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Deja vu for China's stock markets
By Mark A DeWeaver
Something remarkable happened in China's A share markets this summer. As of
August 19, the Shanghai and Shenzhen indices had each risen 16% from nine-year
lows reached in June and July, and both appeared to have broken out of their
four-year-long downtrends. Much of the credit for this remarkable turnaround
appears to be due to the generous incentives now being offered to minority
shareholders by companies converting state-owned to tradable shares. But
another factor may be even more important. While macroeconomic fundamentals
generally seem to have little correlation to Chinese market trends, there is
one rule that has worked ever since the markets opened in the early 1990s:
share prices go down when austerity programs begin and up when they end. And
there are now signs that, after two years of tightness, policy may again be
easing, as officials begin to express the view that deflation has become a
greater risk than inflation.
The origin of the markets themselves was part of a policy easing that began in
1990 after the inflation of the late 1980s had finally been brought under
control. The period following the Tiananmen incident of June 4, 1989 had seen a
particularly severe contraction, and there had even been some doubt about
whether the post-Mao policy of reform and opening would continue. But, as Deng
Xiaoping's reform faction gained the upper hand in the central government, all
such concerns were finally put to rest.
What followed was one of the great asset bubbles of all time. Valuations rose
to dizzying levels as small investors piled into the shares of the small number
of companies that had listed, while the companies themselves colluded with
brokers to manipulate prices. At the same time, Shanghai and Shenzhen were
flooded with unauthorized liquidity from financial institutions, state
enterprises, and government units throughout the country, which had diverted
funds to the new bourses from less lucrative legitimate purposes. At the peak
of the frenzy in March, 1993, the Shanghai index was up 14 times from its
starting value of December 19, 1990, while its Shenzhen counterpart had risen
three and half times from a slightly later initial date of April 3, 1991.
What finally brought this party to an end was an austerity program that began
in mid-1993 to rein in money supply growth and inflation. As is generally the
case when the Chinese government decides to cool the economy, the main
macroeconomic control measures involved cracking down on practices that violate
regulations but are ignored during normal periods. Naturally, one of the
primary targets was financing for stock market speculation. The desired effect
was achieved almost immediately - liquidity dried up and prices fell. The
crowds of punters that had once swarmed about the trading rooms were a thing of
the past. And the flow of funds from the hinterland reversed as local
"institutional investors" were forced to cash in their chips and return to
their regular lines of business. The markets lost 70% of their peak values
before bottoming in August, 1994.
The next bull market began when the 1993 austerity program ended in early 1996.
This time, there was nothing quite as dramatic as Deng Xiaoping's high profile
1992 tour of the South to signal the end of the policy. In fact, the central
bank continued to talk about a tight credit policy and bringing down inflation
even as it began to lower interest rates. But policy easing seemed quite likely
as inflation fell to 7.7% in the first quarter, below the official 8% target
for the year. The change was confirmed by lending rate cuts averaging 0.75
percentage points in April.
This time, the bull market would last for five and a half years. Even as the
rest of the Asian markets crashed during the '97-'98 Asia crisis, even through
a multi-year period of decelerating Chinese GDP growth and the deflation years
of 1998 and 1999, the trend remained steadily up. In the midst of all of this
negative economic news, the Shanghai A share index went up almost four and a
half times, while the Shenzhen index rose six and a half times in the period
from January 1996 to June 2001.
Paradoxically, it was just as the Chinese economy finally began showing signs
of reaccelerating in 2001 that this second bull market came to an end. While
austerity programs have always produced bear markets, investors learned that
the converse is not necessarily true - bear markets can begin even in the
absence of austerity. This time the market's decline began following the
announcement on June 12, 2001 of a government plan to begin selling off its
vast holdings of "state shares" in listed companies. These unlisted government
holdings had been hanging over the markets like a sword of Damocles for years
and it finally seemed as though the thread was about to be cut.
The markets trended lower for the following two years. Both the Shanghai and
Shenzhen indices were down over 40% by November 2003, when a rally finally
began on speculation that there might be buyers for the state shares after all.
While there was much talk of new local investment by mutual funds and insurance
companies, stories about newly authorized qualified foreign institutional
investors (QFIIs) entering the market seemed to have the greatest impact.
(Under the QFII system, each of a small number of large financial institutions
is allowed to convert a fixed amount of US dollars, typically several hundred
million, into local currency that can be used to purchase A shares on behalf of
clients. This scheme makes it possible to allow foreign investment in the stock
market in the absence of a freely convertible currency.)
Just as it seemed that the foreign investor might be the white knight that
would rescue the market, however, the specter of a new austerity program once
again reared its ugly head. Having bounced almost 40% from the November 2003
lows, the markets turned sharply lower in April 2004, following the
announcement of new policies to restrain out-of-control fixed asset investment
through restrictions on credit and land use. The indices fell over 40% during
the following 14 months, before rebounding this summer.
Which brings us to today's situation. As of August 19, the Shanghai and
Shenzhen indices are down 48% and 60%, respectively, from their 2001 highs.
Naturally, it is impossible to say how much of this decline is due to the
state-share overhang and how much can be blamed on the austerity program. But
it is worth emphasizing that prior to the austerity measures of April 2004,
investors seemed optimistic that the former problem would be solved (as perhaps
it finally has been). Had there been no policy tightening, the bear market
might well have ended in late 2003. In that case, all of the post-April 2004
losses are attributable to macroeconomic policy, while the policy on state
shares can account for no more than the pre-April 2004 declines of 20% in
Shanghai and 30% in Shenzhen.
In other words, while commentators have generally put most of the blame for the
bear market on the planned state-share sell-off, it is possible that this is
not the primary problem. And if the main reason the markets are at such low
levels today is tighter economic policy, then this summer's rebound may have
more to do with the possibility of policy easing than with the great deals that
state-owned enterprise minority shareholders are now being offered.
In fact, things are starting to look a lot like they did in early 1996, long
before there were any definite plans to sell the state shares. Now, as then, an
austerity program has been going on for an extended period. Now, as then, while
the tightening policy is still officially in place, the inflation data are
signaling that it is no longer necessary. And now, as then, share prices have
bounced, following a prolonged bear market.
Mark A DeWeaver, PhD, worked as a research analyst in Shenzhen
from 1991 to 1995, first for W I Carr and later for Peregrine Brokerage. He
manages Quantrarian Asia Hedge, a fund that invests in Asian equities (on the
web at www.quantrarian.com)
and can be reached at deweaver@quantrarian.com.
(Copyright (c) 2005 Mark DeWeaver) |
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