All the hype about a super-charged Chinese economy has meant very little to foreign investors in recent years because the country’s stock market has not benefited from its economic growth. In fact, the Chinese stock market is in a dismal slump, trading below five-year lows, and stocks of Chinese companies trading on foreign exchanges have not fared much better.

The Shanghai composite price index closed at 142.7 in U.S.-dollar terms on March 31, 2005, up from a low of 66.8 on Dec. 29, 1995, but way below its high of 267.9 on June 29, 2001. The index had not traded at this level since March 1999.

The Shenzen composite price index, the junior of the two major Chinese exchanges, closed at 35.9 in US$ terms on March 31, its lowest level in more than eight years. The Shenzen index reached a low of 13.4 on Dec. 29, 1996 and a high of 79.5 on June 29, 2001.

Shareholders in Chinese companies trading on overseas markets have probably seen the prices of their investments decline, as well. The Hang Seng China-affiliated corporations index (HSCCI) in Hong Kong, which lists Chinese “red chips” (companies at least 35% held by state-owned
organizations or provincial/municipal governments in China) closed at 196 in US$ terms on March 31, down from a high of 685.8 on June 30, 1997, and up from a low of 115.9 on March 31, 2003.

The broader Morgan Stanley Capital international China price index has not performed any better. It closed at 25.1 in US$ terms on March 31, up from a low of 13.6 on April 30, 2003, but well below its high of 133.6 on Dec. 31, 1993.

“Typically, there is a weak correlation between economic and stock market growth,” says Chuck Bastyr, managing director and portfolio manager of BPI Global Asset Management LLP in Toronto. This is generally true for any country because the stock market is a leading indicator of economic growth, not the other way around.
However, equity investors often look at overall economic conditions when making investment decisions, which is why China is seen as a hot spot.

In reality, Chinese economic growth has been fuelled to a large extent by local and foreign direct business investments. The stock market is not considered an efficient source of funds by Chinese citizens who have more than US$1.4 trillion in private household savings sitting in Chinese banks — at an estimated 2005 interest rate of 4% and a forecast inflation rate of 6%, for a real interest rate of -2%.

In 2005, US$65 million in foreign direct investments is expected to flow into China, up from US$59 billion last year, providing further impetus to business growth. At the same time, local business investments have reached such a high level that the government has taken measures to curb flows to prevent the economy from
overheating. Last month, Chinese Premier Wen Jiabao stressed the need to clamp down on “overambitious” investment — a call that followed earlier central bank and government action to restrain business investment.

With business investment driving economic growth, the role of the stock market has been marginalized. “China has taken a top-down, state-driven approach to facilitate development,” says Bastyr. “Capitalism is still new to the Chinese in terms of use of the stock market and the population is not familiar with the workings of the market.”

Mark Grammer, vice president of investment at Mackenzie Financial Corp. in Toronto, says: “Investment trust is not nearly as high as in Canada. There is a high degree of suspicion and a lack of transparency.”

This is because of a weak regulatory environment, poor corporate governance, insufficient disclosure and high-profile scandals, adds Bastyr, that have led to “a lack of confidence in the market.”

Nonetheless, politics is probably the most important underlying determinant of the market environment in China. “The markets are more policy-driven and less fundamentally driven than in developed countries,” says Chuck Wong, vice president and portfolio manager of Toronto-based Dynamic Mutual Funds Ltd. The Chinese government has been managing economic growth through controlled policy measures that do not include development of the stock market.

“Shares on the Shanghai and Shenzen exchanges are trading at bubble valuations and there are concerns about overvaluation,”
says Wong. Valuations are made complex by wide differentials in price of the same stock on domestic and foreign exchanges, he adds. Although in most situations this would give rise to arbitrage opportunities, he says, “foreign investors cannot invest directly in domestic Chinese markets and, consequently, cannot take advantage of such opportunities.”