China: No stock market revival, yet

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More regulation is needed in China to reverse the decline in stock market prices.

(This article appears courtesy of International Financial Law Review, sign up for a free trial on their site

As readers may recall, the Chinese government implemented the non-tradable share reform in late 2006. In a nutshell, the reform consisted of converting non-tradable shares in PRC listed companies (which were mostly state-owned) to become tradable on the PRC stock market. To obtain the shareholders' approval needed for such conversion, holders of non-tradable shares would offer compensation to public holders of tradable shares who would suffer from the increase in liquidity.

As part of the share reform, holders of the non-tradable shares were also subject to a moratorium of 12-36 months before their shares became fully tradable. Due, in part, to successful implementation of this reform, the PRC stock market enjoyed a strong performance in 2007. Indeed, the Shanghai Stock Exchange Composite Index reached its historical peak in October 2007. However, since late 2007 weak investor sentiment has pushed the stock market into steep decline. To make matters worse, the moratorium imposed on previously non-tradable shares of a large number of companies will soon end, making the market even more nervous.

The effect of this could be big – by some estimates, the value of tradable shares flooding the market in 2008 will amount to about Rmb3 trillion ($430 billion). In response to this looming threat and mounting pressure from PRC investors, the China Securities Regulatory Commission (CSRC) issued the Guiding Opinion on the Transfer of Shares of Listed Companies Released from Sale Restrictions. This was followed shortly by the Operational Guidelines of the Shanghai Stock Exchange for the Transfer of Shares Released from Sale Restrictions on the Block Trade System by the Shanghai Stock Exchange (SSE), which sets out detailed operational guidelines on the transfer of the newly-released tradable shares.

The CSRC Guiding Opinion aims to regulate how newly-released tradable shares could be sold. This includes requiring any sales of 1% or more of the issued share capital to be done through the block-trade systems of the Shanghai or Shenzhen exchanges. These systems are more than just trading platforms – they are reserved for members of the stock exchanges and qualified investors, such as securities brokers and fund managers, allowing for fully underwritten sales of shares, and a mechanism for price consultation with other participants before trading. The SSE Guidelines also restrict the price at which trades can be made through the block trade systems, to ensure that the price is consistent with the market price (and does not push it down). The SSE Guidelines also "encourage" trades for newly-released tradable shares which are below the 1% threshold but exceed 1.5 million shares to be conducted through the block-trade system.

Market consensus is that the CSRC Guiding Opinion and SSE Guidelines were an attempt to arrest the stock market decline, particularly as trades conducted through the block-trade system are not taken into account by the Shanghai Stock Exchange Composite Index. However, it is unclear how effective these new measures will be. Shanghai and Shenzhen stock exchanges have already indentified four cases (one in Shenzhen and three in Shanghai) where the rules have been breached and newly-released shares totalling more than 1% of companies' share capital were sold through normal bid trading, rather than the block-trade system. The accounts were promptly suspended and the CSRC may impose further sanctions. Despite this promptness, investor response to the new measures has been cautious and there has been no sign of real revival in the market. Investors are holding their breath for more regulation to reverse the market decline.

By contributing editor Paul Chow and Zhiyi Ren of Linklaters LLP