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May 14, 2007

Is China's Equity Market Poised for a Violent Burst?

China's equity market has reached such a frenzy of irrational exuberance that Chinese authorities are not the only ones sounding warnings about the market becoming overheated.

China's benchmark Shanghai Index soared 130% in 2006 and, since the February correction, is up another 40%. The nation's economy rose 11.1% in the first quarter and 10.4% in the previous quarter, while China's trade surplus is double what it was a year ago.

With all of this excessive liquidity, billions are pouring into new mutual funds on the very first day of their debut. Every day, 200,000 Chinese join the investing ranks, with 91 million mutual fund accounts now open with $126 billion in assets.

Lacking traditional measures to cool the market, the China Securities Regulatory Commission has been dragging its feet on approving new mutual funds and forcing companies to set lower prices on their IPOs. But that's only contributed more to the casino-like madness.

China's securities regulator is now considering only allowing better-quality, "red-chip" companies to offer IPOs as a way to stabilize the market. Meanwhile, the People's Bank of China has raised the required reserve ratio for banks, now 11%, seven times in the past year and is now considering raising interest rates.

But a number of economists are not convinced these measures will suffice. Xia Bing, director of the finance department at the State Council of the People's Republic of China, recently warned investors to be cautious. BCA Research issued a note saying, "We have no doubt if China's market continues to spike up, the stage will be set for a very violent drop."

Morningstar Analyst Bill Rocco also recently cautioned investors in China-focused funds, noting that they have lagged emerging markets funds over the past three, five and 10 years. Rocco points out that China is a communist country, and with that comes political and governmental risk. In addition, China's economy, heavily dependent on exports, would be hurt by protectionist measures by its trading partners in the U.S. and Europe.

If none of these stats are convincing enough, take a look at one last fact: The average price-to-earnings ratio of the Shanghai and Shenzhen markets is now over 50. If that's not setting the stage for a market burst, I don't know what will.

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