Chinese Stock Market Set for Growing Pains (Commentary)

China’s economy is an enigma; a booming capitalist free-for-all managed by communists and the world’s largest exporter whose citizens can hold only the domestic currency. China’s stock market is a baffling blend of progress and protectionism.

A domestic construction boom has fueled the Chinese economy in recent years, resulting in double-digit GDP growth. And its export dominance has left China awash in currency. In fact, Chinese citizens have a pool of $2.2 trillion in savings to invest. Over the past few years the Chinese government has taken many state-owned companies public and the Chinese have invested enthusiastically. The Chinese stock market, represented by the CSI 300 Index of A-share stocks traded on the mainland exchanges, is up over 180 percent this year through the end of October. These same companies have also listed shares on Hong Kong’s exchange. An index of these issues, known as H-shares, is up over 97 percent this year through the end of October. A nice return, to be sure, but only about half of the return of the index of the same and very similar companies listed on the mainland.

With a few exceptions, the China-listed A-shares are available only to Chinese citizens. The Hong Kong-listed H-shares are available to all investors, but currency restrictions imposed on Chinese citizens prevent Chinese investors from buying the H-shares. This leads to a situation where there is a lot of demand among Chinese investors, but only a limited supply available through the A-shares. Economics tells us that strong demand coupled with limited supply means prices are moving higher, and with the artificially constrained supply of A-shares, prices have moved higher in that market than they have in the more widely available Hong Kong market.

For instance, PetroChina, a company recently in the news for being the first to have a trillion-dollar market cap following its A-share listing, also has an H-share listing in Hong Kong. Converting each country’s currency to U.S. dollars for the sake of comparison, you recently could buy an A-share of PetroChina for $5.20 in China or an H-share for $2.10 in Hong Kong. These are equal shares in the same company, the only difference being where each is listed, but one costs more than twice the other. This is clear evidence of the closed nature of the Chinese market. No doubt a Chinese citizen interested in owning shares of PetroChina would rather not pay double what other investors pay.

This discrepancy would not last long in free and open markets. Investors could buy the lower-priced shares and simultaneously sell the higher-priced shares, pocketing the spread in a risk-free trade known as arbitrage. This buying and selling pressure would eliminate the spread between the two exchanges very quickly. But with foreigners unable to trade on the Chinese exchange (and short-selling not allowed either), and Chinese investors unable to buy outside the country, there is no opportunity for arbitrage.

With strong returns and a growing middle class new to investing, China is in the midst of an investment frenzy. More than 45 million new trading accounts have opened this year, nine times the total for 2006. Shares have been bid up on the mainland to the point that those with dual listings trade at a premium of anywhere from 20 percent to 900 percent of the same shares listed in Hong Kong.

Higher prices for the same shares implies higher valuations, and as expected mainland stock indices boast very high price-earnings ratios compared to other nations.

Even Chinese regulators have become concerned about excessive valuations and have floated an on-again, off-again plan to allow Chinese citizens a limited access to the Hong Kong exchange. When the plan was first announced, Hong Kong’s markets jumped in anticipation of the coming inflows. Subsequent concerns about currency control, lack of investor sophistication and the potential for a domestic stock slump as money flows out of Chinese markets have led regulators to postpone the plan for further study.

As China continues to grow in the global economy, expect eventual deregulation of their currency and financial markets. Competition for talent and capital will demand that their markets be on par with those of developed nations, and certainly Chinese investors deserve more options than the limited menu currently available.

(James B. Bell is a certified financial adviser with Garrison Asset Management of Fayetteville. E-mail him [email protected].)