Small is Not Beautiful When It Comes to China's Uninviting Stock Market

Stephen Green (Head of the Asia Programme, Royal Institute of International Affairs, London)

(This article originally appeared in the May 12, 2003 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher)

China's stock market is not half of what it is cracked up to be. Despite fast growth during the 1990s, it is still relatively small. The shares traded on the Shanghai and Shenzhen exchanges were worth about 1.38 trillion yuan (HK$1.3 trillion) at the end of March this year, only 14 per cent of China's gross domestic product (GDP).

The stock market in Russia - the epitome of a failed transition state - is worth US$110 billion (HK$857 billion), about 33 per cent of GDP. Those in developed markets are usually worth in excess of 150 per cent of GDP.

Not many people trade on China's bourses. The headline figure of 69 million trading accounts includes the millions of accounts that have been opened fraudulently, those that have fallen into disuse, and others opened to allow their owners to buy (and very quickly sell) shares at initial public offerings (IPOs).

Probably fewer than 10 million people own equities in China, less than 1 per cent of the population. In the United States, well more than half the population owns them in one form or another, even in these dark days.

For those professionally involved in China's stock markets, recent months have been desperate. The China Securities Regulatory Commission (CSRC) has cracked down on extensive price manipulation and false accounting by listed firms, causing the exit of much "hot" money. The regulator's attempt in July 2001 to sell off state shares (shares that the central government retains when a state-owned enterprise restructures and generates an IPO) failed disastrously. Fearing a deluge of new shares, investors fled, and 506 billion yuan was wiped off the value of the market. Prices are now flat.

Retail investors in the mainland's 70-odd investment funds have lost money and faith in the market. Proposals to give pension funds access to the market have been put on hold. Foreign investors have turned up their noses at the Qualified Foreign Institutional Investor scheme - which allows some favoured international firms to invest in mainland shares - for being too restrictive.

Most international firms have decided not to set up joint ventures as allowed under China's World Trade Organisation accession agreements. And, embarrassingly, the government has not even caught the two men, Zhu Huanliang and Lu Liang, who were allegedly behind Zhongke Chuangye, the biggest price manipulation scam of them all.

There are several reasons for the mess. But the main one is that the central government has used the stock market to support its own value-destroying firms. Only about 70 private firms have been allowed to make IPOs. More than 1,200 former state-owned enterprises (SOEs) have been listed. They are bywords for mismanagement, asset stripping and abuse of minority shareholder rights. Serious investors see only a few dozen firms worth a long-term investment.

Look into the future, though, and there are at least three reasons to believe that things will improve. Large-scale privatisation of industry is now on the cards, thanks to the growing recognition among senior officials that SOE reform is failing. The hope is that the new State Asset Management Commission will facilitate the sale of most of the remaining 170,000 SOEs (more than 95 per cent of which are run by provincial or sub-provincial governments). The central government also appears content to allow listed firms to privatise properly.

Second, the government has a keen interest in raising funds through asset sales. It has a deficit pushing 3 per cent of GDP, and a liability for pensions and recapitalising the banking system totalling more than 100 per cent of GDP. But for privatisation to raise significant funds, the government clearly needs to restore public trust in the stock market. So it is in its own interest to continue pushing through regulatory improvements.

Third, not only does the government need to raise funds, but it also has to ensure that the infrastructure for managing these funds is in place. The provincial and national pension pools, money being accumulated by enterprises and employees in unemployment and health insurance funds, as well as life insurers (most of whom are still owned by the government) all need a well-run stock market to invest in.

Many in the government know that a casino-like stock market simply will not do. They are fighting hard to push through the difficult structural changes - the privatisation of listed firms, protection for the CSRC from administrative interference, and a larger role for the courts - that will result in a more mature market. The transformation will not occur overnight, though - entrenched interests will fight it every step of the way.

state-held legal person shares. This has happened quietly - the CSRC has hardly been involved. By buying listed shell companies, private firms gain access to money-raising opportunities. The hope is that they can transform the companies they buy into entities worthy of a public listing. If this trend can be sustained, then the mainland's stock markets could be entirely privately held by 2010.

The other positive recent move is the Supreme People's Court decision to allow shareholders to sue those involved in making false disclosures at IPOs - listed companies, their senior managers and accountants, lawyers and underwriters. The guidelines governing such actions are strict, but at least 12 cases are now before the courts. A couple of cases have been settled, involving cash payments by some managers. In addition, about 80 criminal prosecutions are apparently taking place. Senior managers at one firm, Zhengzhou Baiwen, are already reported behind bars.

The challenges facing CSRC chairman Shang Fulin are legion. It will be painful to put right the mistakes of the 1990s. But for all the brouhaha the media rustles up, he and his colleagues can comfort themselves that a little short-term pain will result in long-term gains. And when they fight their corner in the State Council they will know that, whatever the impact on prices of their actions, since the market is small, their policies should not adversely affect macro-economic growth or trigger mass protests.