Bubbling Chinese equities

One of the core truths about every equity market is that eventually prices in it will decline. Indeed, paradoxically, the stronger the apparent basis for the market's positive growth the more certain it is that the decline will be severe. Why? Investors are a greedy lot and cannot resist the temptation of an apparently easy buck, or rimimbi.

The Shanghai market has increased 102% in the year to November 14 based on Chinese macroeconomic growth of 11% annually and massive re-investment of capital gains by individuals and firms into it. Firms have been taking capital profits and reinvesting them and are now, according to Business Week, putting the real Chinese economy at risk because of their dependence on such gains.

'By now every investor on the planet is trying to handicap what happens when China's scorching-hot stock markets finally start to cool off. The conventional wisdom is that China's greenhorn individual investors will take the hit, while corporate China—the companies that make shirts, build ships, and run utilities—won't feel much at all. The real economy these companies operate in is far too strong to be affected by stock wobbles, goes the argument. The price of corporate shares may fall, but underlying earnings will power on. (my bold)

That line of argument, though, is looking suspect for the simple reason that companies big and small are now playing the markets with abandon, using corporate funds to invest in each other's initial public offerings and bolster their bottom lines. ...Morgan Stanley figures 1/3 of reported corporate earnings in China stem from investments outside companies' core businesses—which in almost all cases means plowing money into stocks.

...these gains have no cash basis,' says Ding Yuan, a professor of accounting at China Europe International Business School in Shanghai. 'It's really frightening.'

...If and when stock prices start to fall in earnest, companies will have to report these portfolio losses on their income statements, depressing their earnings. That, in turn, could hurt their own stock prices, pushing the market down both further and faster.

'It's a replay of what happened in Japan during their bubble,' says David Webb, a Hong Kong-based corporate governance expert and non-executive director of Hong Kong Exchanges & Clearing. Japan Inc. gorged on stock and real estate, only to tumble into the red when those markets collapsed.

...In China, few investors possess the ability to comb through financial statements and distinguish a company's operating earnings from its stock plays. "People overestimate Chinese investors' sophistication," says Jerry Lou, head of China research at Morgan Stanley. 'Somebody needs to point out that the emperor has no clothes.'

No one inside China Inc., it seems, wants to think about what happens when the bubble bursts'.

It is a bubble and its self-destruction can damage the Chinese economy and, of course, the economies heavily dependent on trade with China.