Friday 8 June 2007

"China bubble" - the political dangers ahead

The Chinese stock market bubble has slowly re-inflated itself after last week's share sell off. The Chinese government is in a quandary. If it lets the bubble inflate further the eventual crash will be severe. If it acts now it will get the blame for investors losses.

The true economic costs may be limited. However, the political ramifications may be far greater. My bold highlights.

Today's FT has an excellent article on this topic. We have previously covered a lot of the points raised here regarding the hundreds of thousands of small investors etc. The key here is to think "politics" (see the Stock market tab in the sidebar for previous posts).

I like this quote from the article:
"Only the government knows how the stock market will develop next. The government decides everything. We are helpless, helpless."

As stocks falter, Beijing mulls the chances of an investor backlash
The remarkable rise of China's stock market in recent months has left the government mulling two bad alternatives: let the market surge too high and the subsequent crash would be ferocious; but act too aggressively to cool it down and the authorities would be blamed for the losses.

With the Shanghai exchange again showing signs of fragility since the government increased the tax on share trading last week, there are many reminders that if the market turns sour, investors will consider it the government's fault.

Three years ago, when discontent was spreading among ordinary investors after a prolonged slump, one man set himself on fire outside the regulator's Beijing headquarters, while the manager of a beauty products company in southern China called in two bomb threats to the same building.

These stories are an indication that although the Chinese economy could easily emerge unscathed from a further plunge in the stock market, the political consequences are potentially much larger.

"In the case of a severe correction, this could lead to social instability," said Dong Tao, an economist at Credit Suisse. Some observers have even pointed out that market crashes in other developing economies - especially in post-Communist countries - have ended up undermining a whole generation of economic reformers.

The new bout of turbulence in Shanghai has brought to an end one of the more remarkable episodes in the history of stock markets. In an atmosphere that sometimes resembled a gold-rush, several hundred thousand new share trading accounts were being opened every day in April and May. Share prices became a staple of daily conversation, not just for urban professionals but also for domestic cleaners, janitors and sweet-potato sellers on street corners.

The influx of these new investors helped push share prices to record highs, a fourfold increase from the middle of 2005, and spawned myriad tales of (almost) overnight millionaires.

The popular frenzy over share trading led the government to intervene last week, trebling the tax on share trading. Just over a week later, the authorities are likely to be comfortable with the situation. After a 3 per cent jump yesterday, share prices have now fallen 10 per cent from their high last week since the stock tax was increased and trading volumes are considerably lower, indicating that some of the frenzied speculation of the last two months has disappeared.

However, further sharp declines cannot be ruled out. "If it falls 30 per cent, that would be the moment that warning bells would go off in Beijing," says Stephen Green, an economist at Standard Chartered in Shanghai.

The potential political problems from a 30 per cent drop in the market have been amplified by the scale of the current boom. At the height of the last bull market in 2000-2001, there were around 60m trading accounts. Now there are more than 100m.

A 30 per cent drop would bring the market down to around 3,000 points, a level it last saw on March 19. Since then, more than 17m new trading accounts have been opened, many of which would be showing losses.

The new investors range across all age groups. Brokerage houses in big cities are full of pensioners who treat playing the market as a new career, while so many students have been trading stocks that the education ministry put out a warning telling them to concentrate on their studies.

With the Communist party holding an important congress in the autumn to discuss top leadership positions and the Olympics next year, Beijing will not want to galvanise the middle class against the status quo.

As well as the potential for discontent from middle-class investors, a sharper fall in the market would also damage the government's plans for financial reform. Over the last two years, Wen Jiabao, the prime minister, has made one of his priorities the creation of a strong capital market in order to take pressure off the banks, promote more stable economic growth and to provide a platform for the development of pension assets.

One part of that strategy was to encourage citizens to put some of their bank deposits into equities and bonds. However, if the new retail investors end up with heavy losses, it could push back reform several years.

In recent days, it has not been hard to find disgruntled small investors who say they have been put off investing. Internet chatrooms have been full of outrage at the tax rise. "The only thing I have to say is that China is not a market economy," said a man with the surname Wu as he came out of a Shanghai brokerage earlier this week. "Only the government knows how the stock market will develop next. The government decides everything. We are helpless, helpless."

There could also be pressure on the government to bail out various parts of the public sector. While the small investors have been grabbing all the attention, some analysts believe there have been much bigger investments by state-owned companies, local governments, the police and the army.

Most of these investments are hidden - one of the few public examples is the Shanghai agency responsible for housing maintenance, which appears on the list of 10 largest shareholders for three listed companies. But Fraser Howie, co-author of a book on the Chinese stock market, argues that the investments by these government bodies could account for half of the traded shares.

Yet even though the authorities could face an uncomfortable backlash from some investors if there is another sharp drop in share prices, few China-watchers believe that the stock market has the ability seriously to undermine the government and generate broader political instability.

For a start, the number of small investors is probably much lower than implied by the figures for trading accounts. Many investors open two accounts - one at the Shanghai exchange, the other at the Shenzhen exchange. Moreover, a large proportion of the accounts are dormant. The number of people actively trading in shares could be as low as 10-20m.

Moreover, while there are cases of people pawning their houses to buy shares, the Chinese middle class has substantial savings to fall back on in the event of a stock market meltdown. Personal bank deposits in China are currently worth around $2,000bn (£1,010bn, €1,490bn).

"We are highly sceptical about the idea of a serious middle-class political backlash in the current environment," says Andrew Gilholm at Control Risks, the London-based consultancy. "The middle class consists of people whose lives have improved very significantly under the Communist party reforms. They are winning, so why rock the boat now?"

Wang Yuanqing, who spends his days investing at a Shanghai brokerage and giving advice to other small investors, is relaxed about the recent setback and takes a long-term view of the market. "After the rise over the last two years, I personally think the latest adjustment is very reasonable," he says. "The majority of investors have still made money."

Copyright The Financial Times Limited 2007

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