Is a China Stock Bubble Forming?

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Qilai Shen / Bloomberg News / Landov

Investors monitor stock prices at a securities exchange in Shanghai on May 7, 2009

When the outlandish stock-market events of 2009 are tallied up, the initial public offering (IPO) in Hong Kong of Chinese herbal shampoo maker Bawang International will be a standout. Within 10 minutes of the June 22 opening of the subscription period for shares, one local brokerage, Bright Smart Securities, was swamped with the equivalent of $129 million in orders. In all, the shampoo company received more than $9 billion in orders from Hong Kong retail investors for an IPO that initially sought to raise just $215 million.

Such examples of excessive investor ardor for new Chinese stocks aren't hard to find. Shares of Chinese water-treatment-equipment supplier Duoyuan Global Water soared 37% on June 24, its first day of trading on the New York Stock Exchange. Back in Hong Kong, Chinese thenardite producer Lumena Resources (thenardite is a key ingredient in powder detergents, textiles, glass, chemical feedstock and pharmaceuticals) rang up 19% in gains on June 17. On June 22, the IPO of China Metal Recycling closed 22% higher.

Have Ben Bernanke's green shoots magically turned into tropical forests overnight? Hardly. There may be some justification for how stock-market indexes in the U.S. and Hong Kong have soared from their lows in March, when it seemed the global economy was sliding off a cliff. But this incipient IPO mania is a different story. Investors are bidding up the stocks of Chinese companies not because their shares had been unfairly pummeled, but because of expectations for future growth that may or may not pan out.

The thread that binds them is the China story. The Organization for Economic Cooperation and Development recently revised its GDP growth forecasts for the country from 6.3% to 7.7% in 2009 and from 8.5% to 9.3% in 2010, on the back of government stimulus spending that appears to be making up for a steep drop in exports. The World Bank has also raised its 2009 forecast from 6.5% to 7.2%, and projects that China will replace Japan as the world's second largest economy in two years.

With China one of the few economies that's showing an economic pulse, a lot of the cash that's been sitting on the sidelines is piling into almost anything Chinese, driving stocks to lofty valuations. Bawang's IPO, for example, which begins trading on July 3, is expected to be priced at more than 20 times the earnings it reported as a private company last year.

Such rich multiples are unjustified in a recession. Duoyuan is seen as a direct play on China's $585 billion stimulus-spending program, which is focused on infrastructure projects like water and sewer systems. But for the company to benefit (it manufactures equipment for wastewater circulation and filtration), government money must actually go to infrastructure building and not be wasted through inefficiencies and corruption. Bawang, which competes with P&G and Unilever, among other companies that make personal-care products, is supposed to ride China's rising personal consumption. That may be a dicey proposition in a country of thrifty citizens who have long been accustomed to saving nearly 40% of their disposable household income.

Like the dotcom and property bubbles before it, the nascent IPO mania is being inflated by outsize expectations and good old-fashioned greed. Retail investors are growing tired of keeping their cash in banks that pay next to nothing in interest and are increasingly fearful of missing out on the stock market's continuing rise.

With the IPO market suddenly booming, China's companies are only too happy to indulge pent-up investor demand. The crash in global markets had virtually shut down new listings. Only two Chinese enterprises went to market in the U.S. last year, down sharply from 29 in 2007. Now there's a rush to list. Accounting firm Ernst & Young says it is working on 108 IPOs; most of the offerings are by Chinese companies planning to list in China, Hong Kong or both. Meanwhile, Chinese technology firms are expected to head to the U.S., which has long been the market of choice for cutting-edge companies.

All bubbles eventually have the air let out of them, sometimes with disastrous results. The danger today is that overheated enthusiasm for Chinese offerings may end very badly, particularly if the vaunted green shoots of global economic recovery were to turn out to be no more than yellow weeds.