China meltdown won’t mean Feb rerun

HONG KONG: When the Shanghai stock index skipped a heartbeat on Thursday, after its gravity-defining run in recent weeks, the question popped on the minds of many China watchers: is this the dreaded beginning of the end? And will a meltdown in China drag down markets across the world, as it did in February?

By the end of the day, the market had lost half a percentage point, unnerved by former US Fed chairman Alan Greenspan’s grim warning overnight of a “dramatic contraction” in Chinese stock valuations. But although the day’s loss was barely a blip when seen against the phenomenal 55% appreciation this year (on top of a 130% gain last year), game theorists are increasingly drawing up worst-case “what if” scenarios to map China’s post-meltdown landscape.

Yet, curiously, for all the froth that is manifestly floating around China’s stock market, the prognosis - in even the worst-case scenario - appears to be reasonably sanguine for China’s economy, which has shock absorbers to ride out any turbulence.

“Even a significant domestic equity market correction - for instance, a 30% erosion in valuations in a short period of time - will have little or no impact on the rest of China’s economy,” asserts UBS chief Asia economist Jonathan Anderson. “That’s because the tradable equity market is still a very small part of wealth holdings in China.”

Indicatively, by 2005-end - before the start of the bull run - total stock holdings by Chinese households and firms accounted for only 10% of domestic financial wealth (against an average of 38% for emerging Asia). And although that proportion shot up to 25% in China by April 2007, reflecting the sharp rise in stock values, it’s still well below the regional and global average, says Anderson. “Keep in mind also that the bull run from 2005 up to now has added only around 15% to financial wealth in the economy - which means that a 30% market correction going forward would entail a financial loss of only 8% wealth holdings.”

There’s one other statistic to consider while estimating the downside in the event of a meltdown: more than two-thirds of China’s A Share market is still locked up in illiquid, non-tradable state shares. Unlike the non-free floating portion of other global markets, these shares are “owned” neither by households nor the corporate sector. “If we restrict ourselves to ‘liquid’ financial wealth - that is, using free-float market capitalisation, which is the way actual households and firms would look at their financial holdings - it turns out that free-float A shares account for only 11% of domestic financial wealth today,” adds Anderson. “Clearly, even a very large correction would hardly make a dent in total liquid wealth.”

Even after the dream run of the past year and a half, China’s equity market is still very small: total market capitalisation accounts for only about 20% of GDP. (In India’s case, for example, it is almost twice that.)

There is also reason to argue that a meltdown won’t impact consumer spending, reasons Anderson. That’s because although consumption spending - as reflected in real retail sales - has been growing steadily since 2004, there hasn’t been any correlation with the “bull market”. For instance, there’s no sign of any further jump in the past two to four quarters as the share market soared.

Likewise with fixed-asset investment; it accelerated in mid 2005 when the government eased restrictions and injected more liquidity into the economy, but in the past 12 months, when the market was rising, fixed-asset investment actually slowed down.

What this means, reasons Anderson, is that there’s no consumption boom to reverse: just as there was no spending response when the market was going up, there may not also be a spending response when it heads down.  Turn  to Page 23

And in his reckoning, even the extent of debt taken on by households and firms to invest in equity isn’t heavily skewed. “On the one hand, it seems clear that more leverage has come into the stock market in the past quarter or two, but on the other there’s nothing to suggest that the market is heavily geared. Indeed, the best-available evidence points to a predominantly retail interest driven by portfolio reallocation out of existing deposit savings and into equities.”

Noting that there had been at least four daily sessions this year when the Shanghai index dropped by 5% or more, Anderson recalls that in every case, prices rebounded immediately, with no sign of the kind of “knock on” selling to cover leveraged long positions that one normally sees in highly geared markets. “All this, taken together, leads us to conclude that while equity market leverage is growing, it has not even come close to reaching a point where a correction leas to significant balance sheet stress.”

In other words, even if China’s markets crash, there may not be blood on the streets!