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Slide in Chinese stocks sends a wake-up call

By Caroline Baum
BLOOMBERG
Monday, Mar 12, 2007, Page 9

In the days since a 9 percent plunge in China's benchmark stock index triggered a global shakeout, many trees have been felled in an effort to analyze the causes.

Most of the explanations make no sense. How is it that a one-day dive in an undeveloped, insular stock market of a country whose economy is one-fifth the size of the US and whose prime virtue is cheap labor could have such a potent spillover effect?

It sure sounds as if China's stock exchange has more in common with a casino than a marketplace for price discovery.

"It's even worse than a casino," Chinese investor Li Daqing told Toronto's Globe and Mail. "At least a casino has some rules."

China's market lacks transparency and is fueled by rumor and speculation. Foreign investment in yuan-denominated shares is limited to institutions that have been approved by the Chinese government. The total quota is currently US$10 billion, less than 1 percent of China's stock market capitalization.

TOO EAGER

Individual investors are so hungry for an alternative to bank deposits that they buy a company's shares even when bad news comes out, according to a Feb. 28 New York Times story.

In other words, share prices in China don't reflect expectations for the economy or corporate profits.

"It's a centrally planned economy funded by the state," said Carl Weinberg, chief economist at High Frequency Economics, who publishes weekly notes on the Chinese economy. "The role of markets in corporate finance and investment finance is small."

Instead, state-owned banks channel money into state-owned enterprises, such as railroads and utilities -- what Lenin called the "commanding heights" of the economy. The export-led manufacturing sector is financed by foreign capital, with international companies building their own factories in China or forming strategic partnerships with Chinese companies, Weinberg said.

"Either way, there's no role for capital markets," he said.

Imputing any fundamental explanation to the Feb. 27 dive in the Shanghai and Shenzhen 300 Index is as futile as trying to explain the 158 percent rise in the preceding year. Or the 9 percent rise in the week before the sell-off. None of these moves is terribly connected to reality.

China's slide affected markets around the globe for the simple reason that it reintroduced the long-forgotten concept of risk into the collective consciousness. Emerging markets don't go up forever. Junk bonds are called junk for a reason. Subprime mortgage loans are made to those with less-than-first-rate credit histories.

Perhaps collective memory played a role as well.

"Too many people remembered the [1997] Asian financial crisis, which started in a stock market -- Thailand -- that no one had watched before," Weinberg said.

For the Chinese stock market to have caused the 3.4 percent decline in the broad Dow Jones Wilshire 5000 Index on Feb. 27, one would have to ascribe a relationship between the loss of wealth in China and reduced profit expectations here. Sadly, causality runs in the other direction.

WORLD PRODUCER

China is the world's producer. Last year, it exported a record US$969 billion of goods. About 30 percent of it went to the US.

The US is the world economy's consumer. A decline in China's stock market, where shares are largely held by individuals, isn't going to curtail Chinese consumer spending. And if it does, so what? The Chinese are net savers.

Now, if the US stock market were to decline on deterioration in the outlook for the economy or corporate profits, that would be a fundamental reason for China's stock market to sputter. The US sucked in US$618.4 billion of imports from Pacific Rim countries last year, helping fuel growth in Asia. Without strong export demand, growth in Asia is sure to slow.

China may buy a lot of raw materials from the rest of the world, but "it is not a critical link in final world demand," said Jim Glassman, senior US economist at JPMorgan Chase & Co. "China's role is primarily on the supply side."

In the past week, I've read that the domino effect in global stock markets demonstrates China's growing clout in the world economy. That may be true. There was certainly a high degree of correlation among markets in Asia, Europe and North and South America.

China's stock market seems to be having an easier time recouping its losses than the more developed markets of the US, Europe and Japan. As of Wednesday, the Shanghai and Shenzhen 300 Index had regained half its losses from last week.

Perhaps there was no fundamental connection between the stock market sell-offs in China and the US. Chinese investors have gone back to doing whatever it is they do, which is buy stocks.

With increased distance from the events of last week, US investors are starting to look at their own house of cards, not to the roulette wheel that is China's market.
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