Walter Hutchens’ Blog

The Standing Committee of the PRC National People’s Congress has, at long last, enacted a Securities Investments Funds Law. The Chinese text is here. Comments by the CSRC chairman Shang Fulin are here. The law does not go into effect until June 1, 2004.

The Shenzhen Stock Exchange has issued “Guidance” concerning management of the relations between listed firms and investors.

PRC law does not require the CSRC to conduct “notice and comment” rulemaking. Nonetheless, the CSRC sometimes solicits public comment on draft regulations. Now it is doing so with respect to “Provisional Measures for the Stock Issuance and Listing Sponsorship System,” per this anouncement on the CSRC website.

It is salutary that the CSRC is asking for public comment. However, I don’t understand why they do so on such a truncated time frame. They posted the draft regulations on the 15th and have asked that comments be submitted by the 24th of this same month!

The CSRC has announced here that they have approved JP Morgan Chase’s application for QFII status. This brings the total number of CSRC approvals for QFIIs to nine. The roster is:

UBS
Nomura
Citigroup
Morgan Stanley
Goldman Sachs
Deutsche Bank
HSBC
ING
JP Morgan Chase

SAFE approves the investment quota (the amount each firm may invest) separately, and JP Morgan will still have to go through that.

According to a story last week in the Financial Times, SAFE is becoming stingy with these quotas, perhaps wanting to keep these firms from making big bets that the RMB will be revalued, giving them instant portfolio appreciation.

It is sometimes said in China that the PRC stock markets are “policy markets” (zhengce shichang), not “market markets.” Ironic, though unsurprising, if foreign investors, are replicating on a big scale what PRC investors do. Foreign capital was supposed to help the markets move away from speculative trading, but given the same environment, why would foreign capital behave differently than domestic capital? PRC investors don’t speculate because they have a genetic or even historical disposition to do so; they speculate or “invest” on policy because that is what often moves the markets, not fundamentals that would be quite hard to ascertain anyway given reportedly low quality of most disclosed information.

Incidentally, Carl Walter, co-author of one of the best books on PRC stock markets, is with JP Morgan in Beijing now.

According to this report from the Financial Times (also pasted below), the QDII scheme–which would have allowed some PRC firms to invest in securities outside of the PRC mainland–is on “indefinite hold”. The QDII proposal thus joins a number of other proposal in the “indefinite hold” purgatory, including: a “second board”, a freely convertible RMB, letting private companies list in meaningful numbers, letting foreign-invested companies list in meaningful numbers.

Increasingly, I think PRC securities markets need revolution, not reform, but all the proposals for change that would significantly challenge the status quo seem to end up on “indefinite hold” while those that promote or maintain the status quo (say by bringing in fresh capital, such as the QFII system) are adopted.

Here is an editorial published in the PRC mainstream press expressing this idea that China needs revolution in its approach to securities market regulations.

The FT story is as follows:

China delays easing of investment controls
By James Kynge in Beijing and Richard McGregor in Shanghai
Published: October 7 2003 21:46 | Last Updated: October 7 2003 21:46

China is set to postpone indefinitely a landmark scheme that would have opened the Hong Kong stock market to legal investments by mainland institutions. The setback might also delay progress toward satisfying US demands for a more flexible renminbi exchange regime, officials and financial industry executives said.

Official opposition has been building towards any early approval of the Qualified Domestic Institutional Investor (QDII) plan, under which a crack was to be opened in China’s closed capital account to allow some mainland funds to change their renminbi into hard currency and invest in Hong Kong’s capital markets.

“There is really a lot of opposition to QDII at the moment,” said one official. “There is no way it will be approved by the end of this year and probably not early next year either.”

The postponement will come as a blow to investors and the government of Hong Kong, which first proposed the scheme as one of several means to integrate the territory’s lacklustre economy with a booming China.

Last month, another Hong Kong proposal to turn the territory into an offshore centre for trade in the renminbi was also relegated to the backburner by Beijing.

The main official reason for opposition to the QDII scheme has been that it would divert funds away from Shanghai’s languishing stock market, possibly causing further erosion in stock prices.

Shang Fulin, chairman of the China Securities Regulatory Commission (CSRC), the market watchdog, was one of the main opponents of early approval for QDII, officials said. The People’s Bank of China, the central bank, which has pledged to ease capital controls selectively to create a more convertible currency, was broadly supportive of the QDII plan but sympathised with the objections of the CSRC at the moment, officials added.

The mothballing of QDII highlights a dilemma for China. On the one hand, it has promised John Snow, US Treasury secretary, that it will move toward a more flexible exchange regime to allay Washington’s concerns over a record $103bn (?88bn, £62bn) Chinese trade surplus last year. But on the other hand, the weakness of domestic markets and financial institutions is frustrating progress in this direction.

Liu Jipeng, one of the country’s best known stock market commentators, said that before China solved the structural problems in its own capital market, any plan to approve an outflow of funds should be suspended.

QDII, at its inception, was not expected to involve large investment flows. The funds flowing out of China were supposed to be roughly equal to those flowing in through a Qualified Foreign Institutional Investor (QFII) scheme that started this year. That would cap QDII funds at less than $1bn.

The significance of the plan lay in the commitment that it demonstrated towards financial reform, and that it was intended to show Beijing’s support for the government of Tung Chee-hwa, Hong Kong’s chief executive who survived mass demonstrations calling for his resignation this summer.

Nevertheless, Beijing was studying several other ideas that could lead to approvals for some of the roughly $150bn held in foreign currency bank deposits in mainland banks finding its way into Hong Kong and other overseas markets, officials said. These ideas, however, remain at a preliminary stage.

The U.S. Congressional Executive Commission on China has released its second annual report. The PRC’s Ministry of Foreign Affairs issued a predictable response here. The South China Morning Post covers it here.

I was quoted in a recent story from the South China Morning Post on the problem of illiquid (mostly state-owned) shares in PRC stock markets, as follows:

Mainland stuck with state shares

Friday October 3 2003

Andrew K. Collier in Beijing

The central government appears reluctant to divest of its holdings as investors fear massive dilution

Two years ago the Chinese government first flirted with the idea of selling its non-tradeable state shares in publicly listed companies.

As state shares account for about 70 per cent of all outstanding stock, the threat of a massive dilution caused the prices of tradeable A shares to plunge. The idea was subsequently shelved, and has yet to be revived.

The central government’s reluctance to revisit the issue has a host of important ramifications. The sale of state shares would have the dual benefit of raising capital for state-sector reform and would make managers accountable to an entirely new group of owners.

China’s listed deadbeats might also finally become active participants in the world’s fastest-growing major economy.

‘The failure of the stock markets in China to contribute meaningfully to help China build world-beating companies or foster innovation suggests there are profound limitations to the model, and China has now run up against them,’ said Walter Hutchens, an expert on the mainland’s stock markets at the University of Maryland’s Smith School of Business.

Two weeks ago, mainland newspapers reported that foreign companies would soon be allowed to buy state shares. There was, however, an important caveat: the government would prevent them from taking outright control of listed companies.

Non-tradeable state shares were created in the early 1990s, when the government was keen to raise capital for state-owned enterprises - but not at the cost of relinquishing control. The State Committee for the Restructuring of the Economic System issued an opinion in 1992 that was to form the legal basis of corporate structures on the mainland.

Two classes of state shares were created. Government ministries which contributed assets to a publicly listed company received state shares. The enterprises held ‘legal-person’ shares. The distinction between these two types of share was not clear, though it was thought that holders of legal-person shares had fewer ownership rights. The key point was what both state and legal-person shares had in common - they could not be publicly traded.

But they are traded elsewhere. Behind closed doors, state companies are cutting deals right and left. The only problem is that without a stock market to value them, no one can be sure what they are really worth.

In 2001, the China M&A Yearbook had listed 400 mergers, restructurings or management buyouts. The average deal saw 21 per cent of a given company’s supposedly non-tradeable state shares change hands at discounts of 54 to 91 per cent to their publicly traded A shares.

Take, for example, mainland appliance manufacturer Guangdong Midea Group Corp. In 2001, the company sold 72 million shares to its third-largest shareholder, Meituo, at about three yuan each. This was two-thirds the company’s per-share net asset value of 4.07 yuan and represented a 76 per cent discount to the company’s A shares, which were trading at 13 yuan.

Meituo, incidentally, was controlled by Midea’s chief executive.

In fact, most sales of state shares have been transacted below net asset value, with the buyers more often being company management. Other shenanigans include setting an unrealistically low initial public offering (IPO) price, allowing insiders to buy-in low before the IPO and sell high after the debut.

Barry Naughton, a China scholar at University of California, said that while the government was quick to publicise wrongdoing by speculators outside the system, it was usually silent about wheeling and dealing among state officials.

‘The NPC [National People's Congress] can and does criticise the [China Securities Regulatory Commission] for not doing enough to expose corruption even as it maintains a basically complacent attitude towards the structural problem of insider control, lack of supervision and market manipulation by state firms,’ Mr Naughton said.

What is particularly troubling are the discrepancies between merger and acquisition deals involving state shares and deals involving publicly traded A shares. They are priced differently, involve different sets of owners and often bear little relation to each other.

The exception was the massive sell-off of state shares mooted by the government two years ago which caused a large drop in China’s domestic markets. Ten per cent of the proceeds were to go to a new Social Security Fund.

Then-premier Zhu Rongji reportedly reversed the ruling after the markets crashed for fear of hurting supposedly 60 million investors. However, as few as five million investors may be active traders, meaning the population of potential users is much smaller than the government originally feared.

Falling domestic share prices over recent years could suggest investors had priced in the risk of future dilution. So how to proceed with the liquidation of state shares? Encouraging foreign companies to buy into state companies is a start in the right direction. Another suggestion posted on CSRC’s website last year called for holders of tradeable A shares to be given the right to buy a given number of non-tradeable state shares.

Another possibility is to create a ‘tracker fund’ - similar to Hong Kong’s - that would buy up state shares. This would avoid depressing individual stock prices. The government, it seems, will be stuck with its state shares for some time to come.