May 6, 2010 7:24 pm

Shanghai market feels weight of own success

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In the rankings of the world’s worst-performing stock markets this year, nations drowning in debt feature heavily. Greece is number one, closely followed by Slovakia, Cyprus and Spain. But then, in fifth place, there is China.

Shanghai’s decline – the index is down 16 per cent since January – has caught many investors by surprise, since China is widely seen as a beacon of growth in a world that is still reeling from the financial crisis.

Having fallen to a eight-month low on Thursday, the Shanghai Composite is this year’s worst performing index in Asia.

“A lot of people have been caught offside,” says the head of trading at a global investment bank in Hong Kong.

The irony is that China’s eye-catching economic growth – gross domestic product surged 11.9 per cent in the first quarter – is part of the reason why Shanghai stocks are sliding.

Worried that the economy is overheating, the government has started taking steps to prevent inflation getting out of control and to head off a bubble in the property market. This tightening – and the prospect of more to come – is what has given investors the jitters.

Since late last year, as the global economy has revved up, Beijing has sought to rein in the amount of money sloshing through the economy and spilling into property and equity markets.

But in recent weeks policymakers have become much more aggressive. Beijing has clamped down hard on the property market, fearing excessive price rises could fuel social unrest. “The recent property policies reversed market sentiment,” says Jerry Lou, China equity strategist at Morgan Stanley.

Shanghai graphic for Markets

Beijing has already raised the minimum deposit and interest rates for home mortgages, reintroduced a sales tax, and announced an outright ban on families buying third homes in big cities such as Beijing. A procession of senior government economists and officials have indicated that more measures, including new taxes on residential properties, are being considered and could be implemented soon.

Many investors and analysts fear the increasingly stringent measures may prompt a crash in the property market that could ripple through an economy that is heavily reliant on real estate and infrastructure investment for its overall growth.

“Property tightening policies will continue until the government genuinely believes that the property market is under control, which could be a few months ahead,” says Vincent Chan, China strategist at Credit Suisse.

“It could involve some high-profile arrests or corporate failure, same as the 2004 tightening,” he adds.

Share prices of Chinese property companies have fallen more than 27 per cent since January and more than 45 per cent since their July 2009 peak.

Meanwhile, outside of the mainland, foreign investors have been aggressively short selling the A50 China Index exchange traded fund, which comprises the 50 biggest stocks listed in Shanghai and Shenzhen. Bets against the Hong Kong-listed A50 ETF have risen to a two-year high, according to Bloomberg data.

Yet, when it comes to valuations, many analysts say Chinese stocks are looking cheap. On average, Shanghai stocks are trading at a price-earnings ratio of 16 for the current year, well below the long-term average. New York’s S&P 500 index is trading on a price-earnings multiple of 14.5.

The trouble is, Chinese investors pay little attention to valuations. Instead, the market is driven by momentum and liquidity, which, given current trends, does not bode well for prices. Last year, Chinese banks went on an unprecedented government-directed lending spree that saw total new loans in the economy nearly double to Rmb9,600bn ($1,406bn) compared with 2008.

Many of those loans are believed to have ended up in the stock market, helping the Shanghai Composite surge almost 80 per cent in 2009.

Now that the economy is on a more stable footing, banks have been told to cut loan growth dramatically.

The most recent data, from March, showed that financial institutions in China granted some Rmb510.7bn of new loans that month, down from an average of Rmb1,050bn in January and February.

Even so, credit growth is still running at 21.7 per cent, well above the 17 per cent official target, meaning that more tightening measures will be needed to head off inflation.

The People’s Bank of China has also been absorbing liquidity from the system by issuing sterilisation bills and, since January, by raising the reserve requirement ratio – the amount of deposits banks must hold in reserve – on three occasions. Most analysts believe that there will be much more tightening to come, with the recent moves representing little more than a shift from an “ultra-loose” policy stance to a “moderately loose” one.

“We believe more forceful measures are required to reduce the risks of an overheating in the coming months,” say Yu Song and Helen Qiao, economists at Goldman Sachs.

Treading a careful path between a buoyant economy and an overheating one will be crucial as the Shanghai market braces for a deluge of new share issuance, most notably from Chinese banks replenishing their capital following last year’s lending binge. The total amount of floatable new share supply in 2010 may exceed Rmb6,000bn, according to Frank Li, China strategist at JPMorgan. That figure dwarfs the average daily trading turnover of Rmb202bn in mainland shares.

Agricultural Bank of China, the country’s fourth-largest lender by assets, is preparing for an initial public offering in Shanghai and Hong Kong that is expected to be the world’s largest to date, at about $30bn.

For some analysts, it is this huge supply of new shares that represents perhaps the most direct challenge facing the mainland equity market this year.

Additional reporting by Jamil Anderlini

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