There are many jokes about China's stock market. During the 1990s, goes one, the market never experienced bull or bear markets. Instead, it had pig markets since prices simply followed the direction set by government policy. The then-Premier Zhu Rongji's surname is a synonym for the Chinese word for pig. But for the tens of thousands of small investors who have lost money in the market, it is no joking matter. Lied to by companies who have issued shares, manipulated by unofficial investment touts and by wealthy investors with plenty of inside information, betrayed – some claim – by a government which has not managed to implement effective regulation, herds of retail investors have deserted the market in disgust.
With the accelerated opening up of the markets due to China's WTO entry, foreign financial institutions are now taking a new look at the market as a means of gaining exposure to China's dynamic growth. But they too are hesitant about committing to a stock market that is widely viewed as corrupt and inefficient.
The reasons for this state of affairs are not hard to track down. As in any emerging market, the rule of law is weak. Regulators typically lack knowledge and expertise. But in China, the stock market also suffers from a number of China-specific problems. First and foremost, the market has been forced to fund the state's own enterprises – which tend to be terrible performers that need to massage their numbers to get a listing.
These enterprises do not privatize when they list, but remain state-controlled. Second, the strange regulatory environment firms enter into after listing usually does little to incentivize them to improve their performance. Third, few institutional investors means that shareholder discipline has been lacking. And fourthly, the share market has been "protected" from foreign investment to its own detriment.
The good news is that each of these problems is being solved, albeit gradually, and China's stock markets are undoubtedly on the road to maturity. Radical reforms are being rolled out as the government becomes more relaxed with the ideas of privatization, shareholder rights, centralization of regulatory powers and foreign participation.
Most crucially, the market has so far not been used to really privatize China's state enterprises. Listed firms have largely remained controlled by the state. Whenever a large SOE restructures into a shareholding company in order to list, it has had to issue three different types of shares in roughly equal proportions.
About a third of the shares can be publicly issued and are freely traded by private individuals and institutions on the stock exchanges. These shares are known as individual person (IP) shares (geren gu). Those listed in Mainland China in Shanghai and Shenzhen are known as A-shares, while those traded in Mainland China in foreign currency are known as B-shares. Individual shares listed abroad are called H-shares in Hong Kong and N-shares in New York. About a third of the company's equity is made up of state shares (guojia gu). These shares are held (and supposedly managed) by government bureaux, cannot be listed or traded in the market, and their transfer is subject to government approval. Legal person (LP) shares (faren gu) are allocated to other SOEs that contribute capital to the restructuring company before the IPO. LP shares cannot currently be traded on the stock exchanges, although they can be exchanged between legal persons, (either state entities or private companies).
By the end of 2002, the average listed company had 44% of its share capital held as non-tradable shares. Less than 1% of listed firms have all their shares freely tradable. A realistic estimate of the market capitalization of these companies, taking into account only those shares that are freely tradable, would result in a total market value of around RMB 1.3 trillion (US$162.6 billion) in June 2003, some 14% of GDP.
A regulatory mess
A second problem with China's stock market is regulatory confusion. Competition in the 1990s between local and central government officials to profit from the stock market damaged efforts to introduce good regulatory standards. Prior to September 1997, market regulation was managed by the provincial and city-level governments, rather than by the central government. Local securities offices were managed by provincial leaders who wanted to see their worse performing SOEs restructured and listed.
In China in the 1990s, the media and the legal system had little regulatory influence on the markets. Shareholders had virtually no means to defend themselves through the courts. The accountancy firms often had close relations with the state-employed owners of the firms they were auditing. Price manipulation scams were common.
Another problem, and one common to other emerging markets, has been the lack of institutional investors. Mutual funds, pension funds and insurance companies can have a healthy influence on listed firms' corporate governance practices and also tend to invest for the long-term, reducing price volatility.
Up until 1997, however, China's investment fund sector was all but non-existent. Local governments had sponsored some 75 funds in the early 1990s that were largely poorly managed and lost money for investors. The last problem was that foreign investors have not been allowed full access to the Mainland share market. They have instead been invited to buy Chinese equities overseas, particularly in Hong Kong (socalled H-shares) and in the B-share market. The local B-share market, established in 1992 for foreign investors, hosts shares denominated in foreign currency, and has some 130 companies listed. However, it is very illiquid.
Because of all these problems, China's stock markets have failed to provide much support to China's economic reforms. So bad was it that in the first half of 2003, China's stock market only provided 1.6% of all financing (including all bond issuance and new bank lending), down from 7.6% in 2001. Thankfully, the government seems willing to do something to reform the market to make it more useful.
Privatization of listed companies is already occurring as legal person shares are sold off to strategic private investors. Since these shares represent about one third of the equity of the average firm, these firms are becoming 'two-thirds privatized'. According to analysis carried out by the Shanghai Stock Exchange, private companies controlled 15% of its 729 listed firms in 2002, up from 12% of 660 listed firms in 2001. That proportion is probably around 20% now. Local governments are also gearing up to sell large numbers of state firms, often at Property Rights Trading Centers, which could develop if care is not taken into rivals to the stock exchanges. Although some of these private buy-outs are little more than scams, the chances are that these deals are going to have a positive effect on listed firms. Privatized firms will have a harder time getting cheap credit. Owners will have real profit incentives. The regulator will have a freer hand to investigate and punish those firms who break the law. Privatization is no panacea but it will do much good. There have been improvements too in regulation. The China Securities Regulatory Commission (CSRC) has been empowered as the sector's sole regulator taking control from the provinces, the Shanghai and Shenzhen city governments.
The CSRC is increasingly acting to protect investors – at least within the bounds of political constraints. For instance, it demanded that one third of listed company boards (which, on average, are made up of 10 members) be comprised of independent directors by June 2003 (though, admittedly, this target has been missed by a long margin). It banned listed companies from making loans to their parent companies (a common method of asset stripping), and has introduced a penalty system for underwriters who collude with firms to make false disclosures. More dramatic has been the government's recent move to allow shareholders to sue listed companies for faking their accounts.
The CSRC is also growing the investment fund sector. By June 2003, some 19 fund management firms held 71 funds managing RMB 140.5 billion (US$17 billion) worth of assets. This sum was equivalent to some 11% of the stock market's free float, up from almost zero five years ago. That is still well below the proportion held by institutional investors in more mature markets (upwards of 50%) but it does show that the sector is growing fast. Some 20 to 30 additional firms are currently waiting on CSRC permission to start business. The industry is rapidly heading for over-capacity, not ideal but it will force firms to improve their competitiveness. The regulator has also encouraged domestic firms to form joint venture fund management companies. By September 2003, it had authorized seven Sino-foreign FMCs. Although the foreign side may not currently take more than a 33% equity stake, most of the foreign firms are taking de facto control of their ventures through the appointment of senior personnel.
The China Securities Regulatory Commission is now clearly working to open up the market. So far, the Qualified Foreign Institutional Investor (QFII) system has allowed 12 international investment firms into the A-share market to invest over US$1.65 billion. UBS, for instance, reported in mid-October that after a quiet period during SARS if had completed raising US$300 million in client money for investment through its QFII channel. Foreign investors complain about some of the restrictions set on QFII investment, such as a minimum US$50 million capital requirement and a one-year lockup for funds. But it is likely that these restrictions will quickly be relaxed. Despite high valuations and the generally poor quality of most listed companies, UBS has already started lobbying for a bigger quota.
There are clear signs that senior economic policy makers understand the problems of the market and are moving to resolve them. Implementing this agenda, however, involves considerable cost. Selling off the state's equity stakes will likely mean more share price falls, which will cause both retail and institutional investors pain. Allowing more private firms to list will mean denying financing to former SOEs, something their managers will lobby against. Implementing regulations properly could well mean prison-terms for some government officials. The political reasons for not pushing forward with this agenda are obviously strong. But the economic rationale for pushing ahead is unquestionable. Structural reforms will be worth it in the long run, even if these first steps will be painful.
Dr. Stephen Green is head of the Asia Program at the Royal Institute of International Affairs in London and author of China's Stockmarket published by The Economist Series.