Chinese IPOs are back - but for how long?

Here we go again. The thirst of Chinese investors to own stocks appears undiminished despite the recent bloodbath.

I have been surprised by the strength of the recovery in the stockmarket and the return of IPOs is an interesting development that needs watching carefully.

Thirst-quenching [Economist]

IT IS like a downpour after a drought. In 2007 and early 2008, hundreds of Chinese companies worked feverishly with accountants and bankers to prepare for initial public offerings. Their work came to nothing. Collapsing share prices, a contracting economy, unrealistic expectations on the part of sellers and, finally, restrictions from regulators crushed the IPO market. Now the companies and bankers that have managed to survive a brutal year are once again seeking capital, through listings on bourses in the mainland and beyond.

The first raindrop in China has been Guilin Sanjin, a manufacturer of Chinese medicine, which is expected to issue shares on June 29th on the Shenzhen Stock Exchange, the market for the country’s smaller companies. The size of the offering is likely to be a bit under $100m—a mere rounding error compared to the mega-deals of two or three years ago, but a sign, nonetheless, that business has resumed.

Another 30 companies have reportedly received regulatory approval to list and have begun final preparation and marketing; 400 more sit in a queue waiting to be approved. Several state enterprises that went public on offshore markets, including China Mobile and CNOOC, an oil firm, are also expected to list at some point in Shanghai. So too may a handful of non-Chinese companies, with interest already expressed by HSBC, in deference to its Shanghai roots, and the New York Stock Exchange (NYSE).

In Hong Kong, a few companies did manage to float in the past few months but the going was tough, with price estimates cut repeatedly prior to the offering, buyers corralled from friends, families and affiliates, and a lacklustre aftermarket. Conditions have turned. Many of these deals are now up significantly. Three small companies have gone public since June 16th, with shares in each case rising by at least 20%.

Bawang, a Chinese toiletries company, is in the final stages of a roadshow and appears likely to price at the top of its pre-marketing estimate. More sizeable deals are expected by the year’s end, including a listing of the Asian life-insurance operations of AIG, and dual China-Hong Kong listings for Agricultural Bank of China and two Chinese electrical-distribution firms.

America’s capital markets are benefiting too. Two Chinese companies, one producing specialty chemicals (Chemspec) and another water-treatment equipment (Duoyuan Global), made splashy debuts on the NYSE on June 23rd. In every case, regardless of where the listing venue might be, the underlying appeal is the same. Says Jonathan Penkin of Goldman Sachs in Hong Kong: “People are looking for growth. You can find it here.”

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The Chinese credit crunch

Coface, one of the world’s biggest credit insurers, make a good point in today's FT.

Whilst the world seems to have paused for breath on the way to global meltdown the cracks are beginning to show before the next step down.

With the massive fall in exports, the inability of Chinese companies to pay suppliers was always going to happen. Only now are we getting the details.

So what are the implications? My belief is that credit management in China has been very poor in the past and that these bad decisions could lead to a chain reaction of failure across the supply chain.

This is not a time to be buying Chinese stocks.

Fears rise on China groups’ payments [FT]

A rapid deterioration in the ability of Chinese companies to honour payments to their suppliers as a result of the economic crisis is significantly increasing the risk of doing business in China, according to Coface, one of the world’s biggest credit insurers.

Xavier Farcot, who heads the French insurer’s underwriting and claims business in China, said the cost of insuring against customers defaulting on payments in domestic trade had risen by 30 per cent since the financial crisis, even for the best customers who have not made any claims previously.

“It is a reflection of the change in the overall risk environment [of selling to Chinese buyers],” said Mr Farcot.

Chinese companies, particularly in the export-oriented technology and electronics manufacturing sectors, faced a liquidity crunch at the end of last year as China’s exports plummeted. Many of them were also unable to access bank loans to tide them over the tough times, especially if they were small to medium-sized private businesses, said Mr Farcot.

Even though Chinese banks, unlike their western counterparts, have ample liquidity, “they are accustomed to lending to large state-owned enterprises rather than small companies who often do not have large resources or equity”, he said.

This cash crunch forced many Chinese companies to turn to their suppliers for credit, thus forcing the pain up the supply chain.

Nearly 90 per cent of Chinese suppliers are extending credit to their domestic customers on more than half of their sales, compared to just 70 per cent a year ago, according to Coface’s annual survey of the country’s corporate credit management practices.

This was bad credit management, said Mr Farcot. “Now is not the time to extend credit, it is time to restrict it,” he said. Most Chinese suppliers, however, have never experienced such a downturn.

“A lot of these companies never had to deal with the problem of not getting paid, because sales had always been increasing,” he said, “There’s not enough financial resource, not enough management.”

As well as customers demanding longer payment terms, the vast majority of Chinese suppliers said they had increasing problems with overdue payments last year. A quarter of them said accounts that were overdue by more than half a year now made up more than 2 per cent of their sales, which “is usually the threshold above which you start running into problems”, Mr Farcot said.

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Stockmarket prediction update November 2008

I return again to my predictions for the Chinese stock market first made in May 2007.

It has been over a year so it is time to assess where we are and where we might be going.

From a 4000 start I predicted a high of around 5000 and a low of 2000. I missed the top and the bottom but generally speaking we are not too far out. I also thought the bottom of 2000 would have been reached before now. The delay in the bubble bursting is why I believe we went over and under based on irrational exuberance (and other reasons) for China's very own stock market bubble.

The balance between fear and greed is always hard to predict but one thing is for sure fear takes effect a lot faster and fortunes are lost quicker than they are made.

The losses from the 120 million trading account holders will have a large knock on effect on the real economy as fear takes over and investment slows. I still worry that we have my no means seen the worst yet. There are companies and banks with truly dreadful balance sheets and massive numbers of none performing loans.

Yesterday's stimulus package has the smell of desperation.

Is the current 1800/1900 figure the bottom? I doubt it. My prediction would be for 1000 to be tested in the next 5 months. That represents close to another 50% fall. The caveat, as always with China, is that I also believe that the government (and other powerful interest groups) will try pretty much everything to prevent a fall of this magnitude. Given this very real possibility and the fact that Chinese firms are still improving in terms of governance and productivity I suspect that we may only get as low as 1400.

Here are my predictions from back in May 25th 2007. A good forecaster always returns to him original estimates.

When the first article was written the Shanghai Composite Index was around the 4000 level. So far so good then - although I missed the top the fall back so far is bang on with potentially worse to come.

China's Stockmarket - "how does it work"? [China Economics Blog May 25th 2007]

and a later update:

China Stock Market Bubble update [China Economics Blog 30th August 2007]

Before the article here is my prediction - let time be the judge.

1. Stockmarket will continue to rise perhaps by another 25-30% over the next 6 months to a year. 5000 could be the psychological barrier that is a digit too far. There will be a series of small hiccups on the way.
2. What will follow will be a trigger than may, by itself, seem quite unimportant that will lead to a widespread sell off of Chinese stocks with perhaps a 10-15% one day fall.
3. Over the next year shares will fall by as much as 40-50% off their all time highs before stabilising.
4. The knock on effect on the world markets will not be as great as some commentators fear but there will be some contagion effect on neighbouring exchanges.
5. Internally, real estate prices will fall and many individuals will be wiped out. Given the large share holdings by the Police, Army and state owned enterprises what happens then is anyone's guess but it could conceivably get quite ugly quite quickly.

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Hot money and the calls for a maxi-revaluation

Brad Sester over at RGE monitor has a neat little article (with good figures) outlining the dangers of holding off the revaluation much longer.

For the record I cannot see it yet. The political implications are too great (the perceived job losses associated with a loss of competitiveness).

A good article and worth reading.

What keeps Zhou Xiaochuan up at night [RGE monitor]

Friday’s Lex column highlighted the possibility that China’s real reserve growth may be far higher than the published increase in its reserves – and thus a lot more hot money may be flowing into China than the published increase in China’s reserves implies. Michael Pettis – drawing on the work of Logan Wright of Stone and McCarthy - and I have both published online estimates of the “true” pace of Chinese reserve growth. Wang Tao – formerly of the Bank of America – and Stephen Green of Standard Chartered have done similar work.

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Stockmarket bounce and stamp duty

Good coverage of the recent stockmarket bounce of 9% following large recent falls that saw the main index fall below 3000. All predicted here at Chinaeconomicblog of course.

To the West such blunt policy reversals seem to undermine the credibility of the government but given the importance on "stability" we should not be surprised.

Stock market rises 9.3% [China Financial Markets]

Last night the Ministry of Finance and the State Administration of Taxation announced that the stamp tax on the purchase and sale of stocks would be cut from 0.3% to 0.1%. Today, in response, the Shanghai Composite Index surged 9.3%.

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The cutting of the stamp tax was a widely-anticipated reversal of the move last year, on May 30, when in order to cool what seemed like a vastly overheated market, the stamp tax was raised from 0.1% to 0.3%. The market fell 6.5% the next day, and lost another 6.5% that week, if I remember correctly, but not for long. It quickly turned around and returned to its dramatic rise, surging another 75% or so to reach 6124 on October 16. Government attempts to manage stock market prices in China do work, for a while at least.

Since its peak in October, however, the market has plummeted to just below 3000 on Tuesday, losing over half its value, and creating a great deal of concern for the government – China’s is the world’s worst performing stock market year to date. The government is afraid both that the continued market slump may anger the newly-emerging urban middle classes and that it may translate into reduced consumption as savings are eroded (although according to Andy Rothman at CLSA at its peak the total market cap of traded shares was only about 36% of GDP, and is much less today).

This fear is a real one. However, I suspect this 9% will be short lived. There will be more pain to come imo.

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“killing the rooster to scare the monkey” over "ratholes"

So many animals in one article made this FT piece a "must blog post".

It will come as no surprise that there exist a large number of loopholes and shady dealing in the Chinese stockmarket.

The financial sector will always be ahead of the giant lumbering government. This is also true for Western countries as the sub prime and Northern Rock fiasco's demonstrate.

At least China is moving in the right direction:

China cracks down on market ‘ratholes’ [FT]

China’s securities regulator has banned one fund manager from the country’s capital markets for life and another for seven years in a warning to the industry to clean up lax internal controls.

The two managers were banned after buying shares in companies their funds invested in and then selling them for a profit – a practice known as “building a rathole” in Chinese.

Tang Jian, a former manager for China International Fund Management, a joint venture between JPMorgan and Shanghai International Trust Co, was banned for life after storing up Rmb1.53m ($220,000) in his rathole, according to the China Securities Regulatory Commission (CSRC).

Wang Limin, formerly a manager at China Southern Fund Management, was banned for seven years after similarly making a profit of Rmb1.5m.

Both managers were also fined Rmb500,000 and had their illicit earnings confiscated.

The transactions occurred in 2006 as the Chinese stock market was heating up and investors began pouring into a market that rose nearly six-fold in the two-and-a-half years to October 2007.

The benchmark Shanghai Composite Index has since dropped by almost half from that peak.

The index rose 1 per cent on Tuesady to 3,148 points, on expectations the government will introduce new measures to support slumping prices.

Such punishment, and the public release of details of such cases, is a common tactic – referred to as “killing the rooster to scare the monkey” – used by the regulator in the face of widespread irregularities and malfeasance in the country’s capital markets.

“The scale in China of corruption, poor disclosure, insider trading and market manipulation basically swamps the regulator’s limited resources,” said Fraser Howie, author of a book on China’s capital markets. “This is just how the market works and these guys were either unlucky or stupid.”

The CSRC issued a warning to fund management firms through state media yesterday that it was prepared to punish companies whose lax internal controls allowed managers to break trading laws and regulations.

It also ordered firms to monitor all communications of investment managers in the workplace.

Assets under management in China’s mutual fund industry total Rmb2,500bn, with funds controlling about 23 per cent of the market capitalisation of all tradeable shares on the Shanghai and Shenzhen exchanges, according to CSRC figures.

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Stockmarket continues to slide - 46.3% down from the October 16th high

The FT report on the pain being suffered by the small Chinese investor. With large shareholding being owned by local officials and even the army a major meltdown is only a few economic and political disasters away.

Click on the stockmarket label to see our previous posts and my historic predictions which are beginning to look rather good :-)

Investors in China brought back down to earth [FT]

Shares in Shanghai have plunged as sharply in the past six months as they surged during the first part of 2007.

The Shanghai composite index closed on Wednesday at 3,291 – down 46.3 per cent from its all-time high of 6,124 on October 16.

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Rumours abound that Beijing will do something to boost the market. But prices fell by 5.6 per cent on Monday alone.

“The reason for the repeat this week of ‘Black Monday’ is mainly because people were still expecting a policy change from the government over the weekend,” says Chen Huiqin, analyst at Huatai Securities in Shanghai. “As long as there is nothing new coming out, the pessimistic atmosphere will affect the market.”

So why have share prices fallen so rapidly. Most readers of this blog will already know the answer. The short answer is that shares became insanely overpriced based on standard measures such as PE etc. It was a simple bubble and retail investors felt like they were in a casino where they could never lose. Do not underestimate the share lock up factor - share sales could prove a major drag on prices.

But Mr Evans says there are other reasons for the sharp declines of the last six months.

Beijing does not want the economy to overheat. Inflation has been persistently high – consumer prices are rising at 8.3 per cent a year.

The central bank, the People’s Bank of China, raised policy lending rates by 135 basis points last year and it has lifted the bank reserve requirement 15 times since mid-2006 to a record 15.5 per cent. The PBoC governor this week hinted rates might have to rise further to stamp out inflation at near 11-year highs. “Being in a market where the authorities are tightening is not good for investors,” Mr Evans says.

Steven Sun, HSBC China equity strategist, says there are still billions of non-tradable shares locked up from earlier flotations that will be released on to the market in the second half of this year. That may depress prices further.

Many companies that planned to float in Shanghai have thought again. Figures compiled by Thomson Financial show that the amount of cash raised in initial public offerings so far this year at $7.95bn is 28.7 per cent lower than the same period last year. Thomson says the premium on the first day of trading has fallen from an average of 110 per cent last year to just 30 per cent.

Another worrying trend emerged late last month when shares in China Pacific Insurance dropped below the price at which they were offered to the public in December. Since then, several other recently floated companies have sunk below their offer prices.

The Shanghai market now trades at a more realistic 26 times historic earnings and 20 times estimated profits for the next 12 months.

I still think we could see 3000 short term. Other economists are saying a 50% fall from its highs should be the limit. I disagree. 2500 is not out of the question by any means once investors reach the "puke point". Sheer panic to me and you. Things are bad but no where near bad enough. From someone who rode the dot.com bubble never underestimate the power of panic.

Be warned.

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Stockmarket crash update

It is time again to revisit my stockmarket predictions on light of the 45% fall off its peak in October last year.

Here are my predictions from back in May 25th 2007. A good forecaster always returns to him original estimates.

When the first article was written the Shanghai Composite Index was around the 4000 level. So far so good then - although I missed the top the fall back so far is bang on with potentially worse to come.

China's Stockmarket - "how does it work"? [China Economics Blog May 25th 2007]

and a later update:

China Stock Market Bubble update [China Economics Blog 30th August 2007]

Before the article here is my prediction - let time be the judge.

1. Stockmarket will continue to rise perhaps by another 25-30% over the next 6 months to a year. 5000 could be the psychological barrier that is a digit too far. There will be a series of small hiccups on the way.
2. What will follow will be a trigger than may, by itself, seem quite unimportant that will lead to a widespread sell off of Chinese stocks with perhaps a 10-15% one day fall.
3. Over the next year shares will fall by as much as 40-50% off their all time highs before stabilising.
4. The knock on effect on the world markets will not be as great as some commentators fear but there will be some contagion effect on neighbouring exchanges.
5. Internally, real estate prices will fall and many individuals will be wiped out. Given the large share holdings by the Police, Army and state owned enterprises what happens then is anyone's guess but it could conceivably get quite ugly quite quickly.

The New York Times cover this issue in today's paper. I include some of the more interesting quotes although the whole article makes excellent reading. The real life stories bring home the potentially devasting long term consequences.

To See a Stock Market Bubble Bursting, Look at Shanghai [New York Times]

The Shanghai composite index has plunged 45 percent from its high, reached last October. The first quarter of this year, which ended Monday with a huge sell-off, was the worst ever for the market.

Suddenly, millions of small investors who were crowding into brokerage houses, spending the entire day there playing cards, trading stocks, eating noodles and cheering on the markets with other day traders and retirees, are feeling depressed and angry.

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Si Dansu, 68, and a retired engineer, is even more distraught, but she blames the government.

“I devoted my whole life to the country. I went to the countryside after graduation, and worked as an engineer in a Shanghai factory until retirement. I invested almost all my savings and retirement fund in the market 10 years ago. But now I’m totally penniless. All my stocks went down.”

This next quote shows the scale of the possible problem:

In China, the government fears that angry investors can be a social problem. And so while the state-run media report on the ups and downs of the market, and even warn investors of the risks and pitfalls of investing, the press does not usually report on investors’ anger.

“Actually there are a lot of complaints, but the Chinese media can’t report this,” says Mr. Guan, the former real estate company owner.

Now, in the brokerage house corridors — corridors of pain — one can hear complaints about all the market flaws: the government doesn’t regulate the stock market and it participates in it by allowing mostly big state-owned companies to go public.

There are also complaints about insider trading, stock manipulation, and big investors with government connections, pumping and dumping stocks on small investors.

Finally, it appears that the Chinese are finally working out that fear and greed are not equal and opposite. Greed is a slow burner while fear strikes hard and fast.

“Look,” he said, “it took two years to go from 1,000 to 6,000 but two months to go from 6,000 to 3,500.”

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Chinese allowed to buy shares abroad?

In a move that could result in a fall in Chinese domestic share prices, the FT today report on the possible liberalisation of share trading in China with Chinese citizens being allowed to buy shares in London, Hong Kong or Tokyo.

That would unleash a wave of money looking for safe havens. This article mentions the fear for local Chinese shares although the government seems keen to push ahead.

China signals it could ease share curbs [FT]

The head of China’s central bank said on Thursday that Chinese citizens could be allowed to invest directly in stocks in London, Tokyo or Singapore as well as in Hong Kong.

A plan to allow the right to invest directly in Hong Kong – which was abruptly suspended late last year – is still on track but could be modified to include markets beyond the territory, Zhou Xiaochuan, governor of the People’s Bank of China said.

He was speaking on the sidelines of the annual meeting of the National People’s Congress, China’s legislature.

The comments from Mr Zhou and other senior officials indicate that Beijing remains committed to reducing controls on offshore investment by its citizens in spite of concern among other parts of the government that such a move could trigger a collapse in the mainland stock market.

Mr Zhou refused to give more details but said that Chinese investors should be allowed to invest directly in other global markets, including London, Japan and Singapore.

“The controls and regulatory approvals we have implemented in the past [on capital flows in and out of China] will be gradually reduced and abolished,” Mr Zhou said. “We will support overseas investments by domestic residents.”

The central bank is trying to encourage outflows of capital from China to relieve pressure on the renminbi and reduce excess liquidity that is feeding rising inflation.

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Mr Zhou’s Thursday comments echoed those of Dai Xianglong, chairman of the National Council for Social Security Fund and until last month mayor of Tianjin, who told the Financial Times last week that the government was still planning to allow individuals to convert renminbi into foreign currencies and make investments in overseas stock markets.

And on Wednesday, Xiao Gang, chairman of Bank of China, also said his bank was working on technical details of the scheme.

In a follow up post, the FT also report on the massive revenues that the Chinese government earnt from its share purchase tax.

Beijing reaps rewards of shares tax [FT]

The increase in a turnover tax on share trading introduced at the height of China’s stock market boom last year has delivered the government a windfall of Rmb182bn in new revenues.

Most of the money, equal to nearly half of the country’s official defence budget, was collected in just seven months following the increase in the stamp tax from 0.1 per cent to 0.3 per cent on each share trade last May.

According to figures released on Wednesday, Beijing collected a total of Rmb200.5bn ($28.2bn, €18.5bn, £14.1bn) in stamp tax on share trading for all of last year, compared with Rmb17.9bn in 2006, an increase of 1,000 per cent year on year.

The surge in collections made the share market nearly as bountiful a source of revenue for the Chinese taxman as the nation’s 1.3bn citizens.

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Short list of 100 to manage China's $30bn

Not before time China is going to employ outsiders in the investment of $30bn. The Chinese government has already lost billions buying US paper and there is no doubt that outside expertise is needed.

China fund gears up for $30bn drive [FT]

China’s $200bn sovereign wealth fund is preparing to grant mandates of as much as $30bn to international fund managers and is expected to receive another injection of capital for its offshore investments from the country’s $1,530bn in foreign exchange reserves.

China Investment Corp is about to notify shortlisted candidates from more than 100 applicants hoping to manage its investments in global equity markets and is planning to put about $4bn into a fund managed by JC Flowers, the US private equity firm, that will target ailing financial institutions.

This is why they need to make the correct decsion. The Chinese people will only put up with so many terrible investments.

China’s foreign exchange reserves are increasing by nearly $40bn a month, reaching $1,530bn by the end of December. The bulk of these funds is invested in low-risk overseas assets such as government bonds, particularly US Treasuries. Beijing has mandated CIC to make riskier investments in the hope of earning better returns on a portion of those reserves.

But CIC and the large Chinese financial institutions that have ventured abroad are under immense pressure to make smart investments rather than just shovel money out the door. CIC’s Blackstone investment has been criticised as it has lost more than 40 per cent of its value after a steep drop in Blackstone shares. Ping An Insurance, the country’s second-largest insurer, has also been blasted for its $2.7bn purchase late last year of 4.2 per cent of Belgo-Dutch financial group Fortis, whose shares have dropped about 30 per cent since then.

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Chinese Stockmarket Falls - crash coming?

Do the recent large falls in Chinese stocks represent the beginning or the end?

I believe there is a lot further to fall yet once certain positions start to unravel. For now it is holding. I agree that the bubble can burst for a number of reasons and that domestic pressures are far more serious than foreign ones - however, the trigger may still come from worries over the US. The rest of the house of cards will follow.

The FT consider this issue in a comment in today's LEX.

Chinese stocks [FT]

Red polyester lanterns dangle across Shanghai’s store fronts while office lobbies are a riot of scarlet and gold. But one ingredient is missing as China prepares to usher in the lunar new year – the traditional stock market rally. Instead, the Shanghai Composite Index has tracked global volatility, shedding 12 per cent on Monday and Tuesday and recovering 3 per cent on Wednesday.

The falls, however, may be an excuse to exit an overvalued market rather than evidence that China’s domestic currency “A” share market – in which foreigners have only a tiny stake – is turning global. Sure, slower international demand will crimp Chinese earnings, and US subprime exposure is (slightly) denting Chinese banks’ balance sheets. But this is small beer compared with issues at home. On the economic front, tighter monetary policy, alongside the slowdown in external demand, is expected to prune growth to 10 per cent or so. Some sectors will take a bigger hit. Banks go into 2008 with a constrained ability to lend – reserve ratios are higher and lending growth has been curtailed by diktat – and thinner interest rate margins as a result of asymmetric rate rises. Companies with earnings bloated by fat stock market gains will suffer if the market continues to wilt – in aggregate, perhaps one-fifth of net income was accounted for by investment gains last year.

Meanwhile, early indications point to massive equity issuance. A few weeks in, $9bn has been raised on the “A” share market; another $30bn is due in the coming weeks. Issuance this year is expected to trump 2007’s $78bn. On top of that, some $200bn of newly tradeable shares – following reforms designed to scale back state-held stock – could be unleashed this year, representing 17 per cent of free-floated “A” shares, according to HSBC. There are plenty of reasons for China’s stock market bubble to implode, but most are internal.

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US rate cuts puts the PBC under increasing pressure

China's slapdash approach to economic management that has so far appeared to work in spite of the PBC often not seeming to know what it is doing will come under increasing pressure as recession in the US and perhaps the EU gets closer.

The dramatic rate cut of 0.75 points in the US also brings with it problems. Massive Chinese trading losses on exchange rage movements will also anger the Chinese people.

The loss the Chinese will realise on US paper has been inevitable for years. This policy of buying US paper to keep exchange rates low to boost exports was never sustainable. These losses are in many respect a travesty.

This excellent article outlines the technicalities. It also illustrates very clearly that macroeconomics can get complicated very quickly.

US action adds to pressure on China [FT]

The sharp cut in US interest rates has increased the conflicting pressures on Beijing's management of its economy and its simult-aneous efforts to stem potential losses of billions of dollarsin its foreign exchange holdings.

To keep the currency stable, the People's Bank of China buys almost all incoming foreign currency, and then attempts to "sterilise" the monetary impact by issuing renminbi bills to take the funds out of circulation.

The US cut means China's central bank will pay almost 200 basis points more on the bills it issues at home to manage its currency than it will get on purchases of US Treasuries.

The PBoC pays about 4 per cent on its so-called "sterilisation" bills, while one-year US Treasuries now carry an interest rate of 2.07 per cent.

Both countries are likely to maintain their policy biases in coming months, the US cutting rates, and China lifting them, a trend that will intensify the pressure on Beijing's currency policies.

"Things just got a lot more complicated for the managers of China's economy," said Stephen Green, of Standard Chartered bank, in Shanghai, yesterday.

China does not release the exact makeup of its foreign exchange holdings, nor how they are invested, making it difficult to get a precise reading on their profitability.

But Hong Liang, Goldman Sachs China economist, calculates the PBoC is losing about $4bn a month on its bills because of the turnround in the interest rate differential over the past 18 months.

"The trend is clearly accelerating as the reserves continue to grow faster than GDP," she said.

China has lifted rates eight times since early 2006, to cool an economy that grew by more than 11 per cent last year and, more recently, to combat inflation, which hit an 11-year high in November.

But further use of interest rates is constrained by Beijing's tight management of the renminbi, a policy aimed at preventing it appreciating too rapidly.

The government fears more rate rises could attract speculative capital inflows, adding to already swollen foreign reserves, which stood at $1,530bn at the end of 2007.

Despite this objection, the government's commitment to fighting inflation means further rate rises are inevitable, China economists say.

The PBoC, in expectation of losses on its sterilisation bills, has used other tools in the past year to drain the funds, mainly by requiring commercial banks to leave more money with it on deposit. Chinese banks are required to place 15 per cent of their deposits with the PBoC, at a much lower interest rate than the 4 per cent offered by the sterilisation bills.

The heavy use of this measure has allowed the PBoC to limit losses on its foreign exchange holdings.

Some economists argue the reserve losses are only on paper, but "at some point, that paper loss may result in a fiscal loss", said Brad Setser, of the Council on Foreign Relations. "It certainly represents a fall in domestic purchasing power of China's external foreign assets. Money held in dollars will end up buying fewer Chinese goods in five years than it does now," he said.

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Chinese Stock Market Crash

We have posted many times on this topic (see Stockmarket label).

The FT weigh in. I tend to agree with this article.

A crash is China’s chance for reforms [FT]

The spectacular run-up in equity prices in China in the past two years has created a classic asset bubble. The likelihood that the stock market will crash in the not-too-distant future has recently increased because of rising inflation at home and a global economic slow-down. The Chinese stock market has already begun to correct – the main stock indexes have fallen 15 per cent from their highs. However, with Chinese equity price levels disturbingly close to those of Japan’s Nikkei in 1989 prior to its meltdown, the Chinese market will have to fall much further to reach reasonable valuations.

Most analysts argue that such a collapse will have minimal impact on the real economy. This might well be the case. But such thinking ignores the fact that, when it comes, a Chinese stock market crash will produce serious political consequences. Official figures show that more than 100m people have invested in equities, mostly during the recent bull market run. A massive sell-off will hit their household net worth. Because the Chinese government has been perceived as an active promoter of the country’s stock market, tens of millions of individual investors, members of the privileged urban middle-class, will direct their ire at the government. To make matters worse, most publicly listed companies are state-owned, so investors assume that the state is liable for the collapse of their share prices.

Because economic performance and, by extension, a booming stock market help legitimise the ruling Communist party, a collapse in equity prices will seriously damage the leadership’s credibility as competent technocrats. Therefore, the Chinese government needs to develop a political strategy that will contain the political fallout from a market collapse while using it as an opportunity to push through financial sector reforms to restore investor confidence.

It is reasonable to expect that angry retail investors will either ask the government for compensation or demand an investigation into corporate foul play after the bursting of the bubble. Large-scale public protest is a possibility: thousands of irate investors demonstrated at the headquarters of the Ministry of Finance the day after it increased trading tax by 0.2 per cent last May, precipitating an instant sell-off.

While Beijing should resist the calls to bail out investors, it must respond to public pressure to punish companies and individuals that have engaged in illegal dealings during the bubble years. The government should seize their ill-gotten gains to set up a fund to compensate investors. The China Securities Regulatory Commission, the chief market watch-dog, should make its investigative proceedings open to the public. Although such measures might strike one as cheap tricks to scapegoat companies and their executives, they are politically necessary and can help calm an agitated public.

To restore confidence and revive the market, Beijing must turn the crisis into an opportunity to enact structural reforms that will improve corporate governance, make the CSRC truly independent, increase competition and raise the level of transparency in the stock market. Many of the specific reform proposals, such as increasing financial products and expanding institutional investing, are well-known. But two deserve special attention. First, the institutional autonomy of the CSRC will be a crucial indicator of Beijing’s commitment to post-crisis reforms. Today, the CSRC is a bureaucracy staffed by political appointees with limited power to enforce regulations. A priority should be to de-link the CSRC from the Communist party’s patronage system and appoint truly respected individuals, including foreigners experienced in financial regulations, to a genuinely independent new CSRC.

Second, the desire to protect China’s growing domestic market in financial securities has seriously limited competition in this sector and led to the domination by state-owned brokerage firms, many of them implicated in previous scandals (only three years ago, the entire brokerage sector, beset by corruption and mismanagement, was on the verge of collapse). The Chinese government must accelerate plans to allow foreign firms to enter the sector. It must abolish its requirement that foreign firms form joint ventures with Chinese partners. This bold move will not only help restore stability in the market, but also create conditions for a future boom in equity investing in China.

Economist: "The Old Chinese Myth"

The Economist looks at China's ability to weather any fall in demand from the US if, as seems likely, it heads in a recession with consumers tightening their belts.

The issue is whether domestic consumption can be encouraged to offset any decline in exports.

An old Chinese myth [The Economist]

Contrary to popular wisdom, China's rapid growth is not hugely dependent on exports

MOST people suppose that China's economic success depends on exporting cheap goods to the rich world. If so, its growth would be seriously dented by a stuttering American economy. Headline figures show that China's exports surged from 20% of GDP in 2001 to almost 40% in 2007, which seems to suggest not only that exports are the main driver of growth, but also that China's economy would be hit much harder by an American downturn than it was during the previous recession in 2001. If exports are measured correctly, however, they account for a surprisingly modest share of China's economic growth.

When measured correctly (although the methodology employed is still debatable) then the ratio of exports to GDP falls to 10%.

But what about employment (and then all important political stability). Not such a problem:

Employment figures also confirm that exports' share of the economy is relatively small. Surveys suggest that one-third of manufacturing workers are in export-oriented sectors, which is equivalent to only 6% of the total workforce.

However, 6% of the Chinese work force is a seriously large number of people that you would not want camped out on your doorstep.

Many of China's foreign critics remain sceptical. They argue that China's massive current-account surplus (estimated at 11% of GDP in 2007) proves that it produces far more than it consumes and relies on foreign demand to buy the excess. In the six years to 2004, net exports (ie, exports minus imports) accounted for only 5% of China's GDP growth; 95% came from domestic demand.

The economist correctly goes on to link exports with investment. Whilst China moves up the quality ladder via increasing investment in high technology and high valued added products a lot of this investment is driven by export potential.

China's economy is driven not by exports but by investment, which accounts for over 40% of GDP. This raises an additional concern: that weaker exports could lead to a sharp drop in investment because exporters would need to add less capacity. But Arthur Kroeber at Dragonomics, a Beijing-based research firm, argues that investment is not as closely tied to exports as is often assumed: over half of all investment is in infrastructure and property. Mr Kroeber estimates that only 7% of total investment is directly linked to export production. Adding in the capital spending of local firms that produce inputs sold to exporters, he reckons that a still-modest 14% of investment is dependent on exports. Total investment is unlikely to collapse while investment in infrastructure and residential construction remains firm.

Again, things are not so simple. Property is built for a reason and needs to be sold to someone. Likewise with infrastructure. A fall in exports could trigger a reversal in more than just exports as the fall in confidence reverberates around the economy.

The article concludes:

Dragonomics forecasts that in 2008 the contribution of net exports to China's growth will shrink by half. If the impact on investment is also included, GDP growth will slow to about 10% from 11.5% in 2007. This is hardly catastrophic. Indeed, given Beijing's worries about the economy overheating, it would be welcome.

I think this is an overly optimistic forecast. For one a recession in the EU or Japan would have an effect of a similar magnitude to the US. Second, the asset bubbles in China do not require much encouragement to burst.

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"A Bull in China": New book of the month

Jim Roger's new book on China is called "A Bull in China: Investing Profitably in the World's Greatest Market".

A Bull in China: Investing Profitably in the World's Greatest Market

This book is now the current book of the month (it was book of the week but I am too lazy, so much so that it really should be book of the 1/2 year).

The reason I have been jolted into action is that Jim Rogers is one reason for my interest in China after reading his previous book "Adventure Capitalist".

Adventure Capitalist: The Ultimate Road Trip

If the book contains the vision of his previous book it will be a valuable read. It will also be an entertaining read I am sure.

I have similar concerns to the reviewers on Amazon. It seems a little late to bring out a book on buying Chinese equities given the current bubble. Moreover, buying Chinese stocks in not that easy for foreigners. However, I said this about commodity stocks in 2002 and got that spectacularly wrong as prices soared.

Click HERE for an interview with Jim Rogers from August this year.



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The imminent China CRASH

There is nothing an economist likes better on a Friday night that a little bit of doom and gloom. We are not called "dismal scientists" for nothing.

Asia Times has come up with a good one. I have reprinted it in full as it is a real pleasure to read. I will not argue the the opposing bull case here suffice to say I am in total agreement with a lot of the text that Martin Hutchinson at Prudent Bear has to say.

The coming China crash [Asia Times]

While the Chinese stock market, as measured by the China Securities Index 300, is down 18% since October 16, that follows a period of almost two years, since January 1, 2006, during which the CSI 300 soared 535%. Chinese economic growth is currently running at more than 11% and the big money is convinced that it will continue. At the same time, the country’s foreign exchange reserves have grown to US$1.4 trillion, the largest in the world.

A crash would appear to be imminent!

Bears on China have been common for the last decade, and their track record has not been good. To take just one unfair example, Henry Blodget, the former Internet genius, wrote in Slate in April 2005: "You've probably been daydreaming about the fortune to be made in Chinese stocks. Well, keep dreaming ... you'll eventually conclude that you could have done better selling insurance in Toledo." That was about six months before the Chinese market took off, and if anybody has made 500% on their investment by selling insurance in Toledo during that period, I haven't met him.

To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation, the US$200 billion sovereign wealth fund set up by the Chinese government in September. Now $200 billion is a fair chunk of cash; you could almost buy all but three US corporations with that (at today's prices, ExxonMobil, General Electric, Microsoft – there are four or five others including Google that barely top the bar.) Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment's moves into the market were awaited with bated breath.

Well, so much for that. A third of China Investment's portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. About $3 billion of the fund was invested in the private equity manager Blackstone in May - that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in US Treasury securities - which are also losing money steadily in yuan terms.

The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses and have been propped up by the banking system. Since 2004, loss-making state-owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses have resulted in bankruptcy; instead the cash flow deficits have been covered by the Chinese banks. As a result, these banks have an enormous volume of bad loans $911 billion at May 2006, according to a later-withdrawn estimate by Ernst & Young, which must surely have ballooned to $1.2 trillion to $1.3 trillion now.

That explains why China Investment is somewhat unaggressive in its international investment strategy. China's $1.4 trillion of reserves will in fact almost all be required to prop up the banking system when the inevitable liquidity crisis occurs. If the banks are to survive, China Investment will have to be followed by six more sovereign wealth funds of equal size, each of which will have to abandon its attempts to take over Exxon or Google and pour its money down domestic rat-holes.

A $1 trillion problem in subprime mortgages has caused even the US money market to seize up and has required frequent applications of sal volatile by the Fed. Since China's economy is around one fifth the size that of of the United States, the Chinese banking system's bad debt problem is in real terms about five times that of the United States, or about 40% of its gross domestic product.

We have seen this movie before; the Japanese banking system's bad debts after 1990 totaled around $1 trillion, about 30% of Japan's GDP. The result was the bursting of the 1980's bubble and a period of little or no economic growth that lasted well over a decade. Admittedly the Japanese authorities made matters worse by refusing to face up to their bad debt problem and issuing more government bonds to fund witless Keynesian public spending schemes.

Nevertheless, we can have very little confidence that the Chinese authorities, once the same problem stares them in the face, will do any better. After all, at least one of the alternative policy mixes, that tried by Herbert Hoover and the Federal Reserve in 1930-32, proved very much worse. Per capita US gross domestic product was no higher in 1940 than it had been in 1929, as in the Japanese case, but in the interval it had declined by a horrifying 28% and had recovered very slowly. If China faces the choice between a decade of stagnation, as in Japan from 1990-2003, and a decade of economic collapse, as in the United States from 1929-1940, it will rightly prefer the Japanese alternative.

It may not however have the choice. One of the factors that kept Japan out of real trouble in the 1990s was continued strong growth in the US and world economies; thus its magnificent export industries were able to continue growing, albeit at a slow rate, and provide a certain amount of traction for the economy as a whole. However, China will find it difficult to do the same, since the next decade does not seem likely to be a period of robust world growth. Far from it. The United States seems fated to endure at least a few years of very sluggish growth due to its housing market crash, and Britain appears to be in a similar mess, so even relatively robust growth in the resurgent economies of Germany and Japan may not be sufficient to keep Chinese exports growing.

At that point, China will have two alternatives. It can allow the banks to work their way out of their bad loans, condemning the domestic economy to probably a decade of little growth and extremely tight credit (high Chinese savings would alleviate this problem, but they will be trapped in the Chinese banks because the authorities foolishly do not allow Chinese citizens to invest abroad). Alternatively, it can inject more or less its entire foreign exchange reserves into the domestic banking system in order to recover its bad debts, which would allow the Chinese economy to continue expanding, but at a cost of devastatingly high inflation from the additional money pumped into the system (the $100 billion plus of Chinese bank initial public offerings carried out in 2006-07, pumped into the domestic economy, already appears to be worsening Chinese inflation and China Investment’s $130 billion will doubtless further aggravate the problem.)

We have seen societies with low economic growth, very high inequality (as China has now) and persistently high inflation; they are collectively known as Latin America. Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses. That would be the worst possible outcome for the Chinese people, but it is not by any means impossible.

Many observers of the current US financial market downturn comfort themselves with the thought that the world now has more than one growth engine, and that China, with four times the US population, can because of its very high growth pull the world economy along sufficiently even when the US stalls. However, if China is about to incur the inevitable backlash from its recent debt and equity bubbles, during which practices have flourished that have no place in a well-functioning free market, then we may be entering a world in which the two main growth engines of the last decade are both broken. Growth in such a world will be truly sluggish and inflation high, as the world struggles to cope with the effects of an excess of cheap money now grown toxic.

The problem with major recessions is that they tend to produce foolish political reactions. In the United States, it seems likely that a major recession if we have one will produce resurgent protectionism and an aversion to world trade, which to the voting public will appear to have been responsible for the loss of millions of good US jobs without any corresponding gains to the living standards of the majority. Japan, bless it, remained admirably politically stable during its sluggish decade, and eventually found a leader in Junichiro Koizumi who was able to lead it back into renewed growth.

In China, there can be no assurance whatever that a populace whose living standards have suddenly stopped improving will not turn to violent nationalism and/or counterproductive economics. Since the country is not a democracy and not likely to become one, the authorities are likely to react to hardship as did Vladimir Putin to the chaos of late 1990s Russia, imposing even more draconian repression and seeking a military adventure abroad to occupy the masses of disaffected youth and distract the public from its new poverty. That too would produce a future in the West far worse than would be cased by a mere domestic recession.

Bears who weary of observing the chaos in the US financial markets can cheer themselves up by looking at China. There will be more than one source of the oncoming world downturn!

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Insider Trading and Chinese cultural differences: real or imaginary?

One aspect of working in academia is the claim of "cultural differences" in student approaches to higher education.

Although this excuse has previously be used as a defence for plagiarism this is the first time I have seen such a defence used for "insider trading".

The judge said she was ``mystified'' why the couple, both ``classic overachievers'' raised in China, would trade on inside information. Wang's lawyer, Catherine Redlich, said there may have been a ``cultural'' basis for the crime.

The defence lawyer then stated:

``In the People's Republic of China, insider trading is only rarely, and not until very recently, prosecuted as an offense,'' Redlich said.

This story gives us an insight into the behaviour of the Chinese stockmarket and to me is another bear signal. The Chinese stockmarket is a sell at current levels in my opinion. With corruption clearly rife, current share prices resemble of classic ponzi scheme.

Ex-Morgan Stanley, ING Couple Sentenced to Prison [Bloomberg]

Dec. 4 (Bloomberg) -- An Ex-Morgan Stanley vice president and her husband, a former ING Investment Management analyst, were sentenced to 18 months in prison as a judge assailed the ``pure greed'' that drove them to trade on secret stock tips.

U.S. District Judge Colleen McMahon in New York today turned aside a request by Jennifer Wang, of Englishtown, New Jersey, that she get probation so that she may care for her infant son. Wang and her husband, Ruben Chen, faced as long as 37 months in prison after admitting in September that they made $611,000 through three trades based on inside information.

``A clear message does need to be sent to everyone who works in this industry,'' McMahon said. ``You are both culpable. You are both going to do prison time.''

U.S. prosecutors this year have stepped up efforts to combat insider trading. A former Bear Stearns Cos. broker last week became the ninth person to plead guilty in a wide-ranging insider case that also involved UBS AG and Morgan Stanley employees. In August, a former Goldman Sachs Group Inc. associate pleaded guilty to making more than $6.7 million through illegal trades.

McMahon ordered the couple to pay $611,000 in restitution. She staggered the couple's prison terms, ordering Wang to prison after Chen completed his sentence.

The judge said she was ``mystified'' why the couple, both ``classic overachievers'' raised in China, would trade on inside information. Wang's lawyer, Catherine Redlich, said there may have been a ``cultural'' basis for the crime.

Rarely Prosecuted

``In the People's Republic of China, insider trading is only rarely, and not until very recently, prosecuted as an offense,'' Redlich said.

``Pure greed,'' McMahon replied. ``That's all I'm left with.''

Wang and Chen were arrested in May for trading in the securities of Town and Country Trust, Glenborough Realty Trust and Genesis Health Care based on information Wang learned from New York-based Morgan Stanley. They made their illegal trades from December 2005 to March 2007.

According to the government, Morgan Stanley was advising its Morgan Stanley Real Estate unit on the acquisition of both Town and Country and Glenborough. Wang learned about the firm's failure to acquire Town and Country and the successful purchase of Glenborough before the transactions became public and tipped her husband to the news.

``The people who committed this crime, like most criminals, didn't believe they'd get caught,'' Assistant U.S. Attorney Reed Brosky told McMahon at the sentencing hearing. ``That's a sad reflection on our society and Wall Street.''

`Take the Fall'

Wang and Chen each pleaded guilty to one count of conspiracy and three counts of insider trading. Chen, a former hedge fund analyst, had asked to be sentenced to 30 months in prison.

McMahon said she wouldn't permit Chen ``to take the fall'' for his wife, who was ``more culpable.''

``You are a thief,'' McMahon told Wang.

The couple was arrested on the same day that Randi Collotta, a former Morgan Stanley compliance officer, pleaded guilty to insider-trading charges. Collotta was sentenced to probation and 60 days in custody on nights and weekends. Her husband, who also pleaded guilty in the case, was sentenced to six months of home-confinement.

Redlich cited ``the other Morgan Stanley couple case'' when she sought probation for Wang.

Neither defendant spoke during the sentencing.

Representatives of ING Groep NV, the largest Dutch financial-services company, and Morgan Stanley have said their firms cooperated with federal investigators.

The case is U.S. v. Wang, 07-cr-730, U.S. District Court, Southern District of New York (Manhattan).

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Stockmarket off 20% since its peak

The bubble had to burst - whilst I got the final size of the bubble wrong its eventual bursting remained inevitable and whilst large profits were made on the way up those mug punters who bought for the first time at the peak are already nursing loses of up to 20%.

Shares trading on a PE of 46 are still way overvalued. China has specific issues relating to asset allocation and the choices available then may limit the fall but this should not detract from the overvaluation and small investors move in a herd it may be hard to reverse this downward trend in a hurry.

The question is whether a large deflation will have knock on effects across global stock markets.

Chinese stocks face biggest monthly drop since 1995 [China Post]

SHANGHAI -- Chinese stocks are poised for their steepest monthly decline in more than 12 years as the government deflates a bubble that caused prices to quadruple in a year.

The Shanghai Composite Index has fallen 16 percent in November, the most since February 1995, when Bloomberg started keeping records of the benchmark. Shares in the index trade at an average 46 times earnings, according to data compiled by Bloomberg. The MSCI Asia Pacific Index and the Standard & Poor's 500 Index are valued at 18 times.

While this year's rally turned Beijing-based PetroChina Co. into the biggest company by market value and made Industrial & Commercial Bank of China Ltd. the largest bank, five interest rate increases by the People's Bank of China and higher taxes on trading shares sent the index down 18 percent from its Oct. 16 record. The past five times the Shanghai Composite Index dropped 20 percent or more from a high, losses deepened to an average 35 percent before recovering, Bloomberg data show.

"The risk facing the stock market is considerable now, as the government is trying to squeeze an asset bubble," said Zhang Ling, who manages the equivalent of US$1.1 billion with ICBC Credit Suisse Asset Management Co. in Beijing.

U.S. billionaire Warren Buffett said last month investors should be "cautious" about China's stock market. Six months ago, Li Ka-shing, China's richest man, said it "must be a bubble."

The decline in China compares with a 21 percent decrease in Japan's Topix index from its February record to Nov. 22, the first of the world's 10 biggest stock markets to enter a bear market since the summer's U.S. subprime-mortgage collapse. A 20 percent drop within 12 months is considered by traders as the start of a bear market.

The two-year-old CSI 300 Index, which tracks shares on the Shanghai and Shenzhen exchanges, fell 21 percent from its Oct. 16 peak through Wednesday, and rose 4.2 percent Thursday. It's still the world's best-performing national index of the 90 benchmarks followed by Bloomberg.

"It's far too early to talk about a prolonged bear market as domestic demand is still strong," said Leo Gao, who helps manage the equivalent of US$2.3 billion at APS Asset Management Ltd. in Shanghai. "We could see a rebound when banks get their fresh quota of loans in the new year."

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Chinese "A" shares to fall further?

China "A" shares fell again on news of fresh tightening. I have a feeling that this is only the beginning.

There is nothing like fueling a fire but the rumour posted on China Financial Markets is too good not to repeat here. China Financial Markets is an excellent blog with accurate and informed opinion.

Chinese shares down 2.4% on fresh tightening measure [Peoples Daily]

Chinese share prices were sharply lower on Monday as the benchmark Shanghai Composite Index dropped 2.4 percent after Saturday's half percentage point increase in reserve requirement ratio for banks.

The key index, which covers both A and B shares, lost 127.81 points to close at 5,187.73 points.

Here is the Pettis piece. I am providing the "rumour" in full to ensure no misunderstandings. I, for one, buy the analysis spelled out here. The possible problem though is that if funds begin to sell off in expectation of this rumour then the index might not be introduced for fear of causing even greater sell off (even though one could then argue that it is already in the price). Things might get messy, quickly.

Index futures? [China Financial Markets]

One of the advantages of having so many of my students become traders in Hong Kong and the mainland is that I get to hear a lot of the rumors. Two of my former students recently told me about a rumor that seems to be very current in the market, and I called a third who also told me that he had heard it and he thought it was reasonably credible. The rumor is that last week the Social Security Fund was asked to sell off up to 30% of its A-share positions over the next 30 days.

The last time these kinds of rumors surfaced, I am told, was last May, just before the May 30 increase in the stamp tax that trashed the markets. The interpretation that these guys are putting on it is that we may finally see, early next month, the introduction of index futures. Since these instruments are not available to retail investors, who would probably use the futures as a way of taking leveraged long positions, but are likely to be used by institutions, who are expected to use this largely for shorting purposes, most people expect that the introduction of index futures will drive the market down.

Among other things a number of investors told me that they plan to buy H-shares and B-shares, which are at a deep discount to the A-share market, and hedge market risk by shorting the index. There will be lots of tracking error, but given the size of the discount most people are not terribly worried about it.

I have no idea if this true or not and of course make no representation that it is, but this does seem to be a common rumor, and even if it is not true it may affect market behavior in the near future.

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Chinese bubble begins to burst

Not a moment too soon the Chinese market is beginning to see the first signs of some reality sinking in.

Chinese share prices fall drastically [People Daily online]

Chinese share prices nose dived on Thursday after a timid rebound on the previous trading day, with the benchmark Shanghai Composite Index closing at 5,330.02 points, down 4.85 percent.

The Shenzhen Component Index on the smaller bourse in Shenzhen ended at 17,465.46 points, down 4.21 percent.

The combined daily transaction volume on the two exchanges stood at 128.2 billion yuan (17.2 billion U.S. dollars), up from the 112.58billion yuan (15.1 billion U.S. dollars) on Wednesday.

So what were the catalysts?

Clearly the recent stock market floatations that went to huge premiums on day one and numerous articles about the first trillion dollar company, PetroChina, ram home the excessive valuations.

PetroChina tops trillion-dollar mark[LA Times]

Secondly, we had the Buffet and Greenspan warnings:

Buffett calls for caution over China stocks[FT 24th October 2007]

Chinese investors reject Greenspan warning[Reuters May 25th 2007]

Greenspan's warning for China [Independent 25th May 2007]

third, we have the recent regulation changes delaying the ability of Chinese residents to buy Hong Kong shares. This may have been the straw that broke the Chinese camels back.

China puts Hong Kong share plan on ice [FT November 4th 2007]

China has in effect frozen a proposal to allow mainland citizens to buy shares in Hong Kong, a decision that threatens to undercut the recent surge in the former colony’s equities market to record highs.

Wen Jiabao, the premier, has attached four conditions to final approval for the scheme, all of which are so open-ended that Beijing could take months, if not longer, to permit it to go ahead.

In reality there could be any number of reasons (the falling dollar, political pressures, oil price rises, inflation in food prices, increases in wages) but what it is important to remember is that the political ramifications from a share price collapse are potentially enormous. With the military and state owned enterprises owning a large amount of stock in addition to the millions of individuals the implications for the stability of China should not be underestimated.

I am sure this topic will get more coverage in the days and weeks to come.