The China Series - Part 1: The Fundamentals
November 26th 2006 01:54
An Overview of China's Stock Market
Part 1 - The Fundamentals
Part 1 - The Fundamentals
Introduction
The stock market primary function is to allocate capital efficiently to the best companies or industries sector, yet it could be speculative for many, like a casino. To many, China’s stock market is perceived more as a casino set than to exist as an apparatus to raise and allocate capital. Gambling is officially banned in mainland China and the nearest legal gambling precinct the mainland Chinese could head to, is Macao, otherwise the stock market is the second best gambling alternative. The function of allocating capital in China’s stock market could be best described as near dysfunctional in conventional sense as insider trading, management manipulation, massive speculation and politics-influenced decisions by managers, makes research into the listed companies is much a waste of time (Anderlini, 2004)
All the problems described above are strongly correlated to the restricted share allocation invented, ingeniously, by the Chinese State Council in the early 1990s. Couple it with weak regulations and enforcement, inefficient management and massive speculation contribute to the market being inefficient to take on its conventional role.
Despite the problems, the Chinese stock market grew leaps and bounds with 1,400 odds listings in a relatively short time. It has the biggest trading floor in Asia and run one the most sophisticated exchange systems. There are two types of market; the A-shares and B-shares, the former being the bigger of the two and the latter is less liquid, smaller and restricted to foreign investors with transactions conducted in either US or Hong Kong Dollars. The A-shares market will be focused here as being the most relevant one among the two markets.
As of 2002, the market capitalization of the A-shares market stood at RMB 1,070 trillion, 32 times that of the B-shares market at RMB 33 trillion. (Green, 2003)
In 1993, shortly after official birth of the Chinese stock market, the state council created three categories of shares for restructuring SOEs (State-owned Enterprises) into shareholding firms in order to be listed on the market. Only one-third of the shares are tradable on the stock exchange while the remaining two-thirds remain in direct state hands and quasi-state enterprise bodies. This is widely known as “one-third privatization”.
The three categories are explained as follow;
1. State shares (guojia gu). Shares owned by the State Council but under the management of the Ministry of Finance (MoF) bureaus. The shares are not listed on the market and therefore are not tradable but could be transferred subject to the discretion and agreement of the central government in Beijing.
2. Legal Person Shares or LP (faren gu). These shares are allocated other SOEs for contributing capital or assets to the restructuring company before the IPO launch. These shares are not exchange-tradable but could be transferred through variety of ways, usually through auctions or over-the-counter , at a discounted value.
3. Individual Person Shares or IP (geren gu). These are exchange-tradable shares which can be freely traded on the stock market by individuals and institutions.
With the IPs being the only share type that can be exchanged freely, this in effect makes the listed firm one-third privatized and the majority of the listed companies are actually restructured SOEs. True to its intention, the stock market was initially created to help SOEs to obtain capital and be more management efficient in the long term, for which, however did not materialize in a strict sense. Together with lax regulation and archaic accounting system, there are no incentives for the listed SOEs to improve its performance as accountability to private investors is virtually non-existent and only answerable to the central or provincial government.
The barriers to entry is relatively tight as the CSRC (China Securities Regulatory Commission) have the final discretion in approving IPOs and the restructured SOEs are usually favored for the line up, which appear to be most undeserving of capital.
The stock market in China is just one of the avenues for the restructured SOEs to raise capital but the dominant mode of choice in terms of financing, enterprises in China still rely far more heavily on the banks. As such the stock market is relatively small to the size of the domestic’s economy. In all markets, the soft infrastructures of reliable accountants, lawyers, underwriters, journalist and equity analysts must be providing information on the companies in the market which is often what emerging markets lack. China is no exception. (Green, 2003) This further adds to the problems of allocating capital efficiently.
With the soft infrastructure in China not performing its role, which acts as extra scrutiny in addition to official regulation, the question fair play, regulation and enforcement arise.
The Shanghai Stock Exchange Building
Coming Up Next - Part 2 - Regulations and Enforecement
*References will be posted in concluding post.
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