Comment 44: A prognosis of China's stock market: what have we learned from Taiwan's stock market movements?
Recently China's stock market has become the talk of financial circles around the globe; the composite index of Shanghai Stock Exchange has quadrupled in less than two years. A new type of China phobia, claiming that if Shanghai's stock market sneezes, the global stock markets will catch cold, has emerged among financial market observers. This phobia arises from the global stock market debacle of late February; Shanghai market happened to be the first to cave in during the debacle. Subsequent events have shown that the global stock markets are actually decoupled from Shanghai market, and this new phobia should have been put to rest. Some view China's stock market as casinos, and some have uttered the word, “irrational exuberance”. Many experts expect that China's stock market bubble will burst soon. Even though China's stock market is not in tune with the global markets, the collapse of China's market will certainly have grave implications for the global economy. Therefore, we must first ask whether the recent China's stock market rally is really a bubble that is waiting to burst as those experts claim.
Observing the day-to-day gyrations of stock markets, one will get a feeling that the movements of stock markets are like the walks of a drunken person, and are simply not predictable. However, if viewed from a long-term perspective, stock market movements are well synchronized with the economic, political and social conditions of the underlying society. If we want to understand the long-term movements of China's stock market, we must first have a clear understanding about the true nature of China's economic development without the fantasy of China phobia nor China euphoria. China's economy develops along the script provided by the globalization scheme. The script will boost an under-developed society to a “quick-rich” society within a short time span. In essence this script is to use very low cost labor and almost non-existent pollution control as the bait to lure foreign capitals to set up factories and produce goods to be exported to developed worlds. The society following this script will see a large influx of foreign currencies, from its rapidly expanding trade surplus, from foreign investments and from foreign hot money. In order to keep its own currency undervalued to maintain its export potential, the government must enter the currency market to buy up those surplus foreign currencies. During the foreign-currency buying operations, massive amounts of local currency are inevitably released into the financial market, creating an enormous liquidity glut. It is this liquidity glut that induces unchecked infrastructure construction and an explosive economic expansion led by fixed asset investments. China is not the first one to embark on this course. We consider Taiwan as the pioneer of this game so we dub this development model as “Taiwan model”. Taiwan had started to adopt this model in 1960's and has graduated from this model by early 1990's. The detailed description of Taiwan's experience of this model and beyond is contained in Comment 39 (Chinese translation). The basic characters and the patterns of development as discussed in the comment fit the current situation of China well. Thus the study of the movements of Taiwan's stock market during the period when Taiwan was within the scope of Taiwan model will help us to understand what stage the current China's stock market is in.
In the graph at the right quarterly highs and lows of Taiwan Stock Exchange composite index from 1967 to 1993 are plotted in the conventional logarithmic scale. Two sharp rallies can easily be spotted from the graph, the first one from point “a” to point “A” and the second one from point “c” to point “B”. From “a” to “A” the composite index quadrupled within 18 months. During the period leading to that first rally in the graph, Taiwan's economy advanced rapidly and steadily, so the stock market was lagging behind the real economy of Taiwan. That was the result of constrains imposed on the market by the ruling Nationalist regime; it feared that a financial excess like the burst of a stock market bubble will destabilize the society. In April 1971, Nixon administration started the “ping-pong” diplomacy with The People's Republic of China (The Communist China), Kissinger visited China secretly in the summer of 1971, The Republic of China (Taiwan) was expelled from UN and its seat in UN transferred to The Communist China in October of the same year, and President Nixon visited China in the early part of 1972. That series of events rocked Taiwan society. Many thought that the takeover of Taiwan by The Communist China was imminent, and capitals escaped from Taiwan through all kinds of channels. In order to restore confidence in Taiwan, the government removed constraints on the stock market and a powerful rally, from “a” to “A” in the graph, emerged. This rally that pushed up the composite index 400% within 18 months could be interpreted as the catch up of the stock market with the economic growth in prior years. The powerful rally was snapped by the first energy crisis of 1974, and the composite index fell by more than 60% from “A” to “b”. After the first energy crisis, the composite index rose again, but with a moderate pace, matching the advance of the real economy. In 1978 USA under Carter administration officially recognized The Communist China and broke the diplomatic relation with Taiwan. Then the second energy crisis, and the hyper inflation period of US followed. That series of events caused a bear market in Taiwan for nearly four and half years. As Reagan administration vastly accelerated the pace of globalization and ushered in the first phase of run-away US trade deficits, Taiwan's trade surplus with US rose sharply from 1982 to 1987. At first Taiwan's stock market responded enthusiastically, but soon its advance stalled. By that time Taiwan's labor cost had risen substantially and the society had become more conscious about clean environments. The inflow of foreign capitals had slowed down substantially. Local capitals that grew with the Taiwan model wanted to move into the mainland China to take advantage of very low labor cost and free to pollute environment there in order to continue their “produce and export to USA” strategy. However, under the tight control of the authoritative Nationalist government backed up by the marshal law, those local capitals were not allowed to migrate into China, from the fear that such moves will strengthen both China's economic and military powers. In January 1987, the Nationalist government abolished the marshal law and relaxed the restrictions barring the migration of Taiwan businesses into the mainland China. The stock market responded with enthusiasm and the great stock market bubble of Taiwan began; the starting point of the bubble is marked as “c” in the graph. The great rally of 1987 was cut short by the US market crash in the fall of 1987. In 1988 President Chiang Chin-kuo passed away. The next president Lee Tung Huei pushed Taiwan toward democracy, and opened the floodgate for Taiwan merchants to migrate in whole sale into the mainland China. Thus the great stock market bubble of Taiwan resumed its vigor. By the first quarter of 1990, as marked by point “B” in the graph, Taiwan's composite index had risen more than 1,000 % from its starting point “c”.
The great stock market bubble of Taiwan from 1987 to 1990 was marked by rampart insider trading and large scale pool operations due to the almost non-existent regulatory oversight at that time. The typical insider trading of that time was for a company insiders to buy its own stocks to drive its stock price sky high. During the rapid rally of the stock, unwary individual investors were sucked into the rally. At the high of the rally the insiders unloaded large blocks of stocks to unwary individual investors to gain enormous profits. The operation of pools was for outsiders to pool resources together to perform similar acts on certain targeted stocks as the above discussed insider trading. As those manipulated stocks rose like rockets, more and more individual investors were sucked into the market and bidded up other stocks not under manipulation to sky-high levels as well. Thus the whole market caught fire. When this madness ran its course and insiders and pool operators cashed in, the bubble naturally burst. The composite index fell from its high of point “B” by more than 80% to point “d” in a very short time. Looking back, the great stock market bubble of Taiwan served as the mechanism to transfer a massive amount of wealth from the newly emerged middle class of Taiwan into the hands of a small number of winners. A portion of the profits generated by this great bubble became the seed money to launch Taiwan into a new phase of high tech based economy after it exited from the Taiwan model along with the burst of the bubble. Other portions of the profits flew into the mainland China, and helped to launch China as the global factory of lower-end consumer goods.
A-shares traded in Shanghai and Shenzheng stock exchanges were originally designed for domestic institutions and individual investors in China. Foreign entities were mostly directed to trade H-shares listed on the Hong Kong stock exchange. Shanghai Stock Exchange composite index flirted with the level 2000 in years 2001 and 2000, and than fell steadily until the index touched 1000 in year 2005. During that prolonged period of slump, China's economy expanded rapidly year after year. The reason of prolonged under-performance of A-shares during that period probably came from the general mistrust of government affiliated companies that populated the A-share market. There was also wide spread anxiety that Chinese Government might unload large blocks of A-shares on the market, causing prices to drop sharply. Apparently frustrated by the lagging A-share prices, Chinese Government has allowed a limited amount of foreign money, like 10 billion US dollars, to be invested in A-shares in 2005. Chinese Government has also cleared up the issue of unloading blocks of A-shares on the market. Chinese Government will still control the majority of A-shares in a government affiliated company but will give a portion of newly issued A-shares free to the existing A-share holders to sweeten the pot. Those two measures brought the life back to A-shares. As the prices of A-shares rise, it naturally sucked in more and more newly enriched young middle class individual investors to cause the composite index of Shanghai Stock Exchange to rocket up more than 400 % from its low in 2005, as if the A-share market is catching up with the stellar economic performance of the past years. Compared to the case of Taiwan, the current bull run of China's A-share market resembles Taiwan's bull run of 1972 to 1973, but not similar to Taiwan's final blow out of 1987 to 1990. If this conclusion is correct, then the current bull run of China is merely the first leg of a long lasting bull market as long as the current globalization scheme is not derailed and a disaster scenario does not strike. China still has a large number of under-employed population in its inland region, so it needs to retain its export-oriented labor intensive industries of manufacturing lower-end consumer goods. At the same time industries employing higher level of technologies like steel, chemical, auto, computer chips and so on are emerging thanks to the stampede of US and Taiwan companies to bestow higher level technologies to their partners and subsidiaries in China in order to replace their higher cost facilities in their home base countries; such a move usually brings a windfall profit to high level managers and stock holders of the company, but at the expense of laid off workers at their home country. We should expect that China's trade surplus will have another quantum jump once the industries with higher technology levels also become strong global competitors. Then following the cycle of government buying of foreign currencies from the run away trade surplus, release of local currencies to create an even more devastating liquidity glut, more rampant infrastructure construction and more rapid economic growth, the bull market of A-shares can indeed last for many more years. The original rapid bull run will certainly correct at certain point and than be replaced by a more steady and less frenzy bull run in synchronization with the real economic growth.
The rosy scenario of A-shares outlined above depends on the condition that the disaster scenario does not come into play. What is the disaster scenario then? It is when Chinese Yuan is forced to appreciate substantially and rapidly. If that happens, labor intensive lower-end consumer goods producers in China will be wiped out since those industries operate with thin profit margins. The bud of emerging higher technology level industries will also be snapped. As China's trade surplus declines under the weight of substantially more valuable Yuan, the government will have less need to buy up dollars, the domestic liquidity glut will disappear, infrastructure construction will slow down, economic growth will stagnate, and A-share prices will tumble and stagnate for a long time. Readers may ask what will cause Yuan to rise substantially and rapidly to fulfill this disaster scenario. This will take a lot of space to discuss and will not be covered in this discussion. Interested readers are advised to stay tuned for other coming discussions and articles about this subject.