Chinese Red-Chips Soar Into Orbit

2006 was a year of extreme volatility in the global money markets. Once again, the biggest stock market winners were the emerging giants of Brazil, China, India, and Russia, the so-called BRIC countries. Together, the BRIC account for 50% of the world's population, yet their rapidly growing economies account for only 13% of global economic output. The four emerging markets have been star performers, while European, Japanese and the US markets lag behind their blazing trail.

The global economy produced around $36.7 trillion in goods and services in 2006, with emerging economies expanding an average 7% this year, largely as a result of high commodity prices, and booming demand in China and India, the World Bank said. The pace of expansion in emerging economies could remain above 7% in 2007, lead by 9.5% growth in China, 8.5% growth in India, and exceeding the 2.6% average growth rate of high-income countries in Europe, Japan, and the US.

China’s Enterprise H-share Index listed in Hong Kong, wins the gold medal for market appreciation across the globe in 2006, after posting a 93% gain so far this year. Most foreign investors interested in China’s companies prefer to trade the H-shares, or mainland companies that list in Hong Kong or New York, and comply with international accounting and governance rules.

[Investors can utilize the MSCI shares ETF for China (FXI), to play the Chinese craze. FXI contains the top-25 Chinese blue chips including: PetroChina (PTR) 9.5%, China Mobile (CHL) 8.4%, ICBC Bank [1398.HK] 8.3%, China Life (LFC) 7%, Bank of China [3988.HK] 6%, China Telecom (CHA) 4.5%, China Construction Bank [0939.HK] 4.2%, and China Petroleum (CEO), 4.1%.]

The H-share index is fueled by a 29% annualized increase in industrial profits, and a 17% increase in the Chinese M2 money supply. China’s economy is expanding at a 10.4% rate this year, the fourth straight double-digit annual gain. Chinese traders have discounted several more years of double-digit gains for the local economy, with the H-share index eclipsing the psychological 10,000-level on Dec 27th.

China’s exports grew 32.8% from a year earlier in November to a record $96 billion, while annual import growth stood at 18.3 percent. China is set to run up a $229 billion trade surplus with the US this year, more than 13% greater than the record 2005 surplus. China passed Mexico as the second- largest US trading partner in the first 10 months of this year, only behind Canadian-US trade. Nearly 87% of China’s trade surplus is derived from the one-way highway to the US market.

China’s stock markets went ballistic on Dec 27th, when the China Securities Journal revealed that Beijing plans to set a unified corporate income tax rate of 25%, and will scrap the decade-old preferential tax rate of 12% for foreign firms. The draft law under consideration, if approved by the People’s Congress, could be introduced after March 2007. Right now, domestic based companies have the heavier tax burden, and are at a disadvantage when competing with foreign based firms.

Chinese banks are currently subject to a statutory 33% income tax rate on top of a 5% business tax. The expected corporate tax reform will enhance the earnings of most domestic banks by between 10% and 20 percent. But Chinese banks are not cheap, and trade at a sector average of 2.5 times their forecast book value in 2007, a 20% premium to the 2.1 average of global emerging market banks.

China is the emerging economic super-power of the 21st century, and has moved into fourth place, ahead of the UK economy, quickly catching up to number three Germany, but still far behind Japan and the US. Beijing’s foreign currency reserves have soared to one trillion dollars, and are on course to reach $1.5 trillion by 2010, with cash inflows expected from foreign trade, foreign direct investment, and interest earned on US and foreign debt. Where will Beijing direct its future FX reserves?

Capitalization of the Shanghai Stock Exchange reached 6.3 trillion yuan and the Shenzhen Stock Exchange amounted to 1.7 trillion yuan, making China the largest emerging stock market in the world. China’s capital market equals 40% of its GDP, up from 18% in 2005, and has been soaring in leaps and bounds since June, overtaking South Korea and India in market value in the past two months.

Chinese stock markets soared last week, when the US Treasury Department, under Henry Paulson, refused to label China as a currency manipulator, and instead agreed to steps by Beijing to let its yuan currency rise in value against the US$ at a snail’s pace. Also, the US Commerce Department rejected a petition on Dec 19th, asking it to label China’s currency policy a subsidy that could have led to the imposition of tariffs on Chinese-made imports.

News that the US Treasury would not label China as a currency manipulator led a stampede into the Chinese H-share Index, rocketing higher to a record 10,213 on Dec 27th, and up 92% from a year ago. It’s not wise to try to pick a top in a frenzied Asian stampede, but traders should carefully elevate their protective sell-stops along the way, while Chinese red-chips mimic the US Internet craze of the late 1990’s.

Hong Kong brokers say the recent market rally is driven by excessive liquidity as plenty of hot money is waiting to buy initial public offering stocks in Hong Kong and in mainland China, but the market may need a consolidation in January. The People’s Bank of China is printing huge amounts of yuan in exchange for foreign currency entering the country from trade surpluses with the US and foreign direct investment.

The only 3-day pullback in the Chinese H-share index since early October occurred on November 27-30th, when Chinese central banker Wu Xialong warned that excessive availability of funds in the money markets would lead to asset price bubbles. “The basic situation now is that liquidity is excessive, this is very dangerous. The central bank’s growth targets for the M2 money supply and bank lending have not been strictly met,” Wu was quoted as saying.

China’s 7-day repo rate erupted to as high as 3.9% on Nov 20th, amid fears that the Chinese central bank was ready to take strong action to drain yuan liquidity. On Oct 27th, the PBoC had lifted bank reserve requirements by half-point to 9 percent. But the 7-day repo has since plunged to 2.05% once traders realized that Xialong was bluffing, and the PBoC wasn’t going to drain enough liquidity to bust the bubble.

Hong Kong Stocks Climb to Record Heights
Hong Kong’s benchmark Hang Seng index hit a record of 20,033 on Dec 28th, hitching a ride to the soaring Shanghai and Shenzen stock markets. (Investors can utilize the MSCI share ETF for Hong Kong (EWH).) A free trade agreement started in January 2004 between Hong Kong and China has reinforced China’s influence as a key driver of Hong Kong’s economy. One third of China’s external trade goes through Hong Kong, and re-exports account for 92% of Hong Kong total exports. Its three top export partners are China, Japan and Taiwan.

Hong Kong is Asia’s main trading hub and one of the world’s most open economies. Business environment is favorable to foreign investments: simple legal framework, soft taxation and above all, almost no customs duties and no non-tariff barriers. Hong Kong is the second destination for foreign direct investments in Asia, and is the second largest Asian money market and the world’s fifth largest banking center.

Re-exports thru Hong Kong, are expected to boost the city’s economic growth rate to 5% in 2006, but strength from the financial sector and the property market could lead to upside revisions. Hong Kong surged past New York this year and became the world’s second most popular place, after London, for companies to float new stock listings. Hong Kong’s big advantage is that it has a solid legal and financial system that can handle big initial public offerings, or IPOs.

Shanghai isn’t close to being able to match this city, and that’s why a parade of China’s biggest banks decided to launch record-breaking IPOs in Hong Kong this year, led by the $21.9 billion offering in October by Industrial & Commercial Bank of China, 1398.HK, the mainland’s largest bank with 155 million depositors. 1398.HK overtook HSBC Holdings Plc (HBC), as the world’s third largest bank by market value after its share value rose to a record $214.2 billion this week.

Hong Kong has raked in $39.57 billion in IPOs, nearly twice as much as last year. London was the world leader for IPO equity with $48.92 billion, Hong Kong was second and New York was third with $33.61 billion, which included the January-November period. If China becomes a large economy rivaling the US over the next 20-years, then Hong Kong could outpace New York and London. Hong Kong is heavily dependent on listings by mainland Chinese companies. The firms make up nearly 50% of the total market capitalization of $1.6 trillion.

Hong Kong Exchanges and Clearing 0388.HK, which operates the local stock exchange, has tripled in value this year, riding a big bull run to record profits of HK$2.1 billion this year, up 50% from 2005. It earned HK$566 million in July-September, up 45% on a year ago and beating a 5% gain in Singapore Exchange’s SGXL.SI earnings for the same period. Since Oct 1st, the Hong Kong Exchange’s daily turnover has averaged nearly HK$40 billion, up almost one-third from the volume generated in the first nine months of the year.

Comments

[Paul Meyer]

This article was written very well. I really think FXI, and China growth indexes in general will keep performing awesome. But when there is going to be a pull-back it's probably going to be substantial.

[Anand Gupta]

Great Article! Just wanted to point out that the ticker symbol of China Mobile is CHL and not CHU. CHU is the ticker symbol for China Unicom. CHU is also part of FXI.

I invested in FXI in 2005 October and from that time it has been up 91%!

Thanks,
Anand

[JonathanLiss, SAEditor]

Anand,

You are correct about the ticker for China Mobile being CHL. Thanks for pointing that out.

Jonathan Liss

[AngeloBertillini]

FXI is parabolic! Not even the QQQs in '99 reached a parabolic state. When this finally decides to turn south, it'll be doing it in a big way (at least as big as in May and June). Time to put your short caps on!