 20 on the news, 0.62% the next day, and another 2.78% on Aug. 22. By some estimates, as much as $100 billion in additional money could flow into Hong Kong-listed stocks by Chinese retail investors in the next 12 months. "Given the appetite seen onshore for share investments and the name recognition [of mainland stocks] in Hong Kong, this is going to be significant," says Green.

Much of this money is expected to pour into mainland companies and their foreign subsidiaries listed in Hong Kong, which trade at a substantial discount to their mainland counterparts. According to JPMorgan Chase (JPM), of the 43 companies whose shares trade both in Hong Kong and on China's A-share markets (open only to mainland Chinese and certain foreign institutional investors), the average weighted A-share premium on Aug. 20 was 87%.

The premium on some companies is far higher. A shares for Datang International Power Generation, for example, trades at a premium of about 360% while Aluminum Corp. of China (ACH) trades at a 180% premium, even after climbing 26% for the three days ended Aug.22.

Short-Selling is Banned, For Now

Adrian Mowat, JPMorgan's chief Asian and emerging markets equity strategist, says this huge discount on Hong Kong-listed mainland companies now represents an excellent buying opportunity for investors to accumulate Hong Kong-listed shares of mainland companies. What message is Mowat conveying to clients in the U.S.? "I am telling them to buy, and buy aggressively," he says.

Chinese investors will remain at a disadvantage to their foreign counterparts however, as they will not be allowed to sell equities short in Hong Kong. Short-selling, when investors sell shares they don't own in the hopes of buying them later at a lower price, is also banned on mainland markets, though the Shanghai stock exchange plans to introduce index futures trading later this year.

Balfour covers China's financial markets for BusinessWeek from Hong Kong and Shanghai