Why are foreign analysts considering China plays as internationally relevant?

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The tempestuous dragon and global stock markets

By Jon Byrne and Chris Devonshire-Ellis

BEIJING, Aug. 23 – The China stock market continues to sizzle; and with fears that a bubble is developing it is only natural to ask “should investors outside of China worry about a correction or collapse in China’s stock market impacting global markets?”

Some foreign analysts have started to argue that China’s stock market is rapidly emerging as a prime global market mover. The performance of the stock market in world’s fastest growing major economy, so the story goes, is now a key driver of global investor confidence.

This argument seemed to gain traction when a major, near 9 percent slide in Chinese stocks in Shanghai in February was followed by a marked sell-off in global markets. This quickly led some analysts to suggest we were seeing the emergence of China as a major financial center, capable of sending shock waves around the world’s financial markets. The slump served to “demonstrate the impact sharp deteriorations in Chinese stocks can have on international investor sentiment” they cried.

In fact, whilst the Chinese stock market fall may have provided the initial spark, several other factors unrelated to this contributed to the global equity sell-off in late February. Investors were rattled when former Federal Reserve chairman suggested that a U.S. recession was possible later this year, cracks were appearing in the U.S. sub-prime mortgage market and Iran was raising tensions by rattling its nuclear saber.

The Chinese stock market saw even greater falls in early June. What was the global market reaction to this? Largely unruffled, indeed, many major markets continued to climb.

So why is it that the Chinese stock market is currently not a leading global market mover?

For starters, the Chinese stock market is largely tangential to its real economy and a plunge in Chinese stocks is unlikely to have a major impact on the nation’s economic growth. For example, the total value of tradable shares (that is, excluding shares held by the government) is only 25 percent of GDP. This compares with 150 percent in America and over 100 percent in India.

Next, the Chinese stock market is comparatively small from a global perspective and any correction or collapse needs to be viewed in this context. Lehman Brothers, an investment bank, said in a recent equity strategy research note that whilst Chinese stocks display many bubble characteristics they do not carry the same implications for the global stock market as the technology, media and telecoms excesses seen in 2000. For instance, China’s market capitalization is worth just 7 percent of the global total. This compares with 39 percent for technology, media and telecoms stocks in 2000.

Furthermore, China’s domestic stock market remains largely walled off from global capital flows. Its currency isn’t convertible, stringent capital controls prevent “hot money” from entering and exiting the market with the push of a button, and the vast majority of investors are Chinese nationals with no easy access to foreign stocks bonds. Any correction or collapse is likely to remain quite constrained and largely an internal affair.

There are also issues of transparency, credibility and international access. Most of the markets analysts dissect are underpinned by strong transparency and regulatory systems that by and large work. Not so in China, where some 90 percent of the Shanghai bourse much quoted by the “Chinalysts” is actually wholly or partially owned by the State. And the Securities watchdog responsible for monitoring activity? It reports to – the State – the same body much of whose stock quality it is supposed to be monitoring – and consequently has no real regulatory authority or bite. So much for a free market economy then when the government effectively controls what happens – including the lack of punishment meted out to firms who blatantly disregard the regulations. Massive liabilities being undisclosed, assets being over-declared – our consulting practice, Dezan Shira & Associates, has seen them all. You want to quote China plays, you’d better have conducted your due diligence. It’s rather more than a matter of “fundamentals.”

There’s also the small matter of market access – much of Shanghai’s stock still remains off limits to foreign investors anyway, being purely for domestic traders, going around and around on a State-run carousel. Not much global interaction there.

News of market declines in China undoubtedly makes for good headlines and provides the opportunity for much scaremongering amongst analysts. However, the Chinese stock market is currently too small, too undeveloped, too unregulated and too little understood for any correction or collapse to lead to any long lasting effects on global markets. There is no doubt that China’s stock market will eventually matter a great deal to the world. However, it is not there yet – and is not likely to be for years.