It was a fair bet that China Citic Bank Corp. would sizzle when its shares debuted on Friday. But few experts anticipated that China's latest bank to go public would see its stock price double in Shanghai within hours, even as it rose a modest, albeit respectable, 14 percent in Hong Kong. By day's end, according to Bloomberg data, Citic Bank's market capitalization had hit $49.2 billion, some 100 times what it earned last year, a premium unheard of anywhere but in China these days. "This shows that foreign investors [in Hong Kong] are more rational in valuing this bank," said Dominic Chan, a bank and insurance-sector analyst for CLSA in Hong Kong, adding that the huge run-up in Shanghai "just doesn't make any sense."
Citic's bifurcated debut adds to mounting worries about China's high-flying equities. Just a few years ago, troubled banks were seen as one of the big sinkholes that could bring down the China miracle—but suddenly they're in every emerging-market portfolio. Industrial and Commercial Bank of China now has a market cap of more than $250 billion, higher than the Bank of America's. On Hong Kong's exchange, where mainland companies now account for more than half the market by value and banks are dominant, the Hang Seng index rose 34 percent in 2006 and is up another 4 percent since then. But that's barely a blip compared with what's been happening across the border in China. So far this year the Shanghai Composite Index is up 37 percent and Shenzhen's index has posted an 85 percent gain. "We believe it is a retail investor-driven bubble, and we advise clients to consider taking profits," HSBC warned in a blunt April 19 appraisal, reversing a bullish outlook held since 2005.
Leading market watchers deliver a litany of interrelated concerns. One is that China's megabanks, despite persistent nontransparency and evidence of mounting bad loans, have eclipsed many foreign peers in their paper valuations. Another is the gold rush of newbie Chinese retail investors, many staking their life savings on dubious companies. And finally there's the ever-widening gap between valuations in Hong Kong and China, where shares in the 40 companies listed in both places now trade at an 80 percent premium. "In Shenzhen a few weeks ago I sat at a McDonald's, and the radio was broadcasting stock tips rather than music," says HSBC's regional strategist Steven Sun. "They're buying based on news, not fundamentals. That's pretty dangerous."
China's banks are the biggest part of today's bubble fears. Together, they've taken in more than $20 billion in strategic investments from foreign counterparts like Bank of America, Goldman Sachs and Singapore's investment arm, Temasek, in the past three years, and garnered more than $60 billion through IPOs. So what once were policy lenders in China's old planned economy are seen to be embracing Western accounting, risk management and lending norms in time to capitalize on their nation's emergence as a global economic giant. True or not, that "story" is already reflected in their soaring share prices. In Hong Kong, Chinese banks now trade at a price-to-book ratio above 3.0 (meaning a market capitalization three times their net assets), roughly double the standard for blue-chip multinational banks elsewhere in the world.
But there are big doubts about whether the banks can deliver on the hype. Since mid-2006, their results show slower than expected growth and weakening asset quality, which could lead to mass defaults if there's any major economic downturn. Meanwhile, seasoned investors no longer drive the market. According to official figures, 10 million new trading accounts were opened in the past four months, more than in the previous five years. That jibes with anecdotal evidence suggesting that small-time punters are plowing whatever reserves they have into the market—even if that means tapping retirement accounts or mortgaging their homes.
Bald market manipulation is also evident. Take the case of Hangxiao Steel, a small listed company specializing in parts for the construction industry. Its share price has more than tripled this year based on its claim to have procured a $4.4 billion contract for a vast housing project in Angola—a deal valued at almost a fifth of Angola's annual GDP, or about five times China's 2006 exports to Africa. Although the transaction seems orders of magnitude beyond Hangxiao's and Angola's scope, news of it nonetheless drove the stock price higher until regulators suspended trading in mid-March. The run-up continued when trading resumed 10 days later, forcing regulators to intervene a second time on April 5. The company maintains that its Angola contract is legitimate, but investigators are now probing suspected stock manipulation.
Nobody knows just how widespread such problems are. One disquieting indicator, highlighted recently by HSBC, is that stocks with high price-to-earnings rations (and hence, low profitability) have outperformed value stocks by some 40 percent in 2007—suggesting that investors are buying on buzz, not fundamentals.
Small-time retail traders speculating with their life savings stand to lose big if the markets reverse course. But the bigger risk today is systemic. In the current positive-feedback loop, companies like China Life Insurance can generate growth from its portfolio and tout its performance even if its core business suffers a setback. (In a prescient essay last week, South China Morning Post columnist Shirley Yam noted that last year China Life posted a 71 percent jump in underwriting losses yet saw earnings more than double thanks to the surging stock market.) Banks get in the game by lending more to big state-owned enterprises and residential mortgage holders alike, turning a blind eye to the possibility that the funds are flowing into stocks.
How might it end? Best case, the bubble will deflate slowly, punctured by government tightening measures that are even now being crafted in Beijing. But if it balloons as Japan's did in the late 1980s, then pops, vast fortunes will be lost, and a significant number of China's listed companies will go belly-up. The banks Beijing and the world have put so much faith in will have a whole new nonperforming loan crisis to contend with—and the fallout won't be limited to China.