Closing the losers

Whenever something happens, [policymakers] are afraid of displeasing big shots or causing market fluctuations,"Li Shuguang, a professor at Beijing's University of Political Science and Law, told Caijing magazine recently. "Those responsible must be punished severely to make an impression on other potential rule breakers."

Li was talking about securities fraud in the context of recent efforts to restructure China's disaster-prone brokers, which between them piled up more than US$1 billion in losses and debt in 2004. It would be going out on a very long and brittle limb to suggest the end of the big shots is at hand. But perhaps we are seeing the beginning of their end, what with recent moves to accelerate conversion of non-tradable A-shares and other stock market reforms. The big shots, many of them heads of dinosaur state enterprises, have ruled the roost since the dawn of China's capital markets – which for years have been drifting further and further down, such that an early summer headline that shouted "Market hits six-year low – was easily superseded by a later one proclaiming "Market hits eight-year low."

It really is time the big shots left the banquet. Over 85% of medium and small investors incurred losses in the first half of 2005, according to a China Securities Journal-commissioned survey, their losses ranging from 30% to 50%.

Put another way, only 4% made money – so the poll, conducted by Shenzhen-based Huading Market Survey Corp, revealed a huge middle group that basically marked time. Given their options, and there are precious few in China, investors would have been better off plowing their cash into property, or if property was too exciting, parking their pile in a bank to let inflation nibble away at it.

What a bizarre state of affairs for an economy blasting along at near double-digit growth: capital markets so ineffectual that China's top companies continue to opt to list offshore, putting the best and brightest beyond the reach of Chinese investors. As one state media report noted recently, the Chinese economy grew an annual average of 9% over the last 25 years, while in the last five, the Shanghai composite index lost 50% of its value.

Huading canvassed 2,792 investors in 20 major cities, so one assumes unhappiness is widespread. Revealingly, most people polled said they would be watching how the market regulator handled its most ambitious reform to date – converting non-tradable securities held by state agencies.

Since the poll, of course, the downward drift has continued: 26% of respondents said they would either stop making investments or pull out, and only 3% said they would put more money in the market.

The dilution problem

With the overwhelming majority of listed company shares out of play, companies have been largely free to stumble along in their incompetent ways, despite the regulator's more recent efforts to improve governance and give voice to minorities. On the other hand, the huge overhang has been threatening to dilute share values for years. Investors large and small have truly been caught between a rock and a hard place.

Between split share problems and lax rules (and the even laxer enforcement of securities laws that Li Shuguang complains about), investors have been understandably running shy. But the one reform that addresses both issues, painful as its implementation might be, is to end this double-dealing charade once and for all. Like the FECs (foreign exchange certificates) of yore, like double pricing on planes and trains for foreigners and nationals, and like all the other real world-netherworld concoctions earlier generation Communist mandarins cooked up, Beijing must move beyond the double dealing and join the world of grown-ups.

Another survey commissioned by the People's Bank of China in the second quarter polled depositors on their investment preferences and found there was more interest in treasury bonds than shares, China Daily noting that "people have little confidence in the nation's stock market which has remained bearish for the past eight years?

So the share conversion experiment that started in May with a handful of companies, and expanded in June to 42, is now set to go all the way with the government's late August announcement that all 1,400 listed companies on mainland stock exchanges would be encouraged to convert their non-tradable shares, increasing the size of company floats, easing the way for flotations and secondary share offerings.

A more strident government might use a stick to get the conversion program going, but Beijing has opted for the carrot, saying companies that reform their shareholder structures will get an early shot at raising new funds. Though some think the job can be completed by year-end 2006 or even sooner, the government set no timetable, at least publicly, to complete reforms.

The conversion exercise allows Beijing to reduce its stakes in companies it controls and will conceivably lead to some privatizations. With luck, it should also lead to a trimmer, more robust stock market as the losers are seen for what they are and de-listed.

No sell-out by the state

But nobody should confuse the reform with the government's wholesale pullout from China's corporate life. As China Securities Regulatory Commission Chairman Shang Fulin has pointed out, "Making all shares tradable doesn't mean selling out all shares." How many would be freely floated, "would depend not only on the shareholders' strategic choice, but also on relevant restrictions", as China Daily put it in a late June report.

Restrictions would come into play in strategic areas such as power and telecoms, for one thing, so that after reforms were implemented in some sectors, state-held shares would only be allowed to trade with the approval of the state-owned assets authorities, namely SASAC, the State-owned Assets Supervision and Administration Commission.

That wrinkle aside, the state will want to hold onto a controlling stake of some companies, keeping a safe number of shares out of the float.

CSRC Chairman Shang cautioned controlling shareholders to unwind non-tradable shares gradually and to disclose information in a timely manner, the worry being that prices would crash were the market suddenly swamped with shares. But unless the conversion exercise is dragged out interminably, which would only delay the market truly getting back on its feet, existing shareholders undoubtedly face the prospect of holding diluted assets in the short-term.

Although compensation in the form of cash or extra shares was offered in earlier pilot conversion schemes, companies are not required to provide it in the market-wide exercise. The received wisdom seems to be that, unlike the 46 pilot companies which were chosen for their solid performance, the vast majority of listed firms have performed so marginally that they cannot entertain compensation – while "some blue chips may only be willing to pay a little," according to one state media report.

A, B, H and now G

The A-share merger project covers companies listing their shares on China's A-and B-share markets, the latter open to Qualified Foreign Institutional Investors (which just saw their collective quota shoot up from US$4bn to US$10 billion) and companies that in addition to their China listings sell H-shares on the Hong Kong market. Whether holders of A-or H-shares will see any compensation will be up to the companies, but any talk of the latter group having a say in how companies dispose of non-tradable shares has been ruled out.

If handled well, the share merger should make other reforms more meaningful, like June's suspension of stamp duties or the scaling back of dividend taxes, and earlier promulgated rules giving minorities a stronger voice in decisions and protecting them from asset spin-offs. Indeed, the same applies to market incentives going forward, including the CSRC's plan to establish a securities investor protection fund, protecting individual investors against brokers stealing, misappropriating or otherwise mishandling their money.

All these developments dovetail into the most ironic of announcements: a plan unveiled last month to allow Chinese nationals to invest in Chinese companies listed offshore, through instruments dubbed (for the moment) Chinese Depository Receipts to be sold on the Shanghai Stock Exchange. Like the prodigal son, China's best companies could virtually be returning to the Motherland.

If their departure was an indictment of China's shambolic markets before, their return might reasonably be viewed as the dawn of a new era. They should be a market hit, provided the rules aren't bent to provide surviving big shots unearned benefits, but more than that, they should provide a beacon to laggards and lesser performers to clean up their acts.

To help things along, there has even been talk of launching a G-share index -G for gaige, reform – tracking companies who have completed their share conversion programs. Despite China's languishing indices, or perhaps because of them, reforms over the last few months have picked up considerable momentum. Who knows? Shanghai's capital markets might one day hum like Hong Kong's.