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China: First BRIC to crumble?

November 23, 2007 15:22 IST

The likely bursting of the Chinese stock market bubble will probably depress consumer confidence and spending as well as business investment. And the fall could be great since Shanghai shares now sell at about 55 times earnings after tripling in price in the last year, compared with 18 times for the S&P 500.

Chinese households have around 22 per cent of their financial assets in stocks compared with 8.6 per cent in 2005 at the end of the last bear market. Some of the hottest stocks in China and here include CTrip, Baidu, China Mobile and CNOOC. So the negative effects could be much greater this time.

Many companies invest in other firms' stocks, just as Japanese corporations used to do and suffered when stocks there collapsed in the 1990s. Studies show that one-third of listed Chinese company profits in the first half of 2007 came from stock price gains and other investment income. So if Chinese stocks tank, corporate profits and investments could be damaged severely. Banks could also be hurt as investor loans to buy stocks, disguised as mortgages to avoid the prohibition on these loans, go bad with a stock price collapse. And estimates are that around 20 per cent of bank loans are already nonperforming. That's down from the earlier 50 per cent peak, but far higher than the 7 per cent official number.

Savvy investor Warren Buffett recently unloaded the PetroChina stock he bought in April 2003 after a gain of over 600 per cent, suggesting that at least one savvy long-term investor believes the Chinese stock bubble is close to bursting. The frothy IPO market in China delivers the same message and is reminiscent of the late 1990s US dot-com bonanza. Recently, the Chairman of the China Securities Regulatory Commission said, "I want to express my concern over the lack of risk awareness among investors."

This year, first day returns on Chinese IPOs have averaged 192 per cent. Extremes tend to be greater in retail-dominated markets like China's at present where foreign institutions are permitted little participation. The 121 per cent leap in the Shanghai Composite Index so far this year has only spurred investment bankers to issue and retail investors to buy IPOs.

Government Rescue?

Some argue that economic slowdown from any source can be offset with fiscal stimuli since the government budget deficit is close to balance. But government outlays already are approaching 20 per cent of gross domestic product, big in a fiscally conservative country. And it's questionable whether, like most governments, Beijing would act in time to prevent serious economic disruptions.

BRICs

Our examination of the global decoupling argument has concentrated on China with some attention to India. But the hope that the other two export-led BRICs (Brazil and Russia, India and China) will continue robust growth as the US consumer retrenches is also questionable. A US recession will no doubt collapse energy prices to the extreme detriment of energy export-led Russia.

And even if the BRIC nations continued to grow rapidly, they are just too small economically to carry the global economic ball. Their collective GDP was $5.6 trillion at the end of 2006, only 45 per cent of America's and 56 per cent of that of the 13-country eurozone. Furthermore, Japan, the world's second largest economy, is slipping with a 1.2 per cent decline in real GDP in the second quarter, and in the EU, business confidence is falling.

So we conclude that the rapid growth of major developing lands, especially China, is still driven by direct and indirect exports to US consumers. Local middle classes aren't big enough yet or likely to be for at least a decade to generate domestically led growth, much less promote US expansion through massive imports from America. All the PCs owned by citizens of those countries and the 450 million cellphone users in China and 150 million in India are the result of exports earnings and direct foreign investment.

And with US consumers likely to end their 25 years of borrowing and spending and mount a saving spree as American housing collapses, exports to the US, and hence growth in local spending in Asia, will be severely restricted.

This in no way dims the sunny future of China, especially if the private sector continues to flourish. Since 1978, when China started to nurture her private sector, it has been the engine of economic growth. In that year, it was officially shifted from "the tail of capitalism" to "a complement to the private sector economy." In 1998, the private sector was enhanced further by officially moving from a "complement" to "an important component" of China's socialist market economy.

Then in 2002, the non-public sector was in effect institutionalized as a principal sector of the economy and treated equally with the public sector. A report to the 16th National Congress of the Chinese Communist Party that year said that "all legitimate income from work or not should be protected" and "we should improve the legal system for protecting private property."

We were in Beijing during the 17th National Congress and entrepreneurs, who are now party members and delegates, were lauded. The policy-setting Central Committee of 204 members and 167 alternates included 20 entrepreneurs, one of them from the private sector. The rest were senior officials of the party, government and military, but none were peasants or workers.

In 2006, the private sector contributed 40 per cent to China's GDP, up from 0.9 per cent in 1978, with 25 per cent compound annual growth in the meantime. And the private sector would no doubt be a greater share of GDP if it weren't necessary to keep many inefficient, money-losing public businesses in business in order to avoid big layoffs and further unemployment problems. Some 160 government-owned enterprises control $1.6 trillion in assets, and the public sector produces 60 per cent of GDP.

Long term, China has a bright future, but in the meanwhile her glitter may be tarnished much as was the radiance of Japan in the 1980s that became a black hole in the 1990s. Our recent in-depth research reinforces this long-held belief, as does the information gathered on our just-concluded trip to China. But one aspect of Chinese life was truly surprising. In all the meals we ate during our two weeks there, we never were served any fortune cookies.

Excerpted from a recent edition of Gary Shilling's Insight. For more information or to obtain a risk-free trial, click here.

A. Gary Shilling, Forbes.com