Why it's worth anticipating the next great bull market in China stocks

If a further substantial opening of the mainland's capital account happens, the inflows of cash would push share prices skywards

PUBLISHED : Thursday, 25 April, 2013, 12:00am
UPDATED : Thursday, 25 April, 2013, 5:29am

It might sound counter-intuitive, but international investors are getting increasingly excited about the performance prospects of China's onshore stock markets.

The interest is unexpected because of the lousy performance of mainland markets.

Although China's economy has grown rapidly over the past few years, Shanghai's A-share index remains more than 60 per cent below its 2007 peak.

And despite the best efforts of senior officials over recent months to talk up prices and boost sentiment by cutting off the supply of new share issues, the market has still fallen about 2 per cent so far this year.

Yet that is what has sparked international interest. After recent falls, the mainland share market is within a whisker of its cheapest ever valuations on both a price-to-earnings ratio and a price-to-book-value ratio (see charts).

With analysts forecasting that corporate profits will pick up this year, Shanghai A shares are trading at a price-to-forward-earnings multiple of just 9.6 times. That makes the Chinese market look cheap against crisis-hit Europe on about 12 times, and a steal compared with the United States on 14 times estimated earnings.

"It's a very interesting time to get into it," the head of China equities at Goldman Sachs Asset Management said on Tuesday, according to Bloomberg.

The trouble with this line of reasoning is that China's stock markets are driven by millions of retail investors who think nothing of valuations and care only for momentum.

Their attitude is understandable. Having learned to place little faith in the accuracy of company accounts, they take their investment cues from government policy changes and from the mass movements of their peers into and out of the market.

As a result, it doesn't matter how cheap the mainland market gets, there will be no major rerating of share prices until something triggers a mass migration of local retail buyers back into equities.

But although local investors' caution has defied all recent official attempts to revitalise the market, there is one policy initiative that could trigger exactly such a stampede back into stocks: a further substantial opening of China's capital account.

At the end of last year, China's A-share markets were worth about US$3.7 trillion, or 7 per cent of total world stock market capitalisation.

Yet the presence of foreign shareholders is minimal. Today, the total quota for approved foreign investors is just US$53 billion, or only 4 per cent of the A-share market's free float - and some of that money is earmarked for the bond market.

If Beijing were to relax its restrictions on foreign capital, the inflows would be enormous. The simple inclusion of China in the indices against which international institutional investors are benchmarked would cause a portfolio reweighting generating inflows worth hundreds of billions of US dollars.

Given the prospect of such huge inflows, the mere expectation of any major relaxation of China's capital account restrictions would be enough to trigger a rush into the equity market as local investors attempted to front-run foreign institutions. Prices would rapidly spiral higher, potentially retesting their 2007 high.

It's an enticing scenario. But unfortunately there's a problem with it. As Yu Yongding, a National Development and Reform Committee adviser, pointed out in Hong Kong earlier this month, a full opening of China's capital account could generate even greater outflows from mainland depositors anxious to diversify their savings away from the mainland's shaky banking system.

The consequences could be devastating. As a result, full capital account liberalisation remains a distant prospect.

Still, it might just be worth buying some cheap A shares in anticipation.