CHINA’S EQUITY MARKETS: FLOATING WITH HELIUM, PART I

By Gordon G. Chang

Forget the hype and follow the money. If you want to know the truth about China’s growing equity markets, watch where the green is coming from.

During the preceding three calendar years, Chinese companies raised an average of US$7.9 billion in the domestic equity markets of Shanghai and Shenzhen in initial public offerings. This average, however, masks significant year-to-year changes. In 1999 Chinese companies raised US$6.5 billion in these stock markets. In 2000 that number increased to US$10.5 billion. But last year it fell a whopping 37.1 percent to US$6.6 billion.

To put these numbers in perspective, Chinese companies raised US$1.1 billion on foreign exchanges in 1999 in initial public offerings, US$16.5 billion in 2000, and US$2.4 billion in 2001.

DEPENDENCE ON FOREIGN MARKETS

If nothing else, the statistics show China’s increasing dependence on foreign markets. In 1999 14.5 percent of its funds from initial public offerings were raised in foreign markets. The corresponding percentage in 2000 was 61.1 percent. In 2001 the number was 26.7 percent.

Growing economies need more and more foreign capital, right? The famous Nick Lardy tells us why this should not be true for the People’s Republic. In December of last year the Brookings scholar noted: “China really is fundamentally different from many other emerging markets in that its domestic savings are more than sufficient to finance all of its investment.”

Lardy’s dry words tend to understate the amounts of available capital in the People’s Republic. That capital is truly enormous. For instance, household savings at the end of the first quarter of this year were, according to official statistics, an astounding US$954.1 billion. As large as it is, the official number underplays the true state of affairs because it does not take into account funds left in the custody of the hundreds of illegal deposit-takers.

It should be a simple matter for the equity markets in Shanghai and Shenzhen to put those savings to good use. That is, after all, what stock markets are supposed to do. Unfortunately, however, the country’s stock markets don’t work: They are inefficient and corrupt. They endanger social stability. They are, in a word, failing.

The essential problem is that the Communist Party, having authorized the markets in the era of Deng Xiaoping in the early 1990s, has failed to back crucial reforms during Jiang Zemin’s tenure. Incomplete development has left the exchanges in disarray and Beijing seems paralyzed, unable to do what every observer agrees must be done.

HOW IT HAPPENED

There are a few explanations for this generally deplorable state of affairs. First, state-owned enterprises are powerful in China’s politicized economy and there is virtually no accountability to shareholders. Left to their own devices, managers of these businesses do what they want to: grossly waste resources in a variety of ways. In the past, the state was the victim of this behavior. Now, China’s small retail investors are also losers.

And these investors do, in fact, lose thanks to blatant fraud. In one of worst cases, the major shareholders of Sanjiu Medical Pharmaceutical Ltd. misappropriated US$303 million, almost all the assets of the company. In the eyes of too many managers of listed companies, outside shareholders are there to be fleeced.

Second, the stability of the financial system of the nation could be undermined if the markets worked too well. The country’s banks are in poor shape. Insolvent, these financial institutions are kept afloat by a stream of new deposits from the nation’s small savers. If the domestic markets were really attractive, ordinary Chinese citizens might cash out their deposits to buy stock and reduce the flow of new liquidity that keeps these institutions going. That would be great for the equity markets, but could be disastrous for the nation as a whole. It is true that, from time-to-time, technocrats try to coax a little of the money out of the banks and into the stock markets. Yet at the first sign of trouble, the whole process is quickly reversed: Beijing’s first instinct is to protect these sickly financial institutions, the lynchpin of the economy.

Third, the China Securities Regulatory Commission, the nation’s stock watchdog, seems to be a captive of the industry it is supposed to regulate–this dog just watches all the problems and barks only when prompted. As a consequence, the exchanges of Shanghai and Shenzhen are infested, plagued by market manipulation, insider trading, accounting fraud, outright theft, and a dozen other corrupt practices. The markets are even worse than casinos. “Even casinos have rules and you cannot look at other people’s cards,” said Wu Jinglian, one of the leading Mainland economists, in early 2001. Wu caught some flak in Beijing for that colorful statement, but no one seriously questioned the accuracy of his assessment of the stock markets.

NOT FACING THE PROBLEM

Today, everyone seems to be aware of the problems in the markets, a sign that things are getting better. It is common, perhaps fashionable, for people in Beijing to complain. Deputies at the recently concluded National People’s Congress meeting criticized the CSRC for the mess in the markets as did members of the advisory Chinese Peoples’ Political and Consultative Conference. In the words of the official Xinhua News Agency, the CSRC “should be responsible for the listing of unqualified companies, the falsification of financial statements by listed companies, joint trading of listed companies with their controlling shareholders, excessive speculation and insider manipulation.” But bad practices in the Chinese markets are like the weather: Everyone complains but no one does anything.

The CSRC regulators rail against the situation, of course. Yet, considering all of the misdeeds that occur, extremely few miscreants are punished. Historically, Beijing has tolerated a certain amount of corrupt practices in the markets so as to obtain the political support of the wealthy. Belatedly, the CSRC has tried to reduce the tide of market misdeeds, but only because it has had to.

Financial system risk increased dramatically in 2001 because bank funds were finding their way into the market through securities companies, which were losing money due to mismanagement and corruption. The losses are reputed to have been huge, thereby dramatically increasing the risk of systemic failure. The CSRC finally forced illegal money out of the markets to the tune of US$18.1 billion according to an estimate from Shenyin Wanguo Securities.

The markets did not react well to the crackdown, and the CSRC subsequently backed off enforcing rules according to observers. Moreover, the CSRC has also lost enthusiasm for implementing important reforms as well. Perhaps the most visible retreat occurred this March when the CSRC decided not to impose tough accounting regulations. Instead, it issued a “dramatically watered-down version” of provisional rules issued in December, the last month in the CSRC’s “year of market supervision.” Premier Zhu Rongji can call accounting fraud “a malignant tumour,” but he either cannot or will not do much to cut it out.

So companies try to get away with as much as they can. Guangxia (Yinchuan) Industry manufactured almost 95 percent of its earnings reported in 1999 and 2000. “We all know that the Chinese stock market has a lot of very troubled companies that are propped up by helium,” says James McGregor, a consultant based in Beijing. “You think Enron is bad? You should see some of the companies here.”

Shenzhen-listed Guangxia (Yinchuan) had the dubious distinction of being outed not by government officials but by journalists at the now-famous Caijing magazine. This incident highlights an unwholesome development: Pressure for cleaning up the markets is coming from below and is often resisted by those in authority.

THE FUTURE?

Despite all these problems, those in authority ask us to forget about the present and think about the future. The potential of China’s equity markets is “huge,” says Laura Cha Shih May-lung of the CSRC. There’s no question that the vice-chairwoman of the nation’s stock watchdog is right. But today, her words are a meaningless generality: everything about the People’s Republic is super-sized.

Xie Baisan, a professor at Shanghai Fudan University, gets much closer to the truth. He says that China’s markets are at a “critical point between life and death.” Not everyone would use such stark words, but the facts speak for themselves. Last year saw a drop in stock prices, overall market capitalization, and trading volume on the domestic exchanges of Shanghai and Shenzhen. The money knows that something is wrong.

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

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