Why No One Trusts China's Markets
When China's top securities regulator said recently that it plans to delist Dandong Xintai Electric Co. for falsifying initial public offering documents, it didn't grab many headlines. But it suggested some far-reaching changes may be afoot.
Xintai is the first company to be expelled from Shenzhen's ChiNext board for such an offense, and one of only a handful that have ever been delisted in China. Its expulsion suggests that regulators are facing up to some unfortunate truths about China's capital markets.
Those markets are, in important ways, only superficially market-like. In the stock market, the government has intervened on a huge scale to prop up prices. Investment in the bond market is overwhelmingly directed to state-owned enterprises. There's no derivatives market to speak of. Financial disclosures are often implausible, suspicions of insider trading are rife and doubts about corporate governance are widespread.
All these are symptoms of a common ailment: a regulatory system focused not on disclosure and market mechanics but on setting asset prices and allocating returns.
In most countries, when companies are considering an IPO, regulators require them to accurately disclose information, then let markets dictate prices. In China, the reverse holds true: Regulators assess a company's balance sheet and history, mandate an offering price, and then let the market figure out who might be lying or hiding things.
The result is that investors, both domestic and foreign, have lost confidence in China's markets. Foreign portfolio investment into China is down 60 percent, year over year, through July. MSCI Inc. has repeatedly declined to include China's domestic equities in its benchmark indexes. Even the much-celebrated Chinese retail investor is staying on the sidelines: Individual investment accounts holding less than 500,000 yuan declined to 46.8 million last month, from 47.4 million in July 2015.
This credibility deficit affects all areas of the markets. Major Chinese commercial banks have been trading at a price-to-equity ratio of about five -- compared to an average of about 12 for commercial banks elsewhere -- because investors think their loan portfolios are much worse off than they're letting on. A newly approved Shenzhen-Hong Kong stock-trading link could give foreign investors access to some of China's fastest growing tech firms, but they'll stay away if they don't trust the data.
The delisting of Xintai suggests that regulators are finally taking these pernicious effects seriously. But there are a few things they still need to address.
The first is to focus on creating high-quality markets rather than setting low-quality prices. That means, above all, forcing companies to come clean about their finances in public disclosures. Accurate disclosure, in turn, means that bad news will come out, whether it's recognizing higher levels of non-performing loans or admitting to declining profitability. For regulators, that's nothing to fear.
Finally, China needs market mechanisms that support price discovery, transparency and trading. Too often, Beijing equates high prices with a well-functioning market. China will never become a dominant financial center if traders don't trust that the playing field is level.
Just as investors can no longer rely on double-digit economic growth to bail them out of bad decisions, China can no longer rely on ever-rising stock prices to attract new cash. If the crackdown on Xintai is any indication, China's regulators are coming to accept an annoying fact about markets: To work, they have to go down as well as up.
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