For a US$9 billion initial public offering (IPO), China Construction Bank (CCB) had every right to expect an enduring stint in the financial limelight. But five months is a long time in China's electric economy and the talk of 2006 is if, and by how much, Bank of China (BOC) and Industrial and Commercial Bank of China (ICBC) can beat the country's current record offering.
There is only one guaranteed winner in this multibillion dollar game: the Hong Kong Stock Exchange (HKEx), bourse of choice for CCB and hotly tipped to become home to shares in both BOC and ICBC. With proximity and mutual understanding making Hong Kong first choice for Mainland companies looking to list overseas, the stock exchanges of New York, London and Singapore and NASDAQ have been left to fight over secondary listing rights as well as any big fish that choose not to swim in the common pool.
"There have been significant inflows into China over the last couple of years and I expect the emerging market focus to continue," said Ian Carton, head of Asia capital markets and financing at Merrill Lynch. "It is reasonable to expect that other government controlled sectors in need of capital will come to the market."
Speculation has centered on the power grid corporations as the next major state-owned monolith to get the listing treatment. But the so-called "supporting cast" of companies that don't fall into the large SOE bracket are not to be sniffed at. Add to the mix a healthy number of smaller, more specialized operators that feel the need to market themselves to western investors in place of (or in addition to) an Asian listing, and you have a collection of spoils worth fighting for.
"The private sector is beginning to produce companies of a size and international profile that will enable them to compete in profile with the SOEs," said Carton.
Hong Kong is certainly growing rich off the back of the Mainland's reform program that has seen listings suspended while state-held non-tradable shares in companies are converted into tradable A-shares. Such is the weakness of the Shanghai and Shenzhen markets; even if listings were permitted, it's uncertain the top companies would want to go there.
Mainland companies accounted for 80% of the record US$24.7 billion raised by Hong Kong IPOs last year, according to PricewaterhouseCoopers calculations. This figure is expected to approach US$25.8 billion in 2006. The 22% rise in the exchange's total market capitalization from US$854 billion in 2004 to US$1.05 trillion last year was underpinned by a 58% increase in the market capitalization of Mainland firms, from US$260.3 billion to US$411.4 billion. Mainland enterprises now make up 39% of the exchange's total market value and this is predicted to pass 50% within five years.
"Hong Kong has become the international securities market for Mainland Chinese companies and this is in part due to its capability in providing freely convertible funds," said Lawrence Fok, head of business development at HKEx.
First-mover advantage has also proved important. Hong Kong started listing Mainland companies as H-shares in 1993 and had considerable experience dealing with red chips – companies incorporated in Hong Kong but with controlling Mainland shareholders – before then.
"At that time, no other exchange thought seriously about Mainland China – there was no company or securities law," said HKEx's Fok. "But Hong Kong knew it would be part of China in a matter of five or six years. We saw the opportunity in that, as the Mainland started opening up its economy, sooner or later the SOEs would need capital."
However, the influx of Mainland companies has put Hong Kong's level of regulation under the spotlight, the implication being that the bar must have been lowered for them to get in. Speaking at a Beijing conference in October, US Securities and Exchange Commission Chairman Christopher Cox blamed the fall in Chinese listings in New York on Chinese companies "seeking to avoid higher regulatory standards."
This is matched by concern in some quarters that Mainland companies with poor corporate governance have been allowed to slip under the wire and now pose a potential threat to the integrity of the exchange.
"An economic crisis would create all kinds of problems as it would expose any weaknesses," said Jamie Allen, secretary general of the Asian Corporate Governance Association (ACGA). "Just look at the Asian financial crisis – companies that looked okay suddenly turned bad."
HKEx's Fok is adamant in his defence of the exchange's "international standard" regulation, though. "The key thing is maintaining an adequate regulatory standard," he said. "No one would dare use the word perfect because there is always a dividing line. If you are very loose, you become a Mickey Mouse market; if you are very tight, the burden of compliance on companies is so great you won't have a market anyway."
At the core of this problem is the cloudy relationship between the regulators in Hong Kong who draw up the rules and the regulators in the Mainland whose job it is to enforce them. In 1993, the China Securities and Regulatory Commission (CSRC), the Securities and Futures Commission and the Hong Kong, Shanghai and Shenzhen exchanges signed a memorandum of regulatory cooperation, but questions remain as to how Hong Kong can pursue offenders based in the Mainland.
Fok points out that no regulator can take action outside of its own national borders and that it is in the state's interests to see the big SOEs work within the rules. Nevertheless, as the Mainland share of HKEx's market value creeps towards a majority, it would be reassuring for investors to know that corporate governance standards were policed by something more than a memorandum and a line of dialogue.
"There is the idea in Hong Kong that the CSRC can wave a magic wand and things will be sorted out but it doesn't work like that," said ACGA's Allen. "Just to say 'we have a memorandum of cooperation' doesn't mean much."
This view is supported by Michael Fosh, a Beijing-based partner at law firm Herbert Smith, who points out that the CSRC operates in a much more difficult environment than its Hong Kong counterpart. "There is a fair degree of cooperation but they are approaching the issue from historically very different standpoints," he said.
Ultimately, money flows to where it will make the best returns, subject to an acceptable level of risk and no one can argue with the fact that Mainland companies have raised more through IPOs on HKEx in the last year than they have on the New York Stock Exchange (NYSE) in the last decade.
"The respect that international investors have for the Hong Kong Stock Exchange means that they have no problem buying stock there rather than in New York," said Merrill Lynch's Carton. "The average fund manager doesn't see investing in Hong Kong as a risk per se."
Counting the cost
In fact, the fall in Hong Kong-US dual listings that Cox was referring to is widely seen as being the result of financially prohibitive listing requirements in the US rather than unnecessarily lax rules in Hong Kong. Chinese companies are opting out of meeting the costs and facing the legal risks of complying with the Sarbanes-Oxley law (See: Jumping through New York's hoops: the Sarbanes-Oxley law).
"When Mainland companies consider listing, it all comes down to costs and benefits," said Richard Sun, a partner at PwC in Hong Kong. "It's more cost efficient to get a listing in Hong Kong which allows them to tap international funds."
A NYSE spokesperson admitted that Sarbanes-Oxley has turned the exchange's "gold standard" status into something "more like platinum standard", and this opens the door for rival exchanges. Unsurprisingly, the London Stock Exchange (LSE) is keen to present itself as the natural alternative to New York, an exchange with watertight regulation but less of the bureaucratic hassle.
"We have a different approach regarding corporate governance," said Jane Zhu, head of Asia Pacific for the LSE. "The US is very prescriptive with lots of rules but we take a principle-based approach – you have to comply or you have to say why [you can't comply]. If your explanation is acceptable to the markets, there's no problem. London is more flexible but in a positive way."
A Governance Metrics International survey carried out last year on corporate governance levels in more than 3,200 companies worldwide ranked London number one, with a rating of 7.39 out of 10. The US came in third on 7.03 while Hong Kong placed 19th with a score of 4.05.
This regulatory flexibility tied to a cast-iron reputation has made London popular with capital hungry companies across the world. Up to the end of last year, 56% of LSE's total US$7.15 trillion market capitalization came from international listed companies who were also responsible for 52% of the exchange's US$9.21 trillion equity turnover. There were 93 international IPOs on LSE in 2005 compared to 12 on NYSE and 21 on NASDAQ.
"In terms of non-domestic trading volume, LSE did more business than NYSE and NASDAQ combined in 2004 and 2005," said Zhu. "And since 1997, London has been the world's largest fund management center – there is US$4.68 trillion in funds under management in London and only 26% of this is domestic."
However, it is argued in some quarters that London is not making the most of the opportunity presented by the perceived Chinese disillusionment with US listings. While the Alternative Investment Market (AIM) has performed well, attracting 15 listings in the last two years (See: Small is beautiful: Chinese companies on AIM), critics point to the paltry six Mainland companies on the main board, compared to 16 on NYSE and 21 on NASDAQ. Since LSE opened its Asia Pacific regional office in Hong Kong in October 2004, Air China has been the only new entrant.
"London has been pushing hard to attract Chinese companies and seems to have succeeded with AIM, but it has not managed to attract many large dual listings," said Herbert Smith's Fosh. "It hasn't yet taken advantage of New York's fall from favor."
Based on this evidence, others seek to turn the argument on its head, suggesting that Sarbanes-Oxley isn't the major force at work here: what we are seeing is a Chinese disillusionment with western markets as a whole. Global capital is shifting towards Asia, which means the big companies are able to raise all the funds they need by just listing in Hong Kong.
"The necessity to go to the US is now far less compelling than it was," said Malcolm Wood, Asia Pacific equities strategist at Morgan Stanley. "People can raise money in Hong Kong, so why do they need to go to New York? It's the same effect, just a question of location. Investors appear to find the regulatory framework satisfactory."
In 1993, Shanghai Petrochemical had to go all the way to New York to raise US$343 million; the fact that CCB can draw US$9 billion in a heavily oversubscribed IPO in its own backyard shows how times are changing. Given China's stellar growth rate and the tendency for money to travel to the places where returns are highest, these developments shouldn't be too surprising – the key is that investors have sufficient faith in the Hong Kong Stock Exchange to go with the flow.
Similarly, the decline in Chinese dual listings can be linked to historical patterns seen elsewhere. While 20 years ago, the habit among European companies was to list on numerous regional exchanges in order to raise as much money as possible, now they are able to raise enough capital placing shares in just one location.
In this way, the challenge for Hong Kong's rivals is to promote the specialist aspects of their business, emphasizing what they have to offer that Hong Kong does not. The success of NASDAQ in China, for example, is largely based on its appeal to high-tech companies who want to see their stocks appear on the radar of the America's savvy tech fund managers. Internet portals Sina.com and Netease.com have each raised about US$1 billion since listing on NASDAQ in 2000. They have been followed by the likes of search engine Baidu.com and online game companies Shanda and The9.
According to a recent report from the Internet Society of China (ISC), six domestic internet companies, including online marketplace Alibaba.com, online community specialist China Interactive Corp and mobile music provider A8, will raise between US$100-200 million each through NASDAQ IPOs. Pointing to the poor performance of Hong Kong-listed instant message service provider Tencent Holdings compared to China's NASDAQ-listed tech stocks, ISC head of communication and development Hu Yanping argued that Hong Kong investors had minimal interest in internet stocks.
Head of NASDAQ International Charlotte Crosswell agrees that, for many of these companies, choice of listing location is about more than just liquidity. "NASDAQ is strong in Chinese tech as well as health care and the media because these areas are very well understood by US investors," she said. "Companies listing outside the US generally do not command as a high a valuation as those listing inside the US and this is not necessarily a liquidity question."
While emphasizing how the merits of NASDAQ's efficient electronic trading system are enabling it to eat into NYSE's dominant position, she admits that NASDAQ's traditional selling point with foreigners is its perception as "the home of the entrepreneur". A significant proportion of foreign entrants come to the market through shell organizations registered in tax havens such as the Cayman Islands.
However, this entrepreneurial mantle is about to be contested by NYSE, which is in the process of merging with electronic stock exchange Archipelago to form a second listing platform for smaller companies. Suntech Power raised US$455 million in December as it became the largest entrepreneurial company on the main board – Archipelago will allow NYSE to cast its net even wider.
"Archipelago will fulfill that role for smaller Chinese companies while the NYSE will likely remain the global market of choice for the leading, largest issuers," an NYSE spokesperson said. "Companies that do not meet, or cannot adhere to, the NYSE's stringent standards but still look beyond their home market will more likely list on a regional exchange such as Hong Kong or London."
The message here is clear: Archipelago aside, NYSE is looking to sell itself to Chinese companies as the home of the elite, a successful listing on its bourse being the crowning corporate achievement. Any company joining the world's largest exchange, with a total market capitalization of US$21.4 trillion, is guaranteed access to sufficient liquidity and unmatched visibility. The US$7.9 trillion of the 450 international companies listed on NYSE is larger than that of the entire LSE. Meanwhile NYSE's 17 Mainland Chinese companies account for US$329 billion – more than the total market capitalization of all NASDAQ's international listed firms.
"Companies listing in Hong Kong but raising money globally are still relying on the US for capital but are trying to circumvent strict rules and regulations," said the spokesperson. For those that choose to run America's regulatory gauntlet, the rewards could be significant. A study of several thousand stocks across 48 countries between 1997 and 2004 concluded that companies with a US cross-listing enjoy an average valuation premium of 13.9%. This figure stretched to 31.2% for companies listing on a major exchange such as NYSE or NASDAQ.
"Companies recognise that compliance indicates very high corporate governance standards and investors will pay a premium for that," said NASDAQ's Crosswell.
At the other end of the specialist scale are the likes of AIM, a user friendly exchange that appeals to fledgling Chinese firms keen to make small listings, and Singapore (SGX), which is successfully pursuing China's growing private sector enterprises. SGX's market capitalization is only a quarter that of Hong Kong so it can't compete on liquidity. But the exchange replicates many of Hong Kong's advantages as a close and culturally familiar listing location and it is using this to build bridges with local authorities in order to attract high growth regional players.
As of January 2006, it was playing host to 89 Chinese companies, 59 of which are in the manufacturing sector. Of the total, 24 originate from Guangdong province, followed by 11 from Shandong, but the vast majority are domiciled in Bermuda or Singapore itself. In November, the exchange signed a memorandum of understanding with Zhejiang Provincial Government with a view to setting up a systematic channel for enterprises from the region to list on SGX. A similar agreement was reached with the Shandong Provincial Government in January.
"Collaborating with selected China provincial governments is part of SGX's listings strategy to attract larger companies to list here," said an SGX spokesperson. "This will be extended to other provinces and cities in the near future."
As Singapore seeks to boost the size and quality of its Chinese listings, it may find a rival in Tokyo, which is showing growing interest in attracting Mainland companies to its bourse. Further reforms are necessary to make life easier for foreign firms trying to list there – when Xinhua Finance became to the first non-Japanese company to have a primary listing on the Tokyo Stock Exchange in 2004, a special clearing system had to be set up for it – but the interest is there, regardless of Sino-Japanese political tensions.
"For companies doing significant trade in Japan, there is a feeling that their profile could be boosted by a listing on the Tokyo exchange," said Merrill Lynch's Carton.
Companies that target a particular country or region often find a listing close to their customer base can prove advantageous – but it is usually done in addition to a domestic offering. While Hong Kong has established itself as a strong source of capital for Chinese companies, Mainland residents can't buy shares there. Many are relying on Shanghai to realize its long-held potential as a strong listing location, but with the Shanghai Composite Index managing to decline 8.3% last year despite China's 9.8% economic growth, the wait has been a frustrating one.
"It doesn't strike me that Shanghai is the threat to Hong Kong people were predicting it would be a few years ago, certainly not in the short or mid term," said Herbert Smith's Fosh. "We need to see further reform of the A-share market and of course that is linked to the things like the full convertibility of the yuan."
Hong Kong can rely on China being big enough to accommodate more than one stock exchange; for Shanghai and Shenzhen, where listings have been banned since May, the challenge is to become competitive. The carrot-and-stick approach to converting around US$200 billion in state-held non-tradable shares into A-shares – under which existing shareholders are compensated and companies banned from issuing new shares until conversion is complete – is proving effective after aborted conversion attempts in 1999 and 2001.
It has been suggested that listings will resume once a clear majority of companies by market value have made their shares fully tradable, a target that should be met in the next few months. Zhou Qinye, head of listing at the Shanghai Stock Exchange, has said the combined value of the Shanghai and Shenzhen markets, currently around the US$400 billion mark, could top US$740 billion by the end of the year.
"If A-share reform achieves market capitalization of 60-70%, the government may start allowing new IPOs," said PwC's Sun. "But the A-share market needs time to settle down and then the reform will go on. No one knows exactly what will happen but I think there will be more integration – A-shares and B-shares may merge."
The days of foreign-focused B-shares may indeed be numbered. Overseas players already permitted to trade A-shares through the Qualified Foreign Institutional Investor (QFII) program are calling for increases in their quotas, while other investors are now entitled to buy A-shares outside of QFII under certain conditions.
But opening the door to global capital is only part of the issue – investors have to be confident the companies they buy shares in will behave themselves. China has still to implement a healthy corporate governance culture among its companies (See: Cleaning the pipes: China's corporate governance battle), and make executives fully aware of the commercial damage that can be inflicted by activities such as accountancy fraud and embezzlement.
"They are making improvements, revising company ordinance and security laws," said Sun. "What they lack is enforcement: they have the rules but inadequate resources to ensure these rules are followed."
The CSRC will need to police the system carefully in order to build up investor confidence and then retain it. However, the verdict on its performance so far is generally complimentary. One Hong Kong hedge fund manager pointed to the corruption-induced downfall of Russia's market in the late 1990s as an example of how badly events could have gone.
With the future very much in the hands of the regulators, no one is prepared to put their reputation on the line and specify a particular timescale, but the long term prospects for Shanghai look positive.
"The legal and regulatory work will take time," said Morgan Stanley's Wood. "But they know what they need to do."