The Shenzhen and Shanghai stock exchanges experienced an historic decline on February 27th, plunging 9.2%, the largest decline in a decade.  Is this drop attributable to changing stock values, or are financial bubbles to blame?

Tuesday's plunge wiped out US$107.8 billion from a stock market that had doubled over the past year, and followed on the heels of record numbers at the Shanghai index, which reached above 3,000 points on Monday after Chinese New Year.  The index soared  130% last year, and had already risen 14% in 2007.

The rapid decline is being attributed to various factors: concern over the government's crackdown on investments with borrowed money; potential capital gains taxes on stock investments; interest rate hikes, or likely measures to be announced by the People's Congress next week investigating illegal activities in the marketplace.

As various measures to levy the pace of how capital enters the Chinese market cannot dramatically change market liquidity, will any fundamental changes result from the plunge?

Industry analysts are concluding that the current market demonstrates a certain level of structural over-evaluation of asset values.  Some stocks were at 40x their price-earnings ratios.  In this sense, the decline in individual stocks can be seen as resulting from natural adjustments to bring them back to rational values.  In a market where liquidity is accumulated, estimated P/E ratios are bound to decline, and re-evaluation of capital product values will still continue.

Rumors of a government crackdown on investments with borrowed money and investigations of illegal activities in the market surrounded the plunge.  Some believe that the market's concerns over a shortage in capital supply undermined investors' interests in the stock market, leading to a rapid decline.  However, although the mainland is a comparatively isolated market that is more vulnerable to local factors, it is unlikely to alter the continuous accumulation of liquidity with Yuan appreciation, even if rumors do translate to actual practices that hit a portion of the capital supply hard.  Since the end of 2006, a significant amount of capital flowing into the stock exchange has been diverted from Chinese deposit savings, and government measures concerning borrowed money would likely have a limited impact on this particular source of capital.

When sensitive investors become emotional, capital from smaller and private investors will likely be adversely affected in the short run.  The plunge negatively affects fund investments, and many are likely to sell out.  Yet there are two types of private investors who are not pessimistic about the stock market's prospects.  The first are investors who have invested for a relatively long time and have many stocks on hand that have multiplied in value.  The second type consists of new investors who are ready to invest in the stock market.  For them, a decline in the stock exchange signals lower investment costs.

China's stock exchanges have undergone rapid development within a short timespan, and in this scenario problems and declines are inevitable.  In the long run, market transparency and security measures will be needed to ensure sustainability.  But does the plunge indicate bubbles in the Chinese stock market?

Credit Lyonnais Securities Asia (CLSA) Managing Director Richard Humphry said that financial bubbles are closely associated with listed companies' valuation and P/E ratio, which indicates a company's level of quality.   P/E ratios of general companies are around 25:1 in the US, 22:1 in the UK, and 12:1 in Hong Kong.  In contrast, in China P/E ratios a few years back reached 100:1 and are currently hovering around 40:1.  This can create dangerous conditions for bubbles.

"Many private investors do not invest through securities agencies or other intermediaries.  They prefer handling their own investments according to their own judgment.  This is partly because China's stock prices are relatively lower, and the stock market's threshold is also lower," said American investor Joshua H. Dominick.  'Therefore, an influx of overseas capital is positive in terns of raising the stock market threshold and stock prices.  With more professional and experienced investors involved, a more stable and rational investment psychology can help reduce market risks."

Humphry added that, according to some analysts, "an inadequate legal system underlies China's stock market problem.  Although China's securities and investment industries still need more laws and regulations, the ultimate problem is not an inadequate number of laws, but rather inadequate execution and monitoring.  Some authorities fail to execute established laws altogether.  Investor confidence and interests are guaranteed by the strict execution of market regulations that ensure security and fairness.  Securities firms in china need to work on human resources, management and profitability." Undisciplined behavior that adversely affects market performance can be minimized only when these bodies raise their level of quality and controls.