Chinese stocks might look cheap, but not in a ‘bubble economy’

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China's stock market has been giving investors a lot to think about: The benchmark Shanghai stock exchange composite index has rebounded 18 per cent over the past two months, after the Chinese economy began to show signs of improving. Yet, the index remains 33 per cent below its 2009 high, and it is 62 per cent below its record high in 2007.

So is China an attractive investment or not?

Strategists at GMO, the highly influential global asset manager, have weighed in with a remarkably downbeat assessment on the emerging markets giant. Sure, shares trade at either 12-times earnings or 15-times earnings - depending upon whether you include financials - which looks attractive.

As well, Chinese stocks have underperformed emerging market stocks by about 10 per cent over the past three years, which also makes China look okay.

However, the economy tells a different story. "China scares us because it looks like a bubble economy," said GMO's Ben Inker, in a paper released on Tuesday.

To be sure, China's property market made a stunning comeback in 2012, credit growth has picked up, and economic growth rose in the fourth quarter, marking the first quarterly uptick in two years. Should economic problems come back, the country's central bank still has a number of stimulus tools it can employ.

But GMO has focused on problems in China's credit system, where they see "acute financial fragility": Excessive credit growth has followed the real estate boom, the government has underwritten all bank risk (creating a moral hazard), off-balance-sheet exposure among banks is on the rise and of course there continues to be widespread financial fraud and corruption.

Equally worrisome, Beijing is losing control over the credit system, GMO strategists Edward Chancellor and Mike Monnelly argue.

"Savings are migrating from deposits in the state-owned banking system to higher-yielding non-bank credit instruments. Furthermore, rich Chinese are increasingly willing to evade capital controls and take their money out of the country," they said.

"As a result of these developments, deposits in the banking system are becoming less stable."

The strategists go so far as to call China a credit junkie – "requiring increasing amounts of debt to generate the same unit of growth." And they reject comforting counter-arguments that China is okay because its debt is funded by domestic savings, that its total non-financial debt is relatively low compared to developed economies, and that its stated public debt is less than 30 per cent of gross domestic product (they believe the real number is closer to 90 per cent when you include off-balance sheet liabilities).

"If Beijing were to attempt to repeat the credit-fuelled stimulus package of 2009, its true debt-to-GDP ratio would exceed that of Greece," they said.

History suggests this will end badly. In fact, GMO believes that the situation in China today looks a lot like that of developed economies before Lehman Brothers went bust in 2008, ushering in the darkest days of the financial crisis.

In other words, standard valuation models might be providing a false signal on Chinese stocks, just as U.S. financial stocks provided a false signal of cheapness before the start of the global financial crisis in 2007.

"Our fears have not stopped us from buying emerging stocks, or indeed some Chinese stocks, but they have tempered our positions relative to what they would be if we were not concerned about the bubbly aspects of China," Mr. Inker said.