The China Bubble Can't Last

I'm sure you all read the Barron's article about Chinese valuations. I mean, iShares FTSE/Xinhua China 25 Index (FXI) has only advanced like 80% in two months time since the credit crunch. What's to worry about that?

But I'm not just talking about that. Let's delve deeper. Chinese stocks have a very small float. There is a ton of hot money flowing to China because the Yuan is expected to appreciate over the dollar. One might argue that China basically needs to adjust higher to the world, more than the dollar needs to adjust down, but since China won't go one way very fast and the world doesn't want to buy real estate advice from the US, it appears the dollar will go the other way, for now.

China should be sterilizing their money flows if they don't want inflation and uncontrolled money growth. I have a suspicion though, that evidence that it is not completely sterilized can be found in the stock market and in Chinese company valuations. Did you know that 40% of Chinese GDP is in investment? Why? Because Chinese companies are heavily weighted towards manufacturing and low ROIC industries. So why should they get the valuation tilt when all the money has to be gobbled right back up by the company for reinvestment at lower rates of return? Any and all growth will require investment, which means the investor isn't going to see a dime of cash until much later.

In short, the EVA of Chinese companies tends to be low and if there's no EVA, there's no reasoning for a premium valuation. So the only real value that many Chinese companies can create is the value created by selling overpriced shares to invest in themselves or other companies in takeovers at lower rates of return, which causes higher EPS growth than if they were priced correctly.

The fact is, the need to adjust the Remnibi, combined with low floats, creates the curious ability of Chinese companies to be able to walk in and buy valuable pieces of our own companies and real cash flows on the cheap, for them at least. Capitalism at it's finest! I digress.

But that's not the train wreck. The possible train wreck is the massive investment at lower rates of return. The dollar is weak, and perhaps getting weaker and weaker and weaker. The US economy is faltering. I have such a difficult time imagining a quasi state-run economy having trouble correctly investing massive amounts of money that I break out in hysterical laughter. Supposedly, China is learning its lesson from Japan letting the Yen appreciate too much. But one might argue that the problem is something unsustainable trying to adjust to something sustainable. The policy decisions just determine the final form of effect, not the fact of an effect.

So what's the final effect of delaying the inevitable? The delay just keeps the money flowing. Into the stock market, into investment. If there is "too much" investment happening in China, one place I might expect a problem to come up is in the banking sector, considering the high capital nature of the businesses involved. The banks are well known for having some previous problems. Counter-intuitively, one thing that banks do when they have a lot of crappy loans is make a ton of new loans, creating a credit boom of its own. I'm sure the recent Chinese economy has been a fervent ground for improving one's loan books. I'm sure the political will runs counter to the mentality of "just let 'em fail", like we mistakenly did in the 30s. But at some point, there's a final hitch in the money train. Probably right around when the Remnibi-dollar peg is lifted. Because then, the reason for hot money to be in China starts to vanish. And you wonder where the dollar will be by that time and what kind of return those massive investments made on being able to sell us even more crap will do? All those extra reserves won't help them one bit.

The real possible train wreck is that this is still a quasi-communist country - possibly inexperienced with a politically controlled Central Bank - that looks set to have a bad experience in capitalism.

Comments

[rlirph:]

My personal opinion is that too many people write about China's stock market without understanding the intricacy of the system. Since most of the authors have never been to China they just use their western parametrics in assessing the situation.

True China is now awashed with liquidity. But that is not caused by hot money flowing into China from the rest of the world. First of all non Chinese citizens cannot buy stocks in China (the A shares). Foreigners including the 6.7 million Hong Kong citizens cannot buy them either because they are considered as foreigners.

China has a strict capital inflow and outflow mechanisms. Even if George Soro wants to invest his US$10 billion in China he must either obtain government's approval which is highly unlikely or do some illegal transfer.

The surplus of liquidity is mostly caused by U.S. (=trade surplus). When Walmart or any other US companies place a US$10 million order, that order would eventually turn into Chinese Yuan (CNY) or Reminbi (RMB). Simply put the Chinese government becomes a US servant by printing more CNY as requested by the US consumers.

This huge liquidity is what caused the runup in A shares. Now the government wants to divert part of the surplus to Hong Kong. The "Through Train Stock Program To Hong Kong". Originally announced in August with a limit of US$20 billion, the latest news is that limit has been increased to US$50 billion. That means an extra
$50 billion will flow into Hong Kong H share market.

Earlier this month the Chinese government also announced the creation of China Oversea Investment Corporation. This is a government agency whose mission is to increase the return of the country's US$1.44 trillion foreign reserves.

The first capital allocation is US$206 billion. Most people estimate that at least 10% of that (another US$20 billion) will flow into Hong Kong buying Hong stocks and as well as H shares.

In other words, in both China and Hong Kong market, the stock market goes up when there is lots of money coming in. However, this will not stop because China is generating something like US$20 billion trade surplus a month!

This is a classic example of inflation when too much money chasing after the assets. As to when the market will crash my guess is that when the money flow stops coming in, that is when the China trade surplus narrows. Remember that foreign capital cannot go into China (unless they obtain a QDII permit with strict restriciton how much the limit is) and many authors are confused with this facts.

I have moved from Los Angeles to Guangzhou for six months now. Even now I am confused as to the facts as to what apply to H shares and what apply to A shares, even though the underlying share is identical.

2007 Oct 30 05:31 AM

[kdo:]

You know, rereading, I very much overemphasized the "hot money" component to this. I know most of the money is the trade deficit. But that doesn't negate much else in the article. The point is there's no float and too much demand for companies. That is a problem. But a quickly falling dollar does present a policy choice for China as to whether or not to follow. Thank you for your response btw.

2007 Oct 30 11:14 AM

[bergl328:]

China will do what is good for China and to sustain their growth. I believe, that to get a handle on whats going to happen in the Chinese economy you must apply the Chinese point of view, not a Western one.

2007 Oct 30 10:08 AM

[huangthomas:]

It was decided by Premier Wen Jiabao in December 2006, the 70% of the stocks still in government's hand will be put into circulation (free float) within 3 years. In their jargon, "complete privatization" in 3 years. The program is call "Equity Division Resolution". You can find the website which details how the shares will be release by each corporation. It is in Chinese.

2007 Oct 30 04:05 PM

[max petrisek:]

Spell out all the details but then something else will happen. It will be the Chinese drive and momentum to let the billion of peasants get some of the "tickie!" No tickie for the peasants, no good. They have smelled the honey. It will keep booming much longer than most expect. No, I'm not going to China to confirm my prognosis. Just ask Confusious.

2007 Nov 01 09:01 AM