The Coming Chinese Crash?

I believe the Chinese stock market is primed for a crash. The question is how a crash will impact the blistering Chinese economy, as well as markets and economies around the world, including those of the U.S. I expect substantial global ripples -- and problems in China.

When I say Chinese stock market, I mean the market that Chinese residents -- and only a few outsiders -- can invest in. These are Chinese "A" Shares. Market tumbles can be contagious, as we learned again on February 27, when the Shanghai A shares plunged 8.8%, touching off a 416-point fall in the Dow Jones industrial average.

The Shanghai market is a thing to behold. Since January 2006 through June 11, it has soared 248%. Chinese investors are reportedly opening 350,000 new brokerage accounts per day, compared with a total of 3 million all of last year. James Stack, president of InvestTech Research, a Whitefish, Mont., advisory firm, visited a Chinese textile factory recently and heard a worker bragging about her stock-market profits.

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Chinese stocks aren't much like U.S. stocks. The government owns big stakes in almost all the companies. The kind of reporting and accounting transparency we're accustomed to in the U.S. and other developed nations is absent in mainland China. Yet some of the A shares have gone public in the U.S. in the form of American Depositary Receipts that trade on Nasdaq. If you own of these, I suggest you sell now.

"People don't realize they have the state to deal with," says David Herro, manager of Oakmark International fund (symbol OAKIX), which currently owns no Chinese stocks. "Frequently, the state makes some very big decisions, and these may or may not be in your interest."

Then there's the little matter of value. Based on analysts' estimated 2007 profits, price-earnings ratios average 37 -- which is about double the P/Es of the Hong Kong Hang Seng index, even though both indexes hold many of the same companies. The Hong Kong market is where most foreigners invest, and it has risen less than 5% this year.

It's not just that the A shares -- with a total market value of $2.5 trillion, or more than is in all household bank accounts -- impact China's economy directly. A shares are also symptomatic of the Chinese economy as a whole, which is growing more than 10% annually (in real, inflation-adjusted terms) -- a torrid rate that even the government says is unsustainable.

But tapping on the brakes hasn't worked so far, either for the economy or the market. "If China doesn't slow its growth, how long does it go on, and does it become a serious risk to the financial system?" asks Mark Headley, manager of Matthews Pacific Tiger fund (MAPTX), my favorite Asia fund. "Do the banks continue to loan billions to white elephant projects that line the pockets of politicians?"

A veteran analyst of Asian markets, Headley says the big provinces and cities of China operate almost independently of the central government: "You have serious misallocation of capital. How does the central government reassert some authority, and say, 'You can't all build ten five-star hotels at the same time'? We all know how this ends. The government is trying to rein in spending, particularly on provincial ego projects, but it's having a real problem."

As far as stocks, Headley says it's hard to predict when the day of reckoning will come. Compared with Japan, which hit a peak in 1989 before falling into a bear market that lasted until 2003, Chinese A shares look downright cheap. The P/E ratio of the Nikkei index hit 78 before it collapsed. More important, Japanese growth was slowing when the fall began.

When the Chinese crash occurs and the economy slows, the crucial question is how the country reacts politically. "A soft landing with a gradual move to a pluralistic political society would be awesome, but that's a lot to ask for," Headley says. Indeed. What's unclear is whether the Chinese government has the tools to manage a soft landing at all. "The Chinese economy is ripe for a pullback," says Oakmark International's Herro.

How much does it spread?

Don't bet on a Chinese economic recession without global repercussions. China produces an immense amount of goods for the rest of the world, especially the U.S., and has served as a remarkable damper on inflation because of its low production costs, which enables it to sell low-priced goods. A Chinese consumer class is rapidly emerging, hungry for goods and services from the U.S. and elsewhere. Then there's the U.S. Treasury market. China's holdings of Treasuries are a huge factor in continued low interest rates in the U.S.

The bottom line: This is no time to be a hero in Asian stocks -- or in any emerging-markets stocks, for that matter. I'd certainly stay away from any China-only funds and stocks. Because the long-term growth story for China and other emerging markets is so compelling, I'd still suggest putting 5% of your stock money in a diversified emerging-markets stock fund. But before you buy such a fund, check the holdings of your broad-based foreign stock funds first. You may have all the emerging-markets stocks you need.

As for specific funds, T. Rowe Price Emerging Markets Stock (PRMSX) is a terrific way to invest in this risky sector. And Matthews Pacific Tiger is probably the best way to invest just in Asia, although it has more than 25% of assets in Hong Kong-listed stocks.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.