Asia InsightOctober 2007 Bubble, Birth, or Both?Andrew T. Foster, Director of Research and Portfolio Manager A rapidly developing economy is in need of substantial capital to fuel its continued growth. The domestic banking system is ill-equipped to provide the financial resources required by the emerging economy. In response, far-sighted financiers form a public exchange for equity securities, where companies can efficiently raise long-term capital to support their expansion plans. Within three decades, the local stock market booms. Its total capitalization expands sharply, driven by a combination of stock issuance and rising valuations on shares. The emerging economy enjoys a market capitalization that is on par with that of the largest and most developed stock market in the world, even though the young country has an economy that is only one third the size of its more developed counterpart. Except for a few inconsistencies, the scenario above could describe the dramatic evolution of China's A-share market over the last few years. But it is actually culled from a different point in history: it depicts the rapid expansion of the United States' stock market at the outset of the 19th century. At the time, the U.S. was a young nation, experiencing an unprecedented economic boom. In 1825, nominal U.S. economic output was about $1.1 billion per annum (this estimate is admittedly a tenuous one, but it serves well as an order of magnitude).1 To place this figure in context, the United Kingdom's economy was roughly three times larger (about $3.3 billion).2 Adding to its prominence, the U.K. could also lay claim to one of the most advanced securities markets on earth: by 1825, London had well over a century of history in organized trading, whereas Wall Street formed only in 1792. Nevertheless, estimates suggest that the younger country enjoyed a stock market that rivaled its more established counterpart in size and value: both countries had equity capitalizations of just under $200 million.3 To a seasoned British investor, the U.S. market must have appeared bloated and unbalanced. How could such a small economy support such a large stock market? The young market was rife with reports of questionable listings with dubious valuations. Surely it was a bubble in the making! Hindsight suggests a different interpretation: one of the world's largest and most formidable economies was emerging onto the global landscape for the first time. To put it crudely, the U.S. economy was being "born" onto the world stage, and contemporaneous observers must have marveled at the seeming dislocations and imbalances that accompanied its arrival. Yet as ever, the market was prescient in its ability to discount the young nation's potential "ahead of the curve." The oversized capitalization of U.S. equities was not a product of excess, but rather an efficient allocation of financial resources, wholly commensurate with the young country's capital needs and growth prospects. As we know well, U.S. equities would surge and stumble many times over the coming centuries, but the market's size in 1825 was by no means an accident or financial fiction. It was exactly what might be expected of a country whose growth prospects might come to dominate the global economy for the next few centuries. The obvious purpose of this historical analogy is to place the emergence of China's own stock market in its proper context. At the time of this writing, the A-share market is capitalized at approximately $3.4 trillion, whereas China's gross domestic product (GDP) is roughly $3 trillion (For reference, the U.S. stock market is capitalized at $18.6 trillion, and U.S. GDP is $13.8 trillion).4 The performance of A-shares has stunned bulls and bears alike—quintupling in a little over two years. Market indices continue to march to record levels. Valuations on individual shares are lofty. Commentators are clamoring to declare that China is in the final throes of a liquidity-driven "blow-off"—though no one is quite sure when or how the balloon might pop. 
That said, the latter view holds some merit—the A-share market is heady, and susceptible to a correction (more on that later). Nevertheless, I find it difficult to label China's markets an outright "bubble." Instead, I view the A-shares' ascendance as principally about the "birth" of a large new market—albeit one that has some bubble-like characteristics. Much like the U.S. nearly two centuries ago, China enjoys a rapidly growing economy—one that already ranks among the world's largest. Both history and common sense suggest that an economy of China's size and potential will require a very large set of capital markets to support investment and growth. China saves about 44% of GDP each year5; however, it is investing at a pace that exceeds 54% of its GDP—and markets help bridge that gap.6 In this sense, there is nothing particularly surprising or counterfeit about the rapid ascendance of the A-shares: the local stock market has simply grown to a size that is proportionate to the underlying economy. The oversize shoe fits the plus-size foot. The rapid emergence of the A-shares also marks a dramatic improvement in China's financial system. For far too long, China has been overly dependent on its state-controlled banking system to provide capital to companies. Historically, the banking system has been opaque and poorly run, answering to political interests over economic ones. Yet until recently, the banks have been the only game in town. Corporate bond markets in the country are tiny, and until the A-shares underwent substantial reforms that enhanced their legitimacy, the stock market was perceived as an irrelevant casino by companies and investors alike. Meanwhile the banks were the dominant facilitator of the country's investment capital. To put the outsized role of the banks in perspective, China's bank loans are equivalent to about 110% of the country's of economy. By comparison, banks play a much smaller role in the U.S., because they have been dis-intermediated by securities markets; loans are only 46% of GDP.7 Like any young market, the A-shares may be wild and poorly regulated—but there is no doubt that they already represent a substantial improvement over the old system, providing enhanced transparency, discipline and efficiency in the allocation of financial resources. The market is already serving its newfound purpose in earnest, providing companies with a legitimate and viable source of capital. During the past year and a half, Chinese companies have raised $64 billion from the A-share market—more than was raised in the prior 6 years combined.7 But as with any new "birth," there is a great deal of attendant excitement—and the A-shares are currently characterized by excessive froth. As long-term investors in Asia, we can state with conviction that the rapidly growing capitalization of A-shares is commensurate with the progress and size of the underlying economy. Yet as "bottom-up" investors who analyze the potential of individual companies, we find it hard to reconcile the valuations that the market is placing on many A-share listings. The market's gains must be viewed with a strong dose of skepticism. Profitless companies have seen their shares soar; tiny companies with opaque ownership enjoy valuations wholly disproportionate with their size. The market lacks transparency and regulation sufficient to protect minority investors. Perhaps most problematic, China's currency controls hinder investors' ability to move capital outside China—and thus the A-shares are something of a "walled garden," where excess liquidity builds up when it is not free to go elsewhere. As China embarks on a new and volatile era of public securities markets, it is entirely possible that it could experience a major correction. There is even a limited chance A-shares will suffer a 1929-style crash. If this does occur, countless pundits will rush to declare A-shares as phony—an artifice promulgated by a totalitarian government. While a correction in China would likely reveal more than its fair share of charlatans, it would not reverse my belief that the A-shares' emergence is both real and legitimate. Their rise is analogous to that of the young U.S. market, nearly two centuries ago, with all the attendant risk and reward. A major crash in the markets may cause a great deal of economic loss and hardship; but the market will remake itself, introducing stronger regulations and minority protections—just as the U.S. did through securities legislation in the 1940s. Only a few years ago A-shares were an afterthought for global investors. Now they are a major source of wealth for millions of Chinese investors, and they set the tone and direction for markets around the Asian region. A new market has been born, and no matter how hard it is shaken, it has a very substantial future ahead. October 5, 2007 1 Angus Maddison, "Historical Statistics for the World Economy: 1 – 2003 A.D.," and Matthews’ estimates. 2 Angus Maddison, "Historical Statistics for the World Economy: 1 – 2003 A.D.," and Matthews’ estimates. 3 Peter L. Rousseau and Richard Sylla, Emerging Financial Markets and Early U.S. Growth, pg 12-13. 4, 7 Bloomberg. 5 Louis Kuijs, How Will China's Saving-Investment Balance Evolve?, World Bank Policy Research Working Paper 3958, July 2006, p23. 6 Bloomberg, IMF. 7 CEIC, U.S. Federal Reserve, IMF. Note: Matthews has no positions in Chinese A-shares. For previous commentaries that Matthews has written regarding Chinese A-shares please visit: http://www.matthewsasia.com/about_asia/on_asia_dec06.cfm and http://www.matthewsasia.com/about_asia/on_asia_september05.cfm The view and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles. |
