Chinese stocks and the risk of economic crisis

In the last year and a half, the value of the Shanghai stock exchange increased by 235%; the Shenzhen market went up by 289% in the same period. The stock market frenzy has spread all along China's coast, the country's most industrialized areas. It is not unusual for university students to gamble on stocks the money they have to cover room and board expenses as well as school fees. Office workers buy and sell shares all day on the stock exchange, and start their salaried work once markets close. Even pensioners are investing in stocks. Some even mortgage their apartment to buy shares. Speculators come from all ages groups and professions, from doctors to doorkeepers; everyone is buying and selling shares. The passion of the Chinese for gambling and their veneration of luck are certainly nothing new, but the novelty today is that companies which quickly grew thanks to the economic development of recent years are neglecting their core business to dedicate themselves to financial speculation.

There is certainly good reason for all the frenzy. In 2006, the economy grew in China by 10.7%; during the first quarter of 2007, GDP (gross domestic product) increased, in annual terms, by 11.1% and this is the fourth consecutive year of growth at a rate close to or exceeding 10%. It is also true, however, that a kernel of truth is the basis for many forms of exaggeration. Stock market growth is by now overly inflated with respect to the real economy, even though the latter has also expanded greatly: this can be deduced by a parameter of evaluation which is quite significant: the ratio between the average stock prices and the average earnings of listed companies. This ratio at the Shenzhen exchange is 60; Shanghai's is slightly lower. To make a comparison, the Dow Jones ratio is about 17. In other terms, for companies listed on the Shenzhen index, supposing that current earning remain unchanged, today's stock prices are equal to what would be the sum of earnings for the next 60 years, and, frankly, this hardly appears to be reasonable. A higher than normal ratio is not always a symptom of overvaluation: economists speak in these cases of expected growth. For example a multiple of 60 could correspond to a prediction that earnings will be 10 times the current levels for the next six years. This too, however, doesn't seem very reasonable. In theory, if stock market trends are sufficiently representative, they should reflect the country's general economic trends. It would hardly be intuitive to think that China's economy can increase ten-fold every year for the next six. Alternatively, we can suppose that the Chinese economy will maintain its current growth rates. If we wanted to consider as realistic the stock market's current capitalization, that is the overall value of all the companies listed according to their listing price, we would have to presuppose that China's national wealth will continue to intensively concentrate around just a few companies and into just a few hands. However, this hypothesis too is rather improbable because, even with growth rates the rest of the world can only dream of, the level of serious social conflict, which amounts to some 300 cases per day, would increase exponentially and quite uncontrollably, even if increased measures of repression, for example, were implemented.

Even supposing a continuing and overwhelming concentration of financial wealth, it would not be easily to fulfil the aforementioned presupposition, i.e. the continuation of current rates of economic growth. In China's case, its population accounts for 22% of the world's, while its GDP is still a relatively small part of the worldwide total, about half of this portion, when calculated at current exchange rates. Maintaining economic growth at a rate similar to current levels, let's say 10%, would mean doubling, in about 7/8 years, the overall value of China's economy. This could seem reasonable or at least possible. All in all, such a level of growth would mean that pro-capite income in China would, in 7/8 years, be close to the current worldwide average.

On the other hand, from year 1 of the Christian era until about 1820, Chinese GDP varied between about 26 and 36% of the world's total. From the first half of the 1800s -- from the introduction of opium by the English -- this proportion decreased until it reached minimum levels during the Mao years (in the early years of the 1970s it accounted for 7% of the worldwide total). According to the World Bank, Chinese GDP was 14.37% of the world total in 2005. This was, without a doubt, a spectacular increase, which, furthermore, occurred over a time frame that can be considered negligible in historical terms, but it could seem at first glace that there still exists room for the doubling of the current value of the Chinese economy over a 7/8 year period. If in 1820, pro capite income in China was 36% of the world's, why could it not situate itself at a level of 20 or 30% of the world's in 2015? The point is that the aforementioned 14.37% is calculated in terms of equalized purchasing power, the only method that allows for more or less reasonable comparisons between countries of the world and very different situations (1). If instead, a comparison is made on the basis of market exchange rates (2), World Bank data shows that Chinese GDP in 2005 was roughly just 5.5% of the world total. The disproportion between these two figures, 14.37% and 5.5% of worldwide GDP, both referring to the same year, is more than evident and is entirely due to the disproportionate undervaluation of China's currency, the yuan, and Chinese authorities themselves are well aware of this. It is evident in fact that a good part of real economic growth over recent years is the result of a deliberate financial device, the undervaluation of the yuan (RMB).

The Chinese economic growth over some 30 years, from 7% to 14.37% in real terms, was powered by below-cost exports and therefore came, in a certain sense, at a cost to the rest of the world. A development model such as this will not likely resist much longer. It is, in fact, perhaps not well known that Chinese GDP is already worth, in real terms, i.e. taking into consideration purchasing power, 8,814 billion dollars and is second in the world only to the United States', which is worth 12,416 billion dollars (2005 World Bank figures). If the current differential of economic growth were to last, it is easy to predict that China's GDP would end up overtaking the US' in a few years. If up until now, for a series of political calculations and specific economic interests, Chinese administrators have had a free hand in their multiannual manipulation of the exchange rate and exports, it would not seem reasonable to suppose that they will continue to find open doors to maintain a development model that comes at a cost to the rest of the world and that is unbalanced from within.

Ever since the People's Bank of China allowed for a bit fluctuation in exchange rates in July 2005 , the value of China's currency increased by just more than 5% and, in the first quarter of this year, it increased by 0.96%. However, to avoid expectations of an excessive revaluation of the exchange rate, the Ministry of Labour and Social Security quickly went into action. According to a note published last May 10 (3), a further increase of 5 - 10% in the exchange rate would translate into the loss of some 3.5 million jobs, while the income, already very low, of about 10 million farmers would be compromised. According to official statistics, there are about 70 million workers in export-producing industrial and manufacturing sectors, while 100 million people are employed in export-oriented agriculture. To be noted, furthermore, is the fact that while unemployment in urban and coastal areas is around 4%, China's overall unemployment rate is actually 10 - 14%, taking into account rural under-employment. If monetary authorities allowed for a revaluation of the exchange rate to align it with domestic purchasing power, the already high level of social conflict would explode; for the moment, tensions are still at a low intensity level and are controllable. And even if Chinese administrators wanted to collaborate with Western authorities, they cannot afford a decrease in exports as that would jeopardize internal political balances, and, in the final analysis, their own power.

This is the root of the financial tangle. With the yuan artificially low in value, China continues to accumulate a record surplus of foreign exchange reserves generated by exports. In 2006, China's commercial surplus reached the record level of 177.5 billion dollars, with an increase of 74% over the previous year. This is why the People's Bank of China holds more than 1,200 billion dollars in exchange reserves, more than any other central bank in the world except for the United States which has no need to maintain such levels. The American Federal Reserve, in fact, can print money at will, generating, ipso facto, currency which, from the Bretton Woods agreement of 1944 and then from the abandonment of the gold standard (August 15, 1971), can be counted as reserves.

China's financial bubble originates in fact from this mass of dollar liquidity generated by the export surplus. The dollars generated by exports, converted into yuan in view of a revaluation of the currency, do not belong to the internal rural areas of China and therefore do not reach those areas that most need them, whether it be in terms of investments in important infrastructure, or in the form of greater consumption, to improve on what is a purely subsistence level of living. This money supply instead goes to nourish on-demand cash accounts, which earn little interest in Chinese banks: overall, such deposits add up to about 4,000 billion dollars. The small savings account owners in China's industrialized areas know from experience that local banks are not exactly paragons of reliability. In fact the Chinese banking system has been, yes, recapitalized various times over past years but has not been thoroughly restructured because the power to discretionally dispense bank credit is one of the main instruments of internal political control in the hands of Chinese Communist management. And so it is that, lacking an adequate pension system or private pension funds and not having any alternative except low-return cash accounts at the bank -- which just a few years ago revealed themselves to be quite fragile -- stock market investment could initially have appeared to be not an entirely bad idea. Even if the Chinese stock market system was in its initial stages and was not guaranteeing a certain flawless level of transparency, the reliability of the accounts of listed companies was, after all, certainly not worse than that of local banks. The alternative to the stock market and cash accounts was real estate investment and in fact prices in the coastal areas, and in particular Shanghai, reached speculative levels which were hardly justifiable in terms of domestic or commercial use. Many building thus remain empty. The truly peculiar characteristic of China today is that, alongside the stock market frenzy, a parallel race developed in real estate, which is usually considered an alternative shelter to the risk of financial markets. Last but not least, it is important to keep in mind that many of the dollars generated by exports are used by banks and the People's Bank of China itself to finance the American debt. It is doubtful however that all this can last much longer. Does AsiaNews thus recommend disinvesting from the Chinese stock market? Frankly, it is not our mission to provide consulting and opinions on asset and wealth management. On the other hand, many consultants have for months already been whispering to their most trusted clients to "lighten" their investments in Chinese stocks.

In any case, it is not entirely certain that the Chinese stock market is on the verge of a crash. The reason is that the governing Communist Party will celebrate its 17th congress next fall to approve important changes to its leadership and to elect a new government in March. On occasions such as these, if any indications can be drawn from recent historical precedents, it can be expected that, in order to spread optimism and enthusiasm in the economy and in society, China's administrators will be more inclined to indulge in public spending and in investment than to be rigorous.

But not everything can be adjusted to the needs of agendas and the political cycle. Some analysts say that if the Shanghai stock market index reaches 4,000 points -- it is currently around 3,500 -- the price/earning ration of China's main stock market will also be 60. This is a very significant threshold: it was the level reached by the Japanese stock market in 1987, before the crash that opened the long season of more than a decade of stagnation throughout the economy, which Japan was barely able to get out of only recently. Similar considerations can be developed in relation to the fall of Wall Street and then the speculative bubble of the "New Economy" and also in relation to the monetary and economic financial crisis that, originating in July 1997 in Thailand, eventually spread to the rest of Asia and in 1998 to Russia.

Thus it seems that a10-year cycle will end in 2007 or 2008, but with a significant difference: central banks and monetary institutions could have a minor role this time around. The crash of 1987 was the result of the monetary restrictions imposed by the United States on Japan with the Plaza Accord of 1985. The then governor of the Federal Reserve, Volker, wanted to limit Japanese exports that, at the time, were flooding the American market, as is now the case with Chinese exports. In 1997, the crash was attributed to restrictions imposed by the International Monetary Fund on the economies of the region. Today central banks and monetary institutions seem to have much less control. "Innovative" finances, such as financial derivatives, high yield speculative hedge funds, securitization and other similar alchemies, as well as the liberalization of markets and globalization have produced what is likely an unprecedented monetary bubble, of which China's is just a corollary. According to data from the Bank for International Settlements of Basel, the "central bank" of the Central Banks, the global volume of "quasi money" is equal to about 50 times the volume of worldwide GDP. It is a fiery, shapeless mass of paper, or rather electronic, money that can take shape at incontrollable speed and can, at this point, easily overwhelm any authority or monetary and economic institution. It takes just a small spark to ignite such a bubble and such a spark could be set off in China. The effects would be felt throughout the world, and would not be different from those which followed the explosion of similar bubbles in history: impoverishment for many and the concentration of wealth and power in the hands of few. Globalization has not cancelled out the economic cycle: it has perhaps only lengthened it a bit and has generalized and probably also deepened its effects.

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