China: The Elusive Hedge



China: The Elusive Hedge

As Foreigners Gain Access to Market,

Shares May Lose Some Allure

By ANDREW BATSON

June 27, 2006; Page C14

BEIJING -- In the market rout that began in May, nearly every major stock index in the world declined. The only exception: China's Class A shares, which are traded on exchanges in Shanghai and Shenzhen. They notched a 17% gain for May, when world stock markets fell 4.7%, as measured by Morgan Stanley Capital International's indexes.

Finding assets that rise when everything else is falling is one of the holy grails of investing. Particularly in recent years, investors have looked at an ever-wider variety of assets -- Hungarian bonds, Icelandic stocks, Japanese real estate -- to cushion their portfolios from a decline in any single market.

So the Chinese markets' lack of correlation with other major stock markets, in theory, makes them an attractive diversifier, or hedge. The capital controls that make the Class A share markets largely off-limits to investors outside mainland China insulate those stocks from the ebb and flow of shares elsewhere.

China offers a good example of how difficult it is for investors to find unique assets in a global financial system awash with cash. Just as putting money into China's Class A shares is becoming somewhat easier for outsiders, the stocks are showing signs of moving more in sync with global markets -- and thereby losing some of their special qualities.

In existence since the early 1990s, the Class A shares are denominated in Chinese yuan -- a currency that isn't readily convertible -- and have often been overshadowed by the bigger and more open stock market in Hong Kong. A combination of capital controls and heavy regulatory influence has made the $540 billion Class A share market perhaps the most isolated major-share market in the world, moving all but entirely to the beat of its own drummer.

A simple statistical analysis by The Wall Street Journal shows that Class A shares have had a correlation of around negative 50% with global stock markets over the past five years -- meaning that when world markets are up, the Chinese market is actually down about half the time, and vice versa.

That is largely because of the strong influence of government policy. Starting in 2001, local investors lost confidence in market regulators' ability to support prices, leading to a prolonged selloff. In recent months, however, regulators found an investor-friendly way to push through changes to the complex share structure of listed companies, and share prices rallied.

The Chinese stocks most widely held by mutual funds and other foreign investors -- those listed in Hong Kong, or as American depositary receipts in New York -- are less affected by such concerns, and their performance isn't as peculiar. The MSCI China index of overseas-listed Chinese shares has a correlation of 92% with the broader global market in the past five years, and of 97% with the emerging-market index, showing that they almost always move up and down together.

China has offered big investors some access to the Class A share market, though the current group of qualified foreign institutional investors is permitted to invest a combined total of no more than $7.15 billion in domestic securities. As the government gradually relaxes those limits, foreign investors will play a bigger role in driving market movements.

"I wouldn't expect the correlation to increase dramatically or suddenly, but once China's capital outflows have been liberalized, then obviously the Chinese stock markets will become more closely plugged into the global financial system," says Geoff Lewis, head of investment services at JF Asset Management Ltd., which this month launched a Hong Kong-registered mutual fund investing in Class A shares.

Research by Éric Girardin of Université d'Aix-Marseille II in France and Liu Zhenya of Renmin University in Beijing suggests that the Chinese markets show an evolving relationship with international stock markets over the longer term, even though daily or weekly movements don't track closely. Since 2001, they argue, Class A shares have used the Hong Kong stock market as an "anchor." This means the two markets are converging to a common level of valuation for stocks, as measured, for instance, by the price/earnings ratio for companies.

This has implications for investors trying to assess the diversification benefits of Class A shares, especially those looking to the longer term. "If the investor's horizon is, say, more than a month, then it is worth looking at," Dr. Girardin says.

In 2006, the Class A share market has gone from a negative to a positive correlation with other world markets, though one that is still fairly low. So far in June, Class A shares are down 1.2%, compared with a 2% decline in world markets, as measured by MSCI.

Yesterday's Market Activity

Asian markets closed mostly higher yesterday, as the end of a merger battle in the European steel industry lifted shares of large industrial groups. Major European markets closed in the red as lower oil and gas stocks offset gains from deal activity in a market nervous ahead of this week's Federal Reserve interest-rate meeting.

In Tokyo, the Nikkei Stock Average of 225 companies ended up 28.36 points, or 0.2%, at 15152.40, its highest level in three weeks. Investors snapped up large industrial issues on expectations that the companies could become targets in the ongoing consolidation wave. Kawasaki Heavy Industries increased 3%, and Sumitomo Metal Industries rose 2.2% Consumer-finance shares were lower on media reports that regulators are considering tightening rules governing repayment periods and capping interest rates on credit loans at lower levels. Aiful, Japan's biggest consumer lender, fell 2.5%.

In Mumbai, the Bombay Stock Exchange's 30-stock Sensitive Index, or Sensex, plunged 370.87 points, or 3.6%, to 10042.06. Tata Steel fell 6.9%, and Steel Authority of India slid 7.6%.

In Seoul, shares of Hynix Semiconductor rose 9.2% after the company and its creditors completed a disposal of shares at a smaller-than-expected discount. Makers of liquid-crystal displays rose on bargain hunting after a recent selloff and on hopes industry conditions will improve following announcements that companies have scaled back production amid high inventories. LG.Philips LCD increased 6.8%, and shares of Samsung Electronics, the world's largest LCD maker by revenue, rose 2.5%.

In Taipei, LCD maker AU Optronics rose 1.8% while rival Chi Mei Optroelectronics increased 3.8%.

In London, the FTSE 100 index ended down 10.90 points, or 0.2%, at 5681.20. Oil companies BP and Royal Dutch Shell slipped as crude-oil futures traded down.

In Sydney, Smorgon Steel Group surged 32% after rival OneSteel announced a friendly 1.6 billion Australian dollar ($1.17 billion) cash-and-stock takeover for the company. OneSteel rose 3.5%.

Write to Andrew Batson at andrew.batson@

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