China Keeps Faith in the Market

Beijing pursues stock market reforms.


The fallout from the global credit crisis has hammered China’s stock prices, but it hasn’t diminished Beijing’s determination to develop its capital markets.

At a time when the West’s faith in capitalism has been badly shaken and governments in the U.S. and Europe have nationalized any number of major financial institutions, China continues to push forward with reforms meant to deepen its equity and futures markets. The authorities have unveiled plans to introduce margin trading and are expected to launch stock index futures as early as this year. They have also moved steadily to reduce the amount of government-held, nontraded shares, a factor that has weighed on the market in recent years. In addition to these direct measures, Beijing has announced a massive 4 trillion yuan ($585 billion) fiscal package aimed at stimulating economic growth and, indirectly, bolstering market confidence.

“Out of this turmoil a healthy and vibrant market will emerge,” declared Fang Xinghai, director general of Shanghai’s Financial Services Office, the local regulator that helps oversee the Shanghai Stock Exchange alongside the China Securities Regulatory Commission, at an investment conference in the city in November.

To be sure, China’s reforms are not a panacea. The country’s regulatory system effectively favors capital markets access for state-owned, Communist Party–linked companies, making it harder for private entrepreneurial businesses to raise capital. And investor confidence has been severely dented by the stock market rout. But it is striking that the government is proceeding apace with efforts to deepen its markets in the midst of a worldwide financial panic — one that has hit China hard.

The benchmark CSI 300 index, which tracks 300 leading companies on the Shanghai and Shenzhen exchanges, has suffered one of the worst falls of any major market in the developed or developing world over the past 15 months. The index was down 68 percent from its October 2007 peak, to 1,862 in late December, after having traded as low as 1,606. The sharp decline has curtailed capital-raising: Chinese companies pulled in a total of $14.9 billion through initial public offerings of stock in the first 11 months of 2008, down 73 percent from the same period a year earlier, according to Beijing-based research firm Zero2IPO Research Center.

The stock market’s nosedive was provoked in part by the government’s efforts to prevent an inflationary overheating of the economy in the run-up to the Olympic Games in August. With growth running at a rate of nearly 12 percent at the start of 2008 and inflation hitting an 11-year high of 8.7 percent in February, the People’s Bank of China tightened policy by raising banks’ minimum reserve ratios five times in the first half of the year to cool inflation.

The equity weakness also reflects contagion from the global financial crisis, effectively debunking the idea that China’s market had somehow decoupled from trends in the developed world. Chinese investors “wake up every morning and see panic selling globally,” and that inevitably affects sentiment, explains Isaac Meng, a Beijing-based senior China economist with BNP Paribas Securities (Asia). “You can no longer consider China’s A-share equities market to be a closed market just because foreign investors have limited access.”

China’s vulnerability to a slowdown in global trade has come to the fore in recent months as the U.S. and Europe have fallen into recession. Growth has decelerated sharply, and Chinese exports actually declined by 2.2 percent in November from a year earlier, the biggest drop in nine years. Michael Buchanan, chief economist for Asia ex-Japan at Goldman, Sachs & Co., predicts that China’s growth rate will drop from 8.9 percent in 2008 to 6 percent this year; that would be well below the 8 percent rate that the authorities consider necessary to create jobs for the estimated 20 million workers entering the labor force each year, according to government economics adviser Yu Yongding. “In China growth of 9 percent is tantamount to recession,” he told investors at a recent conference in Hangzhou organized by BNP Paribas Securities.

Chinese authorities have reversed policy swiftly since the summer in a bid to stimulate the economy, and analysts say the moves should provide indirect support to the stock market. The central bank has eased monetary policy aggressively since September, slashing its benchmark lending rate five times by a total of 2.16 points, to 5.31 percent, and cutting reserve requirements four times.

In November the government announced a huge fiscal stimulus package that officials hope will kick-start the economy. The money is supposed to be given to state-run companies to build affordable housing, power grids and transport projects, but analysts say it’s unclear how much of the package represents fresh spending rather than previous commitments.

“The very large headline number on the stimulus package is basically just a banner telling people that the government intends to do whatever it takes to support growth,” says Arthur Kroeber, managing director of Beijing-based Dragonomics Research & Advisory. “The details will be invented later.”

There is often little direct correlation between economic growth, corporate earnings and stock prices in China. Instead, raw sentiment typically plays a bigger role in driving the market, notes Huang Yiping, chief Asia economist at Citigroup. The average price-earnings ratio on Shanghai-listed A shares hit a historical high of 72 at the market peak in October 2007, but the combination of stock price declines and solid corporate earnings growth for most of the past year brought that multiple down to about 15 as of the end of 2008. The market has been buoyed recently by optimism surrounding Beijing’s fiscal stimulus package and hopes that the U.S. market has hit bottom, says Jing Ulrich, chairman of China equities at JPMorgan Chase & Co. Corporate earnings have started to flag, though; they were down 13.1 percent in the third quarter from a year earlier after having risen 16 percent in the first half of 2008.

Beyond the macro pump priming, the authorities have taken specific measures to support equities. In September the government eliminated the country’s 0.1 percent stamp duty on stock purchases and ordered China Investment Corp., the nation’s $200 billion sovereign wealth fund, to buy more shares of state banks in which it already holds majority stakes.

China has also begun to move ahead with some long-awaited reforms that bankers believe will strengthen the stock market over time. In October the China Securities Regulatory Commission announced that it would allow a few securities firms to begin trading on margin and shorting stocks. Haitong Securities Co., China’s largest brokerage firm by market value, announced in November that it would lend about 4 billion yuan in a pilot margin trading program. Analysts expect that the authorities will give a similar green light to Citic Securities Co., Guotai Junan Securities Co. and Everbright Securities Co. The regulator has set the margin requirement at 50 percent of the purchase price of eligible securities, notes JPMorgan’s Jing.

These reforms are controversial. Zhou Zhengqing, a former CSRC chairman, criticized them in October, saying they could cause panic selling. He argued that short-selling in particular should be avoided. In response the CSRC has apparently put on hold plans to allow short-selling, according to Chinese media reports.

Supporters of market liberalization remain enthusiastic about Beijing’s continuing to loosen trading rules, albeit at a slower pace. The measure on margin trading “shows China’s dedication to financial reforms,” Fang asserted at the Shanghai conference. Gong Shaolin, chairman of China Merchants Securities Co., echoed that sentiment at the same event. “We hope margin trading will be successfully implemented,” he said. “It’s important we proceed with reforms, as it is only through reforms that we can evolve to a higher stage after this global crisis is over.”

Bankers and analysts also expect the government to introduce stock index futures later this year or in 2010, a major development that would for the first time allow investors to hedge their long portfolios or have a low-cost way to boost equity exposure. In anticipation of the move, the China Financial Futures Exchange has been conducting mock trading of a prototype CSI 300 index future.

Beijing continues to address the issue of nontradable shares as well; such shares have had a negative impact on the market in the past. Until 2006 the Chinese government held about 65 percent of the equity in privatized companies in the form of nontradable shares because it wanted to retain ultimate control of them. Such state-owned enterprises make up more than 95 percent of the 1,500-plus companies listed on the Shanghai and Shenzhen exchanges. Concerns that the government might deluge the market by selling some of those shares helped depress stock prices earlier this decade.

In the past two years, though, the government has been slowly transferring some of those nontradable shares to the companies themselves. It has moved about 34 percent of nontradable shares so far and will shift most of the remainder in 2009 and 2010, according to Roy Wang, chief executive officer of Wind Information (Hong Kong), a leading provider of data on China’s stock markets.

“Nontradable share reforms are being implemented and we believe it will be less and less of an issue in the coming few years,” says John Li, the international business officer of China Asset Management Co., China’s largest fund company, with 210 billion yuan under management as of June 2008.

Aaron Boesky, chief executive of Hong Kong–based Marco Polo Pure Asset Management, which has $100 million in assets, shares that optimism. “We are at the tail end of the single biggest challenge to the Chinese stock market,” he says. The overhang of nontraded shares is “significantly less threatening.”

Most companies are holding on to those shares for strategic purposes and are unlikely to sell them, at least in the current climate, analysts say. “Many companies will be using these large blocks of shares as currency for mergers and acquisitions down the road, especially when share prices come up,” says Peter Alexander, founder and principal of Shanghai-based fund research firm Z-Ben Advisors.

The government is also preparing for further privatizations of state-owned banks by injecting cash into two big banks to write off nonperforming loans and ready them for public listings. In October, China Investment Corp. provided $20 billion to China Development Bank, a policy lender to state-owned enterprises that is being transformed into a commercial bank, and another $20 billion to Agricultural Bank of China.

The pace of privatization is likely to be slow, however, given the state of the markets and the fact that U.S. and European governments have been taking over banks and brokerage houses. “Americans have been pushing us for years to privatize, and they’re now nationalizing some of the biggest banks and insurers in the world,” notes Beijing-based securities lawyer Guan Anping, a former aide to ex–Chinese vice premier Wu Yi. “Critics of the Chinese government’s privatization program will use this as an excuse to attack those officials leading privatization. The pace of privatization may slow, but it won’t stop.”

Z-Ben’s Alexander agrees that the financial crisis may retard market reforms in China but does not believe it will deter policymakers from eventual liberalization. “I think senior leaders will just wait for the dust to settle before they move on in the same direction,” he says. “Everything in China has been one step forward — pause — and one step forward — pause again — but never two steps forward and two steps back.”

Even if China does continue to pursue market reforms, there remain plenty of economic obstacles to a quick recovery in equities. The country needs to restructure its economy as urgently as the U.S. does to sustain long-term economic growth and restore the health of capital markets, notes Ha Jiming, chief economist for Beijing-based brokerage firm China International Capital Corp., whose views are often sought by the Chinese leadership.

“We are entering a period of global economic rebalancing, and rebalancing often is associated with bear markets,” Ha explains. “The rebalance will require both the U.S. trade deficit and China’s trade surplus to be reduced to more sustainable levels. In this process firms will see revenues and profits decline. Growth will slow as well. That is why we have a bear market globally, both in the U.S. and in China.”

The stock market would also get a boost if the government stopped giving state-owned, Communist Party–linked companies preferential treatment, including such benefits as easier access to public listings on Chinese exchanges, analysts and economists say. The overwhelming majority of the companies listed on the Shanghai and Shenzhen exchanges are spin-offs of state-owned companies, notwithstanding the fact that private businesses now generate as much as 70 percent of China’s gross domestic product.

“State-owned companies are in general less focused on shareholder returns,” says Erwin Sanft, head of China and Hong Kong equities research at BNP Paribas Securities (Asia). “They are managed by management who are not stakeholders. They tend to be very conservative.”

In spite of the hurdles, foreign investors remain optimistic about the longer-term prospects for China’s companies and stock markets. Marco Polo’s Boesky notes that the Shanghai Stock Exchange has seen four bear and three bull markets since the Communist Party restored the country’s stock markets in 1990.

The exchange fell 75 percent in 1992, only to rebound by 330 percent the following year; stocks then declined 79 percent by July 1994 before rocketing back up 608 percent by June 2001. The market dropped 54 percent over the following four years, then soared 500 percent between June 2005 and October 2007 before falling into its latest slump.

“The stock markets are way down again this time,” Boesky says. “But look at the upside potential. The key is to find the bottom. That’s when you buy.”