The trust gap

A common failing of communist governments through the decades has been a fundamental lack of faith in the people. They need to be reeducated, guided, and micromanaged. Given too many choices, the conventional wisdom goes, people will invariably make the wrong ones and act in their own self-interest instead of for the common good. In social terms, this can lead to purges, social realist cinema, and the Cultural Revolution.

When the same approach is applied to stock markets, we get the mess that we see in China today.

To sum up the situation in one paragraph, which those of you who have been following the Chinese markets closely can skip: the government owns two-thirds of all listed shares, only a handful of companies can issue bonds, the stock market fell to eight-year lows earlier this year, and the securities industry is on the brink of a collapse that has only been averted by government bailouts.

The root cause is that the government doesn't trust the investors to do the right thing – to pick the best companies and the best bond issues, and to buy them for what they're worth. Instead, it micromanages the process, deciding who gets to list and who doesn't, setting the IPO price, setting the rates for corporate bonds.

The lack of trust in the market is exacerbated by way too much trust in employees – in corporate managers (that they won't cook the books) and in brokers and traders (that they won't use inside info for their own personal gain).

But now, finally, we're starting to see some light. In May, the government announced that it would begin a pilot privatization program under which some companies would be able to convert some nontradable state-owned stock into tradable stock.

There have been several previous attempts to do this, but all failed because of investor protests that the value of their holdings would plummet if new shares flooded the market. This time, the reforms seem to be moving ahead well and around 200 companies have announced share conversion plans (there are about 1,400 listed companies in China altogether).

There are other signs of liberalization in the securities market. In September, China Unicom packaged up future mobile phone revenues and sold RMB3.2 billion of the new securities on the Shanghai Stock Exchange. As an alternative to corporate bonds – or bank loans – such a securitization project gives Chinese companies access to low-cost financing, and gives investors another way to invest in China's economy. The fact that the offering was over-subscribed indicated investor interest in the concept.

Meanwhile, in late October, the governor of the central bank said China will move ahead with bond reforms as well, allowing the market – instead of government officials – to determine which companies can issue bonds and at what rate. This will require a good credit rating system as well, something which China currently lacks.

And in November, the chairman of the China Securities Regulatory Commission promised that China would soon have a revised bankruptcy law, which is key to clearing out the dead wood. Also in November, the government called on major shareholders to pay off money they had borrowed from their companies by the end of 2006 and to improve accounting and risk controls.

The Securities Association of China reported that last year 114 brokers lost a total of about RMB15 billion (US$1.85 billion), the fourth year in a row that Chinese brokerages have collectively lost money. In the past 18 months, the government has closed down or taken over 21 brokerages (out of a total of about 130), and another 60 or so may also be doomed. This is a good sign. Foreign investors are optimistic that this is a sign that the Chinese stock market will turn around, and foreign institutional investors have begun picking up the pace at which they move in.

Three of the top five global tech IPOs this year have been Chinese, as was the single largest IPO since 2001 – China Construction Bank's Hong Kong listing.

Credit Suisse First Boston has already used up its US$150 million QFII allotment and is applying for another tranche. CSFB also says that it wants to set up a joint-venture with a Chinese brokerage, which is the only way foreign firms can currently get into the market.

Citigroup and HSBC are competing with CSFB to get in all three have their sights set on a majority stake in Shanghai's Xiangcai Securities. Morgan Stanley, Goldman Sachs, Merrill Lynch and UBS, meanwhile, are already involved with local brokerage firms, but hold minority stakes.

The brokerages I talk to say that they're waiting for certain signals before jumping into China currency convertibility, share ownership reforms, and the ability to buy majority stakes in brokerages (or open their own offices). It looks as though the government is getting ready to take these steps, so if you have been waiting on the sidelines before jumping in, it may be time to start making plans.

Maria Trombly is the Asia bureau chief for Securities Industry News. She was born in the Soviet Union.