Knowing the owner of a joint is a surefire way to jump the queue. Xinhuanet.com, the website of China’s state-run news agency that announced its intention to IPO in January, may be attempting to take this liberty on a grander scale. It may seek to jostle ahead of private companies such as Tulip Media (Shanghai) and Shanghai Edunburgh Elevator who are waiting in a hundreds-strong queue of IPO hopefuls by flashing its trump card – that its owner is the state.
More than 870 firms are now waiting to list on Chinese exchanges, after the China Securities Regulatory Commission (CSRC) stopped approving new mainland IPOs last October. The move was an attempt to breathe life into flagging shares, after the Shanghai Stock Exchange fell below 2,000 at the end of November for the first time since 2009. By halting IPOs, regulators are controlling the supply of new shares that otherwise might divert badly needed funds from stocks already on the market, while also allowing pent up demand for new issues to build.
However, this strategy will prove little more than a quick fix. The government’s attempts in 2008, 2005 and 1994 to manipulate mainland exchanges have shown that shuttering the IPO doors only causes a temporary hike to share prices. Meanwhile, companies have been left stranded without funding and private equity firms are unable to return cash to their investors.
The CSRC should abandon this futile effort to manipulate the market, instead concentrating on the measures to improve investor confidence – such as policing accounting practices.
One’s fair share
Mainland exchanges began rejecting applicants for larger IPOs last year to prevent new issues from draining liquidity and lowering the prices for existing shares.
“Last year, our application to list China National Building Materials Group Corporation worth RMB12 billion (US$1.92 billion) was rejected … If it had floated, it would have drained liquidity and put downward pressure on price,” said Lisa Tian, Managing Director of the Global Capital Markets division of Morgan Stanley Huaxia, who added that her views did not represent those of her company.
The CSRC also hopes that shutting the IPO mill will improve the performance of new offerings, which have recently become a lot less profitable, when listings does resume. “IPOs do not earn money at the moment,” Tian said. The price to earnings ratio for new IPOs – a metric for valuing a company’s stock – has declined to approximately 30 in 2012, from 71 in 2010, according to Tian.
But history shows that halting listings only provides temporary relief from low share prices and poor IPO performance. The CSRC suspended IPOs four times in the Shanghai Stock Exchanges’ 23 years of operation. During each moratorium, share prices would rise, only to slump again a few months after IPOs re-started. IPO earnings would also spike immediately after the end of a suspension, driven by pent-up demand, but they too would soon slip back to normal territory.
Furthermore, halting IPOs has negative side effects elsewhere in the financial industry. It limits the ability of private equity firms to cash out their investments, according to a report released in January by China First Capital. Approximately US$22 billion remains tied up in 2,200 PE deals completed before 2008, meaning time is fast running out for firms to find a way of returning cash to investors within the five- to seven-year period that is generally promised, the report said.
The halt in IPOs has also been bad news for investment banks that generate much of their revenue from new share debuts. Chinese banks such as Guosen Securities and Citic Securities have been forced into the largest round of layoffs and bonus cuts since the 2008 crisis.
The stoppage also prevents IPO hopefuls from raising the capital they need to expand their businesses. Private companies have few other funding options in China’s undeveloped capital environment, where banks lend primarily to state-owned firms and the bond market is limited to certain industries and cities.
Call to account
Rather than opting for an artificial, short-term boost, the CSRC should instead try to bolster its stock markets by deepening ongoing reforms that can improve investor confidence.
It is unsurprising that confidence in Chinese firms is weak, given the recent slew of widely publicized accounting scandals. Caterpillar’s Chinese unit Siwei and China Public Procurement are just two of many firms that have appeared at the center of financial fraud maelstroms.
China’s poor accounting practices have historically kept larger institutional investors away from Chinese stock markets. In 2011, Societe Generale said they would avoid Chinese IPOs in part because they could not rely on the published financials of the candidates.
“There is a pretty serious issue with false reporting,” said Tian of Morgan Stanley Huaxia. “Typically, many [Chinese companies] use internal transactions, or create fake transactions and record them in the financial statements in order to meet requirements for listing, as they have to show growth.”
To deal with these accounting irregularities, the CSRC has introduced measures during the hiatus to tighten China’s IPO approval process. The regulator requested on January 8 that the auditors and accountants for listing hopefuls review their clients’ financial statements and said they would carry out spot checks. Then it began cracking down on violations during last year’s IPOs and fined sponsors on January 28.
These steps will go some way towards improving investor confidence. “It will not be 100%, but it’s definitely an improvement, yes. The measures will improve the overall quality of the candidates,” said Zhao Xiaohong, a capital markets partner at Chinese law firm King & Wood.
The tighter supervision of accounts will also have the added benefit of attracting institutional investors, such as Societe Generale, whose presence will help relieve volatility in mainland markets. According to CNBC, retail investors account for 80% of the turnover at the Shanghai and Shenzhen stock exchanges, whereas institutional investors tend to dominate exchanges in developed countries. In contrast to retail investors, who pursue short-term gains that cause stock prices to fluctuate, most institutional investors adopt a long-term buy-and-hold approach that leads to greater stability.
However, some regulators are getting in the way of the CSRC’s self-proclaimed goal to tighten accounting practices and bring the country’s finance system up to global standards. In May last year, the Ministry of Finance essentially shut out international auditors by demanding that four of the largest global auditors spin off their mainland operations to Chinese partners. It also restricted such firms from hiring overseas staff, a seemingly protectionist move on the part of Beijing. To instill global trust, the government should instead be pursuing the opposite path and widening the scope of work done by international auditors who adhere to recognized standards, not reducing it.
An efficient stock market that breeds investor confidence – one where shareholders don’t need to worry over potential fraud – hinges on the availabil
ity of verified financial information. Beijing needs to comprehensively strengthen its supervision of the accounting practices of Chinese firms, both those that are seeking to list and those that are not. Otherwise, the hundreds of firms queuing for IPOs that finally do gain approval to list will have waited in vain, as they step onto an exchange that performs just as poorly as it did before.