Quietly this week, China has crossed yet another milestone in its evolution as the new economic superpower for the 21st and 22nd centuries. Four of the top 10 companies by market capitalization globally are Chinese, compared to only three in the United States (the other three are European). This is a stunning achievement, and one that deserves kudos from around the world.
I don’t really care that this victory came about due to the unraveling of the financial legerdemain of US banks such as Citigroup and Bank of America, both of which fell below the top 10 this week. This kind of price adjustment to unexpected write-offs may strike some as an overreaction, but not people like me who have been arguing for a long time that US and European banks depend on Asia for bailouts anyway .
To be sure, I am fully confident that US banks will claw their way back, if for nothing else because they work in the unforgiving realm of market capitalism . That is not to say though that they will necessarily exceed the market values of Chinese banks in the near term, because many financial chiefs now acknowledge that it will take more than three quarters for these banks to put their subprime problems behind them.
The other point that doesn’t worry me is that Chinese companies (and Asian companies in general) trade at lofty price-earnings ratio multiples (PER in the equity investors’ parlance) especially relative to the US and European companies. Well, what do you expect when one economy is growing at well over 10% while others are stuck in the 1 to 2% growth range? When adjusted for underlying growth, Chinese ratios do not look expensive. That’s why I don’t really care that billionaire investment guru Warren Buffett sold his stake in PetroChina recently; his record of being a successful stock market investor is anyway overstated by a large margin (but that’s a topic for another article).
The factors that do worry me are not usually discussed in Asian newspapers or indeed the wider financial media, which is why readers here will do well to keep them in mind: these include unsustainable levels of money growth, the implied protection of equity values that has caused excessive investor confidence, poor standards of corporate governance, and lastly the legacy of state control that leaves much to be desired in terms of free capital transfers. In the following paragraphs, each of these four factors are examined in turn.
Too much money
The most important reason for the growth in Chinese stock markets is the unsustainable money growth unleashed by the government’s decision to keep the yuan pegged to the US dollar . By adopting gradual appreciation against the US dollar against a larger one-off movement, the government has effectively shot its own central bank, the People’s Bank of China, in the foot by disallowing price stability.
The new Great Wall of Money in China has effectively corralled its stock and property markets into a web of rapid price rises, protecting the markets from externally induced price adjustments, for example because of any changes in global economic growth expectations.
This is good as far as it goes, but when money growth goes into reverse at some point when China realizes its mistake and allows the yuan to float (as I have long argued it must), the Wall will disappear overnight, and leave the stock and property markets at the mercy of speculators who can easily topple the values of all the large companies in China today.
Declines in the stock market wouldn’t be a problem but for the unique nature of China’s markets. Ever since the fiasco with the trust and investment companies (ITIC) sector in the late 1990s , Chinese authorities have been very cautious about understanding exactly what public expectations are with respect to any investment.
Thus, they clarified the position of the big four “policy” commercial banks – Bank of China, Agricultural Bank of China, Industrial and Commercial Bank of China and China Construction Bank – relative to smaller banks around the country. Similarly, when property markets appeared to get out of hand in Shanghai, then president Jiang Zemin moved to dismiss the local mayor and ensure that the property market did not get too hot.
Unfortunately, and thanks to the government’s obduracy on the yuan highlighted above, the stock market has gone to dizzying heights, propelled by every student, housewife and street corner geriatric imaginable. The stunning growth of brokerage accounts – over 100,000 per day earlier this year, has pushed money out of bank accounts into the stock market, where it chases “cannot fail” companies.
This logic is flawed because while no one expects the likes of Bank of China to fail, that doesn’t mean the stock price will stay where it is now! Investors in China’s local markets simply do not appreciate the difference between the safety of a bank deposit and that of a share, and herein lies a big fault line for the government to cross.
This is why the central bank and concerned officials talk the market down from time to time. Their words go unheeded, and that in turn may force a sharper reaction at some point – because about the last thing the government wants now is for a million shareholders to come on to the streets and demand compensation for stock market losses.
Poor corporate governance
The third major problem with Chinese companies is the abysmal corporate governance standards in place. Granted, there is no real comparable “gold” standard in Asia today – think for example about accounting standards of Japanese companies – but there is still a lot of room for improvement.
Dodgy accounting is certainly something that has recently caught Americans with their pants down, but it is my hope – not my belief – that Chinese companies will do better. A casual analysis of some financial statements shows substantial levels of income from unexplained sources, like investments. While that is all right for investment companies, I am less clear why telecom and steel companies should have a large portion of their annual earnings being derived from gains on the stock market.
This is a dangerous game to play, as the Japanese companies found out in the 1990s. With a large number of cross shareholding and direct market bets helping to boost the Japanese firms’ own earnings, the first decline in stock markets soon produced massive earnings write-offs from companies that had really no business being in stock market investments, like retail stores and tire manufacturers. That in turn perpetuated the stock market decline in Japan, leading to the country’s permanent state of recession since then.
The last troubling bit, and by no means the least, is the significant extent of state control on Chinese companies. This produces multiple distortions. Firstly, the number of shares actually traded is lower than what is available to trade. As market capitalization of US companies almost always covers free floating shares, their values are more believable than those of Chinese companies where more than 50% of large companies’ stocks do not actually trade at all because they are owned by the government. In turn, this produces the phenomenon of too much money chasing too few stocks, known in the markets as the “Dot Con” phenomenon.
The second element of distortion brought by state control is the lack of professional management that could force companies to indulge in sub-optimal behavior. Thus, while a petroleum refiner may or may not choose to deal with Sudan based on commercial interests, the element of state control makes it more likely that the decision is politically tainted, and therefore eventually dangerous for shareholders.
The sector with the biggest risks on this score is obviously the commercial banks. With state-directed lending and government-influenced investments on the rise (for example by a Beijing investment company in the rescue effort of a US investment bank), it is clear that the seeds of further problems are being sown today. For example, there is a lot of talk that US Treasury Secretary Hank Paulson has requested direct assistance from Chinese banks for the problems of the structured investment vehicles sector. With even US banks shying from this proposal, it is very likely that Chinese banks will be left holding the baby of unexpected losses for years to come, should they comply with the request because of government pressure.
Reading all these four factors together, it is clear to me that China’s victory parade must be put on ice for a while. The government should let the currency float and remove excessive money growth as well as sell off its own stakes in these companies in order to get the right market levels. Chinese investors must be better educated about the outcomes of investing in stock markets, and not expect any government bailout.
Without all these factors in play, investors could very well look back in two years time at what went on this year as the seeds of a Ponzi  scheme that eventually collapsed under its own weight. There is time yet, but too many things can go wrong for China’s future for authorities to remain hands-off in the current situation. It is time to act now.
1. Asia and the vicious cycle of bank bailouts Asia Times Online, August 11, 2007.
2. Off with their heads Asia Times Online, November 6, 2007.
3. Deja Wu: Why China must revalue Asia Times Online, June 30, 2007.
4. Attempting to trim the power of Guangdong provincial officials, the authorties shut down the operations of Guangdong ITIC or GITIC, in turn causing a panic withdrawal of deposits from all other ITICs in the country. Only the Beijing-based China ITIC (CITIC) survived, leaving bondholders in other ITICs nursing their wounds for years to come.
5. A Ponzi scheme is a fraudulent investment operation that involves paying abnormally high returns (“profits”) to investors out of the money paid in by subsequent investors, rather than from net revenues generated by any real business. It is named after Charles Ponzi. Wikipedia entry.