SHANGHAI STOCK MARKET DECLINES: DID THE BUBBLE POP?

UNCLAS SECTION 01 OF 04 SHANGHAI 000133

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E.O. 12958: N/A
TAGS: EFIN EINV CH
SUBJECT: SHANGHAI STOCK MARKET DECLINES: DID THE BUBBLE POP?

REF: A) SHANGHAI 25; B) BEIJING 461

SHANGHAI 00000133 001.2 OF 004


(U) This cable is Sensitive but Unclassified. For official use
only, not for dissemination outside USG channels.


1. (SBU) Summary: The 8.8 percent fall in the Shanghai Stock
Exchange (SSE) composite index on February 27 that stunned
international markets was a much-needed and overdue correction
according to Consulate contacts. Market volatility, speculative
retail investors, profit-taking by institutional investors and
attempts by the Chinese government to rein in the market's
growth all contributed to the market's largest decline in 10
years. Market analysts believe that the market fundamentals are
sound and the success in 2006 of stock market reforms and the
underlying growth prospects for most stock market-listed
companies mean that this correction will not presage a bear
market. End summary.


2. (SBU) On February 27, the Shanghai Composite Index fell 8.8
percent to close at 2,772. This was the index's biggest decline
in ten years, since February 18, 1997 when it fell 8.9 percent.
The 8.8 percent fall came the day after the index rose to its
all-time high of 3,046 on February 26, having risen 14 percent
so far this year. In 2006, the market rose 130 percent (Ref A).


3. (SBU) According to SSE Head of International Affairs Li Qian,
on February 27, turnover in Shanghai A shares was 128 billion
RMB (16.5 billion USD) -- higher than the previous daily record
of 108 billion RMB set in January 2006. She said that a total
of 835 Shanghai stocks closed lower while 33 actually had gains;
more than half of the shares dropped to the 10 percent daily
limit allowed by Chinese regulations.

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Institutional Selling Triggers Panic...

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4. (SBU) Li said that the SSE was analyzing the February 27
trading patterns in an attempt to understand what happened.
While no conclusions had been reached, she said that SSE
consensus was that, after the market broke through the 3,000
point barrier on February 26 for the first time, institutional
investors wanted to lock in profits and sold off some of their
holdings. She added that fund managers also needed to liquidate
some holdings in order to fund dividends on profits from the
last quarter that were due in March. This selling prompted "a
panic" by retail investors who then rushed to sell off their own
holdings. Li told Econoff on February 28 that retail investors
would likely sell off a lot of their portfolio in the next two
days of trading.

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...Rumors Feed the Fire...

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5. (SBU) Market experts, who spoke with Econoff on February 28,
noted that individual Chinese investors were very susceptible to
the rumor mill and that this had contributed to the
panicked-response to the sell-off of stocks by institutional
investors. Haitong Securities Firm Vice Director Wu Bing told
Consulate Econ Assistant on February 28 that there were three
main rumors that had contributed to the sell-off. These were:
the Chinese Security Regulatory Commission's notice that it
would crack-down on illegal stock trading; a rumor that the
long-awaited stock index futures market would soon open; and a
rumor that the government would begin collecting a capital-gains
tax on market earnings.


SHANGHAI 00000133 002.2 OF 004


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...But Institutional Traders Not Surprised

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6. (SBU) Lombarda China Fund Management Chief Investment Officer
Ian Midgely told Econoff on February 28 that, since market
volatility had recently been over 40 percent, the market
sell-off was "not really surprising; in fact, it was to be
expected." What had been a surprise, he said, was the size of
the drop. He noted that, given the speculative nature of most
Chinese retail investors, Chinese stock markets were vulnerable
to quick pullouts.


7. (SBU) In the next couple of days, the market could decline
another 10-15 percent, Midgely said, but should not present a
serious problem to a market that had risen so high so fast. In
the long term, he said, there would be increased flows of
institutional money into the market. This would provide a
stabilizing effect and the market should not decline further.


8. (SBU) Midgely observed, "This is not 2001; the market is
fundamentally much more sound. This is not the start of a bear
market." He based this analysis on the successful stock market
reforms and the fact that the average profit growth forecast for
SSE-listed companies was 30 to 40 percent for both 2007 and

2008. Midgely said that the market's valuations were good and
that he was looking forward to picking up some bargains for the
fund he managed.


9. (SBU) Other Consulate contacts said:

- "People are worried that there might be more tightening
measures taken by the government, such as its aim to crack down
on the illegal investments that helped drive benchmarks to
record highs." (Daiwa Asset Management Fund Manager Mono Chung)

- "It's not a bad thing to have a healthy correction since it
provides an opportunity to correct over-valuations and allows
people who have missed out of the past rally to start buying."
(SG Asset Management Chief Investment Officer Winson Fong)

- "This market tumble was unexpected for most retail investors
and a snowball chain-reaction led to a free-falling A share
market. ... On the other hand, this type of correction provides
investors a re-entry point to accumulate undervalued stocks."
(Sinopac Securities Research Analyst Sky Hong)

- "Although we didn't forecast the timing or the large size of A
share sell-off, the consensus among institutional investors was
that a correction would occur after the Chinese New Year. We
think that high volatility will carry through the entire year in
2007, but at the end, we believe the A share will have gained
further ground from its 2006 surge." (Guotai Junan Asset
Management Fund Manager Ruo Lei)

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Can You Slow A Bubble Without It Popping?

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10. (SBU) Beginning in late January, the Chinese government
began sounding alarms about the danger of over speculation. In
a late January report in the government-controlled China
Securities Journal, the China Banking Regulatory Commission
(CBRC) issued a circular that warned banks to be on the alert
for any personal loans from their clients that might be misused
for stock speculation. On February 2, China Central Television
(CCTV) broadcast a report, citing an unnamed source at CBRC,

SHANGHAI 00000133 003.2 OF 004


that after the Chinese New Year celebrations (February 19-25),
the CBRC would launch a series of country-wide bank inspections.
These inspections would focus on banks loan portfolios, and in
particular mortgage loans, which had been misused to purchase
stocks. The CBRC source said that commercial banks were
required to stem the flow of bank loans flowing into stock
markets and mutual funds.


11. (SBU) The government campaign to cool market speculation
continued with the January 25 CCTV broadcast of an interview
with James B. Rogers, Jr. (co-founder with George Soros of the
Quantum Fund and highly regarded by Chinese investors). Rogers
warned that Chinese A shares were overvalued and a bubble was
forming. According to a January 25 Financial Times report,
Standing Committee of the National People's Congress Vice
Chairman Cheng Siwei said that about 70 percent of domestic
A-share companies were not worth investing in, and urged
individual investors to make rational decisions even in a bull
market to ward off risks posed by market bubbles.


12. (SBU) On January 26, State-Owned Asset Supervision and
Administrative Commission (SASAC) Director Li Rongrong
instructed state owned enterprises (SOEs) not to engage in
speculation in the share market. (Note: SASAC controlled more
than 770 SOEs that are listed on Chinese equity markets. End
note.) Li also announced that SASAC would establish an
information-sharing process with the Chinese Securities
Regulatory Commission (CSRC) to monitor SOE capital flows to
make sure that these funds were not entering the equity market.

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Just What the Market Needed

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13. (SBU) Goldman Sachs (China) Chief Representative Xiong Xiong
said on February 28 that these warnings had been necessary in
order "inject some rationality in an otherwise irrational
market." He saw the February 27 correction as "long overdue"
and hoped that the market would not rebound too quickly since
such a rebound would "give retail investors even more euphoria
and push the market to an even higher extreme." Without a dose
of rationality now, the effect of the "ultimate correction would
be even more severe," he said. Xiong believed that a further
decline of 3-4 percent through the end of trading on March 2
would provide an opportunity for speculative investors to
realize the dangers inherent in the stock market.


14. (SBU) Xiong's biggest concern was that Chinese officials
would overreact to the shock of the correction and begin
back-tracking on their statements questioning the soundness of
the market's recent gains. He said that he had already heard
that this was happening and that officials might back off, or
clarify their previous expressions of caution, in days to come.

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Stability More Important Than Gains

--------------


15. (SBU) SSE's Li noted that the Chinese government wanted to
have a successful and stable stock market going into the
People's Congress in early March. That is why, she said, there
were "lots of messages coming out to clarify the rumors that
everyone was pointing to." PRC officials were hoping to dispel
the rumors in order to promote stability. The government would
like to influence the market so that it goes up in the next
couple of days. "But the market is a market," she said.


SHANGHAI 00000133 004.2 OF 004



16. (SBU) In a separate conversation, Haitong Securities' Wu
agreed with Li's assessment. He pointed to the January 19-20
Chinese government financial conference (Ref B) where Premier
Wen Jiabao's reportedly said, "Although the stock market
performance was very good in 2006, the stock market in 2007
shall be stable." Wu told Econ Assistant that the Chinese
securities industry interpreted this remark to mean that,
although the central government would like to maintain the bull
market, it was more concerned about the risks posed by the
speculative bubble. Chinese regulators, according to Wu, needed
to find a way to reduce speculation without "completely
extinguishing investor enthusiasm."

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SSE Doesn't Believe There is a Bubble

--------------


17. (SBU) In a February 9 discussion about the markets prior to
the recent correction, SSE Deputy Director Chao Kejian had told
Econoff that the SSE did not actually believe there was much of
a bubble. Chao said that the market was very different than it
had been in the past and had made many improvements in
disseminating market and company information to investors.
While he would not, at that time, characterize the market in
general as over-inflated, Chao acknowldeged there were "some
clearly overvalued stocks."


18. (SBU) Commenting on the ups and downs of the stock index
since January 1, 2007, Chao said, "The market has its own
cycles," and attributed the declines to institutional investors
locking in profits from the gains in their blue-chip portfolios.
"Blue chips are heavily weighted in the index," and these
institutional investors are "refocusing their funds towards
mergers and acquisitions of smaller companies.JARRETT