Bonds shutdown lets bulls loose

VIEW FROM CHINA
If ever there was a case of one person's loss being another's gain, it was true in spades on the Chinese stock markets last week.

On Thursday Chinese investors awoke to news that the authorities had temporarily closed down all trading in the fast-growing bond futures market. This sent an avalanche of funds scurrying in search of a home. They quickly found it on the Shanghai stock exchange, where bond futures trading had been centred, and on the southern Shenzhen exchange.

In the space of two days the Shanghai market in `A' shares, exclusively reserved for domestic investors, rose by almost 49 per cent. On Thursday alone, prices were up by almost 31 per cent. Prices in Shenzhen were up by 38 per cent in the two days.

This compares with the previous biggest one-day rise of 33 per cent, which took place last year when the government ordered a freeze on new listings. Who says bans aren't good for business?

Not only were the price rises impressive but volumes of trading soared to record levels. Turnover in Shanghai exceeded 10bn yuan (about pounds 770m) on Friday.

Chinese shares are now trading on crazy valuations after a period of disenchantment with the Chinese market, particularly among overseas investors.

Unlike domestic investors, foreigners have more choice about where to put their money. Those who have stuck with the volatile Chinese market could not quite muster the enthusiasm shown by punters who filled stockbrokers' offices in Shanghai and elsewhere late last week.

This is reflected in the growing gap between the `A' market and that for `B' shares, which is open to foreign investors. While `A' shares were soaring to increasingly implausible levels, the `B' share index in Shanghai actually slid back at the end of the week.

Considering that `A' and `B' shares are issued in the same companies, but are now trading at very different prices, the conditions have been laid for a rapid reversal in the prices of `A' shares.

The unhappiest punters are those left holding heavy portfolios of bond futures. Between 400,000 and 500,000 contracts are estimated to remain outstanding, tying up some 2bn yuan (pounds 153m).

The closure of the bond futures market, supposedly for a short while but probably for some time, marks the end of one of China's braver experiments in diversifying its range of financial instruments.

The problem with the experiment was that it was exploited by a number of brokers, including China's largest stockbroking house, in ways that can hardly be described as ethical. This led to the near-collapse of all bond trading.

Obsessed by the fear that a Barings-like situation could develop in China, the authorities felt compelled to act, but appear to have done so in a manner that ultimately will affect the credibility of Chinese financial markets as a whole.

They might have cared to look at what happened in the far more developed market in Hong Kong. A temporary closure of its stock exchange during the October 1987 equities crash severely damaged credibility, and it took two years to recover.

China has also chosen an unfortunate moment to highlight the uncertainties of investing in Chinese equities, which had just started to get their share of renewed American and, to a lesser extent, European interest in all East Asian markets.

The turning point came a couple of weeks ago when overseas funds came flooding in all over the regional markets, much to the surprise of local investors.

In a week of furious trading, beginning on 8 May, the Chinese market joined Hong Kong, the Philippines, Thailand, Indonesia, Singapore and Malaysia in a bull run generated entirely by overseas investors. It has since cooled but has left prices at much higher levels. In part the buying spree was triggered by funds looking for a home as yields on US long bonds continued falling, and in part it was a sudden realisation of how cheap regional equities had become.

In Hong Kong, for example, it was possible to buy blue chips on single- digit price/earnings ratios - in other words, they were trading at valuations almost half of those that prevail in the US and in most European markets.

However, a spur was required to focus investment managers' attention on the underlying value in East Asian markets. This seems to have been provided by the Barings Securities' regional strategist, Alan Butler-Henderson.

He issued a well-publicised report headed with the prediction that Hong Kong's Hang Seng index would rise to 14,000 points by the end of the year - meaning something like a 40 per cent gain.

Mr Butler-Henderson is not as well known as Morgan Stanley's Barton Biggs, who single handedly managed to move the Hong Kong and Chinese markets a couple of years ago with what he described as a "maximum bullish" report. However, as in the case of Mr Biggs', investors were just waiting for someone to lead the herd.

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