Recently announced reforms will, if fully implemented, improve the functioning of China’s capital markets and begin to allow them an expanded role in the country’s economic development. However, without major changes to the social and legal systems it will not be feasible to achieve the Party’s recently stated objective of building a transparent, efficient, open and inclusive multi-layered capital market system by 2020.
In recent years, the authorities have made improvements to what is still a relatively young stock market. For example, in 2005 the Split Share Structure Reform began the process of reducing the dominance of state shareholdings. But the markets remain beset by problems which cannot be ignored after seven years in the doldrums. The Shanghai Composite Index has not regained its peak of nearly 6,000 reached in 2007 and is currently around 2,000, not far above the trough to which it plunged in November 2008.
In the early period of economic reform in the 1980s, China managed without stock markets, but it needs them now. Rapid economic growth was financed by state-owned banks acting as conduits for government funds, with scant regard for efficiency. A massive splurge of investment boosted growth for over three decades, but during the 21st century this has turned into wasteful over-investment, especially during the 2008-2009 CNY 4 trillion stimulus to counter the global economic crisis.
This has left the financial system in a potentially precarious condition. Although non-performing loans are not as dangerously high as in the 1990s, they have re-emerged, and have been joined by massive lending by shadow banks, especially to local governments.
The stock markets are failing to provide a mechanism to allocate capital effectively as they continue to favour large cash-hungry state-owned enterprises with political connections – even those with bad financials – over innovative startups in the private sector.
This is potentially disastrous for China’s GDP growth, which in the past couple of years has become more dependent on capital injections and less driven by advances in productivity.
China’s reluctance to open its capital account has bought the country some time during regional and global economic crises. This policy now needs to be abandoned so that the labour of the country’s workforce can bring real dividends. China’s foreign-exchange reserves are now US$4 trillion after years of trade surpluses. Most are held in low-interest bearing assets like US treasury bonds. Returns on bank deposits and shares are not yielding good returns. Chinese residents should be able to invest their hard-earned savings abroad.
As in other immature markets, irregular conduct is widespread. Insider trading is rife, with relatively few cases being detected and punished. The China Securities Regulatory Commission (CSRC, the regulator) reports that insider trading accounts for an alarmingly increasing proportion of all the cases it investigates each year. The beneficiaries tend to be large investors, with small investors left holding shares valued far below what they paid for them.
In other developed economies, the majority of shares tend to be held by institutions such as pension and insurance funds. In China, individuals own around 80% of shares. Shareholders chase short-term capital gains, with the average share only being held for three months. This, unusually, applies to institutions as well as individuals. The authorities persist in trying to change this by stipulating that companies pay a higher share of their profits as dividends.
Following the announcement of a package of economic reforms at the 3rd Plenum of the 18th Central Committee of the Communist Party of China, the authorities last December announced a change in procedures for initial public offerings (IPOs) and then, on 9th May this year, issued a set of capital market reforms, known as the “New Nine Measures” (a reiteration and development of the original Nine Measures announced in 2004).
IPOs have hitherto required examination and approval by the CSRC. The new system, which was supposed to have started in January, is one in which the market, not the CSRC, will decide if and when an IPO takes place. This will be good news for hundreds of companies who have been waiting to go public. The CSRC operated an effective IPO moratorium between November 2012 and end-2013, apparently partly because the index was down and also because the 900 companies in the queue did not meet the CSRC’s strict criteria. In the first two months of 2014, 48 IPOs were allowed, then the freeze was reimposed. The CSRC has declared that 100 share issues will be allowed in the second half of this year.
A major aim of the New Nine Measures is the facilitation of cross-border investment, both inward and outward. This is a continuation of the policy of recent years of steadily increasing the quotas for both Qualified Foreign Institutional Investors (QFIIs) buying A-shares in China and Qualified Domestic Institutional Investors (QFDIs) buying foreign shares.
An important step in this direction was taken in April with the announcement of the Shanghai Hong Kong Share Connect pilot programme, which will allow investors in Hong Kong to purchase shares on the Shanghai Exchange up to a maximum of CNY 300bn (US$48bn) and investors in Shanghai to purchase shares on the Hong Kong exchange up to a limit of CNY 250bn (US$40bn). The link between the two exchanges will allow individuals, as well as institutions, to buy shares cross-border.
This is a very tentative move. The caps will ensure that resulting foreign ownership remains proportionately tiny – around 2% of Shanghai Stock Market capitalization, for instance. The arrangement is widely expected to start in October, but no official date has been set, so postponement is possible. Nevertheless, if the pilot programme goes ahead as planned and is successful, China will probably seek to replicate it with other major stock exchanges round the world to achieve eventual full international integration of its capital markets.
Stock market reform will continue to be gradual. The CSRC will effectively retain control of IPOs until it feels companies are trustworthy enough to let the market take over. The QFII and QFDI quotas will be raised, as will the caps in the Shanghai Hong Kong Connect programme.
On their own, the reforms announced are a step in the right direction, but they are not enough. The legal system needs to be independent so that it can hold malfeasants to account. Crucially, the bonds between the Communist Party and business need to be broken if China’s stock markets are to play a full part in the country’s economic development.
(The third and final part of this series will appear shortly-Ed)