No sign of an end to China markets' woeful performance

Chinese shares may indeed look cheap, but predictions of a rally in mainland stocks are merely a triumph of hope over experience

PUBLISHED : Friday, 05 July, 2013, 12:00am
UPDATED : Friday, 05 July, 2013, 5:23am

When China's stock markets fell to a four-year low last week, it triggered a spurt of reports from optimistic analysts claiming the mainland's benchmark stock indices had finally found a bottom and were poised to rebound.

Some of these pointed out that on a valuation of just nine times expected earnings for this year, mainland markets now look spectacularly cheap.

Others pored over the charts to detect "technical" signals that mainland stocks were overdue for a rally.

Now, to be fair, mainland stocks are indeed cheap compared to other major markets. And technical analysis isn't all voodoo. Market movements just reflect human behaviour, and there are patterns in price charts, just as there are patterns in the movement of crowds.

Even so, predictions of a sustained rally in mainland stock markets represent a heady triumph of hope over experience.

To see why, take a look at the first chart. Since the beginning of the century, the nominal value of China's economy has risen almost six-fold. Yet today the Shanghai composite, the mainland's main stock market index, is exactly where it was 13 years ago, at a whisker under the 2,000 mark.

Analysts have advanced all sorts of explanations for this lamentable lack of performance. One theory argues that because the mainland's economy is growing so fast, companies constantly need to raise fresh capital simply to retain their market share. As a result, the constant dilution of existing shareholders washes out any long -term stock gains.

It's a neat idea. Unfortunately, it doesn't stand up to scrutiny. As the second charts shows, the growth in China's household savings deposits since 2000 has far exceeded the amount of money raised on the mainland's stock exchanges, which means the pool of potential investment capital has grown far faster than the cumulative equity capital raised. The problem isn't dilution.

A more likely reason for China's poor performance is that the mainland's stock markets aren't real markets at all. Unlike those in other countries, China's stock markets did not evolve as places where private companies could raise long-term capital from investors prepared to risk their savings for superior returns.

Instead they were set up by the Communist Party to further its own political aims of reforming China's state-owned enterprises to ensure their continued dominance over the economy.

As a result, the listing rules were drawn up explicitly to favour big state-run corporations in sectors considered strategic by Beijing, with private companies in China's fast-growing service economy largely excluded.

For example, China's wildly successful internet search engine, which floated on the Nasdaq stock market in the United States in 2005 was ruled ineligible for a mainland listing because of its relatively short trading history.

At the same time, China's market regulator does not exist to protect the interests of ordinary investors like regulators in other countries, but to help state-owned companies to raise capital.

As a result, minority shareholders have minimal rights, while the regulator has shied away from policing China's listed companies, consistently turning a blind eye to rampant abuses by the management of state-run companies and their controlling shareholders.

The result has been a complete collapse in investor confidence that has plunged mainland markets into a five-year-long bear market.

Winning back their trust will not be easy. So although China's markets might look cheap, and while the charts might be signalling a potential rebound, no one should hold their breath for a sustained recovery just yet.