China Stocks: The Great Leap Downward

China may be the world's fastest-growing major economy, but its main stock market has fallen on hard times. Since peaking last October, shares on the Shanghai Stock Exchange have lost half their value—an ignominious tumble capped when prices plummeted 7.7 percent on Tuesday. By the close of trading the Shanghai Composite Index (the broadest measure of all shares traded on the exchange) stood at 3,073, down from a peak of 6,124 last Oct. 16. "The environment is highly uncertain," says Vincent Chan, chief equity strategist at Credit Suisse in Hong Kong. "The market is looking at the emergence of slower growth and higher inflation globally."

China's bear market was not wholly unexpected. In the first nine months of 2007 share prices in Shanghai shot up 1.7 times, prompting financial luminaries like American Warren Buffett and Hong Kong tycoon Li Ka-shing to warn that a dangerous correction was brewing. China's main exchange ranked second in market capitalization behind Tokyo, and fifth globally. And after hugely successful listings, previously unheralded state behemoths like PetroChina, the Industrial and Commercial Bank of China and Air China emerged as some of the most valuable companies in the world in their respective industries.

Yet China's rally differed fundamentally from the global bull market it coincided with. The main actors weren't giddy foreigners who drove Chinese shares into the stratosphere but rather millions of small-time Chinese investors who opened brokerage accounts in 2007 and poured billions from their savings into equities. Initially government regulators cheered these greenhorns on. But soon valuations defied even the most optimistic forecasts for future performance, and fearing a socially destabilizing meltdown, the China Securities Regulatory Commission raised the stamp duty and took other measures to tamp down share prices. "In China [government] policy factors more than company earnings determine share prices," says Nicholas Kwan, regional head of economic research at Standard Chartered bank in Hong Kong. "From late 2007 until now, the government has been trying to cool things off."

The freeze has been deepest in sectors deemed vulnerable to Beijing's ongoing effort to tighten the money supply and quell inflation. Banks, under orders to tighten credit, have fallen hard; shares in Shanghai's Pudong Development Bank dropped 10 percent (the one-day maximum) on Tuesday, for example. Construction companies burdened by a real estate glut, airlines hammered by rising fuel costs and automakers weakened by indications that households are resisting big-ticket purchases have also had it tough in recent months. Overall, earnings at China Inc. are expected to slump this year as corporate financial portfolios turn negative and the surging prices of imported commodities shave profit margins ever thinner. "The issue is the next six to 12 months," says Chan. "I'm most worried about growth in 2009."

One lingering question is the extent to which the market downturn will crimp Chinese household consumption. In other countries, market corrections as severe as China's have set off corporate downsizings, pushed up unemployment, forced small-time investors to rein in their spending and spread the pain everywhere from airlines to restaurants and boutiques. In contrast, China's boom-bust cycle hasn't yet jumped the firebreak from finance to the real economy, though a survey conducted by Deutsche Bank in May suggests that urban Chinese investors have suffered market losses equivalent to three quarters of their annual income and as a result now spend less traveling, shopping and dining out.