Threat from the west
Chinese alphabet soup
CHINESE SOVEREIGN DEBT’S arrival at a lofty A1 credit rating with a paltry spread to US treasuries of roughly 50 basis points is a shining example of the bullish frenzy among global investors for all things emanating from the People’s Republic.
Whether looking at systemic risk, inflation, GDP growth, or the trade surplus, the fundamentals underpinning the fixed income market – and to a large extent the nascent private-equity business – propel China to the top of the “hot markets for the 21st century” league tables.
An investor willing to take on risk in the search for yield will find far juicier pickings – albeit with more potential for downside volatility – in the US corporate bond market. In short, Chinese sovereign debt, according to market prices, is actually safer than US corporates.
In stark contrast, though, one need only look at the local equity exchanges in Schenzen and Shanghai to find a massive stagnant swamp of uninvestable companies, corrupt and opaque corporate governance, fictitious accounting numbers and a layer of Soviet-style regulatory restrictions. While fixed-income markets hover near an all-time high, Chinese domestic equities have recently fallen close to an eight-year low.
A complex array of issues has impeded any substantial Chinese equity market development. The market’s convoluted shareholding structure is one problem [see Chinese alphabet soup, this issue]. Although China has steamrollered towards privatization, there are still a huge number of state-owned enterprises holding non-tradable shares that create a potential tidal wave of dilution and a huge glut of unsold shares. For most equities, standards of transparency and corporate governance, particularly when it comes to the accurate reporting of accounts, have improved little from the communist era.
“The stagnation of the Shanghai composite, down about 50% since 2000, simply reflects a lot of the localized market problems – a huge overhang of state-owned shares, poor regulatory structure, lack of corporate transparency or internal controls... The list goes on and on,” says Steven Champion, portfolio manager for the Taiwan Greater China Fund. “But a lot of these problems may be just an initial stage of development – similar to what Taiwan faced 20 years ago. Trying to get a hold of that Chinese economic miracle for an equity investor is not easy.”
Apart from the state of the regulatory environment, most investors express uncertainty, if not outright fear, about the restructuring being undertaken by the Chinese Securities Regulatory Commission (CSRC), which is better known for its belief in order, control, and stability than investor-friendly commitment to the free flow of capital and protection of shareholder rights.
Regulatory roadblocks
The multiple share classes in China have presented investors with a variety of ways to enter the market. While the original direct route – through the specially designated B shares – was created expressly to increase the foreign ownership base, the qualified foreign institutional investor (QFII) framework has thrown a spotlight on the far larger A-share market. Further, Chinese equities listed in global financial centres – such as Hong Kong and Singapore – can readily provide exposure to the market for more liquidity-oriented hot-money investors. In theory, this multi-tiered share structure might have seemed like a great way to bring under one umbrella different competing interests – control-minded domestic regulators, international investors and reform-minded corporate executives.
In reality, there is now a chaotic volatility of pricing among different shares issued by the same corporate, different underlying regulations, and a lack of institutional investor interest in making sense of it all. Further, the different share classes are non-fungible – it is physically impossible to arbitrage between different shares if an investor believes, for instance, that an equity in class A is overpriced in relation to the same equity in class N.
“If a manager wants to take a view on a Chinese company, then he wants to take a view on a Chinese company – and not try to figure out what is going on with the pricing differentials, liquidity, and regulations behind the A shares versus the B versus the H versus N or whatever,” argues a Hong Kong fund manager. “You get paid to take on firm-specific and market risk. Few are willing to take on, or even fully understand, the complicated inherent risks in multiple share classes – the rules for which may be rapidly changing. The multi-tiered share structure simply acts as a huge obstacle for the free flow of capital and kills any hope for substantial price appreciation for the domestic market.”
As an example of the dizzying array of prices, there are four benchmark domestic indices: Shanghai A and B shares, and Shenzhen A and B shares, whose constituents have significant overlaps. In addition, there is the Hong Kong H-share index as well as the Taiwan Stock Exchange index, which many global fund managers believe is the most effective proxy for China exposure.
Apart from multiple share classes, an enormous overhang of blocked shares haunts the market. The CSRC is faced with a dilemma. Releasing all shares at once might result in a market collapse, like the domino effect that swept Asian markets in 1997, and it is certainly not in anyone’s interest. In fact, Chinese regulators proudly point to their strict market controls as the saviour of the economy during a period when market after market in Asia dived into a tailspin. On the other hand, sooner or later these shares must somehow be sold and traded in the open market. There is only so long that the government can play the contradictory role of marching towards privatization and free market reforms while simultaneously restricting the sale of an enormous chunk of the national economy.
At the start of the year, the government embarked on a long-awaited phased listing programme aimed at allowing non-tradable shares to be released into the market. Phase one took place in May and involved only four companies. Phase two came in August, when about 40 companies were added to the programme. The government is expected eventually to allow all remaining companies with non-tradable shares to participate. When the programme is completed and shares are freely floated, the restructured market should encourage government-appointed company managers to look at precisely what is happening to their company’s share price and, in theory at least, encourage them to show greater respect for the interests of minority shareholders.
On the down side, the immediate effect of this has been to create uncertainty – particularly among foreign investors, who fear a wave of new issues will dilute their holdings. Further, while the CSRC has announced a compensation plan applicable for A-share holders that might suffer significant losses through dilution, it is not clear if there will be any compensation – such as a discounted rights issue – offered to help the investors in all other share classes. Unequal regulatory treatment of different classes, or more important, the enormous uncertainty about the effect of regulatory changes, will certainly stifle or all but kill any near-term hope for a market rebound. In fact, since the CSRC announcements of last August, most foreign investors have been exceedingly reluctant to gamble on the effects of a release of huge blocks of shares on market prices as a whole.
Domestic investors lie low
Traditionally, domestic equity markets, even in most emerging economies, have derived the bulk of their liquidity from domestic institutions – such as mutual fund managers, pension funds and insurance companies. Despite huge advances in the Chinese real economy, such as manufacturing, technology, consumer goods, telecommunication and energy, the financial services sector has just started the painful process of consolidation and reform that, it is hoped, will lead to greater institutional participation in the equity market.
On the retail side, domestic investor interest in the equity market is limited. A recent survey of 20,000 people by the central bank, the People’s Bank of China, reported that just 6.5% were interested in buying stocks while 37.9% said they preferred to put more money in bank deposits, up from 33.4% in 2004. Among the reasons for the lack of interest in equities is that investors have repeatedly been burnt – usually as a result of a botched government attempt at structural reform of the market. Insurance companies are sitting on a huge pool of liquid assets but there are severe restrictions on the amount that they can put into local equities.
The situation contrasts markedly with that in Taiwan. “In Taiwan, initially there was a nearly 90% retail participation rate in the domestic equity market – now its down to 70% with the remaining 30% accounted for by the growth of institutional investors. For major Chinese institutions, to have much more than 10% of their assets in the local market might not only be against regulations, it may also be very dangerous,” says Taiwan Greater China Fund’s Champion.
Corporate governance – back to the USSR?
Although many Chinese equities appear cheap compared with their peer universe on a fundamental ratio basis – such as rock bottom price to earnings and price to book measures – this is highly deceptive. Chinese accounting numbers, particularly among small cap companies, are often more fiction that fact and still based on the old communist system of announcing great and glorious achievements in meeting production quotas. It remains a common complaint among fund managers that there are not enough good companies to buy and that the supply of shares among the quality corporates is in tight supply – and often appear grossly overpriced.
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| Average prices of Shanghai luxury apartments, which made much of New York City look cheap by comparison, have fallen over 20% over the past two quarters. |
“Corporate governance is very much dependent on the existing infrastructure – such as regulatory and enforcement agencies. If you look at past actions by the CSRC and high court decisions, there has been hardly any enforcement and thus almost no incentive for managers to implement good corporate governance,” says Zhiwu Chen, a professor of finance at Yale University. As a case in point, the maximum fine that the CSRC can impose has recently been equivalent to less than $50,000. And there is usually outright collusion and partnership between the local government enforcement authorities and corporate executives. “Given the thin to zero chance of getting caught, and the paltry fines, effectively there is clearly little or no incentive for good corporate governance or respect of shareholder rights,” says Zhiwu Chen.
Further, despite much ballyhoo about progress towards privatization, much of the Chinese economy is operating in the same way as it did in the era of communism. “In China, the corporate governance issue is particularly problematic because of the high degree of ownership of the economy by the central government. “There is a concept of yi gu du da – translated as ‘one large shareholder’ – that still pervades the corporate sector,” says Winston Wenyan Ma, the author of an upcoming textbook on Chinese capital markets. “When the majority of a company’s shares are held by a state entity, then the state effectively controls the company. It is as though there is no visible owner.”
In fact, for the handful of up-and-coming world class corporates, the allure of an international listing in Hong Kong or New York is so great that the local mainland exchanges are usually stuck with third-rate issuers with such stagnant prospects and meaningless accounting numbers that they stand little hope of raising any funds from foreign investors [see Threat from the west, this issue].
Light at the end of the tunnel?
Bin Shi, head of international advisory at Shanghai-based Boshi Fund Management, one of the largest fund managers in China, is often accosted by clients with the laundry list of complaints about the market and asked when, if ever, the market will break out of its stagnation. On a recent trip to Japan, he reminded the audience one of his favourite quotes from Sir John Templeton. “The best time to invest is when there is maximum pessimism in the market,” the legendary international investor said. Shi also likes to point out that China’s prime minister has made it known that he checks market prices every day.
In fact, a recent research report by Lehman Brothers speculates that the Chinese market might soon be at rock bottom. For one, the red-hot property sector might finally be retracting, leaving investors to look for the next dirt-cheap trade. Average prices of Shanghai luxury apartments, which made much of New York City look cheap by comparison, have fallen over 20% during the past two quarters. “After a four-year decline, China’s lacklustre stock market has shown some encouraging signs of bottoming out,” Lehman reports.
In terms of building a sizeable domestic investment industry that will create substantial liquidity, transparency and stability to the equity market, China’s commitment as a member of the World Trade Organization might open the door to a foreign-led revolution. The restrictions on foreign security firms advising private Chinese investors will change at the end of next year, when WTO requirements will let foreign banks compete freely with local rivals. Further, the CSRC has already tabled proposals on permitting commercial banks, pension funds and insurance companies far greater limits on investing in domestic equities.
All this might help move the spotlight for global fund managers interested in China away from New York and Hong Kong and towards the mainland exchanges. According to Jing Ulrich, head of markets for China at JPMorgan: “Many international investors so far have invested in Hong Kong H-shares to gain exposure to China rather than invest in the A-share market. This is because, until recently, the A-share market has been overvalued. But after several years of underperformance, A-shares have finally become attractive for the very first time.”
Despite the regulatory complexities, fear of a softening economic bubble, and the fact that much of the People’s Republic’s corporate governance is still stuck in the era of Mao, there is one indisputable fact: after Japan, China has the largest equity market in Asia and cannot simply be ignored. “Even though there may be a short term oversupply of newly tradable G-shares and perhaps weak prices, at least we can see the commitment by the government to fundamentally reform the market. After reforms, we can expect better corporate governance, greater institutional investor participation, as well as a newly enacted securities law aimed at protecting shareholder rights,” Ma adds. “There are definitely reasons to be optimistic – at least in the medium term.”
Perhaps the best sell for the market in its current state of stagnation is the classic emerging-markets ticket to success: bottom fishing. Chen says: “We have hit rock bottom where the government has drawn the line. At this low level, the government may very well step in to support prices and prevent any further weakening – particularly given the extensive supply of new G-shares waiting in the pipeline that the government is absolutely committed to releasing”.
