Betting on the Dragon

Since January 2000, the Shanghai Stock Exchange composite has grown by an average of 20% a year. Compared to other past market bubbles, we can see that while the shanghai market isn’t matching the heady 500% growth of the NASDAQ during the 1995-2001 dotcom bubble, it is coming close. Over the long-term, stocks offer some of the best investment returns available; if we look at the returns on the S&P 500, the compound growth rate was 10.4% per year from 1926-2006. However, economists in general agree and history proves that no economy is immune to economic cycles and for every boom, there will be a slowdown. The Chinese economy is no exception. Even with a vast labour supply and one billion potential customers, the economy will go through the same oscillations that every other large economy has gone through in the past. The question then becomes, when will it happen and how will that affect the Shanghai stock market.

A piece of research we recently completed found that 36% of Chinese A-share investors are expecting an 80%+ return on their investment already gives us an indication that they are positive about where the market is going. Indeed, 67% of investors said they will invest more money in the next year and only 33% will invest the same or less. The Chinese investor is indeed an optimistic one, but the two factors that will most likely affect investor confidence in the stock market in the near term are liquidity and projections for strong earnings growth.

Excess liquidity in the market is part of the macroeconomic challenge for the government in 2008. Despite raising the required reserve ratio 10 times in 2007, and an for 11th time on January 16th of this year, financial institutions’ total deposits are nearly 160% of GDP and the gap between the actual reserve and required reserve ratios is still 3%. Banks are lending aggressively and the result is, as we mentioned yesterday, an inflation rate of 6.9% in November 2007, the highest in 11 years. Even with an interest rate rise on the 21st of December, returns on bank accounts are still negative, thus pushing consumers towards the stock market and real estate where the returns are greater. This further aggravates the bubble that we’re seeing in both the stock and real estate markets.

Earnings growth has been extremely strong in 2007. In 3Q07, earnings grew by an average of 73.8% over the previous year for companies listed companies in the Shanghai A‐share market. Some analysts have estimated that up to one‐third of the earnings growth was a result of revaluations of investment portfolios and capital gains from companies that have either invested in the market or other companies. To certain extent, the earnings growth and market rally are mutually enhancing. There is, however, risk that earnings growth will disappoint in the future and have a negative effect on the market.

One critical issue is the likely impact on the economy if there is a stock market correction. Historical data reveal no correlation between stock market performance and macroeconomic indicators whatsoever in China. But that has probably changed, given the much broader investor community and much bigger market capitalization today.

Business as Usual

Beyond the Olympics, there a number of smaller events that will prove interesting as 2008 progresses. The first of which is the first plenary session of the 11th National People’s Congress (NPC) which is scheduled to convene on March 5, 2008 during which new State and government leaders will likely be elected. However, no big changes are expected here, and with the 2008 Olympics and 2010 Shanghai Expo, any newly elected officials are unlikely to stray from the party lines.

A new anti-monopoly law, which aims to ensure fair competition, will take effect on Aug. 1st. Lawmakers indicate that the statute will improve market regulation and provide a better environment for both domestic and foreign investors. This may be timed with the ever eminent auction of 3G licenses. Many see 2008 as the year it will finally happen (although the same has been said every year since 2003). With the anti-monopoly law coming into effect, it would be a good chance for the government to demonstrate through action that it takes the antimonopoly laws seriously as China Mobile inches towards a near monopoly on Chinese mobile subscribers.

Out of this world 

Continuing its space dream, in 2008, China will also launch the Shenzhou VII spacecraft. It will be China’s third manned space mission and unlike the others, include a spacewalk which will make the mission slightly more complex.

Tomorrow: the Olympics and what Fintech firms should expect in 2008.