Walter Hutchens’ Blog

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.