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Are Chinese Stocks Contagious?

Prepared by: Lee Hudson Teslik
Updated: May 31, 2007

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China’s soaring stock market spun into a nosedive (China Daily) May 30, dropping nearly 7 percent on news that the government will triple a tax on stock trading. Stocks stabilized (FT) the next day, but the plunge rattled investors nonetheless. An official from China’s finance ministry said the tax hike is aimed at promoting the healthy development of China’s economy. He didn’t use the word “bubble,” but his meaning was implicit enough.

All of a sudden, China’s white-hot stock market is prompting some serious jitters. The country’s leading stock index, the Shanghai Composite Index, has swelled more than 250 percent since the beginning of 2006. Alan Greenspan, the former U.S. Federal Reserve chairman, spooked some traders (MarketWatch) in late May by commenting that China’s stocks appear ready for a “dramatic contraction.” These words had the eerie echo of Greenspan’s admonition of “irrational exuberance” in advance of the U.S. tech-bubble burst in the late 1990s. Yet Greenspan’s warning did little to cool the enthusiasm (Bloomberg) of Chinese individual investors, who continued to turn out in droves to buy up shares the following week.

The enthusiasm of Chinese civilian stock buyers presents one of the most remarkable—and potentially damaging—aspects of China’s boom. On one hand, market involvement has proved a powerful democratizing influence, drawing millions of civilians into direct contact with major Chinese and multinational companies. Bloomberg says over three hundred thousand brokerage accounts are opened daily in China, and that diverse social groups—“maids, monks”—are getting in on the action. China Daily estimates thirty million Chinese, and over ninety million if you include traders’ dependents, are directly or indirectly invested in Chinese equity markets.

But it’s unclear how wisely these new investors are spending their money. In February, Chinese stocks already sported bloated valuations (PINR) with respect to earnings—the average stock on Hong Kong’s leading exchange was valued at eighteen times its company’s earnings, as compared to thirty-three times earnings for companies listed in Shanghai. Moreover, the Wall Street Journal notes, some investors are turning to dubious practices like numerology to help them pick stocks.

Assuming a correction is in order, the pressing question is how it will affect markets outside China. As cascading global stock declines in March 2007 demonstrated, financial markets are interconnected to an unprecedented degree, and a Chinese bubble would not pop in a vacuum. Still, there is broad disagreement over just how damaging a sell-off would be. CFR Senior Fellow Roger M. Kubarych commented in March that China’s market is relatively isolated, but said a sharp correction could still have a psychological impact on international investors. Looking specifically at Shanghai’s May 30 dip, Tony Tassell of the Financial Times notes in a video segment that its short-term contagiousness appears to have been “fairly limited, even in Asia.” The Economist examines the impact a market correction might have on China’s underlying economy, arguing any effect ought to be “modest” given strong economic fundamentals. The article warns, however, that a dip could dampen consumer confidence, potentially spurring a broader downturn.

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