Vlad Signorelli and Scott Gillette submit: There is so much talk about China’s Shanghai stock market being a bubble – from the Financial Times, China’s richest man Li Ka-shing, to Chinese government officials, and even former Maestro Alan Greenspan -- that it seems almost a foregone conclusion this market should have collapsed yesterday. We’ve seen the historical studies all over the place surmising that the Shanghai bourse is a like America’s Dot.com “bubble” of the late ‘90s or the stock market of roaring ‘20’s. But we don’t see any compelling parallels of doom at this time. China’s yuan is not in deflationary territory, like the dollar was in the late ‘90s, which helped cause the tech boom & bust. Meanwhile, the most serious protectionists in Washington even admit privately that they are not at all interested in starting a Smoot-Hawley trade war with China.
The valuation arguments do not convince us either. While it is true that some companies -- which enjoy dual listings on the Hang Seng and Shanghai bourses -- are trading for multiples several times higher on the mainland than in Hong Kong, it does not mean Shanghai valuations are set to go snap, crackle, pop. Nobel laureate Robert Mundell recently explained that these price differentials reflect the fact that the mainland's financial development is "still immature." Or put another way, this is still a growth market.
The Shanghai Stock Exchange Composite Index currently has an average P/E range of around 44. The only major index in the U.S. to trade at such a valuation today is the Russell 2000 Index, which trades around 43. That’s the market for U.S. small caps, which we associate with greater volatility, but also greater growth potential. London’s FTSE Small Cap Index has a P/E of 70! Around the world, markets with elevated P/Es tend to be in growth markets like Peru (47), or in tech/growth bourses like the Nasdaq (38), Germany’s TecDax Index (33), and Japan’s Nikkei 225 Index (38). The point being, the P/E valuations we are seeing with Shanghai do not seem that far out of line with high growth, high volatility markets.
Of course, there is always the risk that Shanghai’s stock market could fall significantly if the government imposed incredibly destructive tax policy, such as an increase in the capital gains tax. Rumors of this lopped about 10% off the index in late February, early March and sent a chill through world markets. The fact that authorities came out quickly to reject these rumors, signals they understand the import of their words and their intention to continue fostering the development of their capital markets.
Without capital markets, China really does not have a very efficient way of allocating capital to its best possible use. This is where the mainland's vaunted savings rate (47% of gross GDP according to IMF figures) comes into perspective. Here's how Professor Mundell described it recently: "The large savings comes about through population policy. Historically, Chinese had children as durable goods to provide for retirement. When the one-child policy was introduced, it cut off this form of social security so the Chinese turned to high savings—instead of investing in children, they invested in savings for their old age." But these savings, much of which are stored in bank deposits, return a reported paltry 2%. So China's equity markets are an attractive vehicle for allocating capital toward new businesses with the promise of higher returns. And profits appear to be growing mightily. In the first quarter of 2007, profit growth for "industrial enterprises" (which is the official designation for non-state owned Chinese companies) registered a remarkable 48.7% increase. Already, the market enjoys, in dollar terms, a capitalization greater than Canada's Toronto Exchange and Germany's DAX index, and it will probably overtake France's CAC by the end of the year, despite Sarkozy's best efforts to kick start the French economy with his pro-growth, tax-cutting agenda.
China's development is unprecedented and singular in world history, with 1 million people being pulled up from poverty each month. On the whole, the optimism we see with Shanghai stocks look, dare we say, warranted for an economy growing at 10%+ clip (in GDP terms). Specifically, here are some key reasons for being bullish on China and in Chinese exchange traded funds such as FXI.
1) China’s slow and steady revaluation of the yuan. Shanghai's market may never have emerged from the doldrums a couple years ago had not the government dropped its strict dollar peg on July 21, 2005. From about 2003 until then, the government had used heavy-handed tactics to keep inflation and economic "overheating" under heel, from growth curbs to interest-rate manipulation, which had kept Shanghai in a near-permanent slump. By breaking the link and gradually appreciating their currency to more a favorable yuan-gold level, Chinese authorities signaled that they would be working away to correct an incipient monetary inflation by correcting the problem at its source, the yuan’s link to the inflationary dollar. By November 2005, Chinese officials were already remarking that the economy had achieved its soft landing; and by January 2006 the market began trending higher from there.
Since July 20, 2005, the yuan has strengthened about 8% against the dollar. We note other dollar-pegged countries have become aware of the inherent problems with pegging to a dollar that can't hold steady against gold, other commodities, and the Euro or pound. Kuwait is just the latest example. As the Kuwaiti press release that announced their break with the dollar noted, "The massive decline in the dollar's exchange rate against main currencies ... has contributed to the increase in local inflation rates and this step is part of the central bank's efforts to curb inflationary pressure."
To its own benefit, China has adopted the classical economic model as its basis for economic development, which will help to ensure that it avoids the some of the nostrums of the IMF and World Bank. These Keynesian institutions, along with many U.S. Congressmen, fail to grasp that changing the value of a currency does not change the terms of trade between countries, but creates an enormous wedge on future economic activity. By revaluing the yuan at a gradual pace, China can avoid these dislocations, mollify foreign protectionist tensions, and eat away at the global inflation being promoted by the dollar at the same time. Official inflation statistics and anecdotal information on the ground both affirm that inflation has been moderate, and has in fact declined recently, falling to 3.0% in April from 3.3% in March.
So long as China’s avoids deflation -- and we think it will during the foreseeable future -- China's gradual revaluation should provide a sound backdrop for continued robust growth. For foreign investors, especially Americans, robust economic growth coupled with a yuan rising against the dollar presents a rare, double-plus situation.
2) China’s recent tax reform should help domestic companies. Earlier this year, the Chinese unified their corporate tax rate for foreign and domestic firms to 25%. For domestic firms, especially those listed on Chinese equity markets, the tax rate reduction from the previous 33% rate, was an automatic addition to the bottom line. And with more profits, there can be additional growth and importantly, a fueling of animal spirits (i.e. more risk-taking).
3) China’s construction boom is organic and mostly demand driven. Shanghai is like Vegas: everyone thought the hotel market was saturated in the 1990s. Now Vegas is twice as big, and the occupancy rate is still incredibly high. Everyone thinks that there has been an excess in building in Shanghai, yet demand has remained insatiable. And this is taking place in a 100 cities throughout the mainland. Joined with our first point on the currency, this minimizes the possibility of a liquidity-led construction boom going bust.
There are likely other strong reasons to believe that China will continue to present a fantastic growth story for international investors. But all this bubble talk remains a flawed approach to assessing China’s risks and opportunities. As the esteemed Jude Wanniski once said on the subject on bubbles: “In all of economic history, the only time ‘bubbles’ appear is when economists are not around who understand why the broad market suddenly decides a downward adjustment in asset prices is necessary. So those available announce ‘a bubble’ as the reason for the sell off. This means the marketplace is irrational and steps must be taken to control it through new laws and regulations.” We believe the market in Shanghai is a rational one on the whole, and is reacting to risks and opportunities just as markets do elsewhere in the developing world.