The Chinese Bubble?

Written by Matt Hougan
November 12, 2007 5:16 PM EST





China weighs heavy on commodity investors. If we are currently in a demand-driven commodities boom, it’s China that’s driving the bus.

According to a recent study by The Wall Street Journal, China accounted for the largest share of new demand for crude oil over the past 13 years.

The Journal’s data show that China added 5.04 million barrels per day in new demand since 1995, compared to just 4.26 million barrels per day in the U.S. and 1.03 million new barrels per day in Europe.

The country’s impact on the metals space is even larger. Although estimates vary, most people agree that China accounted for about half the new demand for steel, copper and aluminum this decade, and virtually all the new demand for lead, zinc, nickel and tin.

Even gold is exposed to the Chinese economy. China is the third-largest consumer of gold in the world, behind India and the U.S., and demand is rising.

Chinese gold demand jumped 17% in 2006, as rising wealth drove demand for gold jewelry.

In short, while the U.S. is still the largest consumer of many commodities, the current commodities boom has been built largely on demand growth from China. If the Chinese economy sputters, the commodities boom could suffer as well.

So will it?

An Incipient Bubble?

One of China’s biggest supporters over the past decade has been uber-commodities bull Jim Rogers. Rogers loves China so much that he is publishing a book in December called A Bull In China: Investing Profitably In The World’s Greatest Market. In it, he calls China “the greatest economic boom since England’s Industrial Revolution.”

Not surprisingly, that boom drives part of Rogers’ bullish stance on commodities.

But in an as-yet-unpublished interview with the Journal of Indexes, Rogers appears to be hedging his bets.

“[The Chinese equity market] is an incipient bubble and will turn into one within a few months unless something causes a significant correction soon,” Rogers says.

When asked if the Chinese stock market will be a strong performer over the next 5-10 years, he adds: “If a full-fledged bubble develops, it will be one of the worst [markets]. If something causes a significant correction, it will be one of the best.”

It’s enough to give you pause: If one of the world’s largest China bulls is worried about a bubble, should other investors be, too? And has Rogers’ “prospective bubble” already arrived?

Bubble-icious

While there’s no formal definition of a “bubble,” a new stock market index developed by Hang Seng Indexes gets pretty close.

Followers of the Chinese equity markets know that different investors access the market through different share classes. Domestic Chinese buy “A Shares,” which are listed locally on stock exchanges in Shanghai and Shenzhen, and are not available to foreign investors.

Foreign investors, meanwhile, primarily access the market through “H Shares,” which are mainland Chinese companies that trade in Hong Kong.

There are about 60 companies, however, that trade both A shares and H shares. These shares are fundamentally similar, offering an equal stake in the same companies. The only difference is that one is offered to domestic investors and one is offered to foreign investors.

The Hang Seng China AH Premium Index measures the difference in valuation between these two share classes. As of November 12, the A Shares were valued at an average 61% premium to the H Shares. In other words, a stock in the domestic market costs about 61% more than the same stock in Hong Kong.

Hello, Tulip-mania.

The Example of PetroChina

The recent domestic IPO of PetroChina makes the case loud and clear. Shares of PetroChina have been available to foreign investors for a while, both through the H share market and as ADRs in New York. Warren Buffett even owned shares in the company until this spring, when he sold them because they had become too pricey.

But when PetroChina sold a 2.2% stake to domestic investors, they ignored Buffett’s opinion and drove the price up nearly 300%: Shares rose from about $1.80/share to $5.90/share on the first day of trading. That valuation gave PetroChina a total market capitalization of $1 trillion, making it by far the largest company in the world.

The H Shares, however, stayed relatively stable at just $2.32/share, giving the company a valuation of $424 billion. $424 billion or $1 trillion? It’s the same company.

What’s worse, there are signs that even the $424 billion measure is inflated. For starters, the H Shares trade at a P/E ratio of 20, compared to about 10 for domestic market peers like Exxon-Mobil. Meanwhile, the domestic shares in China trade at a P/E of 50. PetroChina may be well-positioned for growth, but a major oil company trading at a P/E of 50?

"It's very difficult, almost impossible, to predict bubbles. But what we can say is that based on historical examples, this kind of miracle is never sustainable," said Zuo Xiaolei, chief economist for China Galaxy Securities in Beijing, in a recent Wall Street Journal article. "Whether foreign investors believe in this or not is up to them."

There’s no way to arbitrage the difference in value in the shares, as they are not interchangeable, and domestic investors are not allowed to short stocks.

Will It Matter?

With stats like these, it’s hard to argue with the proposition that the domestic Chinese markets are in a bubble. One day, that bubble will probably pop, with possible consequences for the domestic Chinese consumer.

The question is: Will it matter? Will a bursting of the domestic equity bubble harm the Chinese economy enough to slow commodity demand?

Some investors say no. In their opinion, the Chinese economy is driven by exports, and a bursting of the domestic equity bubble will have little impact on global shares or the global economy. A recent and convincing report from UBS argued differently, deconstructing the China boom and saying it was led by domestic consumption.

Regardless of who you believe, it’s certainly a situation that merits attention. China plays a huge role in the commodities market right now, and any serious dip in growth would have consequences for the commodities market.

For now, though, it’s still 10% GDP growth as far as the eye can see. And as long as that remains the case, investors have nothing to worry about.