EMERGING MARKETS REPORT Goldman Sachs: China at risk of "market euphoria"
By Polya Lesova, MarketWatch Last Update: 2:56 PM ET May 10, 2007
NEW YORK (MarketWatch) -- China's booming A-share market could turn into a bubble if speculation among exuberant domestic retail investors is not curbed, Goldman Sachs warned Thursday, as the Shanghai Composite Index hit yet another intraday record high. "Market trading statistics, liquidity indicators, and anecdotal evidence all point to optimistic, if not exuberant, sentiment in the domestic market," said Thomas Deng, analyst at Goldman Sachs, in a Thursday research report. "As speculation continues to be nurtured among domestic retail investors, we see genuine risks of market euphoria materializing if regulators fail to step up their efforts to contain market irregularities," Deng said. Other financial firms, including UBS Securities, as well as Governor Zhou Xiaochuan of the People's Bank of China have also expressed concern in recent days about the possibility of a bubble forming in the stock market. "A-shares are at the beginning of a bubble, and could go even higher before the eventual reversal," said Henry Ho, strategist at UBS Investment Research in a May 7 research note. "Liquidity and sentiment seem irrationally high, but does not appear to abate," Ho said. "At this stage, we believe the self-correcting mechanism of stock market is also not able to reverse the overpricing." The Dow Jones CBN 600 index, which reflects about 80% of China's free-float market capitalization, has rallied 91.8% year-to-date. The Shanghai Composite Index, which tracks shares listed on the larger of China's two stock exchanges, set an intraday record of 4,072.14 on Thursday, before scaling back to a record close of 4,049.70, rising 0.9%. The benchmark crossed above 4,000 for the first time Wednesday. See Asia Markets. 'As speculation continues to be nurtured among domestic retail investors, we see genuine risks of market euphoria materializing if regulators fail to step up their efforts to contain market irregularities.' — Thomas Deng, Goldman Sachs On Feb. 27, the Shanghai Composite tumbled nearly 9% on fears that the Chinese government would intervene to slow down the market. The move sparked a sell-off on markets around the world. Read more. Despite its February plunge, the index recovered its losses and is currently up a whopping 51.3% year-to-date, making China the best performing stock market in the world. "I quite agree with the [Goldman Sachs] report," said Richard Gao, lead manager of the Matthews China Fund (MCHFX : Matthews Asian:China News , chart , profile , more Last: 27.39-0.13-0.47%
6:03pm 05/10/2007
Delayed quote dataAdd to portfolio Analyst Create alertInsider Discuss Financials Sponsored by: MCHFX27.39, -0.13, -0.5%) . "The A-share market is extremely speculative at this point. It's become one of the most expensive stock markets in the world." The market will be "extremely volatile" going forward, Gao said. China's A-share market, which is open mostly to Chinese nationals, has risen over 150% since the second half of 2006. The Shanghai A-share index is up 51% year-to-date, while the Shenzhen A-share index is up 73.7% year-to-date. The participation of domestic retail investors in the Chinese equity market has gone through the roof. The total number of domestic individual equity accounts was 94 million, or over 7% of population, as of April 30, according to Goldman Sachs. In contrast, only 5% of the population had equity accounts in 2001. "Moreover, new account opening is accelerating at a lightning pace--new individual account openings on April 30 alone exceeded 1 million, and total new individual account openings in April exceeded the sum of [those opened in] 2005 and 2006," said Goldman Sachs economist Hong Liang in a separate research report Thursday. "As a result, about 17% of the total existing accounts were opened just in the past 4 months." "Rising optimism and speculative activities have propelled valuations above the constantly improving market fundamentals," and some stocks are trading at unsustainable levels, Deng said. The "market could develop into a bubble if speculative activity continues to spread among retail investors." "It is now a critical time for the government to take action and prevent the excess from building up further," Deng said. First-quarter earnings-per-share growth for the A-share market this year totaled 82% year-on-year. Goldman Sachs warned that if negative real interest rates are left un-checked, asset inflation may soon advance into unsustainable territory. "To ensure the sustainability of the market over the medium term, we believe policy makers need to act quickly," Liang said. "Delays in policy actions will run the risks of severely impairing households' balance sheets, exacerbating income and wealth distribution, and setting back years of progress made on capital market reform." The majority of Chinese households' financial assets are in the form of cash and bank deposits, which now stand at $2.5 trillion, roughly 88% of GDP, and 390% of the free float capitalization of the A-share market, Liang said. "Policy actions taken so far have been inadequate to contain the bubbling overheating pressures in the broad economy, while little has been done to anchor inflation expectations," Liang said. "The 50 basis points reserve requirement ratio hike in late April had little teeth given commercial banks' excess reserve ratio stands well above 2%, and the absence of any adjustment in interest rates will continue to feed exuberant asset demand." Goldman Sachs expects the central bank to raise interest rates three more times this year, by 27 basis points every time. The government will likely take more measures to curb loan growth and fixed asset investment expansion, and warn investors of the risks in investing in the A-share market, Liang said. Gao of the Matthews China Fund said that when Chinese authorities have take measures in the past to cool the stock market, that resulted in even more volatility. "They [the government] don't want to create a panic in the market," Gao said. "Rather, they will educate retail investors to be careful about the risk of investing in the markets." However, "if this kind of craziness continues, there could be more drastic measures from the government," Gao said. Polya Lesova is a MarketWatch reporter based in New York.
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