Long march to sanity

IFR Review of the Year 2015
11 min read

The dramatic rout that followed the latest bull run in China’s equity markets was a case of history repeating itself. Regulators are still grappling to understand the root cause, but they must realise there is only one solution – and it’s surprisingly simple.

The definition of insanity, Albert Einstein once postulated, is to do the same thing over and over again and each time expect different results. We all do it, of course: yet no one person or institution is more insane than the nation-state that adamantly refuses to learn from past mistakes. If a plan failed last time, governments often tell themselves, it was surely the result of bad implementation – and not because it was just a bad plan. So why not try it again?

Over the past year, we have seen that sort of skewed thinking again invade the minds of China’s securities regulators and share investors. By lifting a long-standing ban on short selling and margin lending in November 2014, just as the central bank began cutting interest rates, officials at the China Securities Regulatory Commission initiated a bull run that stretched through the first half of 2015.

Retail investors, who account for around 80% of daily onshore trading, borrowed heavily, ploughing capital into soaring stocks. They were tacitly encouraged by a government desperate to tap new seams of capital formation in a slowing economy.

For a while, everyone was happy, as state firms and private enterprises rushed to list shares that were snapped up by punters at bargain prices. When the bear finally roared in June, the government, keen to wrap a consumption-driven middle class around a vibrant, capital-forming equity market, appeared genuinely startled.

A clumsy plan to force “national teams”, which included lenders, investment companies, mutual funds and brokerages, to buy and hold shares cost the state an estimated US$200bn. By the time it gave up trying to prop up a slumping market in August, the ruling Communist Party, instead of appearing wise and far-sighted, seemed shrunken. There were things, it was clear, that even Beijing’s apparently all-powerful mandarins could not control.

No surprise

Yet no one should have been all that surprised by the gyrations. Since being founded in 1990, the Shanghai and Shenzhen bourses have enjoyed a half-dozen bull runs, including in 2001 and 2007 – none lasting much beyond six months and some ending in precipitous drops.

So what can alter this stubborn and self-harming dynamic, and prevent yet another generation of leaders from making the same set of mistakes in, say, 2021 or 2028? Will China ever have a capital markets system worthy of an economy that aspires to being, and indeed is on track soon to become, the world’s largest?

Plastering over the cracks

At first glance, the fissures that run through the mainland’s capital markets might appear too deep to ever truly heal. Yet there are solutions – some painful, some neat and simple – that the ruling Communist Party can adopt if it wants to create a capital markets structure fit for purpose.

Take insider trading, a problem that is, said Andrew Polk, a senior economist at The Conference Board China Center in Beijing, “absolutely rampant. If Beijing wants to create a strong equity market that functions properly, it has to solve that issue first.”

That won’t be easy. During the 2015 bull run, investors received text messages from brokerages foretelling how much a particular stock would rise in value the following day. These predictions were often spookily precise. Chief executives regularly tipped off friendly fund managers about their prospects, warning or encouraging them to buy or sell stock before issuing quarterly results.

Likewise, the formation of a group of powerful institutional investors – insurance firms and pension funds run with the interests of their shareholders in mind – will take time, yet is essential if Beijing is serious about creating a diversified economy packed with ways for the middle class to put their money to work.

If China’s stock markets remain beholden to the whims of capricious retail investors more interested in short-term profits than in holding stocks for the longer term, they will never shake off the volatility that pervades the market a few times every decade.

“China needs to find a way to convince global funds that such interventionist measures are not going to become a regular occurrence”

Beijing also needs to keep calm and carry on during times of stock market stress. Regulators have long had a penchant for slapping a full ban on new IPOs when a bull market runs its course (as it did in July 2015), for fear of further undermining a fragile equity market. To China’s mandarins this makes sense, yet such bans deny investors the right to put their capital to work in new – and potentially exciting – listing vehicles.

When Beijing clamped down on anyone keen to sell shares into a falling market in mid-2015, it also sent a signal to the wider world. Qualified foreign institutional investors found themselves the subject of a whispering campaign that emanated from Beijing, and which sought to blame the whole sorry mess on malign outside forces.

Many foreign funds retreated from the mainland, and may take some convincing to return.

“China needs to find a way to convince global funds that such interventionist measures are not going to become a regular occurrence,” said Polk.

Treasonous behaviour

Domestic fund managers and even journalists deemed to have talked down stock prices were accused of treasonous behaviour and forced to issue public mea culpas. For a while, Beijing, as a collective political consciousness, seemed on the verge of panic.

Probably the biggest stumbling block to creating a genuinely world-class onshore equities market is the lack of quality investible stocks. Too many of the 2,800 companies listed on the main boards in Shanghai and Shenzhen are state-run firms more interested in expanding their balance sheets than in instilling good governance and paying regular dividends.

Many of China’s best-run companies are listed in Hong Kong, while 132 mainland corporates, including internet giants Alibaba and Baidu, have primary listings in New York. Beijing “needs to encourage firms that have listed overseas to return home”, said Liu Li-gang, chief economist, Greater China, at ANZ.

“They should also encourage foreign firms that have been operating in China for decades to list onshore. The introduction of a number of blue-chip global corporates would boost the quality and credibility of the country’s stock markets.”

Foreign companies, Liu added, would exert a positive impact on local peers. “They would follow global rules and stick to the highest levels of corporate governance and transparency,” he said. “Over time, mainland firms would in turn start to adhere to the same rules and norms.”

One company regularly linked to a mainland share sale is UK lender HSBC, which was founded in Hong Kong in 1865 and still retains a listing in the former British colony. Another positive step would be the removal of the qualified foreign institutional investor quota, which stood at US$78.77bn at end-September 2015, according to the State Administration of Foreign Exchange.

The process

Finally there is the thorniest issue of all: the listing process. Often overlooked, this might prove the toughest obstacle of all for Beijing, in large part because it will pitch one set of powerful and fabulously wealthy party officials against another.

In London or New York, the IPO process is reasonably simple: a potential listing candidate puts together the requisite paperwork and, so long as its books are in order and it meets the exchange’s requirements, the regulator should, in theory, give it a nod of approval.

In Shanghai or Shenzhen, the CSRC is all-powerful. It first vets candidates, before deciding whether a listing should go ahead. Much of the corruption and insider trading embedded into most mainland stock listings starts here, as the regulator alone dictates which companies are allowed to come to market – and when.

Stocks are also rarely properly valued during the IPO process – given that it is the regulator, and not investors and underwriters, that has final say on the listing price.

Most IPOs are deliberately under-priced, ensuring that they jump as sharply as possible on debut, benefiting the lucky (or influential) few who were able to secure IPO allocations.

As well as poisoning the well for all investors, this process sucks all of the air out of the secondary market for weeks either side of a new listing. Independent China-focused consultancy J Capital Research reckons that the average mainland IPO in the first half of 2015 was 200 times oversubscribed, tying up US$470bn in capital.

The latter point, at least, looks set to be addressed by proposed reforms to the IPO process announced in November by the China Securities Regulatory Commission.

In a major departure, under the proposed rules investors will no longer be required to disburse funds before the shares are allotted. Instead, they will only pay when they receive the shares – similar to the mechanism used in Hong Kong and other international markets.

According to the CSRC, this will sharply reduce the volume of funds set aside for IPO subscriptions and ease the impact on the secondary market and money market, since investors will not have to pre-emptively free up cash to cover potential subscriptions.

What won’t change under the proposed new rules, however, is the unofficial price cap that results in newly listed shares surging on debut.

Rather than fixing the underlying problems, China’s latest reforms have left observers wondering whether the current leadership can break the damaging cycle that seems inherent in the way China governs its equities markets. Can the regulator shatter the cosy and corrupt cronyism, fully open the country’s stock markets to global funds, and convince China’s best corporates to move their stock listings back home? Doing so won’t be easy, and it may take a long time, but anything else risks proving Einstein’s thesis all over again.

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Long march to sanity