Walter Hutchens’ Blog

This Yahoo Finance graph shows the depressing trajectory of the composite index of the Shanghai Stock Exchange over the last five years. Thursday there was an 8% up-tick, with fainter progress on Friday. But the general trend is clear: China’s markets are spiraling down, despite robust growth in the PRC economy overall.

Why should China’s stock market fall while the economy surges? I think there is general agreement about the explanation: China’s domestically listed companies are state-owned enterprises, not the value-creating, export-mad parts of the economy. Moreover, the PRC government 1) picks which SOEs are allowed to get capital infusions through public share issuances but 2) does not, in tandem with conferring that privilege of getting public money, allow for public discipline of listed firms.

Public discipline over listed firms is blocked in a variety of ways. First, public shareholders remain a minority in most of China’s listed firms; the government retains voting control. China has experimented with corporitization and securitization without privatization. Lacking control rights, the public minoirity shareholders cannot vote out a listed firm’s management, no matter how atrocious it is. Likewise, there is no threat that some LBO fund will launch a tender offer, acquire control of the company, appoint a new board and fire those bad managers. There simply aren’t enough publicly floated shares to make that even theoretically possible in most PRC listed firms. Management doesn’t fear those without control rights—and consequently China’s listed firms are not run for the benefit of public shareholders. (This is why I think China’s recent decision to allow class voting by holders of listed shares is a really important step, though it apparently came too late to arrest the market decline).

Second, given some of the “special characteristics” of the Chinese legal system, rights that might otherwise help minority shareholders discipline companies are either non-existent or ineffective. For instance, if a firm lies blatantly in its disclosure documents, public shareholders have little recourse. They can sometimes sue the firm, if the Chinese government takes initial enabling action. If they do get to sue, they will have to plead their case before a judge who was appointed by (and whose future is substantially controlled by) the provincial government that often owns much of the defendant company. The Chinese, as many of them are quick to tell you are pragmatic; not many of these cases have been brought.

Without market discipline or effective legal avenues to challenge fraud, firms have predictably not been operated for the benefit of public shareholders. Thus gradually investors have decided not to put their capital at risk. Like all ponzi schemes, waning confidence is disastrous. As less and less hope exists for appreciation in the secondary markets, fewer and fewer people put money in the markets, causing there to be less and less hope for appreciation, causing fewer and fewer people to put money in the markets . . . causing a long-term, chronic downward spiral.

If it is relatively easy to identify what’s wrong, the hard question is: what can China do about these problems? Gradualism hasn’t been working. Cuts in the stamp tax, promises to better monitor managers, increased administrative enforcement, decreased administrative enforcement, letting in more foreign money, bank money, insurance money, social security money—none of that, nor a whole host of other attempted and discussed reforms—has arrested the downward slide.

But revolution hasn’t been attractive, either. Who would support the status quo, given its obvious disappointing performance? I can think of a number of forces aligned against change:

1. SOEs wanting to list (and reportedly hundreds are already approved and in line—presumably thousands would like to be in line). They probably don’t want the government to stop picking issuers, and they certainly don’t want choice that would cut into their offering prices or make the listing opportunity vanish.
2. Regulators wanting to preserve their power and perhaps their rent-seeking opportunities that result from approval powers.
3. Investors who already put money into the status quo and fear that real change will cause even more of their money to vanish. If you already bought a lot of shares of SOE, Inc., do you really want other market participants to have a chance to buy Private Enterprise, Inc. or, perhaps even worse, Private Foreign Enterprise, Inc.?
4. Perhaps a few ideologues who are wed to the notion that the government must control the means of corporate finance.
5. Pragmatists, who simply fear that revolution would be too unsettling–they may fear the anger of millions of investors in the status quo, the anger of SOE bosses or employees deprived of the chance to get “free” IPO money. All these actors could lead to much-dreaded “social instability.”

A final thought: there is a debate about the role of law and institutions protecting property rights in development. Some say you must have these things to develop. Others say China is a counter-example (great growth, bad courts or unclear property rights). Well, it seems the failure of China to develop the kind of stock markets it wants could be marshaled as evidence that at least this kind of economic activity (markets in abstract legal rights that require transparency to overcome information asymmetries) do not flourish in environments lacking supportive law and institutions. The failure also seems to once again show that markets generally outperform government planning; PRC government planning has ruined the stock market just as it ruined the consumer economy before the reform era.