Crap Economy

China's CSI 300 Index has plunged 20 percent for the steepest drop in at least three years. It may need to fall another 20 percent if history is any guide.

The benchmark gauge of Chinese companies traded in Shanghai and Shenzhen is valued at 41.12 times earnings, twice the average ratio of 19.71 for mainland shares traded in Hong Kong. That's more than the historic premium of 65 percent that Chinese shares have commanded. Jiangxi Copper Co., the nation's second-largest producer, trades at 30.26 times profit in Shanghai compared with 11.88 in Hong Kong.

The valuation gap has widened even as the CSI 300 slipped from an all-time high and into a so-called bear market during the past four months. The last time Chinese stocks traded at a higher premium to their Hong Kong counterparts, they lost 15 percent over the next month.

``My short answer is: Yes, valuations still do need to come down,'' said David Lazenby, who oversees about $6 billion in emerging-market equities in Boston for Legg Mason Inc., the second- largest publicly traded U.S. asset manager. Compared with the 32 percent drop in the Hang Seng China Enterprises Index of mainland shares in Hong Kong, Chinese stocks ``haven't done near as much, even though they were more expensive,'' he said.

Lazenby, 45, sold all his yuan-denominated holdings, including Baoshan Iron & Steel Co., China's biggest steelmaker, at the end of the third quarter of 2007 after being ``overweight'' Chinese equities in the first half of last year.

Past Levels

For the valuation gap to narrow to its historic average, the CSI 300 would have fall to 3,696.87, or 32.52 times profit. That represents a 21 percent drop from last week's close of 4,674.55. The CSI 300 gained 2.2 percent at 1:40 p.m. local-time.

In 2007, the premium climbed to as high as 87 percent after mainland stocks posted gains that were almost three times as large as the 56 percent advance in so-called H shares, the mainland companies trading in Hong Kong.

Yuan-denominated stocks traded on the Shanghai and Shenzhen stock exchanges, known as A shares, are more expensive partly because the government limits foreign investment, preventing arbitrage with the freely traded H shares.

``Mainland stocks are different,'' Mark Mobius, 71, who oversees $40 billion in emerging-market equities at Templeton Asset Management Ltd., said from Mumbai. ``We don't want to tie our money up for years'' as part of the licensing system Beijing requires for foreign investment. Mobius prefers H shares, whose declines he says have already priced in the risks of a global economic slowdown.

The CSI 300, which entered a so-called bear market after losing a fifth of its value since October, has room to fall further, according to Gabriel Gondard, who helps manage $10 billion at Fortune SGAM Fund Management Co. in Shanghai.

Recession, Inflation

Gondard says a possible U.S. recession, the fastest Chinese inflation in 11 years and the worst winter storms in five decades will undermine the economy and slow profit growth.

The first decline in U.S. home prices since the Great Depression, record foreclosures, and higher borrowing costs are causing demand for everything from flat-panel televisions to household appliances made in China, the largest source of U.S. imports last year, to slacken.

``The valuations are a concern, the U.S. economy is a concern and corporate earnings growth is a concern,'' said Gondard. ``The dynamic isn't the same as it used to be.''

Rising consumer prices may also force China's central bank to add to its six interest-rate increases last year, clamping down on the economy just as the U.S. is faltering.

Blizzards

Chinese inflation accelerated to 7.1 percent last month, the fastest since 1997. Blizzards, ice and freezing temperatures since late January exacerbated price gains by raising transport costs and delaying road and rail deliveries to factories.

Jiangxi Copper cut production because of power and raw- material shortages. The company, which in October reported a 16 percent drop in quarterly profit, trades in Shanghai at a valuation that is 2.75 times its shares in Hong Kong. Four months ago, the premium was 2.6 times.

Earnings growth in China, which New York-based brokerage Morgan Stanley estimates will slow to an annualized 25 percent in the first quarter from 53 percent last year, may also be hobbled by falling share prices and a slew of planned stock sales.

One-third of earnings at companies with A-share listings in Shanghai last year came from investment gains as stocks soared, New York-based Citigroup Inc. said Feb. 26. About $420 billion in shares can be also sold this year as restrictions expire on institutional investors who bought stock in state-owned enterprises. That equals 11 percent of China's current market capitalization.

Faster Growth

Chan Kum Kong, who manages $15 billion at DBS Asset Management in Singapore, says shares might still gain. China, whose 2008 growth forecast of 10.25 percent would be its slowest in four years, is still expanding six times faster than the rate projected by economists for the U.S. in 2008, according to data compiled by Bloomberg.

``China's shares are definitely more attractive,'' he said. ``Domestic consumption can hold up with the U.S. slowdown.''

Aberdeen Asset Management's Nicholas Yeo disagrees.

``It's a question of valuation,'' said Yeo, 34, who helps oversee $50 billion at Aberdeen in Hong Kong. ``People argue that the growth is also higher, and hence deserves the premium, but then the growth rate is a question mark at the moment. China's not totally insulated.''