The Chinese stock market continues to intrigue and perplex international spectators . While Beijing is experimenting with some corrective measures at a macro level to avoid overheating and bubbles, now seems to be a good time to revisit the fundamentals and study the structure and make-up of the Chinese stock market. The article will address the structural particularities of the Chinese securities markets as well as the historical factors that influence volumes and consequently the current price levels. In China, volumes of stock are divided between different local markets and between different classes of stocks—this fragmentation and the lack of arbitration affect price levels. There are, however, readily available tools for Beijing to address these challenges, for instance, promoting the transformation of “non-tradable” into “tradable” securities. The volume of tradable securities—the “free float”—is still small in China. Continued efforts to make non-tradable shares tradable will increase the free float and bring down the present high price-earnings ratios.
Beijing Policy Styles
The segmentation of markets and of problems in general has over time become a rather common solution for Chinese policymaking. Beijing, while in isolation, often had to solve problems by trial and error, and such trials are better attempted on a limited territorial or sectorial basis, as opposed to a grand design. “Feeling the stones while crossing a river” is an age old adage originating from the ancient Chinese proverb that has been carried over to nearly every walk of contemporary Chinese walk of life.
The vastness of the country and uncertainties with communication lines made it desirable to keep lines of food transport short in order to prevent famines. That same vastness in the provinces, which are still rather unconnected, made it possible to proceed gradually with various reforms in separate regions by trial and error. That was shown when attempts to introduce a bankruptcy law were made in a single province.
The time, however, in which such methods could hold sway, may be close to an end as the country becomes more and more integrated both in a geographical sense and in various sectors of activity, and as policy lines become intertwined. The recent proposal to create a few coordinating “super-ministries” may be intended to foster the linkages between various policy domains (China Brief, January 4) .
The General Viewpoint
If we approach the Chinese stock markets from a more general economic point of view, many imbalances can be observed that for convenience can be labeled as “excesses” (China Brief, December 13, 2007).
Partly because of the absence of sufficient services like retirement plans, healthcare and education for children—after state enterprises were liberated from these social burdens and the “barefoot doctors” disappeared—costs for these services have risen exponentially. Moreover, people feel a need to save more in order to hedge the risks of increasing vagaries in life’s security. An excessive portion of these savings has been going into low-earning bank deposits because no other investment vehicles are available. The banks in turn used the barrage of deposits to finance loans to enterprises, often without sufficient credit analysis and at the party’s directives. As a result, many loans are currently non-performing. The chain continues: too many loans and internal financing are directed towards export industries, and an excessive amount of that export activity is based on foreign technology, which in turn is causing a dangerous level of environmental damage through cement and steel production, in quantities that are not proportionate with what is needed inside the country. The emergence of China as a production platform involves many overlapping variables, which at one time seemed innocuous, but were not well planned and now cause unexpected and unfavorable externalities like pollution and large trade surpluses.
These “excesses” and their corollary “deficiencies” are now being recognized at higher levels of government. Unfortunately, the relevant government offices—often understaffed—have difficulty in disciplining the provincial authorities. This is partially explained by the fact that local public officials see (often unnecessary) project expansion as the best way for their career advancement.
Insufficiencies of the Capital Market
Stock markets, as part of the wider capital and financial markets, suffer from similar fragmentation. For instance, the absence of bond markets in sufficient depth leads to cash hoarding, equity, and real estate investment (International Herald Tribune, September 7, 2007).
Enterprises then rely too much on self-financing. The state-owned firms can do that with relative ease since they did not have to pay out dividends to their shareholders—state or public—and paid little in the form of taxes .
The picture of the Chinese capital market is therefore still one of an unbalanced and not fully integrated system. There is a growing framework of surveying and controlling government agencies in the field, but their cooperation is not always guaranteed. The preference for vertical and “imperial” lines of authority and hesitation about engaging in lateral links and cooperation is still common.
Walls between the Markets
The insularities found with the institutions mentioned above are also visible in the securities markets. There is for instance a division between tradable and non-tradable securities.
The non-tradable securities—which still account for about 50 percent of all shares held—were justified in Beijing by the chaotic and unwieldy privatization process in Eastern Europe. Keeping state property untradable may have been a reasonable measure when looking at the mistakes made in Russia in the 1990s, and the current redirection of some privatization deals by President Vladimir Putin.
The Chinese choice for enterprise reform was to start with conversion of state companies by incorporation. This allowed for increased legal autonomy, clearer responsibility, and introduced the possibility of adopting some further professional forms of corporate governance.
All the while, the shares were kept firmly in government’s hands and safe from private owners. Keeping separate classes of stockholders had its drawbacks, however, in the formation of an open, national stock market.
In recent years, corporations were allowed to negotiate with the owners of their tradable shares ways to convert the remaining non-tradable-shares into tradable shares, or floating shares. The negotiators had to ensure that the previous owners of tradable shares did not suffer losses. Previously, the very prospect of converting non-tradable shares created the fear of an overhung market—a possible tsunami of state-owned shares flooding the markets. The fear of such an inundation of new tradable stocks has kept the Chinese stock market in the doldrums for years. The general economy and the stock market have been highly disconnected in China. When the overall economy was in malaise from 1995-2000 the stock market was booming. When the real economy was booming from 2001 to 2005, the stock market was sluggish .
Only recently has that anxiety been somewhat allayed. A variety of agreements with holders of floated shares to make more “non-tradables” shares tradable has been concluded. Various methods were adopted including providing options and cash payments. By now, most state-owned enterprises have negotiated such formulas to make the non-tradable shares gradually tradable after a lock-up period. The completion of that process however may take many more years. The free float of Chinese stocks is still comparatively very low .
However, if there are still a lot of concerns about Chinese bubbles, many would argue that part of the recent price increases is simply a correction against earlier years’ accumulation of economic woes .
Walls within the Market
Apart from keeping shares divided between tradable and non-tradable securities, there are other insularities in the Chinese system that prevent its various parts from acting like a system of communicating vessels. For instance the Chinese stock market is carved up into locations like Shanghai and Shenzhen, where foreigners cannot deal—until the recent exception made for a few institutional investors—and Hong Kong—where the floated shares are the basis of the American Deposit Receipts traded on the New York Stock Exchange. While foreigners can freely trade on the Hong Kong market, the Chinese investors are kept away in so far as their Chinese currency accounts are not yet convertible.
By keeping the markets in various locations separate, “arbitration” between them is not possible. As a result, the same shares may command different prices in the different locations. Shanghai and Shenzhen price-earnings ratios, in some instances, do not follow logic, but they have their origin in the present fragmented institutional make-up as described earlier.
The shielding of domestic exchanges from international arbitration has lead to less discipline on corporate governance over the enterprises concerned. The Chinese companies with quotations in the United States are usually subject to better governance and often command more reasonable price-earnings ratios . Even then, some forms of “reverse mergers” allow immediate selling of the former owners without a lock-up period. Meanwhile, those Chinese corporations that have not only a quotation in the United States, but are fully incorporated under U.S. laws, are of course fully subject to U.S. governance discipline. Those incorporated under Hong Kong laws and registered in the United States as “foreign private issuer” also have to follow strict U.S. governance requirements.
Ideas of ending the separation of markets are not mute. Recently the State Administration for Foreign Exchange (SAFE) suggested that China was going to experiment with allowing its citizens a limited freedom to deal outside China, namely in Hong Kong, provided that they had an account with the Bank of China in the city of Tianjin.
If that measure had been implemented, the law of communicating vessels could then function. Where Chinese corporations had double quotations, the Shanghai quotation might drop, and the Hong Kong quotations might rise by arbitration. In fact, Hong Kong and other foreign investors have anticipated this. Nevertheless, it seems that there has been reflection and considerable doubt on this idea of opening trading possibilities for accounts in Tianjin. Indeed the proposal still had the characteristics of Chinese policymaking habits. The long accustomed habit of preferring to “crossing the river while still feeling the stones,” and try something out on a limited geographic scale before applying it to the country as a whole. In the current example, the opening would be made only through accounts in the Bank of China and only in the city of Tianjin. In the end, the idea was shelved, since it could have undermined the Chinese long-term preparations for currency convertibility on capital accounts.
In conversations with shareholders of Chinese companies—when this author asked why so few shareholders were present—the typical answer, unfortunately, was that they did not yet have much confidence that their voice would be heard. It was tempting to say: “no wonder” . The Securities Association of China, a trade association of the professions involved, is aware of this general disinterest. It found that of 136 million private individual stockowners, more than 70 percent had a monthly income below $700. “[They] have little awareness of their rights as shareholders. Most of them are just interested in short-term speculation,” said Huang Xiangping, president of the association. A private association for the protection of shareholders does not yet exist (China Daily, January 16).
China stock markets share the general lack of mutual trust, which still characterizes Chinese society today. Investors not infrequently rely rather on speculation and lucky examples. The lack of trust needed for an operational stock market and a flourishing economy goes deep in China. The old authoritarian past and the effects of the Cultural Revolution are still present in modern China. The structure of a stock exchange also depends on an independent press and on shareholder’s active interest, in addition to transparency and trust .
In this field and in other fields of Chinese policymaking, one is reminded of the astute observer of old Datong. Arriving in that city a long time ago, this author was surprised by its vast and high city walls, but even more surprised by the same high and thick walls within the city itself, closing off neighborhoods from each other. Why those high internal walls? Perhaps against fires which might break out in one part and could easily spread to other parts? Or could the prudence be aimed at preventing social disturbances, such as riots? With high walls inside the city, the authorities could close off parts of the town and send in either the fire brigade, or their soldiers.
This view of old Datong, a city in the northern Shanxi Province in China, resonates when one sees the Chinese predilection to carve up big fields into small segments, and to install division gates in various domains of policymaking. The habit of segmentation is still engrained in the system. The time, however, when that was a possibly prudent strategy is no more. Many lines of policymaking are now intertwined and require cross-sectional management. It is high time for the “Datong internal walls” syndrome to end.
1. In the 1980s, the author spoke in Beijing and Shanghai publicly on the history and basic requirements for any successful stock exchange. This was done at a time when that topic was generally dealt with in whispers and in some academic circles.
2. Jianwu He and Louis Kuijs, “Rebalancing China’s Economy—modeling a policy package,” World Bank China Research Paper no. 7., September 2007.
3. The OECD now sees and applauds Chinese initiatives in increasing corporate taxes.
4. Jonathan Anderson: “Bling! Bang! Boom! China’s stock markets zoom. Far Eastern Economic Review December 2007
6. See Cao Hong Hui and Yan Xiaona, “Recent Development of Macro Economy and Finance in China,” World Bank Working Paper.
7. One of the bad habits, which tend to creep in locally, is insider dealings associated with the Initial Public Offers. In many IPO’s, large amounts of stock are allocated to friends, who count on immediate hefty gains in the stock market on the first day of trading. The stocks then are very quickly sold and the difference pocketed.
8. When the author attended a Chinese company shareholders’ meeting, he was told that these function seldom see a foreign shareholder. The company is one of China’s big power providers, quoted on the New York Stock Exchange with a market value of $3 billion. In spite of being there in person, the author was given a proxy form, and told that one of his neighbors, who represents one of the big government related financing institutions supporting the company, was going to represent him in any voting, since the representation of all American Depository Receipts was entrusted to that company. If the procedure followed in this instance was according to rules, one wonders why holders of “American Deposit Receipts” receive any invitation to participate in such meetings. If in other Chinese companies the experience should be similar, one wonders whether sending invitations to holders of ADR’s of Chinese companies is not useless.
9. Alain Peyrefitte has shed light on the need for trust in a modern economy “La societe de confiance, essai sur les origins et la nature du developpement.” Odile Jacob 1995.