Are we in for a China crisis?

The latest big thing on the Chinese stock market soared almost 70 per cent on its debut yesterday. How much longer can the good times last?
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The Independent Online

Investment experts believe China's stock market has all the characteristics of a bubble, but the market debut yesterday of China Railways suggests it is one that has yet to burst. The state-owned railway builder's shares soared 68 per cent in Shanghai after a hugely oversubscribed IPO.

Still, the sceptics are increasing in numbers and in the starkness of their warnings. As the Chinese market was closing yesterday morning, Aberdeen Asset Management, the UK investment company known for its emerging markets expertise, became the latest industry voice to warn that stocks listed in the country have become dangerously overvalued other sceptics having included the legendary investor Warren Buffett.

Hugh Young, the managing director of Aberdeen Asia, believes it is no longer a case of "if" but "when" a correction in the mainland market will occur, and predicts it may need to halve in value for any semblance of order to be restored.

"Corrections can be very savage, as we saw in the dotcom boom, and this is a similar phenomenon," he said. "People are chasing Chinese shares without having a clue why they're buying them and it's certainly not based on fundamentals."

Predicting when this will happen, however, is another matter entirely. Liquidity-driven markets have a tendency to go on for longer than expected, points out Mr Young, but the likelihood is that it will eventually end in tears.

"It's like all bubbles that occur in stock markets you realise it's going on but you never know when the music will stop until it's too late," he said. "The experience of millions of Chinese investors is that markets can only go up. It's impossible to predict when but you can be fairly sure the stock market will have a terrible wobble."

So how has it come to this? Well, to answer this question you need to understand the difference between companies that are listed in China and those trading in places such as Hong Kong, says Mark Harris, head of funds at New Star.

Those listed in Shanghai are known as A-shares and only really available to Chinese investors. Although foreign institutional investors do have some exposure to this market, it is very limited. Stocks listed in Hong Kong, meanwhile, are known as H-shares and these are the stocks that most investment funds will buy.

"I wouldn't disagree that A-shares are overvalued but you need to differentiate these from H-shares where the valuations are more reasonable and you've got good earnings growth," explained Mr Harris.

While Hong Kong's Hang Seng Index has doubled in value over the past three years, the A-shares are up a staggering 260 per cent, according to figures compiled by Thomson Financial to the end of November.

At their peak in the middle of October, they were actually up by 350 per cent, but values dipped in November and industry observers are now waiting anxiously to see what happens over the coming months.

"It could simply be one of those blips that happen in markets from time to time before continuing on an upward trajectory or it could prove to be a turning point," commented one fund manager. "At this point we just don't know."

So why have the A-shares gone so mad?

According to Ben Yearsley, investment manager at Hargreaves Lansdown, the tremendous growth that China has been enjoying in recent years has led to the creation of a wealthier society. "There's a lot of urbanisation going on with people moving into the major cities and getting richer," he said. "Individuals are becoming richer and can spend more money on luxuries such as mobile phones, cars and tele-visions."

And the soaring domestic stock market has provided them with another outlet for their spare cash, adds Mr Young at Aberdeen, who points out that millions of Chinese investors have been pouring their cash into companies over recent years.

"The net result of this is that you're getting some amazing anomalies as far as stock prices are concerned," he warned. "The same company can be trading in Hong Kong at half the price it's trading at in Shanghai and that's just not healthy."

Regardless of whether or not a major correction takes place in the domestic market, fund managers focused on the region still believe the investment case in China remains pretty compelling.

According to Charlie Awdry, manager of the Gartmore China Opportunities fund, the three main reasons to be optimistic are: the country's robust economic growth, government reforms and the increas-ingly wealthy Chinese consumer.

"Along with strong investment and infrastructure spend, you've also got a really vibrant, growing domestic economy," he said. "People are moving to the cities, getting better paid jobs and have more disposable income. As well as saving it, they're also spending it and this is one of the most dynamic forces in the Chinese economy right now."

There is also the Olympic Games factor, adds Julian Chillingworth, chief investment officer at Rathbones. Beijing will play host to the 2008 athletics spectacle next summer, he points out, and it won't be in anyone's interest for a major slump to be taking place at the same time.

"I'm sure the Chinese authorities will be desperately keen to make sure everything runs smoothly up to the Olympics," he added. "However, if the world economy is slowing down then China won't be completely immune so you may well see a bit of a slowdown in the second half of the year.

"China is undoubtedly a great growth story on a five-year view but it's bound to have a few holes in the road so you need to be slightly careful. There will be pockets of overvaluation from time to time and we may be experiencing one of those now so the general advice to investors is that they need a well-diversified portfolio if they're investing in this area and not to get too carried away."