Investors looking to gain more direct exposure to China received an early Christmas gift in 2011. The country’s regulators issued rules on December 16 for the long-awaited “RQFII” (Renminbi Qualified Foreign Institutional Investor) program, which provides holders of offshore yuan in Hong Kong with a means to tap mainland securities markets.
Renminbi-denominated stock markets in Shanghai and Shenzhen – dubbed “A-share” markets – are closed to all foreigners except those investors approved under the Qualified Foreign Institutional Investor (“QFII”) program. RQFII is a (so far) small subset of that scheme that allows the Hong Kong subsidiaries of mainland fund management companies to invest renminbi back into mainland exchanges.
QFII is consistently oversubscribed, indicating that investors have a strong appetite to access mainland equity markets. Regulators have indicated that the broader QFII program should expand rapidly in coming months from its current quota of US$41.8 billion.
However, mainland stock markets are no sure bet. Isolation from international capital flows, poor regulation and corporate governance concerns often mean the moribund Chinese stock market bears little resemblance to other stock markets or the country’s robust economy. Investors would do better to view A-shares as a useful but limited tool in their portfolio, rather than a straight proxy from the China growth story.
Destroying shareholder value
The benchmark Shanghai Composite Index peaked at 6,124 on October 16, 2007, before tipping into an epic crash. It has yet to recover to half that level, despite the country’s spectacular economic growth in the interim. In 2011 alone, the Shanghai and Shenzhen composite indices fell by more than 20%, destroying about RMB6 trillion (US$950 billion) in capital. Xin Chang, associate professor at Singapore’s Nanyang Business School and director at Rega Capital Management, estimated that about 80% of investors in the stock market lost money last year.
At first blush, this lackluster performance might seem an odd contrast with China’s blistering GDP growth. After all, economic expansion both increases the value of companies and encourages individuals to put more of their savings into the market (either directly or through pension funds), thereby pushing up prices. Common sense dictates that people buy stocks when they feel bullish about the economy and sell when they feel bearish.
Unfortunately for China’s stock market investors, however, the idea that a developing country’s GDP and equities should grow in tandem is a straight-up myth. A landmark 2006 study by Peter Blair Henry and Prakash Kannan, then of Stanford University, found “no systematic long-run relationship between stock returns and economic growth in emerging economies over the past 30 years.” Many other studies have since supported this claim.
China has been no exception. The country’s inflation-adjusted GDP grew by around 9.5% annually between 1993 and 2010, but mainland equities grew by just 2.2% during the same period, according to a report by Nomura, an investment bank. Chang of Nanyang Business School points out that those who bought into China’s stock market 10 years ago would have seen no growth in their investments today.
A number of factors come into play to create this phenomenon of lackluster stock performance, some of them fairly benign and common to other developing countries. Growth in emerging markets is largely driven by rapidly rising productivity, which generates surplus savings that is in turn channeled into investment, such as infrastructure and real estate. This trend drives GDP growth, but it doesn’t necessarily affect stock markets.
Many companies in emerging markets are unlisted, usually because they are family or state-owned firms. Those companies which are listed, meanwhile, quickly attract the attention of eager investors, meaning their future growth gets factored into stock prices from the get-go.
Other factors, however, are unique to China’s A-share market. For starters, its relative isolation means valuations of companies on the mainland are often out of sync with international valuations; because mainland stock exchanges are closed, international investors cannot arbitrage price differences across markets. Chang’s research suggests that mainland shares trade at around an 11% premium to near-identical equities in Hong Kong.
Moreover, the makeup of A-share stocks makes the market much more sensitive to economic highs and lows than exchanges in Hong Kong or the US. The exchange is heavily weighted towards chemical, energy, brokerage and metals equities, sectors which are prone to volatile shifts in response to broader economic trends.
Volatility is exacerbated by the unusual makeup of China’s investors: Manop Sangiambut, head of China A-share research at CLSA, says that retail investors make up over 70% of A-share market capitalization, while institutional investors represent just 20-25% – almost the opposite of the ratio in Hong Kong and the US.
“Given the high contribution of retail investors, market sentiment becomes very important, and this sentiment tends to be governed by policy direction,” said Sangiambut. “The A-share market is a policy-driven market.”
Guarding the guardians
The real bette noire for many mainland equity investors, however, is not volatility but the impression that mainland exchanges are minefields of fraud and insider trading, giving a big home field advantage to well-connected investors and corporate executives at the expense of everyone else. “China stock markets sometimes behave like a Ponzi scheme and are rife with speculation,” said Chang of Nanyang Business School.
Part of the problem is that mainland markets lack many of the basic trading options and features found in other bourses. Short selling and margin trading are tightly limited, meaning investors have little motivation to root out fraud. Commercial law is not nearly as developed or transparent – making it ultimately less predictable – than other jurisdictions, a problem which both hobbles legitimate investment and encourages nasty behavior.
This malfeasance is easy to spot. Stock markets often move erratically before official economic data is released, suggesting leaks.
The most flagrant problem is in IPO markets. Before 2005, China’s securities regulator systematically underpriced Chinese IPOs to help guarantee headline-grabbing successes. Following a series of reforms intended to reduce government involvement, firms now take to setting prices via “offline subscriptions” with institutional investors.
Though hard to prove, it is widely assumed that well-connected institutional investors collude with brokerages to set IPO offering prices too high. These investors then exit their positions quickly once trading starts to turn a profit. The result is that about 75% of all IPOs fell on their first day of trading in 2011, compared with just 42% in 2010.
Even Zhang Yujun, head of the Shanghai Stock Exchange, has lamented lack of regulatory oversight of IPOs. “If a mature market-driven system is not in place yet, it is not appropriate to loosen regulatory control,” he said in December.
Picking and choosing
These regulatory and corporate governance concerns have eroded investor confidence across the board. “We have clients talk about losing faith in the A-shares because of insider trading and IPO [irregularities],” said Huang Fan, Shanghai-based vice president for private investment management and investment director at Deutsche Bank.
However, he notes that some progress is being made, especially since Guo Shuqing was instated as the CSRC’s new head in October. Guo, who pledged a “zero tolerance” policy on securities crimes, made headlines by prosecuting a small Guangdong-based securiti
es firm for market manipulation in December. It could be a promising start, but high-profile crackdown campaigns on insider trading are nothing new – in the past, day-to-day enforcement has all too often slackened once the media coverage dies down.
In the face of uncertainty, the best strategy for foreign investors may be to cherry-pick A-share exposure to specific sectors of China’s economy which they cannot access in less volatile and better-regulated markets. Sangiambut of CLSA points to China’s defense equipment, power transmission, manufacturing and healthcare as some plays which can only be done cleanly via A-share equities. “There are quite a number of sectors to which you just can’t get exposure elsewhere,” he said.
In that sense, greater access to A-share markets should be a boon to investors looking to build a portfolio of diverse exposures to the Chinese economy. They need only look at the Chinese market’s recent performance, however, to understand its dangers.