Chen Daofu

I. China's Fundamental Economic Conditions Are Able to Support the Sustainable Development of its Stock Market Although Some Structural Irrational Development Is Already Visible at Present

China's stock index has risen from the lowest 998 points in 2005 to the current level of more than 4,000 points, increasing by three times within less than 2 years. Objectively speaking, this surge at the beginning reflected the correction to the originally under-estimated value following the non-tradable share reform, and it was also linked with the sustained rapid growth of national economy and the continuously increasing profit of listed companies. But the following factors show that some irrational signs have already appeared in the current stock market. First, concept speculation becomes more and more frequent in the market. At one time, institutional investors became so cautious that they were left with no chance to buy because the stock price had been driven up rapidly by individual speculators. Staff members of many listed companies didn't even dare to hold their own companies' shares. Second, the gap between A shares and H shares becomes increasingly large. Third, turnover rate is close to historical high record during the surging period of the market and the number of newly opened stock exchange accounts has far exceeded the historical high record.

There are disagreements over the judgment of the market's price-earning ratio (PE). With the stock index staying at about 4,000 points, the market PE should be at about 40 times if calculated on the basis of the profit level in 2006. According to the profit data collected during the first quarter of 2007, however, the dynamic PE ratio is only about 30 times. A dialectical approach should be taken to judge this issue. First of all, China's macro economy has maintained a sustained and rapid development in recent years with companies' profit increased continuously. In 2006, the profit of listed companies increased by 26.24% over 2005, and the profit level of the first quarter in 2007 witnessed an increase by 1.37 times over the same period of 2006. All these factors have constituted support to the sustained development of the stock market and they are expected to last for quite a while. On the other hand, the profit data of listed companies need to be treated cautiously. First, a major source of the increased profit was a much more investment return, which was a result of listed companies holding each other's shares and may also reflected the fact that some listed companies carried forward during the current bull market some concealed profit from previous years. The return of investment in 2006 was 75.2 billion yuan, up by 1.38 times compared to 2005 and accounting for 14% of total pretax profit. The return of investment in the first season of 2007 was 54.8 billion yuan, up by 6.5 times compared to the same period of 2006 and accounting for 22% of total pretax profit. Second, the profit growth in 2007 was linked with the modification of accounting system which brought forth one-time income which led to a 10% profit growth in the first quarter. Third, mergers & acquisitions, restructuring and IPOs all can significantly influence the profit level. Although the quality of listed companies were greatly improved, the profit data was not comparable with previous years.

To sum up, it is not advisable to judge whether there exist bubbles in the current stock market only based on PE level. Both the components of current profits and growth sustainability need to be taken into account. Although being rational to some extent, the rapid growth momentum at present has shown some irrational elements, or structural irrationality, i.e. the market has both blue-chips with low PE level and junk stocks with high PE level.

In this case, it should be recognized that the structural irrationality for the most part reflects the deficiency of the stock market system, rather than just the problem of speculations. In a stock market consisting only of a main board market where going public must pass strict formalities, a listed company is a valuable "shell" resource and would not be given up easily. Therefore, assets restructuring such as capital injection or borrowing "shell" occurs with a high probability. In a mature market, these events are not likely to cause big fluctuation in stock prices because all transactions are equivalent. This is not the case in China, however, due to the existence of market segmentation and hence the liquidity premium between assets of listed companies and that of non-listed ones, as well as the fact that transactions are not conducted according to market values, which is related to China's state-owned assets management system. Due to the deficiencies in the design of stock index composition, plus the much attention of the government to the excessively fast growth of the index, most investors tend to take a cautious attitude over the rise of blue-chip stocks. Therefore, it might be more important to change these distortions than to educate investors.

Secondly, "speculations" could not be effectively suppressed simply by raising transaction cost. The first reason is that investment and speculation cannot be differentiated simply through such indicators as blue-chip stocks, price earning ratio or turnover rate. The second one is that capital market is always accompanied by speculation and that we should not restrict the development of capital market while suppressing speculations. In other words, speculations should be properly guided so as to develop the stock market. The third reason is that, tax is based on state power and should not be easily used as a frequent means to adjust stock market, but rather, it should be targeted at long-term strategic goal.

Thirdly, it is not necessary for the government to judge whether a rise in stock prices is reasonable. The judgment should be left to the market. Even for blue-chip stocks, excessive price hikes are not always justifiable.

II. Monetary Policy Should Take into Account the Development of Assets Market without Intervening Assets Prices. The Benchmark Interest Rate Should Be Raised Appropriately

There are different opinions among international scholars as well as the implementation of monetary policies over whether assets prices, especially stock prices, should be taken as an object for regulation by central banks' monetary policy. One universally accepted opinion is that, a central bank should not intervene as long as the fluctuation is not caused by distortion, no matter how big the fluctuation is. Otherwise, the central bank should be concerned with the fluctuation. However, considering the fact that assets market regulation requires intense monetary policy and the difficulty to choose the right time for intervention, most central banks are cautious on this issue because they are worried that the economy might be excessively tightened.

Different opinions also exist within China's central bank. In a short time, it is rather difficult to determine the necessity to do so in both theory and practice. In fact, however, there is no need to identify it. What we need now is to pay more attention to the stock market and correct monetary status which may cause abnormal fluctuations in the stock market. In Japan, maybe it is not wrong to take a relaxed monetary policy when the Japanese Yen appreciated a lot, but maintaining it for a long time regardless of the soaring assets prices and failing to tighten monetary supply timely is the main reason for the asset bubbles.

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