China’s Stealth Market Crash

04/09/2008 12:00 am EST

Focus: GLOBAL

Jim Trippon

Editor-in-Chief, China Stock Digest

James Trippon, editor-in-chief of China Stock Digest, says mainland China has experienced an actual stock market crash, which has not been reported in western media.

The invisibility of Chinese stock markets hit home this month as the Shanghai Composite index went into a nosedive. The index is now off more than 40% from its peak last October.

In any other stock market this kind of setback wouldn’t be called a slump or a correction; it would be known as a crash. In fact, many individual Chinese investors do see it that way. One trillion dollars has been shaved off the market capitalization of Chinese stocks on mainland exchanges in just six months. It’s an astonishing loss, and it has gone largely unreported and unexplained in western financial media.

Those who have mentioned the stock plunges in Shanghai and Shenzhen have loosely associated those setbacks with western economic events including the subprime fiasco and the Western liquidity crunch. But China operates differently from the West, and its stock markets are influenced by unusual factors. To be sure, China’s internalmarkets were in a bubble last year with valuations far out of whack with international standards, because Chinese markets operated in isolation from the world.

China’s stock markets and most of its investors are still relatively immature and inexperienced. Investing had become a kind of sport among many Chinese people. With no mechanisms to short sell stocks and no futures market, the only way to make money was to bet on increasing share prices. The system was set for a perfect storm.

A speculative bubble developed, and it didn’t take much to pop it. Chinese investors became increasingly aware of the premium they’re paying for stocks traded within China compared to valuations of stocks and American Depositary Receipts for the same companies abroad, and the slide began in Shanghai and Shenzhen.

Despite the crash on mainland exchanges, investors are still paying a premium for most shares. That’s partly because shares of internationally traded Chinese companies declined sharply in tandem with the overall decline in US and world markets caused partly by the subprime mess. China’s internal “A” shares fell hard, but international shares like Hong Kong’s “H” shares fell also, keeping some of the spread intact.

The People’s Bank of China recently announced that it was about to [revive the plan to allow mainland Chinese to invest in Hong Kong,] effectively opening the floodgates for overseas investing. The People’s Bank of China has little choice: the huge pools of capital created by China’s growing trade surpluses could touch off widespread economic overheating. Opening the floodgates to foreign investment [by mainland Chinese] will drain liquidity from the system.

Currently many China based stocks are undervalued on the Hong Kong and New York exchanges compared to their industry peers. A green light for [overseas] investment from Beijing may be the signal that turns the tide after a six-month correction in Hong Kong and what amounts to a crash in Shanghai. 

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