The CSRC's decision a year ago to abandon its
policy of selling off nontradeable state shares may have helped shore up share
prices but many companies could still be undermined by a decline in equity
The recent detention of Yang Bin, the disgraced former president of Hong
Kong-listed flower exporter Euro- Asia Holdings, may have more to do with his
mysterious activities in North Korea than with any financial misconduct in
China. However, Euro-Asia's problems are exacerbating a loss of public
confidence in the accounts of listed Chinese companies – and any resulting
decline in domestic stock prices could have broader effects on the country's
The links between China's
equity markets and its largely bank-centred financial system are in some ways
similar to those in Japan,
where falling stock prices have become one of the gravest threats to the
economic reform programme of Prime Minister Junichiro Koizumi. As recently as
late September, Koizumi's plans to force an aggressive writedown of bad bank
loans were seen as a promising step forward.
The slide in the Nikkei index since then, however, threatens to make such
measures impossible. Since Japanese banks hold a substantial share of the
country's listed equities, the stock market's decline flows directly through to
their capital-adequacy ratios. Below a Nikkei level of around 8,000, the major
banks' ratios would fall under the international standard of 8 per cent,
leaving them little or no room to write down non-performing loans. The Koizumi
government has since announced risky and highly unorthodox plans to break this
financial impasse, including the use of public funds to purchase equities and
support the Nikkei.
The structural backdrop in China
is somewhat different. The country's four leading banks are wholly state-owned,
and until 1998 each of them had negative net worth – in other words, their
capital adequacy ratios were below zero. But the creation of 'asset management
companies' to acquire some of the banks' bad loans has substantially improved
their balance sheets, although capital adequacy ratios are still believed to remain
below international standards. And unlike their Japanese counterparts, China's
state-owned banks do not invest directly in shares.
However, banks have gained indirect exposure to equity prices in ways that may
threaten to worsen their bad-loan problems if the bear market continues. Most
significant, in 1999 the People's Bank of China authorised banks to make loans
to securities firms collateralised by shares – effectively funnelling bank
credit into the stock market.
This rather ill-conceived policy measure was reportedly inspired by the long
economic boom in the US
during the late 1990s, which many economists attributed to the 'wealth effect'
of strong consumer spending supported by rising share prices. With signs of
deflation already becoming apparent in 1999, policymakers hoped a rising stock
market would revive consumer confidence in China as well.
Moreover, the vestiges of the old loanallocation system, which allowed some
state enterprises to continue receiving credit regardless of their internal
investment needs, has encouraged enterprise managers to place company funds in
the stock market in the hope of speculative gains. Assuming that such holdings
are properly disclosed, this makes the balance sheets of many such enterprises
highly vulnerable to swings in the market.
What makes these linkages especially awkward is that Beijing is now trying, as gently as possible,
to unravel the state's equity ownership of listed firms. On June 12 last year,
the State Council issued provisional regulations to authorise the sale of
'nontradeable' state-owned shares to help finance the country's social security
needs – in particular, an enormous overhang of unfunded pension liabilities.
Much like Koizumi's recent pledge to speed up the disposal of bank non-performing
loans, the plan seemed to be a sensible proposal to deal with a looming threat
However, the proposal to sell off nontradeable state shares led to an immediate
collapse of domestic equity prices. Between June 14 and October 22, 2001, the Shanghai A-share index
fell from 2,245 points to 1,514 points, a decline of some 32 per cent. On the
latter date, the China Securities Regulatory Commission announced the
abandonment of the share-sale policy – an about-face that may have been necessary
to avert the collapse of some highly leveraged securities companies.
It is no longer clear, therefore, how China will eventually pay the
pensions of stateenterprise retirees whose employers can no longer support
them. But there may also be trouble ahead in the much shorter term, since the
A-share indices still have plenty of room to fall. The decline between June and
October 2001 reduced the Shanghai
market's valuation from about 60 times earnings to roughly 40 times. This is
still quite high by international standards, even assuming that published
earnings figures are reliable.
Any further loss of confidence in the credibility of listed firms' accounts
(dented both by US financial scandals and by the recent troubles of local firms
such as Euro-Asia) could bring the A-share markets considerably lower. As in
the US market, where price/earnings valuations fell dramatically after
accounting scandals reduced the credibility of corporate earnings reports, the
high valuations of China's A shares may be vulnerable to a crisis of confidence
in local auditing standards.
A steep decline in share prices could undermine both securities firms and
non-financial enterprises with large equity holdings, and the bank creditors of
these entities would likely suffer correspondingly. As China's
corporate reporting season is now under way, too much bad earnings news could
easily spark wider systemic problems.