View from Asia: Booms and Busts

Why you should worry about the Shanghai stock market.

It already feels like ancient history. Two months ago the Shanghai stock market stumbled, falling 9 percent in a single day, and immediately pulling several major Western markets with it. Suddenly, every market analyst was talking about China’s newfound ability to drive global equity prices. Then share prices bounced back and “Black Tuesday,” as some called it, became just another example of stock-market hyperbole.

But was it? In fact, there are two reasons why CFOs should still worry about Shanghai (both as guardians of shareholder value and as investors themselves). One is that global markets are indeed becoming more closely connected. A study of stock-market history conducted a few years ago by economists at Yale University confirmed what many portfolio managers have suspected: global markets are far more correlated now than they used to be (indeed, they are more aligned than at any point since the turn of the 19th century). Research by Harvard University economist Kenneth Rogoff suggests that the global economy is now in a state where blips in unstable emerging markets like China’s can have a profound effect on asset prices worldwide.

The other reason for worry is that the late-February stock-price drop will almost certainly not be an isolated event. Not only do Shanghai’s stocks remain perilously overvalued — they rose 130 percent in 2006 and continue to climb — but the market’s structural problems ensure that volatility is here to stay.

Just after the market’s crash, Treasury Secretary Henry Paulson came to China to urge quicker reform of the country’s capital markets. There are too few institutional investors, he said; the government continues to impose restrictions on how big money managers such as insurance companies can invest their money. That leaves the market in the uncertain hands of individual investors, many of whom are picking stocks using something other than fundamental research. Corporate-governance rules are weak and poorly enforced, increasing the likelihood of market-jarring scandals. And there aren’t enough financial instruments, such as index futures, that could help temper the market’s wild swings.

To its credit, the Chinese government is heeding such criticism. It is introducing international accounting standards and allowing greater numbers of asset managers to invest in local stocks. But it will be years before the wrenching booms and busts of its capital markets will be stabilized. Until then, expect that some of China’s problems will be your own.

Don Durfee is managing editor of CFO Asia.

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