Understanding China’s Stock Exchange – Pt1

May 7, 2014 by Ken Davies

Stock markets have developed rapidly in China during the period of economic reform, as has regulation of the markets. Yet investors still do not have complete trust in them. The next stage will involve further improvements of the Shanghai and Shenzhen exchanges, together with the gradual beginnings of internationalization.

Stock markets existed in Shanghai from the 1860s onward, but they were swept away with the establishment of the People’s Republic of China in 1949. For three decades, stock markets were anathema to the Communist Party of China.

When economic reform was announced in 1979, the revival of capital markets was low on the leadership’s agenda, way below abolition of the rural people’s communes and opening the country to foreign trade and investment. As with other innovations, it was preceded by tentative experiments.

It was not until more than ten years into the reform period, in late 1990, that the first official stock exchanges in China since 1949 were opened in Shanghai and in Shenzhen – the most successful Special Economic Zone, adjoining Hong Kong. Securities trading had already been taking place on a small scale in both cities for several years previously.

To begin with, there was no legal and regulatory framework for the exchanges, which were effectively governed by the People’s Bank of China (PBC, the country’s central bank). Then in 1993 the China Securities Regulatory Commission (CSRC) was established as a ministry-level unit directly under the State Council, but for the next five years, because its scope of authority was not fully defined, it had a tough time competing with the PBC and other government bodies.

The CSRC was provided with a legal definition of its role and functions in a Securities Law passed in 1998. In 2001 the CSRC was beefed up with the appointment of Laura Cha, from Hong Kong’s Securities and Futures Commission, as Vice-President. (Ms. Cha was the first person from outside China to be appointed to such a high government rank.)

At end-2013, the Shanghai Stock Exchange recorded a market capitalisation of US$2.5 trillion, compared to the London Stock Exchange Group’s US$4.4 trillion and the Hong Kong Exchange’s US$3.1bn. In terms of Electronic Order Book share trading value for the whole of 2013, China’s two stock exchanges occupied 4th place (Shenzhen, US$3.9 trillion) and 5th place (Shanghai, US$3.8 trillion) in the world, behind the New York Stock Exchange, NASDAQ and the Japan Exchange Group, but ahead of the London and Frankfurt exchanges.

The predominance of state-owned enterprises (SOEs) in China’s stock markets is not surprising, as SOEs continue to dominate the country’s largest companies more than in any other major economy. According to a recent estimate, SOEs account for 95.9% of sales, assets and market values in China (figures are lower in comparable transition or emerging economies, for example Russia 81.1%, Indonesia 69.2%, India 58.9%, South Korea 9.7%, Turkey 2.8%).

At the end of 2012, the largest listed company by tradeable market capitalization on the Shanghai exchange was Petrochina (China’s biggest oil producer), with 10.9% of total market capitalization, followed by the Industrial and Commercial Bank of China (ICBC, the world’s largest bank by assets and capitalization) with 8.1%, the Bank of China 4.3%, China Petroleum & Chemical 3.6%, China Life with 3.3% and China Shenhua with 3.1%; these six SOEs together account for one-third of total market capitalisation.

Following massive IPOs – ICBC’s 2006 IPO, for example, was the world’s largest at the time – these enterprises are no longer strictly state-owned, as they have substantial minority stakes (like Goldman Sachs’ 5.75% holding in ICBC, made just before the 2006 IPO).

China’s share classification is unique, resulting from the country’s foreign exchange controls, which remain on capital account long after China was recognized as having full current-account openness under the IMF’s Article VIII in 1996.

A-shares are denominated in renminbi (CNY) and are traded on both the Shanghai and Shenzhen stock exchanges. They were originally available only to domestic purchasers. Since 2003, foreigners have been allowed to purchase A-shares via Qualified Foreign Investment Investors (QFIIs). By the end of March 2014, the number of licensed QFIIs approved by the State Administration of Foreign Exchange (SAFE) had risen to 261 with US$53.6bn under investment out of the quota of US$80bn permitted to QFIIs to invest in A-shares . Although the quota has expanded in recent years, foreign A-share ownership thus remains at only around 2% of total market capitalisation.

Both stock markets have issued shares initially (until 2001) available only to foreign purchasers, known as B-shares. On the Shanghai exchange, B-shares are bought and sold in United States dollars, on the Shenzhen exchange B-shares are in Hong Kong dollars. B-shares actually have a face value denominated in Renminbi, but this is as irrelevant as it is in other countries. The B-share market was moribund, with low trading volumes, in the 1990s.

Since China joined the WTO at the end of 2001, reforms have been made with the aim of diversifying shareholding. Before 2005, state shares and legal-person shares (largely held by public bodies), generally making up about two-thirds of total shareholding, were not tradable. Since small shareholders could only buy and sell up to one-third of the value of the company, share prices tended not to reflect market reality. Without serious shareholder voting power, corporate governance may also have fallen short of international norms of transparency and accountability. There is evidence that managers lacking a share-price incentive colluded with major (state) shareholders in behaviours that led to inefficiency and low productivity growth.

The 2005 Split Share Structure Reform has succeeded in eroding the concentration of ownership in SOEs. However, although state shareholdings are no longer a mandatory two-thirds of large SOEs, many of them are still high, and are generally at least a controlling 51%. Ownership of small and medium-sized enterprises is now much more diverse.

As a result, a study published in March this year suggests that share prices on China’s stock exchange are much more reflective of underlying value than before, comparing favourably in this regard with, for example, New York stock prices. Top economist Wu Jinglian’s famous 2001 dictum that the Chinese stock exchanges were “worse than a casino” is, arguably, no longer entirely true. Corporate governance seems also to have undergone a marked improvement.

But there is still much to do. As the Xi Jinping government moves towards further market-oriented reforms and increased integration into the world economy, China’s stock markets will need to ramp up reform so they can play a full part in international capital markets, as we will show in the next article in this series.

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