Frank Newman: China's bubble has burst

While the Samoan rugby test dominated the news in New Zealand last week, the eyes of the world were on a remarkable economic event taking place in China.

Since the middle of June Chinese share prices have collapsed 30%. The response of the Chinese government has been to initiate a multi-trillion dollar bail-out to prevent an economic melt-down. The collapse comes after a year when stock prices rose 100%.

In April the Economist magazine raised questions about the value of China's sharemarkets. They pointed to three indicators in particular:

• "Plainly absurd" valuations. The average stock was trading at 50 times last year’s earnings and the China’s small-cap board at an average price-earnings (PE) ratio of 110, more than double that of internet stocks at the peak of America’s dotcom bubble in 2000 (which subsequently lost 78% of their value from peak to trough).

• Soaring leverage, "up some 300% from a year earlier". It is believed that nearly 9% of all share purchases have been funded by margin debt (borrowing to buy shares), the highest of any market in history, and

• A proliferation of "small-time day traders with little understanding of what they are buying" (day traders buy and sell within the same trading day and therefore avoid having to pay for the shares which is off-set against the sale). Everyone was jumping onto the bandwagon.

The Chinese authorities have responded to the share price collapse by putting in a raft of regulations to restrict supply and boost demand for shares.

• Half the shares (over 1000 companies) have been put on trading halts, preventing their shares from being traded at all!

• Company executives and board members, and shareholders owning more than 5% of any stock, have been banned from selling their shares for six months!

• The central bank is injecting money into pension funds and lending institutions so they can buy stocks.

• Initial public offerings have been suspended to stop new companies competing for capital that could be used to buy shares already listed.

• Companies have been ordered to either buy their own shares or encourage their employees to do so.

In my view these measures not only conceal the real extent of the decline but they put many of China's institutions at greater risk of further losses.

China's recent "correction" has a 1987 feel about it. All of the characteristics that have fuelled their share price boom existed in our sharemarket prior to its collapse in October 1987, when it fell 15% in a single day (Tuesday the 20th), and continued to fall a further 60% before recovering some four years later.

The main lessons to be learnt from our 1987 sharemarket crash is that these events are never short lived, and all other investment markets and the economy are adversely affected. While the Chinese authorities may be able to manipulate share prices in the short-term by tipping in vast amounts of money, in my view their efforts will in the end be futile.

There is no getting around the fact that share prices in China need to fall by about 60% to get back to fair value. In the long-run it's the earnings potential of an investment that drives its price - that is a reality that short-term investors forget  in their over-exuberance, and a reality that interventionist governments have to eventually accept.

While China may seem like a distant land to most of us, it is so dominant in global trade that a melt-down in their economy is likely to have serious implications internationally. It is also going to be a serious test for China's state-run-free-market economic model. Will the heavy hand of the state be able to do what no other government has been able to do; protect its economy against the excesses of the free market and human fear and greed? I don't think so.

So what are the likely effects for us?

History tells us that when a country suffers an investment market collapse its consumers change their behaviour: they spend less to rebuild savings. That means the Chinese economy will slow. Reduced consumer demand is likely to see further falls in commodity prices: oil, copper, iron ore, and more importantly for us, agricultural products and logs. It may also curb tourist numbers from China and cool the flow of Chinese investment capital into New Zealand; quite possibly slowing down the buying of houses or even result in the sale of houses so money can be repatriated back to China.

All eyes are on China.