China's ailing stock market showed some signs of life in June after Beijing announced a series of measures to resuscitate it, providing a ray hope just after the market hit eight-year lows. Under the new rules, only 50% of the dividends received by retail investors would be taxable, and compensation for holders of tradable shares related to the state's non-tradable shares sell-off program would be exempt from the stamp tax and corporate personal income tax.
Additionally, the China Securities Regulatory Commission is allowing those fund management companies with more than US$6m in assets to invest their own capital in mutual funds. This potentially opens the door for more than US$300m to flow into the market, but it would hardly make a dent in the US$400bn yuan-denominated A-share market.
But Bob Liu, a research analyst at CITIC Securities, says the real reason June saw market rally is that the CSRC recently barred fund management firms from selling their shares. "Fund management firms own large caps, and whether they buy or sell could influence the index quite a bit," Liu explains (this is because the market index is over-weighted towards large-cap stocks). In event, Liu says the government's new rules help lower the market's policy risks, valuation risks remain, making the market vulnerable to further drops.
Just how exposed is the market to valuation risks? At 17-times earnings, the mainland A-shares are trading at a 30% premium Hong Kong's H-shares, according to Pauline Dan, executive director of equities of Manulife Asset Management. Given that kind of premium, Dan thinks the mainland market could use a spot of correcting. Those shares are not cheap," Dan says. Yes, the market can definitely go lower."
How low can it go?
In May, the Shanghai Composite Index hit 1,043, its lowest intraday level in eight years, and if it can do that, it can sink further still. Li Feng, assistant director at Shanghai-based Orient Securities, says he would not rule out the Shanghai Composite Index sliding into 700-point territory.
Dan calls a slip to 900-, or even 800-point levels "plausible." "The market always overshoots on the upside – and the downside," she says. "I have no clue on what the bottom of the market is."
Who would? Investors are troubled by the prospect of a second batch of government-held shares hitting the market after Beijing said it would launch an incremental sell-down of non-tradable state-owned enterprise shares, which account for two-thirds of China's market value.
"Currently, the biggest overhang is the state share disposal program," says Fan Cheuk Wan, head of China Research at ABN AMRO Bank, Hong Kong. "Investors are worried about the wider implementation of the program. Unless this is settled, it will be difficult to restore investor confidence.?
One question on investors' minds: will sale terms favor existing shareholders? "Investors are expecting significant discounts and have communicated with the regulatory authorities that the market wants deeper discounts," Fan says.
The prospect of the state-owned shares .flooding the market has also created concerns about the market's liquidity. "The whole system is broke," Li says. "It wasn't set up to handle so many shares."
There is, however, more to worry about than the state sell-off. Earnings are expected to slide, thanks to a combination of raw material price increases (see steel, for a spectacular example) and slower sales on the back of Beijing's measures to cool the economy.
Then, there is the investor backlash. "I think the main issue in the weak market is the corporate scandals," says Ivan Chung, managing director of Xinhua Far East China Ratings. "Investors are tired of them. It's increasingly easy for [Mainlanders] to buy overseas shares, especially the H-shares on the Hong Kong market."
Given that option, choosing between the same company's H-shares sold in Hong Kong and its A-shares sold on the mainland, is a no-brainer for investors. "They feel more protected in the Hong Kong market, so it's a genuine loss of faith in the Chinese market."
"The room for a further drop is limited, but I think if the market continues to drop, companies will find ways to prop up their share price," says Xinhua's Chung. He sees other room for optimism. "We can't exclude the possibility that there are good companies here. I think increasing participation by foreign investors will bring more discipline and increase requirements for disclosure and corporate governance."
But he says improvements are unlikely to happen overnight and the market could be stuck in its rut for awhile.
No matter how you look at it, China's stock market is, thus far, down more than 10% this year after dropping 15% in 2004 to become the world's worst major performer. Beijing's latest policy moves may avert a repeat of 2004, but market fundamentals must also improve before a sustained turnaround can be expected.