Asia Insight

September 2005

Liquidity, or the lack thereof, in the Chinese A-share Market

By Lydia So, Research Associate
Matthews International Capital Management, LLC

On August 23, 2005, five Chinese regulatory bodies jointly issued guidelines for the gradual flotation of non-tradable state-owned shares for all of mainland China’s domestically-listed companies.1 The announcement was long-awaited by many mainland investors who have sought a solution to the non-tradable shares problem. The new proposal may eventually provide a market for $270 billion worth of stock that has rarely changed hands, and whose existence has been a substantial overhang for the domestic stock market for most of its history.

China’s domestic stock market, known as the A-share market, has over 1,300 companies listed on two exchanges, one located in Shanghai, and the other in Shenzhen. Both exchanges were established in 1991 as part of Deng Xiao Peng’s agenda for economic development. Over the past decade, China’s domestic market has developed into one of the largest stock markets in Asia, with an aggregate market capitalization of over $400 billion. Yet despite this progress, the market is subject to certain inefficiencies that hamper its efficacy and attractiveness. Specifically, the market is affected by two main structural problems: non-tradable shares owned by the state, and the country’s non-convertible currency. The first of these problems is discussed in greater detail below; for more information on the latter, please see our Asia Now publication entitled “The Equity Issue: Alphabet Soup”.

Roughly two-thirds of China’s total market capitalization is held in the form of illiquid, “non-tradable” state-owned shares. These shares create a substantial distortion for the domestic stock market: historically, legal and economic rights associated with those shares have been murky. Furthermore, their unresolved status has left the market fearful that non-tradable shares might suddenly be “dumped” on the market, leading to a supply glut that would depress stock prices. According to the new flotation guidelines, the Chinese government’s aims to avoid “flooding” the market with a new supply of shares, yet simultaneously install a more normalized trading mechanism. The government hopes the reforms will establish a disciplined framework to gradually convert those shares into tradable form.

Historically, corporate governance in many Chinese companies has suffered because large blocks of shares lay in the hands of government-linked entities in non-tradable form. As a consequence, private minority shareholders often had little or no say in a company’s operations. To promote minority rights, the new reforms require every company to create a conversion scheme that helps safeguard the economic interests of minorities. Each conversion scheme must be approved by regulators, and endorsed by a minority shareholder vote. The China Securities Regulatory Commission (CSRC) also promised to continuously monitor the process and step in to maintain market stability if deemed necessary.

The non-tradable shares were originated in 1991 when the stock market was established under the stringent socialist framework. When a state-owned enterprise (SOE) wished to issue shares in the market, it was required to divide up its shares into three roughly equal parts. One-third of the company’s shares was freely traded, one-third was held by the state, and one third was held by “legal persons.” The latter two-thirds have been, in essence, “non-tradable” since their creation. State-shares’ ultimate owner is the State Council and the titles are not freely transferable and hence not tradable. Legal person shares are issued to domestic institutions, namely securities companies and SOEs with at least one non-state owner. With this complicated and inflexible shareholding structure, China’s stock market has one of the smallest percentages of free-float among global capital markets. In developed countries like the U.S and Japan, free float is often closer to 80%, and is nearly 50% in markets such as Hong Kong and Singapore.

Non-tradable shares, when combined with the country’s non-convertible currency, have induced substantial inefficiencies in the A-share market. Such distortions are particularly evident in the valuations of A-shares relative to their corresponding H-share securities listed in Hong Kong (the latter are available to international investors). As the chart on this page demonstrates, H-shares have typically traded at very large discounts relative to their A-shares counterparts. Domestic investment funds, held captive in China due to restricted currency convertibility, face limited choices among mainland investments. With the vast majority of shares tied up in non-tradable form, the supply of stock has been artificially constrained. Taken together, these two problems have helped push valuations to rich levels amid weak company fundamentals. Local investors are often aware that investment valuations are unattractively distorted, yet the lack of alternatives leads them to treat the stock market like a casino capable of generating quick gains (known as “stir-frying” shares or “chao gupiao”).

Nevertheless, it is also evident in the chart on this page that valuation disparities in the A-share market have narrowed over time. As reforms in the A-share market continue, particularly among the non-tradable shares, offshore and onshore valuations have converged. This serves as important empirical evidence that, to date, the structural problems that have hampered the domestic market’s efficiency have declined.

The recent announcements regarding non-tradable shares have not garnered the same attention that accompanied the de-pegging of the Renminbi. However, both reforms signal that China continues to take consistent steps towards liberalizing its markets and removing the rigidities that have characterized the past. This progress may not yet prove effective or lasting: the latest announcement regarding shareholding reform represents the third attempt in five years. The new reforms will also be costly for vested interests, which may hamper the process. Regulatory guidelines require that SOEs compensate minority shareholders as they convert non-tradable shares to tradable form; management of state-owned enterprises may be reluctant to lose power and control of their companies. The A-share markets may remain mired in uncertainty as a large quantity of new stock is introduced to the market. In the end, China has exhibited dedication to reform its market; yet the job is by no means finished, with much hard work yet to come.

1 The five regulatory bodies were the China Securities Regulatory Commission, State Asset Management, Ministry of Finance, People’s Bank of China, and the Ministry of Commerce.