CHINA’S EQUITY MARKETS, PART II

By Gordon G. Chang

In China, there is always progress. In January of this year the People’s Supreme Court, China’s highest judicial body, made permanent a ban on shareholder suits against market manipulation.

It may be no mistake that market manipulators are beyond the reach of shareholders, because the biggest manipulator of them all is the central government. If there is a single reason why China’s domestic stock markets don’t work well, this is it. Experts may see the markets as a mechanism to efficiently allocate capital, but Beijing created them as a way to sell off chunks of state-owned enterprises. So the central government, in its dual role as regulator and largest market player, delays necessary reforms when they threaten its ability to sell stock of state enterprises to investors.

As a result, stock prices are kept at abnormally high levels. Chinese stocks in domestic exchanges normally trade at price/earnings ratios well above those in markets outside the Mainland. Chinese stocks trading in nearby Hong Kong, for instance, can be found for ratios under ten. A few miles across the border in Shenzhen the prevailing ratios are five or six times higher on average. Stock prices in China can be more than ten times net asset value, and some high fliers have no net asset value whatsoever. It is a gravity-defying act.

And a dangerous one. Beijing’s leaders are constantly concerned about falling stock prices, in part because of the fear of angering tens of millions of shareholders. And there is every reason to be concerned. “Their markets are an accident waiting to happen,” one broker said, referring to the exchanges in Shanghai and Shenzhen. “They’re like Nasdaq in 2000 or Japan in the 1980s.” A steep fall, maybe even a small one, could spell trouble: According to a recent survey, the average investor commits to the markets a sum close to twenty-three times his annual income.

HOUSE OF CARDS

So far, the central government has kept the markets aloft. It cannot do so indefinitely. China’s social welfare system is almost bankrupt. In the years ahead, Beijing will need to come up with about US$1 trillion, and maybe even more, to make up funding shortfalls. To resolve the problem, Chinese technocrats have devised a general concept that should work: sell more stock of state enterprises. The state still owns a majority of the shares of listed companies, some 70 percent according to state media.

This concept was translated into a State Council plan, announced in June of last year, which essentially required companies selling stock on public markets to sell additional shares equivalent to 10 percent of the original offer size. The proceeds of the additional share offerings were to be handed over to the national social security fund. The rules applied to both domestic and foreign offerings.

In reaction to the June plan, the markets tanked, losing more than 30 percent of their value, some US$181 billion in market capitalization. In October, the CSRC suspended the plan to sell off state shares. Markets soared after the CSRC withdrew the plan: Stocks immediately hit their maximum 10-percent daily ceiling.

Reversing course solved the sinking prices issue, but did nothing about the original problem. But Beijing is nothing if not persistent. Just when technocrats thought that it was safe to reintroduce their plan to sell state shares, local stock speculators proved them wrong. In late January of this year, over a weekend, the CSRC announced several proposals to unload state-held shares. The following Monday (January 28) saw domestic markets plunge across the board–the indexes fell between 6.3 percent to 8.7 percent that day. By Tuesday the CSRC was in “damage control mode” and announced that the plan was only “preliminary” and that “a lot of improvement needs to be made through further discussions.” Stocks, predictably, went back up on the new announcement.

“The hasty introduction and suspension of the scheme, though both well-intentioned, are indications of the CSRC’s inconsistent governance of the market,” wrote People’s Daily. The Communist Party’s paper is correct, of course, but the essential problems are deeper than indecision.

AND THE WIND BLOWS

For one thing, Beijing is finally paying the price for operating wacky markets. “The plan’s fatal problem is that it is based on the premise that the market is operating stably,” said Wang Yuanhong of the State Information Centre. “But we don’t have such a stable market now.”

Even if the markets worked in general, the CSRC plan would not have fared well. The technocrats have little, if anything, to show for all the turmoil they’ve caused in the markets. They were in denial about one of the fundamental building blocks of economics: the law of supply and demand. No one, no matter how much he may think of his own abilities, can announce a plan to sell hundreds of billions of shares without causing a severe adjustment in prices.

The CSRC did say in January that it would compensate existing holders of shares for price declines. The details on how it would do so, however, were sketchy. Apparently, the regulators thought that their good word was good enough to keep the markets high. But credibility has nothing to do with simple economics. “No matter how the reduction is carried out, it means big market expansion,” said Dong Chen, a China Securities analyst. “The plan offers no way to introduce new capital.”

As even CSRC officials have learned by now, sales of state shares at market value will take too much liquidity out of the markets. They could soften the blow by letting go of new shares for something less than prevailing prices. But selling below market, unfortunately, is not considered an option for two reasons. First, there is a matter of finances. “The state needs cash,” says Anthony Neoh, senior advisor to the CSRC. Second, there are politics and ideology. Selling at a low price would look like a giveaway of state assets, dynamite in today’s China, at least among the senior cadres who care about these things.

Because the good options are not options, the CSRC can say only that its sell-down plan will be implemented gradually. But gradualism will not work. The impact might be delayed, but the outcome will be the same. Traders know that the shares will have to come onto the market sometime. “This isn’t going to work,” says Mou Xudong, an analyst at Southern Securities in Shanghai, speaking of the CSRC’s January plan.

The Chinese markets exist in the worst possible of worlds. On the one hand, China’s social welfare system remains “on the verge of bankruptcy.” And on the other, China’s equity markets are, in the words of analysts, “on the verge of collapse.” Investors know that the share sell-down plan is coming, and the uncertainty is making the situation even worse. “It would be very hard for the markets to stage a solid recovery until the final selldown plan is revealed and clarified,” says a stock analyst. Simple common sense.

AND THE CARDS FALL

The current situation is untenable, at least in the long run. On the one hand, there is no doubt that Beijing can keep stock prices high in the long term. After all, it sets the rules and administers the game. So it mostly gets the desired results. In the future, it can continue to employ all of the old tactics to support the markets.

On the other hand, all of its proven tactics just defer the change that must occur if China is to achieve important, and some say critical, goals. There is, after all, no point in having stock markets if they do not allocate capital efficiently and thereby promote economic development.

And what is the future of the markets? There will not be much progress over the next few years: Beijing, even at this late date, is unwilling to endure pain. What forward movement we will see will come about only because the government will not have a choice. We have to remember that in this period of political transition in Beijing, even economic reforms are being put on hold.

If the central government reforms the domestic markets, Chinese issuers will issue at home. If it cannot, they will have to issue abroad. Because reforms will be slow in coming, we will see a stream of initial public offerings abroad, most of them in Hong Kong but many in the United States as well.

And there are other reasons why Chinese companies will list outside the Mainland. Jiang Zemin himself is giving an impetus to domestic enterprises to list abroad. His “go outside” theory is being interpreted by local cadres as approval to have their best enterprises sell stock overseas, which is easier than listing on the domestic exchanges. Famous economist Nick Lardy supplies the reason why the better companies will have to continue to go offshore for at least the next few years. “Very large issues are not possible on the domestic market,” he points out. “The continuing paradox is that a country with the highest rate of savings in the world… can’t float a share offering of significant size on its domestic market.”

As efforts to increase offerings at home fail, the state will seek to increase the flow of stock sales in foreign markets. For example, last Christmas Eve the State Development Planning Commission announced a plan to encourage overseas listings, even hinting that foreigners would be allowed to hold controlling positions in large state enterprises. Even the central government knows the truth by now: its markets don’t work.

Shanghai entrepreneur Chen Rong knows why the markets have not yet been fixed. He has, after all, made more money from stock trading in China than almost anyone else. The exchanges are “irregular,” he tells us. They were “irregular” when they were established more than a decade ago and they are “irregular” today. Because Beijing has not been able to make much progress, there is only one conclusion. In Chen’s words, China itself is “irregular.”

Gordon G. Chang is the author of The Coming Collapse of China, published by Random House.