Asia Insight

December 2006

China's Capital Markets: A Share of Progress

Lydia So
Research Analyst
Matthews International Capital Management, LLC

In our September 2005 issue of Asia Insight, entitled Liquidity, or the lack thereof, in the Chinese A-share Market, we examined China’s latest attempt to address the problem of "non-tradable shares." These shares, which have historically comprised over half of all stock outstanding in the domestic market, have weighed heavily on China’s capital markets. Regulations have restricted ownership of the non-tradable shares to certain "legal persons," typically either the Chinese government or government-related entities. However, Chinese investors have long worried that should the A-share market perform well, legal persons would rush to cash in, overturning ownership restrictions and flooding the market with their non-tradable shares. Fears of a massive oversupply of stock have thus overhung the market for many years.

A little over one year ago, market regulators announced various guidelines to reform the A-share market, including a mechanism by which legal persons could potentially dispose of their non-tradable shares. Since that time, progress has generally been favorable: the A shares have responded positively to the announced reforms. More importantly, China’s capital markets have continued to open and modernize in a manner that is critical to the ongoing health of the domestic economy.

China’s efforts to reform the A-share market were not new: two prior attempts were made in 1999 and 2001. However, the recent round has met with more success, in large part because it has been deemed market-friendly. One agency was chiefly responsible for spearheading the latest set of reforms, the China Securities Regulatory Commission (CSRC). The CSRC stipulated that before companies could float their non-tradable shares, they were obligated to design a scheme to compensate minority shareholders in the event of a large decline in stock prices. Importantly, companies were given the discretion to design compensation schemes individually, rather than adhere to a single, rigid formula. Even more importantly, the proposed schemes were not deemed valid until they met with the approval of at least two-thirds of all voting shareholders, thereby ensuring that minorities were less likely to be abused in the process.

Four companies were selected by the CSRC in August of last year to test the new guidelines on a pilot basis. Typical compensation schemes entailed bonus shares for minority investors, along with managed timetables for flotation, whereby small blocks of non-tradable shares would be sold off in a staged fashion. As those initial companies met with success, the CSRC quickly named 46 additional companies to follow suit. To date, close to 95% of all the A-share companies have restructured their non-tradable shares.

While the reform process has proceeded swiftly, it has not been without friction, especially in more complex situations. For example, a handful of Chinese companies have stock listed both in the onshore, domestic market (A-shares), as well as markets designated for foreign investors (B-shares and H-shares). No compensation was offered to foreign investors in the B and H markets, prompting some complaints from overseas investors. Also, some "legal persons" – typically the controlling shareholder of the company – have been reluctant to brook the dilution and loss of power resulting from these reforms. This has caused some companies to design sub-par compensation schemes, causing substantial discontent among domestic Chinese investors. Despite these setbacks, the market has responded favorably to the change, as evident in the chart below.

The eventual resolution of the non-tradable shares will represent an important milestone for China’s domestic financial markets. Not only will it remove a major, structural overhang, it will also greatly enhance Chinese companies’ ability to raise capital from the market. Since August 2004, domestic regulators banned new issuance (both IPOs as well as follow-on offers) as a means to stem further price declines. Though the ban was meant to restrict stock supply, and therefore lift prices, it had the opposite effect: new companies and blue chips were denied access to the market, and thus went elsewhere (typically Hong Kong, London, or New York) to raise capital. Meanwhile, domestic investors grew frustrated with the lack of access to quality companies, and thus sent A-share prices lower.

In May of this year, the CSRC finally lifted the two year ban on new share issuance. Between May and November, the A-share market digested 78 offerings (both IPOs and additional offerings), raising $17 billion in total. Five of these offerings were made by large companies that already enjoy listings in Hong Kong; these companies sought to take advantage of the premium valuations afforded to A-shares (typically, A-shares trade at a premium to their B and H-share equivalents). Perhaps most importantly, October witnessed a landmark transaction, whereby China’s largest commercial bank conducted its initial public offering in A-shares and H-shares simultaneously, with prices set at parity. While China’s capital markets remain constrained and segregated in many ways, this transaction suggested an unprecedented degree of integration with global capital markets.

Despite this progress, China’s work is by no means done. Without a fully-convertible currency, China’s stock market is still largely closed to foreign investors, except for a handful that have gained access through a new, but onerous, Qualified Foreign Institutional Investors (QFII) scheme. Meanwhile, domestic investors cannot freely convert their renminbi for foreign investment; hence they are forced to default to A-shares as one of very few investment options. Combined, these factors create a substantial distortion in the supply of and demand for capital, which is neither efficient nor optimal for the long run. However, the cure for this issue ultimately lies in the China’s ability to relax its capital controls.

China faces another challenge: its capital markets, plagued with structural problems like those discussed above, have historically been relegated to a secondary status. As a result, companies became overly reliant on other sources of capital – predominantly banks – to fuel their growth. During the past decade, China’s economy has averaged growth around 10% per annum, and it became the world’s fourth largest economy last year. However, as of 2005, China’s market capitalization-to-GDP ratio is only 18%¹, compared to almost 50% in 2000. By comparison, the world’s largest economies, the U.S and Japan, have ratios near 135% and 100%, respectively. China has relied heavily on banks for financing its economic development, placing a disproportionately large burden on the banking system. According to statistics released by the People’s Bank of China (PBOC), in 2005 bank loans accounted for almost 80% of external financing of Chinese enterprises, whereas corporate bonds and equity funding each accounted for only 6%.

China’s capital markets are far from mature and efficient. Yet given the markets’ relatively short history and legacy issues, the progress thus far is very encouraging. However, the capital markets must continue to open, and travel on a path towards reform – the health of the economy depends upon it. At this juncture, China still has a long journey ahead.

¹ A total of Shanghai and Shenzhen A- share market capitalization only. Including H-shares and Red-Chips, the ratio is 35%.