China Policy Helped Fuel Bubble

The 40% decline since October in the Shanghai Stock Exchange's composite index of Chinese-listed shares has coincided neatly with the global financial-market rout. For a government worried about what would happen when the country's 100 million speculators found their portfolios suddenly plunging, this probably is a relief. Beijing can, after all, point the finger at all those subprime mortgages in Florida. That isn't to say the credit crunch hasn't contributed to China's stock-market decline. Its newbie class of equity investors sees many of the same headlines as the rest of the world's punters. And they know the country's sovereign wealth fund, China Investment Corp., has been called upon to bail out ailing financial institutions on Wall Street. Still, global market sentiment isn't the only force at work. China tightly restricts the flow of foreign capital into the Shanghai and Shenzhen stock markets. To blame the recent slide solely on hedge funds and international investors dumping their holdings of Chinese stocks, as Zhou Xiaochuan, governor of People's Bank of China, did this month, is a stretch. The government's own policies surely helped inflate the bubble, which saw the Shanghai Composite index rocket more than 400% in two years. In addition to limiting foreign investment, the government caps the flow of domestic money destined for international stocks. Moreover, the lack of capital gains or inheritance taxes, with only a nominal stamp duty imposed on stock investments, arguably helped fuel share-price inflation. The bubble's deflation has, not surprisingly, damped the erstwhile ebullience of the Chinese market. But rising inflation is a more fundamental threat. Producer prices last month rose 6.6% from a year earlier. Chinese companies will need to pass these higher costs on to their customers if they want to keep profit margins intact. That is a tall order. The Beijing government is alarmed by the rise in consumer prices -- which hit a near 9% annual pace last month. That may not sound scary with the economy growing at an 11% clip. But because the average Chinese household spends a third or more of its wages on food, the worry is that rising consumer prices will fuel social unrest. The headline-grabbing protests in Tibet might be a harbinger of what could happen elsewhere. With the Olympic Games coming to Beijing and the world watching, the government may take more extreme measures to combat inflation. Already it has forced banks to put aside more reserves, which it hopes will reduce lending. It has done this repeatedly in recent years, to little effect. Among other options are further price controls. These might damp food prices, but as the U.S.'s Nixon administration learned in 1971, controls often just make goods disappear from shelves. Either way, companies would bear the brunt of restrictions on their ability to pass on higher costs to consumers. More radical measures could include allowing the Chinese currency to revalue at a faster pace. That would help curb inflation by making imported goods -- including energy, raw materials, grains and meat -- cheaper. It also would slam the export sector. Higher dollar prices for goods at the very moment big clients like Wal-Mart Stores are seeing customers tightening their belts could lead many manufacturers to close shop. Of course, there are companies in China whose businesses can withstand inflation. Morgan Stanley points to infrastructure plays like Jiangsu Expressway; airports; telecom operator China Mobile, and coal-miner China Shenhua Energy as potentially safer havens. And a year or two of clipped earnings might seem a small price to pay if it enables the government to prevent upheaval among China's 1.3 billion people. But Chinese investors thinking their portfolios have been hit by nothing more than subprime fallout should prepare for worse to come.