New Life for China's Exchanges

For much of their 15-year history, China's Shanghai and Shenzhen stock markets have been regarded as little more than casinos and dumping grounds for dud state-owned companies in need of cash. Insider trading was rampant, and the brokerage industry was plagued by successive scandals and bankruptcies. Most of the bluest of the blue chip mainland companies bypassed local exchanges to list in Hong Kong or on overseas exchanges such as NASDAQ and the New York Stock Exchange.

Serious investors steered clear of the market because of longstanding concerns over what would happen when Beijing regulators eventually unlocked the nontradable shares held by government-linked entities that accounted for two-thirds of the market capitalization of the domestic bourses. That prospect had kept potential investors on the sidelines.

But the past 12 months have seen a change in sentiment. The Shanghai Composite Exchange Index is up 38% this year, while the Shenzhen Composite Index is up 40% so far, breaking a five-year-long bear market that started in 2001. Average daily turnover has soared to $5 billion from $1.25 billion a year ago. "As the market rally becomes more sustained, investor confidence is being rebuilt, demand is up tremendously," says Jing Ulrich, Chairman of China Equities at JP Morgan (JPM).


  The market upturn owes much to the success of government reforms of the non-tradable shares. First came a scheme launched officially last August, whereby minority shareholders would be compensated for the dilution caused when government-held stakes were sold into the open market, and thus become tradable. That eased concerns about investors getting hammered.

On top of that, the whole process of easing the government out of the business of owning huge pieces of mainland companies is happening surprisingly fast. By the end of April, companies representing 65% of market capitalization had either announced or completed reforms that would make government stakes tradable after a one-year lock-up period. The government expects all companies to have reached an agreement with minority shareholders on how to proceed by year end.

Encouraged by the progress of non-tradable share reforms, the government on May 8 announced it was lifting a year-long ban on capital-raising on local stock markets. Initially new cash calls will be limited to secondary offerings, private placements, and convertible bond issues, but the government has indicated it will lift the ban on initial public offerings within the next couple of months. "New offerings means the government feels a lot more comfortable with the current market situation following non-tradable shares reform," says Tian Rencan, CEO of Haitong Fortis Investment Management in Shanghai.


  Although securities regulators are still hammering out the details, new rules for IPOs are expected to more closely mirror standards in more developed markets. For example, in the past, new share pricing was determined by fiat, rather than market demand. So virtually all listings were valued on the basis of a price earnings ratio of 20. Going forward, underwriters will be expected to test the market through the standard "book-building" method used elsewhere. A company's management expertise and financial prospects, not its political connections, will determine the success of its IPO.

Indeed, one of the major drawbacks of China's markets is that the majority of the country's most attractive companies have chosen to list offshore in Hong Kong or New York, putting them off limits to local investors. That is set to change with a slew of planned listings on Shanghai. Bank of China -- which kicked off its road show in Hong Kong where it is expected to raise more than $9 billion -- has said it plans to sell 10 billion shares in a secondary offering in Shanghai as early as the fall. That sale could fetch $3.8 billion (see BW Online, 1/18/06, "The Appeal of Listing in Hong Kong").

Other candidates for multibillion dollar local listings are China Mobile (CHL) and PetroChina (PTR), whose shares trade in New York and Hong Kong. The addition of these well-managed blue chip companies will do much to improve the standing of the local bourses.


  There are other indications that Chinese stock markets are starting to behave more like other exchanges as more sophisticated participants have created much-needed market discipline. "You are no longer seeing just Auntie and the man in the street, you are talking about professional players," says Tina So, chief financial officer of BOC International Investment Managers, a joint venture between Merrill Lynch and a subsidiary of Bank of China.

At the same time, institutional investor participation has grown from zero-levels five years ago, to between 20% and 30%, thanks to the growth in the mutual funds industry. Other factors include a huge capital inflow from insurance companies and state pension funds, as well as the arrival of foreign institutional investors like Goldman Sachs (GS), Citigroup (C), and JPMorgan (JPM), that have been allowed to invest nearly $7 billion in the market under the so-called Qualified Institutional Investor program set up three years back to increase overseas participation in the domestic stock market.

Market watchers expect new funds will continue to pour into Chinese equities. Peng Yuliang, a researcher at state-owned Shanghai Securities points out that the interest rate hike announced in late April has pushed up mortgage costs and encouraged speculators to move from the housing market into stocks. And the combined market capitalization of Shanghai and Shenzhen is just $495 billion, less than a quarter of the $2 trillion in household savings.


  Still, not everyone is convinced that China's markets are problem-free. Uncertainty remains over what will happen when the one-year lock-up period on non-tradable shares is lifted -- even though this will be gradual. The government has indicated it will retain a majority control over companies in strategic sectors such as power, steel, and communications, but it's clear how orderly the disposal of state-owned stakes in other companies will be.

There is also concern that the surge in loan growth and investment in the first quarter could spell trouble further down the road. "Capital allocations are being made independently of economics," says Fraser Howie, co-author of the book Privatizing China. "China is failing to produce meaningful companies and is still dominated by state owned enterprises and duopolies. There is still too much reliance on the state and the Party."

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