Two (Or Three Or Four) Chinas

June 05, 2007

Volatility with a capital “V” has come to the Chinese market. Up 5%, down 8%: the market makes the Nasdaq at the height of the Internet bubble look placid.

The government in China isn’t helping. It set off the recent downturn with a promise to triple the share trading tax from 0.1% to 0.3%. Then, it whispered that it would delay the implementation of a capital gains tax for three years, and the market recovered.

Larry MacDonald has a good note on this on SeekingAlpha. He notes the huge discrepancy of valuations on Chinese stocks between those available to domestic investors and those available to foreign shareholders. The Shanghai Index, for instance, is open only to domestic Chinese investors, and it sports a price-to-earnings ratio of 45. The iShares FTSE/Xinhua 25 ETF (NYSE: FXI), meanwhile, which holds foreign-listed shares, sports a ratio of just 16.

There are two reasons for that huge discrepancy. The first is that the domestic market includes more small-cap shares, which naturally have a higher price/earnings ratio. The second is that the recent surge in domestic shares is driven by a huge liquidity bubble, as Chinese civilians pour into the marketplace en masse. If it sounds familiar, it should: we saw a similar speculative bubble appear in domestic Chinese shares in 2000. In fact, the Shanghai and Shenzen markets hadn’t recovered past their 2000-era peak until earlier this year.

All this is a reminder of the importance of carefully picking your index when investing in emerging markets, something I’ve discussed before, and which was covered in this recent WSJ article. In these markets, different indexes can have hugely different exposures.

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