Asian economic powers coming under increasing scrutiny

Although Asian economic powers China and India are expected to fuel Asia’s secular bull market, the sustainability of their performance is coming under increasing scrutiny. India is continuing to surprise, while China’s bull market may be on the verge of a bubble.

India, long in the shadow of China, is now being viewed more favourably as a long-term growth story, while alarm bells are sounding over the potential of a bubble in China. However, says Erik Nilsson, senior international economist with Bank of Nova Scotia’s international research group in Toronto, it is tough to generalize about these two markets, which have different drivers and characteristics.

Economic growth is expected to remain robust in both countries, he says, although India continues to “surprise on the positive side” in terms of economic activity. In 2007, China’s economy was expected to grow by almost 11% and India’s by more than 8%.

But there remains the very real potential of a bubble in China. Nilsson says that the Chinese authorities are cognizant of the potentially destabilizing impact of a sudden correction in overpriced property and equities. They have taken measures to curb money supply by raising bank reserve requirements nine times in 2007, effectively reducing the amount of money flowing through the economy. However, the growth in money supply remains strong.

A report from Hong Kong-based brokerage, banking and private-equity firm CLSA Asia-Pacific Markets agrees that China’s bull market is likely to evolve into a full-scale bubble — unless the authorities become much more aggressive about tightening monetary policy and dealing with an overvalued renminbi. However, according to CLSA’s fourth-quarter 2007 Asia Maxima report: “There is little reason to believe that the Chinese stock market is about to collapse short of the natural, short but sharp, profit-taking corrections to be expected in all bull markets.”

India is the quality equity story in Asia, the report says, driven by a powerful investment cycle. China, on the other hand, is in a liquidity-driven bull market, fueled by an undervalued exchange rate, negative interest rates and seductive arbitrage opportunities between its “A” and “H” shares. At the end of the third quarter, H shares were trading at an average 44% discount to their A counterparts.

A-class shares are listed on Chinese exchanges and are generally available for purchase only by mainland citizens. They are quoted in renminbi. Foreign investors can invest in A shares through a structure known as the “qualified foreign institutional investor” system.

H-class shares are issued by Chinese companies under Chinese law, but are listed on the Hong Kong Stock Exchange. They are denominated in the HK dollar.

“‘A’ shares are ridiculously overvalued,” says Charles Bastyr, chief investment officer and portfolio manager with Meadowbank Asset Management Inc. in Toronto. They were up 173% in U.S.-dollar terms for the nine months to Sept. 30, vs 69.5% for the MSCI China index. “Too much local money is chasing too few stocks, sending prices through the roof.”

This is largely due to the fact that the renminbi is not freely exchangeable and locals cannot generally invest outside the mainland. Interest rates, as well as real savings deposit rates, are negative, making stocks attractive investments.

In India, stocks are currently trading at about 20 to 25 times forward earnings on average, while the Chinese stocks are twice as expensive, Bastyr says. India’s market, which has been somewhat more volatile, is up 39% in US$ terms for the nine months on the MSCI India index.

Both Asian economic powers’ markets have had a good run and, consequently, are expensive, adds Mark Grammer, vice president of investments and lead manager of Mackenzie Universal Global Future Fund, sponsored by Mackenzie Financial Corp. of Toronto. He believes that “an accident is waiting to happen” in these markets and cautions that now might “not be the greatest time” to invest in them.

China’s stock market is awash with cash. Bastyr cautions that this is not good for sustainability. China is the region’s largest recipient of foreign private-capital flows, accounting for 6% of the world total of US$620 billion in 2007, according to the Washington, D.C.-based Institute of International Finance.

Further, Nilsson contends that questions arise over the efficiency of investments in China, especially in grandiose projects.

On the other hand, Bastyr says, India’s growth is driven largely by domestic demand, capital spending and infrastructure development. As Nilsson points out, India has shown a “less welcome attitude to foreign investments.”

India is continuing to surprise, while China’s bull market may be on the verge of a bubble

However, this is not to say that India is not vulnerable. “India is naturally as vulnerable as any in the short term,” the CLSA report says, “with US$46 billion of foreign portfolio money invested into equities in the past five years.”

The risk to both countries is if the U.S. economy falters. China and India both have become more domestically driven, but a slowdown in U.S. consumption will hurt the global economy. Still, Bastyr says, “India is not as dependent as China on world growth.”

China and India have adopted different economic models, developed distinctive competencies and have dissimilar political structures. They each face similar challenges but have taken different approaches to overcoming them. “China has taken a top-down, state-driven approach and India a bottom-up entrepreneurial approach,” Bastyr says.

Grammer says clients must be aware of the run-up in India and China and must be selective in investment decisions: “There is a greater likelihood that they will fall than go up.”

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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