Despite some concerns of overheating, China’s economy remains in strong shape. This presents the ‘fourth generation’ leaders with an ideal opportunity to push ahead with further structural reform of both the economy and China’s ailing state owned enterprises (SOEs). From the new administration’s accession to power in March 2003 to the end of the year it was largely all quiet on the policy front as other issues, primarily the SARS outbreak and the renminbi revaluation debate, consumed attention.
In 2004, we have already seen two major policy initiatives in the form of the recent state bank bailout program and the announcement of the rejuvenated push to overhaul the perennially troublesome SOEs through a planned rash of IPOs to raise capital that the government hopes will be used to restructure and strengthen the SOEs. To date the new administration has been characterized by small, steady shifts rather than the grand economic policy gestures more typical of the former premier and economics ‘Tsar’ Zhu Rongji. It is hoped that this slow and steady approach will lead to major and permanent change over a five-year period, though the ‘Big Bangs’ of the Zhu era may not be so evident.
While some observers worry that the projected increase in the number of Chinese companies coming to market may meet a liquidity crunch with investors limiting their stakes, many more analysts believe that the pools of liquidity available internationally are sufficient to support the program. Lisa Meyers of US-based Templeton Funds stated on a recent visit to Shanghai that there was sufficient positive investor sentiment in the US with all things Chinese remaining ‘hot’ for most fund managers.
Listing fever to continue
The last quarter of 2003 saw H-shares and Red Chips shooting for the stars in Hong Kong – up 90% over the year with half of that growth occurring between September and December 2003. This growth was partly spurred by hopes that Beijing would allow Mainland Qualified Foreign Institutional Investors (QFII) to invest in Hong Kong. However the fact remains that H-shares ended the year worth more than A-shares with companies such as brewer Tsingtao and cement manufacturer Anhui Conch seeing their H-shares outstrip their A-shares in 2003 despite nothing particularly affecting their fundamentals.
Other sectors saw rises in their H-share prices as investors speculated on the continued growth of sectors such as property and construction ignoring talk of over speculation, bubbles and resurgent corruption cases (notably the Zhou Zhengyi case in Shanghai).
The market was further encouraged by several ‘big hitters’ making major plays in China – notably value investor Warren Buffett, who bought a significant position in Hong Kong-listed PetroChina for reasons that no one, least of all the gnomic Sage of Omaha, has yet explained. Buffett’s investment indicated again the strong liquidity available for China plays – one senior US fund manager that knows Buffett commented afterwards that he just wanted ‘in’ on China. With a lead being shown by the influential likes of Buffett it seems that over subscriptions will be the hallmark of the 2004 IPOs. This will encourage Beijing to push for further SOE IPOs as oversubscriptions make for good press in China.
Nothing symbolized 2003 better than Chinese insurer China Life’s New York and Hong Kong listing, which raised US$3.5 billion and was the first offshore listing of a Chinese financial institution – an event that has clearly influenced Beijing’s decision to push more companies to market. The China Life listing had all the characteristics that Beijing like in IPOs: retail investors oversubscribed by 150 times; the stock rose 50% on the first day and; the whole deal was effectively guaranteed by a major US insurer American International Group (AIG – a favored foreigner in China) which bought a 9.9% strategic stake for US$200 million.
The important thing to remember as we face a year of prospective Mainland IPOs is that China Life remains an SOE. This SOE status also applies to one more insurance sector IPO expected in Hong Kong before the middle of this year: Ping An Insurance as well as China Netcom, the fixed-line telephone network operator in northern China that has one of Jiang Zemin’s sons on its board of directors.
Though 2004 may be extremely busy with a possible US$15 billion in potential new Mainland share offerings, 2003 also gave some indications of how the year may shape up. There were 14 IPOs on domestic markets between August and November. The biggest of the year (and fourth-biggest Mainland IPO ever) was Three Gorges Dam operator Yangtze Electric Power Company, which raised RMB10 billion in early November in an issuance split between retail and institutional investors with Qualified Foreign Institutional Investors (QFIIs) Deutsche Bank and UBS buying in the institutional placement and further indicating that the major investment banks are still keen for more Mainland listings.
The other principal listings were Huaxia Bank, which managed to raise RMB5 billion in September and Sanyuan Dairy, the capital’s leading milk company, which raised RMB400 billion in mid-September and saw its shares jump 180% on day one. This trend could well continue into 2004 as China Green, a small Fujian-based vegetable producer, sought to raise US$24.8 million through a Hong Kong offering in January – orders were so strong it could have raised US$4 billion easily.
The listing crunch in 2004 (see box, page 14) will be driven by a renewed urge from the Beijing leadership to force SOE reform forward as well as the relaunching of a number of stalled IPOs from 2003. For instance, the success of China Life in Hong Kong has given renewed encouragement to a smaller firm, Ping An Insurance (in which Goldman Sachs, HSBC and Morgan Stanley are already shareholders), to list in Hong Kong in 2004. Ping An, and some other company, listings were delayed from 2003 partly by SARS and partly by the now traditional back and forth over valuation, pricing and corporate structure.
Another probable early candidate to build on China Life’s success will probably be Minsheng Bank, in spite of an embarrassing disclosure in February regarding falsified documents. Minsheng is looking to raise approximately US$1 billion in early 2004, and has short-listed Citigroup, Deutsche Bank and Goldman Sachs as potential underwriters. Minsheng’s success is as much due to its political connections as to its ownership structure, though the bank should prove to be an attractive stock.
Part of the continuing success of the China listings has been that the sort of companies listing has changed. In the domestic markets one out of three listed companies in the 1990s was an SOE from Shanghai, Guangzhou, Beijing or Jiangsu operating in the manufacturing sector. Typically only 30-40% of the company’s shares were freely tradable and they were held by approximately 50,000 different accounts. However, on average, one third of their total A-shares were highly concentrated in the hands of as few as several hundred individuals. Hence as effectively only a part of the company had been sold off, there was little impact on company management and crucially control remained with the state or its agents with all the adverse ramifications this arrangement held for corporate governance in China.
Under this system listed companies have often received little market discipline in terms of openness, integrity and efficiency and easily avoidable scandals have continued to emerge. This fact has clearly been recognized by the state as a weakness with the direct administrative intervention of the securities market watchdog China Securities Regulatory Commission (CSRC) in a number of companies. As Carl Walter and Fraser Howie noted in their book Privatising China, (2003, John Wiley), ?If the market cannot effect change in a company, then this objective [listing] of the reform effort has failed.?
More recently the profile
of the Mainland listings has changed to companies of a higher standard. This process began with the 1997 IPO of China Telecom (now China Mobile) and the focus has increasingly been on creating ‘national champions’ – major companies with economic scale such as Petrochina, Sinopec, Baosteel, China Mobile and China Unicom. All these have managed to raise billions of dollars at a time in the overseas markets, and hundreds of millions on the Shanghai market. Many of the forthcoming IPOs will be those that fall into this category and consequently attract massive international investor interest spurred by their newly confirmed privileged positions.
The other change that positively affects the market since the 1990s is the shift in investor profile. Early on, China’s retail investors dominated the domestic market. We saw the phenomena of share fever and chao gupiao (stir-fried stocks). This reliance on individuals has shifted increasingly to institutions while in overseas markets foreign money has become more crucial. This foreign money is not just from the US, Europe and Southeast Asia but also from Japan, which is increasingly looking to offload its forex reserves. This truly global liquidity is certainly a plus for Mainland firms listing overseas even though overseas listings force greater transparency on SOEs, something they do not always welcome.
Despite the improved quality of the Mainland companies that are listing, many analysts still see the rush to market as a chance for Chinese firms to take advantage of the currently strong speculative H-share prices. Arthur Kroeber, the Managing Editor of China Economic Quarterly believes that the IPOs are little more than a capital raising strategy for Chinese companies offering foreign investors little in the way of returns. It is true that dividends to date have mostly been paltry with little sign of significant share price appreciation in the near future and investors being afforded little influence over company behavior. Consequently we can expect more post-listing scandals such as that that affected the Bank of China’s Hong Kong division last year.
The test will be whether China’s listed companies can actually start to generate significant profits to provide decent dividends. Prior to the H-share rally things had not been going so well, indicating an alterative scenario for the forthcoming IPOs. In the first half of 2003 four major Hong Kong or US IPOs were canceled: ZTE Corp, the Shenzhen-based maker of telecoms equipment; property developers Shanghai Forte Land Co (trying again in 2004) and Soho China Ltd; and Guangdong Guangdian Power Grid Group, the electricity transmission company controlled by the provincial government.
According to Barron‘s magazine, a sister publication of the Wall Street Journal, of 208 offshore open-ended mutual funds focused on China in the five years to April 1st 2003, the average China fund lost 4.2% a year. A US$1,000 investment in these funds in 1998 would be worth US$807 today – not the story China wants people to hear. The five-year return for 23 US-based China funds was only a slightly less miserable negative 3.7% a year, reducing an original US$1,000 investment to US$828.
The major problem has been production overcapacity – Chinese listed firms have clearly done a terrible job generating profits. To be fair, this mismatch between economic growth and corporate profits is Asia-wide, though China is by far the worst offender. Outside China and Asia, corporate earnings outpaced nominal GDP growth by two percentage points in the same period.
The rush of foreign money into China then is clearly driven by China’s GDP growth rather than company fundamentals. A major problem for many analysts, such as Adrian Mowat, JP Morgan’s chief Asian strategist, is that Chinese companies tend to take their IPO money and run. This may change as investors start getting grumpy – China Mobile’s announcement in 2003 that it would pay out a higher than expected maiden dividend (20% of profits) suggested that maybe Chinese firms are beginning to get the message that simply living in a fast-growing economy is not enough (though China Mobile’s dividend was still a rather parsimonious yield of 1.9%).
Higher and guaranteed dividends would certainly be something that would encourage potential investors in Mainland companies over 2004. Mowat notes that when Chinese companies have a dividend policy at all, it is typically a ‘lazy’ one, guaranteeing the payout of a specified percentage of profits. But if profits take a dive, so do the dividends. A stronger policy would be one guaranteeing larger absolute dividend payouts annually, thereby forcing management to deploy its capital more efficiently. China Mobile says that this is what it intends to do. Investors will have to wait and see if intentions become reality.
So what should those looking to capitalize on China’s growth do? Though analysts such as those at Templeton Funds or CLSA and many others will continue to buy into China others are following the advice of analysts such as Kroeber who advise buying into those companies from Hong Kong, Taiwan, South Korea and Japan who are benefiting most directly from China’s growth and have higher standards of corporate transparency and better dividends. However, those investing in H-shares are doing so largely speculatively, as they have for over six months now, rather than on decisions based on company fundamentals.
Stephen Green, at London’s Royal Institute for International Affairs and the author of the recently published China’s Stockmarkets (2003, Economist Books), also believes that the H share speculation will continue and lead to the enlargement of what is now clearly an H share bubble. Green further adds to Kroeber’s comments that the smart money is starting to move towards foreign companies prospering in China noting that most of the clever investors are already selling China stocks, including most of the Mainland money in Hong Kong.
It is important to note that while this may be a Mainland shares speculative bubble, it is different from the dotcom bubble that soured so many investors a few years ago. Companies like PICC and other recent listees such as Greencool and C-Trip do have revenues and in the case of the future insurance, bank and other IPOs will continue to generate revenue streams. The issue is one of profit margins and significant dividends rather than the relative business sectors of the listing companies.
The rate of IPOs is expecting to continue in 2004 though some companies are now raising the spectre of delaying due to pending lawsuits (in SMIC’s case) or other causes such as the bird flu outbreak. SMIC had initially planned to launch IPOs in Hong Kong and the Nasdaq to raise US$500 million-US$1 billion.
Speculation rather than fundamentals will continue to be the investment theme in 2004. The so-called ‘alphabet soup’ of different share classes, trading at different prices in different markets under different regulators in China and Hong Kong means that it is impossible to determine the true value of any listed Chinese company. Because of the impossibility of valuation, and the continuance of majority state ownership, the markets do not provide effective discipline and listed companies do not provide reasonable investment returns.
The bottom line
Eliminating different share classes is essential for the development of true equity markets in China, though there is little immediate prospect of this. However, while this may be a problem for investors, the new wave of China listings should be successful in keeping SOE reform going, something that needs to happen if the longer-term reform program is to remain on track.
As a capital raising tactic, IPOs have been highly successful – through 2002, nearly 1,300 companies issued A-shares raising US$82 billion and a further US$4 billion in B-shares. Overseas sales of H-shares and Red Chips raised a further US$
43 billion for a grand total of US$129 billion. And these numbers do not include the value of legal person and state share ‘transfers’ for which systematic data is not available.
The big question is whether once Mainland companies reap the financial benefits of an IPO they then focus on shareholder value and profit or simply continue to demonstrate how good they can be at destroying capital.