Bourse Blowout Shouldn't Brake China

Real concerns about overheating sparked the record sell-off. But the mainland's economy is fundamentally sound, and growth looks set to continue

by Brian Bremner

On Feb. 27 the biggest drop in Chinese stock prices in well over a decade started in Shanghai and Shenzhen, then spread like a miasma from Wall Street to Europe and other bourses in Asia. It didn't much matter that China is still on track for double-digit growth in 2007—or that the real impact of the market meltdown elsewhere was primarily psychological. It still fed into worries in the U.S. that have nothing much to do with China.

"Some people are calling this a perfect storm," says Jing Ulrich, head of China equity markets at JPMorgan (JPM) in Hong Kong. "There was a confluence of factors all happening on the same day," she said, referring to the stock market turmoil in China plus disappointing durable goods data out of the U.S.

Nor was it a huge shock, to those who follow Chinese equities, that some sort of cathartic blowout was possible. China stocks, which doubled in value last year, were absurdly priced and widely predicted to be heading for a major 15% to 20% correction. That adjustment seems to be underway (see BusinessWeek.com, 2/27/07, "A Rough Day for China Stocks").

A History of Swings

True, the 9.2% decline in the Shanghai and Shenzhen 300 Index on Feb. 27 was a shocker, but that same index fell 6.5% on Jan. 31 and has been ricocheting up and down in 3% swings all year. The market turmoil in Shanghai and Shenzhen will have little impact on China's $2.7 trillion economy or consumer spending, since most Chinese have their savings stashed in bank deposits rather than stocks.

China remains on course to grow 10% or so this year and likely will overtake Germany as world's third biggest economy in the same period. The Feb. 27 market blowout's "…economic effect on global growth is approximately zero," wrote Stephen Greene, a Shanghai-based economist with Standard Chartered, in a note to clients.

Though markets in Tokyo, Seoul, Hong Kong, and Sydney were down in the 2%-plus range on Feb. 28, in Asia—following the overnight 3.2% decline of the Dow Jones industrial average—China stocks actually recouped almost half of their earlier losses. Key indices at the Shanghai and Shenzhen stock exchanges (where so-called A-share, mainland listed stocks are traded) advanced about 4% on the day.

The Real Danger: Overheating

The Shanghai-based SMC China Fund, with $60 million invested in Chinese shares, actually saw the recent market nosedive as a buying opportunity on Feb. 28. "We didn't panic yesterday, and we are still positive on the future of the Chinese capital markets," said Teddy Cui, a stock analyst at the SMC fund. Though he admits current price-to-earnings ratios of 30 seem expensive to those unfamiliar with Chinese stocks, he says they really aren't when you consider 40% earnings growth expected for the 250 mainland companies he tracks.

The real danger to global investors isn't a stock market crash that affects a relatively small segment of Chinese society, but an economy that grows too fast and then abruptly contracts. Indeed, one of the precipitating causes of the China stock sell-off has been moves by the People's Bank of China to drain liquidity from the economy by requiring banks to park more cash with the nation's central bank.

Some analysts think an interest rate hike is likely in the first quarter, and the government may adopt new capital gains taxes for the real estate sector. "The government stance in China is toward a more tightening approach" and a spike in the mainland's inflation rate is of particular concern, according to JPMorgan's Ulrich.

Money Managers Aren't Leaving

Nor does anyone really expect overseas fund managers to suddenly pull up stakes and stop investing in China because a much-needed correction in Chinese stocks finally took place.