Market reforms spur China on to overtake Indian rival

The Indian stockmarket hit another record high last week, but its great rival China threatens to deliver superior returns for portfolio investors over 2006 after a period in the doldrums.

The MSCI China index, which comprises shares available to foreign investors listed both in and outside mainland China, has risen some 31% so far this year, in dollar terms.

The MSCI India index lags by a sliver, while the All Countries World Index has delivered a return of roughly 10%. This pattern of performance contrasts with the perception that investors in the Chinese stockmarket have failed to benefit from the country’s rapid economic growth. In contrast, stock prices have surged alongside the strong performance of the Indian economy since 2003.

The Indian stockmarket is up more than 240% over the past five years, compared with just 71% for the Chinese bourse. Last year, the MSCI India index rose by 33%, double the percentage return from the MSCI China index. Analysts say the improved performance of the Chinese bourse in 2006 lies partly in accelerating stockmarket reforms, which it is hoped will make Chinese firms increasingly attractive to equity investors, but also in the country’s still-surging economy.

One key reform, begun in April last year, is to eliminate a major overhang of 2.1trn renminbi ($259bn) in non-tradable shares controlled by the state. About two-thirds of shares in Chinese companies are non-tradable.

More than 300 firms have completed or begun the reform process, according to PricewaterhouseCoopers, and $25bn (13.5bn) worth of shares will become tradable by the end of 2006. Existing investors in the roughly 1trn renminbi of already tradable shares get compensation for allowing the overhang of non-tradable shares to hit the market.

Analysts hope this reform marks the start of a trend whereby Chinese companies become more sensitive to the interests and rights of profit-motivated minority shareholders, and cut back on inefficient state control. They say such a development could improve the stockmarket investment climate.

Other reforms include attempts at improving corporate governance, encouraging higher quality flotations following an extended ban on initial public offerings and encouraging more foreign institutional investment into domestic shares. All these initiatives have some way to go, however.

Meanwhile, the Chinese economy is still booming at an annual growth rate of about 10%, according to Capital Economics. Investors continue to back the appreciation of the renminbi, which is widely perceived to be undervalued.

Last month the People’s Bank of China raised its key lending rate from 5.58% to 5.85%, amid fears that the economy could overheat. Other measures to curb industry overcapacity were announced and moves to tackle land hoarding and property speculation could follow, according to Andy Xie, an economist at Morgan Stanley. omists worry that China is set for a sharp economic slowdown. Merrill Lynch, an investment bank, is underweight in China in its emerging market portfolio because of the threat of a slowdown. It says excessive investment threatens overcapacity, which can eat into profit margins. “A buying opportunity awaits a weaker domestic economy and policy easing,” Merrill Lynch says.

“The good thing is that there are still a lot of China sceptics around, and therein lies the opportunity,” argues Ezra Sun, manager of the Veritas Asian fund. “Having said that, we are taking note of the rally in Chinese stocks during past quarters, and have taken some money off the table.”

Sun says he is “only too aware of the pitfalls of investing in China” but that “the Chinese market still has a lot of potential” despite the rally. As the Chinese government tries to encourage domestic consumption growth, Sun feels there is potential for a credit-fuelled consumer boom similar to the one driving the economy in India but “of a much larger magnitude”.

In Bombay, optimism about stockmarket prospects is also the order of the day for many investment professionals, despite the already massive rise in share prices. A minority feel there could be a correction, but many still argue that the long-term case for a bull market is sound.

Even a scandal linked to the allocation of shares in initial public offerings failed to make a lasting impact on share prices. The Bombay Stock Exchange’s benchmark Sensitive Index, or Sensex, sat at roughly 12,300 points at the time of writing, close to a record high.

Foreign institutional investors have pumped just under $4.2bn into the Indian stockmarket over the first third of 2006, compared with $3.5bn over the same period in 2005. There are also signs of a growing appetite for mutual funds among domestic savers.

However, Indian stocks look pricey to analysts who examine emerging market opportunities in the round. Marc Faber, author of the Gloom, Boom and Doom Report, says the Sensex could “easily halve” if it reaches as high as 15,000 points. He thinks the Indian market will be lower in the next “six months to two years” and expects the Chinese bourse to deliver a superior return over 2006.

Meanwhile, Merrill Lynch is underweight in India in its emerging markets portfolio. It says the Indian stockmarket’s forward price-to-earnings ratio is at a 53% premium to the average forward PE for emerging markets as a whole, a development it describes as “not justified”. The bank says inflation in India could rise, pushing up interest rates. “We see that as the catalyst to take profits,” the bank says.