Dispelling the China markets myth

HONG KONG (Fortune) -- It's the start of a new lunar calendar here in China and what better way to commence the Year of the Pig than with profit-taking stampedes on exchanges in Shenzhen and Shanghai that drag down markets around the globe?

On Feb 27, China's domestic exchanges tanked nearly 9 percent, suffering their steepest one-day fall since the death of Deng Xiaoping in 1997. As traders in Europe woke up to word of China's losses, the UK's FTSE sank more than 2 percent, while the French and German exchanges dropped 3 percent.

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In the US, the Dow shed 416 points, its biggest drop since the 9/11 attacks, erasing more than $600 billion in market value in a single day. SARS and bird flu, it seems, are hardly the only forms of lethal Asian contagion.

The grim chain of events, which folks in Asia are (inevitably) calling Black Tuesday, has encouraged a round of bold proclamations about China's emergence as a global financial center and the new 'linkage' between stock markets in China and those in the rest of the world.

The suggestion is that, just as a drop in the Dow routinely has knock-on effects in London and New York, so now with China: Shanghai sneezes, and stock markets everywhere take to their sick bed. But the chatter is getting out of hand.

Yes, of course, what happens in China now has a big impact on the movements of global financial markets. How could it not? Beijing sits on a pile of more than a trillion dollars of US Treasury bills, and in recent years, many of the biggest IPO deals were for Chinese companies listing in Hong Kong. But it takes a great leap of logic to get from there to the notion that the gyrations of China's insular, yuan-denominated stock exchanges must necessarily send shock waves rippling over other markets.

Making sense of Black Tuesday requires untangling two entirely separate questions: What triggered the Chinese market sell-off in the first place? And why in the name of Mao should otherwise well-informed investors in New York, London and Tokyo give a flying fen about the machinations of the insular, crazy casino that passes for China's equity market?

The first question, at least, lends itself to some semblance of rational analysis. By the end of the trading day Tuesday, analysts around the Pacific Rim had concocted all sorts of theories about why China's domestic investors, newly returned from their big holiday, would suddenly yank money out of stocks.

Many cited rumors about ominous changes in government policy. Beijing must be plotting new administrative measures - a crackdown on bank lending to stock investors, maybe, or a capital gains tax on equities - to keep China's stock markets from overheating ahead of this year's all-important 17th Communist Party meeting. There were sober pronouncements about 'profit taking' and investors retreating from "excessive valuations." Some blamed Alan Greenspan's utterances to a Hong Kong financial conference that a U.S. recession might be "possible."

None of it made any sense. As Standard Chartered's Shanghai economist Stephen Green points out, there were no macroeconomic or corporate earnings developments to prompt the sell-off. From Monday to Tuesday, nothing about the underlying health of the Chinese economy changed.

As UBS Asia economist Jonathan Anderson reminds, China's domestic investors aren't that highly leveraged. The capital gains tax rumors had been swirling for weeks. (On Wednesday, the government said it had no plans to introduce such a tax.) The big party meeting? It's not until September, for Pete's sake. And when analysts and the financial press invoke 'profit-taking' in explaining market downturns it's a sure sign they haven't the slightest clue what's going on; it's like saying share prices fell because, well, gosh, there were more sellers than buyers.

So what did prompt the sell-off? I don't presume to know. But the most plausible explanation I heard was that mainland investors pulled back because on Monday the Shanghai Composite index crossed the 3,000 threshold. If that sounds simplistic or patronizing, I invite you to spend a few hours in the lobby of major Chinese brokerage in Shanghai some day chatting with some real Chinese about their investment strategies.

It shouldn't take too long to work out that ordinary Chinese investors (in those Shanghai brokerage lobbies, many will be shuffling around in front of the trading screens in their pajamas) aren't the most sophisticated lot. In China's domestic stock markets, there are no equivalents of Peter Lynch, Warren Buffett, Calpers or TII-Cref. Naive individuals, not experienced institutions, rule the roost. And since not even the savvy investors put much faith in market information disclosed by the companies themselves, rumor triumphs and investors are suckers for complex technical analysis of irrelevant historic stock data and meaningless price points.

Which brings us to Question Two. Why should supposedly intelligent investors in established markets like London, New York or Tokyo pay the slightest heed to whims of Shanghai's pajama-clad punters? It's not like Western investors have direct exposure to China's exchanges; except through an incredibly convoluted and limiting scheme called the Qualified Institutional Investor program, Beijing bars overseas investors to purchase yuan-dominated shares trading on the mainland exchanges.

Perhaps the flighty foreigners imagined China's investing masses were privy to some dark secret about the fragility of the world's fastest growing economy that remained unknown to the outside world? (Curious, though, that on the day mainland bourses collapsed, Hong Kong, the biggest overseas market for Chinese shares, mostly shrugged it off, surrendering less than 2%.)

The linkage argument looked even loopier by late Wednesday, when the Shanghai Composite bounced back, gaining 4 percent, while Japan's Nikkei 225 stock index lost 2.8 percent. Increasingly, it is clear that, for better or worse, the prime mover in global markets remains the US of A. So don't blame Shanghai.

Whatever China's culpability in SARS or avian flu outbreaks, there's no rational reason why a stock slump in China should strike fear in the hearts of investors beyond the Middle Kingdom. If the world's largest consumer market falters, on the other hand, there will be shock waves, and they will ripple in the other direction across the Pacific, battering not only markets in China, but the many other Asian economies that continue to depend so heavily on US exports for growth.