By Frederik Balfour (Business Week)
Updated: 2007-01-26 11:41

Coming Chinese Stock Correction

The procession of quality companies raising money at the two domestic exchanges is definitely a plus for their long-range development and the emergence of an investor class in China. But that doesn't mean there won't be some dramatic times ahead for local investors who have been enjoying stunning returns over the last year or so.

The shares of Chinese companies listed in Shanghai are up 130% during the past 52 weeks and the one-year return at the smaller Shenzhen bourse is 125%. That's pretty frothy, and few analysts see domestic investors getting through 2007 without some sort of sharp correction. Frank Gong, China economist at JP Morgan, is looking for a 10% to 15% downturn in these two indexes where the "risk-reward situation is now not attractive."

The catalyst could be the introduction of index futures expected sometime during the first half of the year, giving Chinese investors the ability to short the market for the first time.

A bracing correction would actually be a desirable thing, most market watchers say, given the unrealistic valuations being accorded some sectors, especially financial stocks. The long-term outlook for A shares is exceedingly bright given the growth curve China is expected to ride the rest of the decade. And the availability of derivatives should help smooth out some of those gut-wrenching market swings that have characterized Chinese markets since their inception in 1992.

Mother of All Bank Makeovers

Few outside of the mainland probably have ever heard of the Agricultural Bank of China. Yet it's a monster lender (the second biggest behind ICBC) with roughly $614 billion in assets and a network of around 28,000 branches. One of the big decisions to come out of the Wen-led financial policy talks was the nod to recapitalize and ready the Agricultural Bank for an IPO, probably sometime in 2008.

It is the last of the four big national state-owned banks slated for an overhaul—and it has about $90 billion in nonperforming loans on its books. Getting this lender ready for prime-time could require an injection of up to $140 billion from the government, according to Standard & Poor's.

Though the bank has a good share of the home mortgage business in the cities, the bulk of its branches are scattered among the less developed and poorer regions of the country that have largely been left behind by China's massive economic juggernaut. The widening urban-rural income divide is uppermost on Beijing's mind, and making credit more widely available to the countryside is a major component of narrowing the gap.

"Getting rural strategy right and improving income levels in the rural sector is absolutely critical for the next stage of economic development," says Dong Tao, Asia chief regional economist at Credit Suisse (CS).

While a cash infusion might enable the bank to write off its dud loans and get its balance sheet looking healthier in readiness for a possible listing in 2008, the bank faces the much tougher challenge of improving risk management and credit assessment. Attracting strategic overseas investors is also likely to be tough. The bank is a huge employer, and getting government approval for layoffs and radical restructuring would be a tall order.

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