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China's A-Share Comeback
The Shanghai and Shenzhen exchanges have roared back to life, thanks to regulatory reforms and more-realistic valuations. Will China finally have a stock market that matches its economic clout?
In recent years the irony of being a struggling fund manager in the midst of the world’s greatest economic boom was not lost on Lü Joon. While China’s output roared ahead at an 8 percent-plus annual pace, exports surged and foreign reserves overflowed, the country’s domestic A-share market tanked. A lack of transparency made it difficult to determine which companies offered genuine growth prospects. And with most corporate equity tied up in nontradable shares held by state-owned enterprises, managements seemed to care not a fig about how their companies’ shares performed.
“Fund managers could not even imagine interviewing top management other than at financial results season,” recalls Lü, chief investment officer at China International Fund Management Co., a joint venture of Shanghai International Trust and Investment Co. and JPMorgan
Asset Management (UK) that manages 11.9 billion yuan ($1.5 billion) in assets.
Lü isn’t complaining any longer. Reforms aimed at solving the problem of nontradable shares have sparked an extraordinary boom over the past year, making China’s A-share market one of the hottest stock markets on the globe. The authorities have lifted a yearlong moratorium on new share issues, opening the way for secondary offerings from leading Chinese blue chips that previously have confined their listings to Hong Kong or other overseas markets. Earnings per share are growing at a double-digit pace. And to top it all off, executives at many companies, newly attentive to their share prices, are even returning Lü’s calls.
“Now it is much, much easier to get access to top management,” he says. “The nontradable reforms were revolutionary.”
The performance of the domestic stock market this year has been no less revolutionary. The MSCI China A index soared by more than 45 percent from January to late August, compared with a rise of not quite 21 percent for MSCI’s BRIC index and a gain of just 4 percent for the MSCI world index. Although prices have eased about 5 percent off their May peaks, the Chinese market notably has avoided the sharp sell-off that hit most emerging markets in May and June. The 2006 surge ended a five-year losing streak for A shares, which posted an average annual negative return of 12.61 from 2001 through 2005.
Other regulatory reforms are also spurring interest in the A-share market. The China Securities Regulatory Commission has unveiled new rules that will allow the short-selling and margin buying of shares beginning later this year. And by the end of 2006, the regulator is expected to approve the trading of stock index futures in Shanghai.
“You can say that the CSRC has redeemed itself,” says Nicole Yuen, head of China equities at UBS Securities Asia in Hong Kong. “They have the beginnings of a good system.”
That optimism is echoed by Paul Bernard, Hong Kong–based head of Asia-Pacific research at Goldman Sachs (Asia). “We’re at the beginning of a radical change to the domestic securities market,’’ he says.
All this adds up to a happy turn of events for a market that has performed fitfully since it was first opened, not least because of the huge overhang of nontradable shares. The problem dates back to 1992 when former prime minister Zhu Rongji, seeking to quell a Shenzhen riot sparked by allegations of corruption in early IPO allocations, required privatizing enterprises to leave two thirds of their equity in state hands in the form of nontradable shares. Today those shares account for 64 percent of the market’s $540 billion capitalization. The holders of nontradables — ranging from the Ministry of Finance to enterprises owned by central, provincial and municipal governments — are typically more interested in maintaining employment or boosting production than in profitability or share price performance.
Two previous attempts at removing this overhang merely worsened the market’s woes. In 1999 the CSRC briefly allowed companies to sell off their nontradable shares, only to order a halt to sales because of fears that the market would suffer. Two years later the CSRC introduced another plan but failed to set clear guidelines on how many nontradable shares could be sold, and when. The market, fearing a deluge of new securities, promptly slumped by some 30 percent.
Seeking to avoid any more setbacks, the regulator decided to take a new approach. Since the spring of 2005, the CSRC has allowed companies to gradually release their nontradable shares into the market if they compensate existing A-share holders for having their holdings diluted. Although specific arrangements may vary, A-share holders typically receive 30 percent of the value of their holdings in compensation, mainly in the form of new tradable shares but sometimes partly in cash.
Companies accounting for 80 percent of the market cap have agreed on plans to sell their nontradable shares. “Our major problem has been solved,” says Lü. “For the first time, corporate China has begun to keep an eye on stock prices, not only at the time they need to raise money, but all the time. After the normalization of the A-share market, now our market can reflect the economic progress we have achieved and are achieving.”
To prevent the market from being inundated with supply, companies are limited to selling nontradables at a modest pace: usually 5 percent within a year of reaching a compensation agreement with A shareholders and then another 5 percent after 24 months. Under agreements reached so far, companies have the right to sell some $9.5 billion worth of shares beginning this year. At that rate it would take decades for companies to sell off all of their roughly $346 billion worth of nontradable shares, estimates Thomas Deng, Goldman Sachs’ China strategist.
By reducing the influence of state-owned entities and getting management to focus on profits and share price performance, the reform of nontradable shares should foster a broader range of corporate finance activity, Deng contends. “We believe this will accelerate corporate restructuring, encourage M&A, introduce strategic investors and improve corporate governance,’’ he says. “This in turn will facilitate the stock market to better allocate resources, as it is supposed to.”
Several other factors have played a part in the market’s recent recovery. The long slide in A shares during the first half of this decade, combined with healthy increases in company earnings, have made valuations attractive once again. Price-earnings ratios of 60 were common at the start of the decade. Currently, they average about 15 for the 200 largest listed companies. Earnings are forecast to rise by 14 percent, on average, this year following 12 percent growth in 2005, says Xu Gang, head of research at Citic Securities Co., China’s fifth-largest brokerage.
“Some investors saw an opportunity to jump into the market,” says Fang Xinghai, deputy director of the Shanghai municipal government’s Financial Services Office, which oversees the development of the city’s financial markets. “Given the huge amount of money in the system, it just needed a trigger.”
Foreign money is also playing a growing role. Under a program launched in 2003, some 39 qualified foreign institutional investors, or QFII, have been awarded quotas to buy $7.5 billion worth of A shares, and the authorities plan to allot an additional $2.5 billion. “When QFII came along it had a big impact — it was like somebody coming along and giving some medicine,’’ said UBS’s Yuen.
The prospect of attractive new listings has given the market a further boost, analysts and fund managers say. Since they were founded in the early 1990s, the Shanghai and Shenzhen bourses have been stuffed with mostly moribund state enterprises while the cream of China’s corporate crop was floated on markets in New York, Hong Kong or other overseas centers. But domestic investors got increasingly fed up at being left with China’s business dregs, and the CSRC reversed its stance on domestic listings in May, when it reopened the market to fresh listings after a one-year ban. It also encouraged leading enterprises with overseas listings to make secondary offerings back home. Bank of China, which raised $11 billion with an initial public offering in Hong Kong in May, became the first returnee when it raised $2.5 billion with a secondary offering on the Shanghai exchange in July. The shares have risen 6.2 percent from the offering price to trade at 3.27 yuan in late August.
More secondary offerings are expected in coming months from blue chips like Bank of Communications, which did its IPO in Hong Kong last year, and China Mobile Communications Corp., which is listed in New York and Hong Kong. Industrial and Commercial Bank of China, the country’s largest bank, plans to make a dual offering in Hong Kong and Shanghai when it launches its IPO later this year; the domestic market is expected to account for as much as $3.75 billion of the anticipated $21 billion that ICBC will raise.
“Think of what’s going to happen to the weighting of the A-share index with entities like Bank of China and Industrial and Commercial Bank of China in there,” says Goldman’s Bernard. “This is the beginning of a multiyear process that will see a total change in the composition of the A-share index.”
The sudden rush of offerings — 21 companies have sold $6.76 billion worth of shares since the market reopening — has raised concerns about investors’ ability to absorb the supply. The A-share index has eased about 5 percent since its May peak. Air China had to scale back its secondary offering in August, to 1.6 billion shares from an intended 2.7 billion, and promise to buy back shares if they fell below the offering price. The shares debuted at the issue price of 2.80 yuan.
“Many foreigners are saying, ‘We’ve made some great returns, so let’s take some money out and reassess,’” says Fraser Howie, Singapore-based head of structured products at CLSA Asia-Pacific Markets, a subsidiary of Crédit Agricole.
The domestic market also continues to suffer from an unsavory reputation. In June the Shenzhen Stock Exchange launched an investigation into suspected price-rigging in connection with the listing of contract engineering firm China CAMC Engineering Co., the first company to issue shares after the CSRC lifted its moratorium. The company’s stock price soared more than threefold on June 19, the first day of trading, to close at 31.97 yuan, then fell the maximum 10 percent daily limit for the next five days. It traded at 15 yuan in late August. The Shenzhen exchange is now investigating more than 1,000 securities accounts at 28 brokerages across China.
“The nontradable reform is definitely a milestone in the development of China’s capital markets. Whether it is a turning point really depends on whether other needed reforms are implemented,” says Shanghai’s Fang. Most in need of reform, in Fang’s view, is China’s weak brokerage industry.
China’s intermediaries are in a big mess. The country’s 130 brokerages posted combined losses of some 15 billion yuan in 2004, and the climate failed to improve last year, when A shares fell 6.7 percent. The government has spent most of the past 18 months bailing out debt-laden brokerages, providing cash-for-equity infusions to most of the major firms, including China Galaxy Securities Co., Guotai Junan Securities Co., Shenying & Wanguo Securities Co. and Southwest Securities Co. An additional 20 brokerages have been shut down over the past three years. Investment bankers estimate that the sector should eventually be reduced to as few as 40 players.
Regulators are encouraging a shakeout by segmenting the industry into brokerages it is willing to support and those that it is not. The preferred group — which mainland reports say includes China International Capital Corp., Citic, Guotai Junan and Haitong Securities Co. — are being allowed to expand into new businesses such as futures, derivatives and wealth management.
“The CSRC is differentiating the good from the bad, and only brokers that meet its standards can apply to expand into new businesses,” says UBS Securities’ Yuen. “Bad brokers will die a natural death.”
In an effort to increase competition and upgrade standards at local firms, the CSRC has authorized the entry of two foreign investment banks. Goldman Sachs paid $94 million for a 33 percent stake in an investment banking joint venture with a team of investors led by prominent deal maker Fang Fenglei; the deal gives the U.S. firm effective control of fledgling Beijing Gao Hua Securities Co. UBS has won preliminary approval to buy a 20 percent stake in, and management control of, Beijing Securities Co., a midsize brokerage with 600 staff, for $210 million. These investments have sparked a backlash from local securities firms, however, prompting the authorities to delay any further market openings (see box).
Shanghai’s Fang says regulators also need to streamline the approval process for new share offerings. The CSRC recently revamped its listings committee to give it more independence, but bankers says the process remains too politicized. After Air China’s disappointing secondary offering, the CSRC decided the committee should not approve new share offerings for two weeks, according to a spokesperson for the regulator.
“The CSRC needs to get out of the way of being seen as an approver of deals,” says CLSA’s Howie. “Ultimately, it has to come to the market whether deals get done or not.”
There is one other missing ingredient that is needed for China’s stock markets to accurately reflect the country’s economic potential: strong private sector companies. “Right now the stock market is still dominated by state-owned enterprises,” says Citic’s Xu. “Do not forget that companies with the most potential are private companies — China’s future Dells, Microsofts and Googles.” Until those companies begin to list, the recent reforms are “a starting point, not a turning point,” Xu contends.
Reform is a never-ending process, though, in developed as well as developing markets. It’s a welcome change that the outlook for the A-share market will increasingly be determined not by bureaucratic shortcomings but by economic fundamentals. And those fundamentals remain strong, fund managers and analysts say. China International’s Lü predicts that corporate earnings will remain strong this year and next because industrial companies are investing heavily in upgrading. “China has accumulated enough capital, and companies are buying better machines and even hiring foreign experts who before only foreign companies could afford,” he says.