Skip to main content

An electronic board shows stock information at a brokerage house in Shanghai, Jan. 2, 2014.

ALY SONG/REUTERS

China was the world's fastest growing large economy in 2013, and one of its worst performing stock markets.

While December data aren't in yet, the country's gross domestic product is believed to have expanded by 7.5 per cent last year, a rate that leaves North American and European economies in the dust. Yet the Shanghai Stock Exchange Composite Index – the nation's largest equity benchmark – fell 6.5 per cent.

The disconnect between the Chinese economy and equities is bizarre. The past decade has seen GDP almost triple (in nominal terms) while equity markets are up only 41 per cent.

Story continues below advertisement

Stock markets look forward, discounting future profits. It seems that investors in Chinese equities must not like what they see looming ahead.

But what exactly do investors fear? At first glance, it makes no sense that Chinese equities trade at eight times forward earnings expectations when GDP is expected to leap ahead by 7.2 per cent in 2014. The S&P 500, in contrast, trades at 17 times forward earnings when U.S. GDP is expected to grow at a measly 2.6 per cent.

To be sure, financial regulations restrict foreign ownership of Chinese stocks and this has limited market performance. But, that can't be the whole answer. China now has twice as many millionaires – 1.25 million – as France and Germany combined, according to the Hurun report on Chinese wealth accumulation. So there's no shortage of domestic funds that could drive the market higher if investors had any type of faith in the profit outlook.

Not only have China's wealthy been avoiding the country's equity market, they've been desperately trying to move their wealth entirely out of the country. Citing a study by property consultant Saville, The Atlantic's Quartz magazine reported that wealthy Chinese were the buyers for 27 per cent of London real estate sold in 2012, and the dominance of Chinese investment in British real estate actually increased during the first half of 2013.

The flood of Chinese money headed to foreign locales is in keeping with a warning last year from the International Monetary Fund, which said that further loosening of China's capital controls would risk a large and destabilizing exodus of wealth from the country.

Why would the best informed segment of China's population – the high-ranking government officials and successful businesspeople that hold the majority of the country's wealth – look to move money overseas when local economic growth is widely expected to continue at three times the rate of the United States?

I suspect the reason that China's moneyed elite isn't pouring their wealth into China's stocks is because they hear the loud ticking of the country's debt bomb.

Story continues below advertisement

Credit market stress was the dominant investment story in China in 2013. Because 42 per cent of the Shanghai Composite is made up of financial service firms, it was also the primary reason for the dismal performance of stocks. The end of each quarter saw sharp spikes in interbank lending and other interest rates as Chinese banks scrambled for funding.

The wobbles in the Chinese credit market reflect several worrisome factors. One is the popularity of wealth-management products – short-term notes backed by dubious underlying assets – that have grown to account for 20 per cent of all bank deposits. In addition, there is the tendency for banks to simply roll over or extend maturing loans for struggling corporations rather than list them as non-performing debt. This is obscuring the health of bank balance sheets.

The severely depressed levels of valuation among Chinese stocks imply local investors have no faith in the profit outlook for Chinese companies. Credit market volatility indicates why – and also suggests a reason why investors aren't more excited by the prospect of strong economic growth. They may fear that more credit-driven GDP growth in 2014 will just add to the problem of bad debt and unprofitable businesses.

The Shanghai Stock Exchange Composite Index is a case where equity markets are cheap for good reasons. Over the long term, it is likely that China will succeed in rebalancing its economy and return to high levels of sustainable growth. In the short term, however, Canadian investors should avoid China-related investments.

Story continues below advertisement

Report an error Editorial code of conduct
Due to technical reasons, we have temporarily removed commenting from our articles. We hope to have this fixed soon. Thank you for your patience. If you are looking to give feedback on our new site, please send it along to feedback@globeandmail.com. If you want to write a letter to the editor, please forward to letters@globeandmail.com.

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff.

We aim to create a safe and valuable space for discussion and debate. That means:

  • Treat others as you wish to be treated
  • Criticize ideas, not people
  • Stay on topic
  • Avoid the use of toxic and offensive language
  • Flag bad behaviour

Comments that violate our community guidelines will be removed.

Read our community guidelines here

Discussion loading ...

To view this site properly, enable cookies in your browser. Read our privacy policy to learn more.
How to enable cookies