China's Bourses: Stock Markets Or Casinos?

They're still roller coasters of instability -- and change may take some time

When shares of Han's Laser Technology Co. began trading on June 26, it was a red-letter day for the Shenzhen Stock Exchange, which hadn't seen an initial public offering since October, 2000. But the joy was short-lived for any investors who had been hoping for more than a speculative pop from the stock. After soaring 367% on its opening day of trading, shares of the Shenzhen maker of laser markers deflated by the maximum 10% limit the next day -- and the next, and the next. By July 7, Han's Laser was nearly 50% off its high and, though still above its offering price, showed no signs of stabilizing. Such volatility "doesn't have any meaning at all," says a Han's Laser spokesman. "It only reveals speculation." To experts, the stock was acting just like the market in which it trades. "It's like a casino," says Zhang Qi, analyst at Haitong Securities Co. in Shenzhen. "Everybody's speculating."

Indeed, Shenzhen and the larger Shanghai Stock Exchange both have a reputation for being little more than short-term trading dens that scare away serious investors. That's a problem, because China has a pressing need for stock markets capable of efficiently allocating capital to its fast-growing industrial base. As in the 1990s dot-com boom in the West, nothing exposes the instability of China's markets better than IPOs. Seven other companies made their debut on the Shenzhen market the same day as Han's Laser. Each rose an average of 129.9% before beginning a downward spiral.

The stock-flipping behind these gyrations, by both brokers and retail punters, even has a name: chao gu, which translates roughly as "stir-fried shares." Fundamentals? Some companies have them, some don't. (Han's Laser, for its part, is profitable, boasting net income of $4.44 million last year.) No matter: In the 13-year history of the mainland bourses, the initial success rate of IPOs has been almost 100%. Last year the average first-day gain among the 64 new listings in Shanghai was an eye-popping 72% -- and last year was a bear market. Most quickly lose altitude. One exception: China Yangtze Power Co., whose shares have climbed steadily since it debuted last November. But trading in new stocks is typically purely speculative. Almost no one in these markets thinks of buying and holding stocks -- a sure sign of an immature market.

BRING ON THE FOREIGNERS

What can be done to create authentic market conditions? The China Securities Regulatory Commission has been declaring its good intentions since it was created in 1992. But the agency has been hampered by its inexperience and lack of independence -- it is basically an arm of the State Council, China's all-powerful Cabinet. Plus, the markets were established solely as a way for state-owned companies to privatize, not as a way to raise money for deserving companies. (The CSRC did not reply to faxed questions.)

One strategy authorities are pursuing to strengthen Chinese bourses is to allow in foreign investors. The theory is that with foreigners demanding higher standards for listed companies, trading will become more regular and IPOs more thoroughly vetted, and the reputation of the exchanges will improve, making them competitive with rival Hong Kong. Thus, under the Qualified Foreign Institutional Investors program, which began in May, 2003, foreign institutions may now invest directly in the $500 billion A-share markets of Shanghai and Shenzhen, which were previously off-limits.

But things are off to a slow start. According to the State Administration of Foreign Exchange, out of $1.8 billion in foreign investment capital approved at the end of March and earmarked for financial investments, only 63% has gone into securities and convertible bonds. The rest is parked in bank deposits. Most foreign fund managers find slim pickings among mainland equities and have concentrated on 50 to 100 stocks from the 1,300 available. "There's certainly nothing like HSBC (HBC ) or General Electric (GE ) or IBM" says Mandy Yang, general manager of China International Fund Management Co. in Shanghai, JPMorgan Fleming's joint venture with Shanghai International Trust and Investment.

The IPO practices on the Shenzhen and Shanghai exchanges are especially exasperating. For one thing, the shares are priced according to a rigid formula dictated by the government, so that IPO prices bear little or no relation to the underlying fundamentals of the company. Strict rules on who can subscribe to an IPO also create a false scarcity that drives demand -- for a short time. "The IPO market is not really market-driven, it's more regulation-driven," says Nicole Yuen, head of China equities at UBS in Hong Kong, and a member of the CSRC listing committee.

An even bigger problem with China's stock markets stems from the government's reluctance to relinquish control over state-owned enterprises when they list. About two-thirds of all listed companies' shares are nontradable blocks held by state agencies and other state-owned companies. This makes for thinly traded shares, which increases volatility. It also deters investors from taking a buy-and-hold approach, for fear the government will one day dilute their holdings by releasing its shares. One solution under consideration: allow existing shareholders to buy untradable shares at a discount.

Yet the government, despite its vow to fix the system, remains reluctant to unleash real market forces. "I don't think the capital markets have anything to do with risk; they have everything to do with funneling money to state-owned enterprises," says Carl E. Walter, chief operating officer for JP Morgan Chase & Co. in China. This in turn provides little incentive for local underwriters to conduct thorough due diligence on the stocks they bring to market. "It's a joke," says Walter.

With such structural problems, it's hard to see how the mainland exchanges will rapidly mature. But fund managers are quietly exerting more discipline on the market by buying stocks of well-run companies, to which they make regular visits. The number of funds has grown to about 135 since 1998, with some $30 billion under management, representing 5% of the market. Beginning last year, a number of foreign houses, including ABN Amro (ABN ), ING Group (ING ), and JPMorgan Fleming Asset Management (JPM ) have set up joint-venture fund companies. "Mutual funds and more transparent institutional investors have brought some sense to the market," says Joon Lü, deputy chief investment officer at China International Fund Management.

The presence of long-term investors hasn't put a stop to the IPO wildness, but some brakes are being applied. On June 29, for example, Jinan Iron & Steel Group's debut fizzled, closing just marginally above its 76 cents IPO price, reflecting investor concern that a Beijing-imposed slowdown in the steel industry would hurt earnings. A flat IPO? That may be a sign that one day mainland exchanges may behave like real stock markets.

By Frederik Balfour in Shanghai, with Chen Wu in Hong Kong

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