Is China Too Hot to Handle?

- Updated June 28, 2010

The Chinese government takes steps to put a lid on an overheated stock market.

New Chinese investors are rushing into the stock market like buyers trying to get their hands on an Apple iPhone or Nintendo Wii.

An average of 300,000 new brokerage accounts for investing in mainland equities and mutual funds were opened daily in the second quarter of this year, according to official statistics. By the end of June, retail brokerage accounts totaled more than 105 million. On some days, investors opened as many as half a million new accounts.

The Chinese stock markets have been on a tear. The benchmark Shanghai Composite Index rose from just 1,400 points in May of 2006 to over 4,300 points by end of June 2007.

Although China has one of the world’s highest savings rates, investors are taking funds out of those accounts. Others are actually borrowing money to invest in the stock market.

Ying Xuefu, who is working on a master’s degree in economics at the Zhongnan University of Economics and Law in the city of Wuhan in central China, is new to investing, but he put 3,000 yuan ($394) into the stock market. This might not sound like much, but last year, the average monthly salary of a Wuhan resident was just 1,052 yuan ($138), according to China’s National Bureau of Statistics.

Ying says some classmates invested as much as 20,000 yuan ($2,621). “Our whole class is in the stock market right now,” he says. “All 40 students in our class are buying stocks with their student stipends, or borrowing money from others.”

But it’s not only inexperienced retail investors who are caught up in the frenzy. Eight of China’s major banks were slapped by regulators this summer, after being caught lending money to businesses for gambling on the stock market. On June 18, the China Banking Regulatory Commission (CBRC) said that the banks improperly loaned money to Shanghai-based China Shipping Group and Beijing-based China Nuclear Engineering & Construction Group.

Since last summer, China Shipping has put 2.4 billion yuan ($320 million) into the Chinese stock market. The money was borrowed from the Shanghai branches of China Merchants Bank, Industrial and Commercial Bank of China, Bank of China, Industrial Bank, Citic Bank and Shenzhen Development Bank.

China Nuclear Engineering has been gambling since 2001, according to regulators. The company borrowed 132 million yuan ($17.32 million) from the Bank of Communications and the Beijing Commercial Bank in order to invest it in the stock market—on top of additional loans for other securities and real estate.

The banks involved were fined and individual officials were publicly censured and fined. In particular, the CBRC fined the Shanghai branch of China Merchants Bank 170 million yuan ($23 million) and charged the other five branches just under 500,000 yuan ($66,000) in fines.

With excesses such as these, the Chinese government has taken several steps to put a lid on the market, including raising interest rates, letting the yuan drop further and tripling fees for individual stock market transactions. The government has also started to open up new investment avenues, including the bond market and overseas investment, in an attempt to cool off some of the pressure on equities.

Yuan on the Rise

Driving the stock market to such heights is China’s booming economy, which grew by 11.1 percent in the first quarter of this year. Earlier this year, MasterCard International’s twice-annual consumer confidence index scored Chinese consumers at 81.2—up four points from six months before and significantly above the Asian average of 64.3.

Not all of this exuberance is irrational, given China’s recent growth history, but as the economy and the stock market continue to climb, so do fears of a hard landing.

In late May, China’s central bank raised the benchmark one-year interest rate by 0.18 percentage points and the benchmark one-year deposit rate by 0.27 percentage points, making it slightly more expensive to borrow money. In June, the central bank followed this with a 0.5 percentage point increase to the banks’ required deposit reserve ratio, making less money available for lending.

So far, the measures have had no discernible effect on China’s economic growth rate, investor confidence or the stock market.

“The currency policy adjustment directly hits the financial institutions, but it’s not going to change consumers’ investment plans,” says Wang Cheng, an analyst with Shanghai’s Guotai Junan Securities Research Institute.

Letting the yuan appreciate didn’t help much either.

In late May, China’s regulators increased the range in which the yuan was allowed to fluctuate each day from 0.03 percent to 0.05 percent. The result was a slight increase in the value of the Chinese currency, from over 7.7 yuan to the US dollar at the end of March, to 7.6 yuan at the end of June.

What did have an immediate, though very short-lived, impact, was a hike in the stamp duty, a fee that investors pay on each transaction.

The Ministry of Finance tripled the fee from 0.1 percent to 0.3 percent at the end of May and the market fell immediately. The Shanghai Composite Index bottomed out at 4,015 points, a 6 percent drop, though the daily turnover broke through 410 billion yuan ($54 billion), a new historic volume.

The Shanghai Stock Exchange had to halt trading on over 800 stocks when they ran up against trading limits.

“The government is clearly showing a constructive attitude toward the stock market through this policy,” says Hua Sheng, an economist and president of Yanjing Overseas Chinese University.

“The adjustment of the stamp duty policy increased the transaction costs significantly and can suppress the excessive speculations on the market,” Hua says.

The next day, another half-million investors opened brokerage accounts and the market began to rebound. By mid-June, it returned to its previous highs.

More Alternatives

Investors have also attracted new companies to the mainland stock markets, companies which previously may have listed in Hong Kong or other international investors.

The wave of new IPOs is helping to sop up some of the excess liquidity in the market.

On June 20, the China National Petroleum Corp. announced a 4 billion yuan ($527 million) IPO on the Shanghai Stock Exchange. Less than a week earlier, China Construction Bank announced a 9 billion yuan ($1.2 billion) IPO.

More IPOs are expected to follow, as the mainland markets are becoming an increasingly attractive alternative to Hong Kong.

But investors don’t just have more choices when it comes to companies to invest in. Regulators are also opening up more investment avenues, including bonds and off-shore products.

Today, most retail investors still have few alternatives to equities—namely low-interest savings accounts or real estate.

“With limited investing vehicles in China, most people have chosen the stock market,” says Niu Li, deputy director of the macroeconomics research office at the State Information Center, a Beijing-based research organization.

In June, however, China allowed domestic brokerages and mutual funds to put money into international investments, which could help channel some of this money flow offshore. In addition, the government took steps to make it easier for corporations to issue bonds.

Today, most bonds in China are government bonds. Creating a corporate bond market could provide another investment opportunity, one that is slightly less risky than the stock market.

“The messy situation around the stock market is temporary and it will be improved by further regulation and reform under the government,” says Niu.

But the single biggest reform in the Chinese stock market is already well under way.

Until two years ago, the Chinese government owned about two-thirds of all listed companies in the form of non-tradable shares. In May of 2005, companies were allowed to start converting non-tradable shares to tradable form—a process that is now almost complete.

Previously, when companies were majority owned by government agencies, their managers were responsive more to political pressures than economics. With the reforms, companies are expected to become more market driven—and more attractive to investors.

“The big [government] shareholders didn’t care about the price of their shares before and also left the administrative stuff alone since they raised enough money,” says Shanghai-based Haitong Securities macroeconomics analyst Wang Hui.

“The situation was not conducive to the development of a healthy capital market in the long term,” says Wang. “The reforms can drive companies to improve their management and administration.”

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