The China Syndrome

Back in February we had our first sign for the potential of China sneezing and the world catching a cold.  As it turned out, it was more of a hiccup, but it was a warning of how important a factor China has become in driving forward the global economy.

One of the causes of the fall, was the Chinese government’s concern that the economy might overheat, leading them to introduce austerity measures (specifically a tax on capital gains).  Adding fuel to the whole situation, however, was former US Federal Reserve head Alan Greenspan who (when commenting on the US economy), talked bearishly about a possible recession. 

Now, 3 months on, Greenspan is at it again with comments made recently about the Chinese stock market.  Greenspan said that the Chinese market was due for a “dramatic contraction” and that the current rate of growth could not continue for much longer.  By way of illustration, over 1 year the SSE180 (Shanghai Stock Exchange 180) is up a staggering 195% (Source: Hindsight/Lipper, for period 28/04/06 – 30/04/07, capital return in local currency).

On the back of these comments Wednesday saw a bit of nervousness creep into the markets and most closed down.  It‘s worth bearing in mind, however, that the Chinese stock market is being driven largely by domestic demand.  A demand that is being fuelled by a savings culture that has historically been conservative and cash based.  At this point there appears to be a large amount of momentum investing, which implies investments are being made becasue the market is rising.  So, should we be worried?  And what should you do if you have China exposure within your portfolio?

Well, firstly, on face value there does appear to be a bubble developing on the Shanghai market; but, as mentioned many foreign investors either shun or are unable to gain ready access to shares listed in China – the risk is mainly being borne by Chinese investors, who have vast untapped reserves of savings.  And this brings us on to a key point for those investing in China or emerging market funds.

The largest percentage increase in share price valuations for Chinese companies comes from what‘s known as A and B class shares.  These are a lot less liquid, i.e. harder to buy and sell (most foreign investors are prohibited from buying A class shares) than what are known as Red Chip or H shares (mainland Chinese companies but listed in Hong Kong).  This means that as a unit or shareholder of a fund with China exposure, you are not necessarily being exposed to as much rampant speculation as you might think.  First State‘s China Growth fund manager, Martin Lau, for example, gains most of his exposure though companies listed on Hong Kong‘s Hang Seng Index; while Philip Ehrman, manager of the Jupiter China Fund, also invests in companies that ‘conduct a material proportion of their earnings from activities in China‘, meaning that he holds investments in countries like Singapore and Taiwan.

Naturally, investing in funds with China exposure is only appropriate for investors who have an appetite for investment risk; and are prepared to be in there for the long term; however, what‘s perhaps more important than the Chinese domestic stock market is the health of the economy as a whole.