The Truth Behind a Bubble in China

By Markets Fool.com

The Chinese economy has been red hot for decades now, routinely experiencing double-digit annual GDP growth driven by massive investment in industry and exports. Many observers, however, think that the Chinese economy has gotten ahead of itself and today sits on top of a massive bubble. Some even think that the bubble has already burst. They point to higher debt levels, slowing GDP, and more recently, ridiculous volatility in the Chinese stock market. Does the Chinese market still have legs, or is this really the moment the bubble bursts?

Continue Reading Below

Buckle your seat belt
Over the last three months the SPDR S&P China ETFhas climbed over 18%. That was driven by a remarkable 21% jump from March 16 to April 16 alone. Since May 5 though, the ETF is down over 4%.

As big as those swings are, they're actually pretty stable compared to the exchanges on the Chinese mainland.

The Shanghai Stock Exchange, for example, popped over 2% on May 26 to a seven-year high. Two days later, the Shanghai dropped a dizzying 6.5%. Another Chinese exchange, the Shenzhen dropped 5% on the same day. The Shanghai and Shenzhen are up 125% and 160%, respectively, over the last 12 months.

The bubble theorist's claim that the rapid rise in the Chinese market is being driven less and less by solid fundamentals, and instead by speculative trading from everyday Chinese. Chinese brokerage firms have raised over $14 billion in new capital this year alone, almost half of which has been used to fund investing on margin.

In my view, the market volatility alone is insufficient to make any real judgement about a bubble. Some of the recent declines were driven by mechanical reasons related to Chinese central bank requirements and margin lending requirements. Those drivers aren't indicative of China's future economic prospects.

Continue Reading Below

From a valuation standpoint, Chinese companies don't seem to be in bubble territory. The CSI 300 Index (a Chinese index similar to the S&P 500 in the U.S.) has a forward price to earnings ratio of 18.1 for 2015 projected earnings, and 15.5 for 2016. Expensive? Debatably so, but definitely not bubbly.

It's stressful if you're watching the markets every day -- a 6.5% one-day market drop would turn even the strongest stomachs -- but that in and of itself doesn't mean the market has advanced too far, too fast.

What about the economy's fundamentals then? Are they bubblicious?
Over the past two years, the Chinese economy has grown at around 7.5% annually. Current estimations for this year's growth are lower at about 6.7%. That's still brisk growth; it's just a considerable deceleration by Chinese standards.

In reaction, the Chinese government has attempted to engineer a "soft landing" for the economy. The Chinese central bank has lowered interest rates multiple times, injected liquidity into the markets, and has announced initiatives to increase spending on the nation's infrastructure. It's too early to tell if these actions will succeed in creating a "soft landing," but it's a proactive move that economists and investors have applauded.

Chinese industrial profits have been stronger recently, and consensus estimates project corporate earnings to rise 12% in 2016 following a relatively flat 2% increase this year. The driver of that growth is gradually changing though, as noted by ChinesePresident Xi Jinpingin his government work report released earlier this year. Jinping suggested that future growth would come from innovation and rely less and less on investment and government input.

It's also critical to remember that China has the largest working age population in the world, and per capita GDP remains relatively low. The sheer mass of workers -- and also consumers -- gives China an economic engine unrivaled in the world today.

So, has the bubble burst?
Based on the reasonable valuations of Chinese firms in terms of the price-to-earnings ratio and also the government's clear willingness to interfere in the markets to create a "soft landing," I do not see the Chinese economy in any immediate danger. If there really is a Chinese bubble, it has not yet burst.

However, over the long term, the Chinese have very serious issues to overcome. The shadow banking system, speculation in both real estate and equities, and shifting population demographics, in my view, do put a ceiling on just how high the Chinese economy can climb.

But for investors in the Chinese market today, that ceiling remains far from being reached.

The article The Truth Behind a Bubble in China originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.