Amid China's Crackdown, Securities Reform Quietly Gathers Pace

  • Worries about leverage push China to reform its IPO regime
  • China seeking more institutional investment in stock market

Brokerage executives have been detained, futures markets have been more or less shut down and tougher rules may squeeze out algorithmic trading. Yet behind the scenes, China’s securities market reforms are picking up speed again, six months after being set back by a $5 billion equities rout.

Among the signs of change: two foreign banks are close to getting securities licenses, discussions have been revived about a new stock market board in Shanghai for technology startups, and legislative approval for a more flexible system of approving initial public offerings could come as soon as this month.

Chinese officials may be more confident about reviving the reform agenda after stocks rebounded, with the Shanghai Composite Index up 20 percent from an August low. Meanwhile, concerns about a ballooning debt burden are prodding China’s reformers to allow greater access for foreign securities firms and to speed up plans to make the IPO market more efficient, providing relief to capital-hungry companies.

"The government is back to pushing for reform in the capital market after the
efforts were sidetracked by the market rout," Scott Hong, a Hong Kong-based analyst at CIMB Securities Ltd., said. "For next year, we can expect the start of IPO registration system and more opening of the securities industry to foreign players."

Borrowing Spree

What is different now, compared with the reform push that ground to a halt during this summer’s market swoon, is a more stringent attitude toward leveraged investing and short-selling. Unwinding of margin debt added to turbulence once the stock market faltered, and authorities have blamed tactics such as short-selling for worsening the rout. In a short sale, an investor bets on anticipated declines by selling borrowed securities, hoping to buy them back later at a lower price.

Stock market investors went on a borrowing spree earlier this year, pushing margin finance to a peak of more than 2 trillion yuan ($310 billion) in June and drawing on unofficial funding sources such as online lending sites. With China’s financial markets still largely insulated from the outside world, the leverage helped inflate a bubble that burst in June.

"The capital market is still not fully-functioning to optimize capital allocation," said Lu Wenjie, a Shanghai-based strategist at UBS Securities Co. "Investors face restrictions to move capital freely across the border, and have limited investment options in the domestic market. All these exacerbate the distortion in credit risk pricing and the bubble in stock valuation."

After largely sitting back while leveraged investing drove share prices higher in the first half of the year, China’s regulators have now cracked down, banning online lending for stock purchases and imposing tougher margin requirements on loans from brokerages.

Course Reversal

China showed this year that it can quickly reverse course on market reforms and could do so again, if, for example, stocks tumble again. Trading volumes on China’s equity-index futures market, once the world’s most active, have collapsed after regulators raised margin requirements, tightened position limits and announced investigations into “malicious” short sellers after the summer’s crash. Authorities also plan to increase their oversight of algorithmic traders whose strategies were said to have fueled market volatility.

"There’s no question that regulators will loosen up control, but they might adjust and tighten up again depending on market conditions," said Chen Xingyu, a Shanghai-based analyst at Phillip Securities Research.

Leverage Worries

Concerns about leverage are also a factor in plans to streamline the IPO process and give Chinese companies better access to equities funding. With Chinese banks facing rising non-performing loans and increasingly reluctant to lend, domestic bond issuance of 12.1 trillion yuan so far this year is almost double the amount in 2014. At least seven companies have defaulted on bonds this year, up from only one in the years since the onshore bond market started in 1981.

China plans to end the cumbersome process under which the China Securities Regulatory Commission pre-approves terms of all IPOs, and shift to a simpler and faster registration system. The State Council, China’s cabinet, will seek approval from the nation’s top legislature this month to roll out the new system, the official Xinhua News Agency reported Dec. 14, indicating that the new regime could be in place early in 2016.

IPOs Suspended

The need for capital has meant that this year’s shutdown of the IPO market, which lasted from July to November, has been much shorter than the year-long freeze that started at the end of 2012 to combat a previous market downturn. China aims to lift the contribution of so-called direct financing, which includes equities and bonds, to one-fourth of total funding by 2020 from less than one-fifth in 2014, People’s Bank of China Governor Zhou Xiaochuan, wrote in an article last month.

"The government didn’t give up on its big plan for the stock market, which will help companies get financing and the economy transform into a more sustainable model," said Polar Zhang, a Beijing-based analyst at BOC International Holdings.

The predominance of retail investors, which account for about 80 percent of the equities market, has been another factor spurring volatility. Plans for a link between the Shenzhen and Hong Kong stock exchanges, mirroring the link between Shanghai and Hong Kong, as well as a program to allow fund sales between Hong Kong and China are aimed at boosting institutional participation.

"There’s still not enough institutional investors in the stock market to provide stability. Letting a mutual fund manage their money is still not a common practice among Chinese retail investors," said Lu at UBS. "Mechanisms such as the Shenzhen-Hong Kong connect and the mutual fund recognition program will help, when the time is right they will be put into good use."

Foreign Firms

The quest for more institutional investment also explains recent moves to encourage foreign banks and brokerages to set up in China. 

HSBC Holdings Plc said in November it would form a majority-controlled securities venture in Qianhai in Shenzhen, benefiting from an economic partnership agreement between Hong Kong and the mainland. Credit Suisse Group AG said the same month its joint venture in China won approval to offer full-range securities brokerage services for the first time, also in Qianhai.

All but two foreign-Sino securities joint ventures are currently controlled by their Chinese partners and their domestic businesses are limited to services such as underwriting stock and bond offerings.

— With assistance by Jun Luo, and Aipeng Soo

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