Risks rise as liquidity inflates China stock prices
SHANGHAI (Reuters) - China's stock market, up some 85 percent this year, owes its good fortune largely to loose bank lending and foreign speculators, leaving it awash with cash and lifting share prices above what economic reality can support.
The China Securities Regulatory Commission and other regulators have taken a series of mild steps to cool trading, such as adding stock supplies through IPOs and tightening supervision, but are loath to disrupt China's economic recovery.
While these moves are unlikely to deter market bulls in the months ahead, the party may come to an abrupt end in the fourth quarter if expectations mount that inflation will eventually reach levels that could spur a shift in China's monetary policy.
A policy change as dramatic as a hike in banks' reserve requirements or a rise in benchmark interest rates is considered highly unlikely this year because of fears they could stall the country's economic recovery.
But the stock market will respond long before any such policy action if clear signs emerge that an inflation scenario is unfolding, an informal survey of eight stock analysts and fund managers by Reuters found this week.
Such expectations could push the benchmark Shanghai Composite Index .SSEC down more than 20 percent to 2,500 points in the fourth quarter, presuming ample liquidity continues to support the index and keeps it above 3,300 points until October, the market watchers said.
"We are now in real danger of creating another stock bubble similar to what we saw in 2006 and 2007," said Ren Chengde, senior analyst at Galaxy Securities in Shanghai.
"And the situation is worse this time. In 2006 and 2007, growth in China's economy and corporate earnings was at its peak. This year, the economy has just started improving and corporate earnings growth is still expected to be negative."
VALUATIONS
The benchmark index hit a 13-month closing high of 3,373 on Friday. It plunged 65 percent last year as the global financial crisis helped to burst a bubble formed by a five-fold surge in 2006 and 2007.
This year's rise has pushed valuations of shares on China's main Shanghai Stock Exchange to 32 times forecast earnings for 2009, while the Shenzhen market's small-cap shares are at 45 times, according to analysts' estimates and Reuters calculations.
Analysts reckon, however, that China's economic potential and a reasonable emerging market premium would justify a forward PE of just 25 times -- still double that of Hong Kong-listed shares.
Those estimates are based on a projected 10-percent fall this year in the combined net profit of the 1,600-plus Chinese firms listed on the mainland's two bourses.
The companies' combined net profit slumped 26 percent in the first quarter and analysts expect no dramatic improvement in the second-quarter figures, to be announced mostly in August.
Earnings growth for all of 2009 will remain negative despite expected improvements in the third and fourth quarters.
"The current market fundamentals, including the prospects for corporate earnings growth, mean that the market is already in a bubble when the index is at 3,000 points," said Qian Qimin, deputy head of research at Shenyin & Wanguo Securities.
LIQUIDITY
Despite brewing risks, analysts believe the index has limited potential to tumble in the next two months given huge liquidity in the system, although they also saw limits to the upside.
Chinese banks' new lending in the first half reached 7.37 trillion yuan, far above the government's 5 trillion yuan minimum target for the year, and some regulators estimate one-fifth of that found its way into stocks, property and other asset markets.
Another major source of liquidity appears to be a renewed influx of money from foreign speculators, reflected in a jump in China's foreign exchange reserves by $177.9 billion in the second quarter to $2.13 trillion, to bet on the potential of its economy and on appreciation of the yuan and asset prices.
The government has taken modest steps to cool the stock rally, and last month's resumption of initial public offerings, culminating in this week's $7.34 billion offering by China State Construction Engineering Corp, the world's biggest IPO in a year, had been expected to curb the stock market's enthusiasm.
"By boosting stock supply and clamping down on excess lending the government hopes to drive money back into the real economy," said Shanghai Securities investment desk head Zheng Weigang.
But analysts noted that liquidity in the primary and secondary markets did not typically come from the same pool, while money raised would flow back into the banking system shortly after shares were issued and would not be drained until companies had invested the funds, which would take time.
"Share prices won't dive immediately, or until there emerge strong expectations of monetary tightening," Zheng said.
And no one is yet expecting the government to tighten policy.
In fact, the Chinese Communist Party's decision-making Politburo said on Thursday that the economic recovery was not yet on a solid footing and Beijing would stick to its relatively loose monetary stance.
But analysts interpreted such vocal reiterations of policy as actually reflecting rising concern within some parts of the government over the possible formation of asset price bubbles.
And expectations of tightening could predominate once a market consensus emerges that inflation will reach 3 percent or so, considered a tipping point by economists that would spur policy makers to abandon their "appropriately loose" monetary stance for tightening.
Chinese consumer prices have seen five straight months of annual declines because of economic weakness, but are expected to pick up later in the year.
Some economists are predicting the 3 percent mark could be hit in December or the first quarter of next year, and think that their view could become a market consensus in the fourth quarter.
http://www.reuters.com/article/reutersEdge/idUSTRE56N1VL20090724?sp=true