Chinese stocks are defying gravity in the face of a global Credit Crunch

Amid all the doom, gloom and looming uncertainty in global markets lately - at least one high-profile stock market has seen smooth sailing. The CSI 300 Index of mainland Chinese shares powered through the 5000 mark last week, closing at a new record closing high. And Chinese stocks have already shot up 147% so far this year alone!
The fact that Chinese stocks are defying gravity in the face of a global credit crunch correction doesn't really surprise me.
After all, the mainland markets in Shanghai and Shenzhen are closely controlled from Beijing. It's a game of chance where the house makes all the rules, and the government strictly regulates activity, or at least attempts to.
Of course China's fundamentals provide a certain amount of underlying bullishness to its stock markets too. Second-quarter GDP growth soared nearly 13%. Industrial production is surging 30% year over year. Retail sales just jumped 16% higher in July - the fastest pace in three years.
While Global Markets Face a Cash Crunch , China has Too Much
China's economy is poised to overtake the U.S. this year as the largest contributor to global growth, according to the International Monetary Fund. So, while the rest of the world has struggled recently with too little liquidity in financial markets, authorities in Beijing are struggling with too much .
China's foreign exchange reserves are a staggering US$1.3 trillion and are growing fast. The nation's trade surplus is expected to top US$300 billion this year. So much cash is accumulating in the People's Bank coffers in fact, that the government has begun speculating in private equity deals and M&A transactions. For instance, China recently invested some of its growing cash stash to buy a stake in private equity firm Blackstone Group.
The People's Bank has another problem besides too much official reserve money chasing too few investment opportunities. The nation's rapidly emerging investor class is speculating too much in mainland stocks. They're making Beijing policymakers nervous.
 
Oh How the Chinese Just Love to Speculate in Stocks!
Retail investors have opened about 33 million new brokerage accounts already this year. That's more than six times the total for all of 2006. Trading by retail investors dominates share volume in Shanghai, with about 60% or market volume accounted for by individual investors, compared to just 5% in the U.S.
Chinese authorities are understandably concerned about too much irrational exuberance on the part of its citizens. Beijing is wary of potential unrest in the wake of a severe market sell off, such as the correction just suffered by nearly every other global stock index.
As a result, the People's Bank just raised lending rates for the fourth time this year, to more than 7%. Beijing also tripled a tax on stock trading in May to help reign in excess speculation. But China's growing army of new investors is still plunging into the stock markets. They're opening new brokerage accounts at a rate of 200,000 every day !
So the problem remains: How do you relieve the speculative pressures building in the Shanghai and Shenzhen stock exchanges?
Solution: Send some of that red hot retail money flowing into Hong Kong instead!
Remember What Happened the Last Time Beijing Loosened Investment Out-Flows
In May, I wrote about how Chinese authorities first cracked the door open for its citizens to move money into Hong Kong. This development involved key changes to China's Qualified Domestic Institutional Investor (QDII) program (see "The Real Story You Won't Get from CNBC ").
As a result, Chinese mainland investors were allowed to move money offshore (narrowly defined as Hong Kong-listed stocks), but only through "qualified" managed accounts held with Chinese banks, brokers and insurance firms. Of course, these accounts had restrictions, which excluded some investors.
Still, these changes to QDII were enough to propel the Hang Sang China Enterprises Index (HSCEI) of Hong Kong to list Chinese stocks to new record highs -- in fact, the index surged nearly 24% over two-months following Beijing's rule change.
During this period, the HSCEI outperformed the Shanghai Composite Index nearly 3 to 1, as a great wall of Chinese institutional investment money surged from the mainland exchanges into Hong Kong.
The last time China cracked open the door to offshore investing, Hong Kong listed China shares surged nearly 24% in just over two months. This time, Beijing has thrown the barn doors wide open!
The People's Bank Authorizes Another Big Cash Contribution for Hong Kong
Just last week, Chinese authorities made another milestone move. Now they're allowing mainland investors to invest directly in Hong Kong-listed stocks through accounts at the Bank of China's Tianjin branch. According to Reuters , the program will be expanded to Shanghai next and Industrial and Commercial Bank of China (ICBC) will also be a designated bank.
Previously, Chinese citizens were restricted to just US$50,000 per year in foreign exchange. That's in addition to the expanded QDII program. But now there is no limit ! "More than HK$300 billion is set to flow" into Hong Kong shares as a result, according to an article in China's business newspaper, The Standard.
A report by Deutsch Bank analysts confirms my expectation that "The most obvious beneficiaries of this new policy will still be those dual-listed H-share companies that are trading at significant discounts to their A-share counterparts" listed in Shanghai.
According to data from JP Morgan (JPM), "Of the 43 companies whose shares trade both in Hong Kong and on China's A-share markets, the average weighted A-share premium on Aug. 20 was 87%." That's a huge trading premium over the exact same company shares listed in Hong Kong.
Closing the Valuation Gap...in Hong Kong's Favor
Of course, the reason for this two-tiered valuation is that only Chinese citizens, and a very small number of institutional investors from outside China, are allowed to trade the A-shares in Shanghai and Shenzhen. And NO short-selling is allowed.
As a result, the mainland China stock exchanges have been mostly closed markets. A buying frenzy from China's retail investors has pushed valuations unreasonably higher. Up to now, investors had very few other choices.
But this latest change from Beijing is clearly aimed at siphoning off excess liquidity that has been driving Shanghai share prices unsustainably higher.
And with such a hefty discount available, newly liberated mainland investment funds should soon flow into much cheaper shares in Hong Kong, in another great tidal wave of offshore diversification.
In fact, the Shanghai CSI-300 Index of A-shares trades at more than 50 times profits. Meanwhile in Hong Kong, the Hang Seng China Enterprises Index trades at just over 20 times earnings.
Nothing like a half-off sale in Hong Kong to attract hundreds of billions in Chinese cash flow!
There's no doubt in my mind that we're about to see the second coming of the great wall of Chinese money flowing into Hong Kong. And it's only going to be bigger and better the second time around.
This offers you another big-time profit opportunity, if you know just how to invest in China to take full-advantage. I recommended that my subscribers target TWO ETFs that look poised to soar in value as a result of this sea of change.
MIKE BURNICK, Senior Editor & Global Markets Analyst
Mike Burnick is Senior Editor, Global Markets Analyst and editor of Global Market Investor.