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Mainland profit surge masks weakening earnings outlook
Chinese stock markets have been on the up recently, but massive over-investment is storing up a raft of problems for the corporate sector
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Three weeks ago this column argued that the Hong Kong and mainland stock markets would continue to surge, buoyed by plentiful liquidity.
Since then both markets have performed admirably. Hong Kong's benchmark Hang Seng index has climbed another 2.4 per cent, bringing its gains since the beginning of last September to a handsome 21 per cent.
The Hong Kong-listed shares in mainland companies have done even better, with the H-share index now up 30 per cent since the start of September.
In comparison, mainland-listed A shares were a late-comer to the party. But they have been making up for lost time, with Shanghai's A-share index climbing 21 per cent since early December (see the first chart) to close yesterday at its highest since June last year.
The latest burst of appreciation, which has seen the index jump 3 per cent in just two days, is being attributed to an improving profit outlook for China's companies.
Specifically, investors were cheered by the announcement over the weekend that industrial profits leapt 17 per cent in December, compared with the same month the year before.
For many the news confirmed hopes that the recent rebound in China's economic growth rate will drive a revival in corporate profits this year, with analysts at Standard Chartered forecasting a gain of 30 per cent.
Not everyone is so impressed, however. Although the liquidity-fuelled rally in both onshore and offshore-listed Chinese stocks looks set to continue for the time being, the longer-term outlook for earnings is a lot less rosy than many investors would like to believe.
December's 17 per cent profit increase sounded impressive, but the year-on-year change in monthly profit figures is too crude a measure to be a reliable guide to corporate health.
According to Diana Choyleva at Lombard Street Research, seasonally adjusted quarter-on-quarter numbers give a far better impression of the underlying trend in company earnings.
And here, as the second chart shows, the picture looks completely different. On this measure corporate profits fell in the fourth quarter of last year - and at an accelerating rate.
At first, this weakening trend would appear to be at odds with the recovery in growth and the pick-up in closely followed leading indicators like China's purchasing managers' indices.
However, the two pictures do not contradict each other.
Yes, growth is picking up once again, thanks to a government-engineered rebound in investment.
But China's companies are already struggling under a burden of massive over-investment following Beijing's all-out stimulus efforts during 2009 and 2010.
Choyleva argues that with so much more capital being invested, much of the extra is being squandered on uneconomic projects. That waste erodes efficiency and undermines future growth.
"A country cannot increase its investment relative to output forever. Ultimately, China's economic strategy is a dead end because, after a while, such investment becomes unprofitable," she warns.
That is bad news for corporate China, which has already been hit by a 43 per cent increase in wages since 2009 and a sharp rise in real borrowing rates from zero just 18 months ago to around 4.5 per cent today.
As a result, much of the private sector is reassessing its investment needs and cutting back on capital expenditure.
Meanwhile, state sector investment is continuing apace. But with the economy already suffering from over-capacity, further investment merely subtracts from future growth.
Without radical economic reforms, the result, Choyleva warns, will be a slump in growth rates to below 5 per cent a year and an accompanying decline in corporate earnings.
So although the short-term outlook for Chinese shares remains bright, dark clouds are gathering on the horizon.