China’s market sideshow now main event – Part 1

By William Pesek Bloomberg

If there’s anything surprising about this week’s plunge in Chinese stocks it’s that anyone would be surprised. One can debate whether China’s equity rally of recent years constitutes a bubble or an outright Ponzi scheme. What isn’t debatable is that stocks in Asia’s No. 2 economy have more in common with casinos than financial markets. Investors on the losing side this week should’ve seen this coming. The real question is whether events in China are a harbinger of increased turbulence in global markets — or just a replay of May 2006, when emerging markets plunged before rebounding. It could very well be the former. It’s not about being a doomsayer or a cynic — it’s about recognizing that bubble-like conditions are popping in markets from Shanghai to Istanbul to New Delhi and elsewhere. Marc Chandler, New York-based global head of currency strategy at Brown Brothers Harriman & Co., wasn’t exaggerating when he called Tuesday’s global slide “a bloodbath in the equity markets.” Here, it’s impossible to overstate the Chinese and Japanese parts of the equation. China needs to be explored because there’s as much hype involved in its outlook as potential; Japan because of the global bubble caused by the so-called yen-carry trade. First, the China angle. “Fueling interest in the emerging markets has been China itself,” said Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.

That’s particularly true of U.S. investors. Over the past two years, Quinlan said, U.S. investors sank just over US$10 billion into Chinese equities. The 9.2 percent plunge in the Shanghai and Shenzhen 300 Index on Tuesday came at a time when U.S. investors have never been more exposed to emerging markets. In 2006, Quinlan said, U.S. purchases of emerging-market equities totaled a record US$52.7 billion. That followed a stock- buying record of nearly US$39 billion in 2005. In 2006 alone, U.S. purchases of Chinese equities jumped to US$5.2 billion from US$4.9 billion in 2005. All this means that on a relative basis, China has become the key emerging market for the U.S. “To a significant degree, as China goes, so go the emerging-market returns of U.S. investors,” Quinlan said. There you have it — the world’s most developed markets are more vulnerable than ever to the policies of officials in Beijing, regulators in Shanghai and companies throughout the most populous nation. Yes, China has vast potential. It boasts 10 percent-plus growth, US$1 trillion in currency reserves and 1.3 billion people, many of whom are becoming richer by the day.

Yet it also has a banking system that’s still a transmission mechanism to funnel money into politically connected companies, little transparency, negligible press freedom and a central bank that reports to the Communist Party. China censors the Internet, undermining innovation in an economy that badly needs it. It faces worsening pollution and widespread risks of social instability. So welcome to the brave new world of global finance, one in which hiccups in Shanghai will increasingly shake up markets across the globe and raise prickly questions about how stable the No. 4 economy really is. China’s stock market is no longer a side show, but a main event.