China's stock market reforms
by George Zhibin Gu

On the morning of May 9, the employees of a leading Chinese investment brokerage in Guangdong returning from the nine-day Labor Holiday were surprised by an unusual memo from company management. They were told that tough days were ahead following the government's announcement that formerly non-tradable shares in Chinese companies would be allowed to float freely soon. The managers predicted that the Shanghai stock index could fall another 10-20%, to the 900-1,000 level perhaps, as a result of the reform measure.

Sure enough, even though the measure to float non-tradable shares had long been expected, the immediate reaction of the market was a sharp dip. By that afternoon, retail investors were calling the day another "Black Monday". Both Shanghai and Shenzhen saw a wave of selling, with the Shenzhen stock index dropping 4% and Shanghai 2.5%. More than a week later, the two markets were still directionless. The key question on the mind of 71 million Chinese investors was: where is the bottom? China's stock market, beset by confusion and worry, now stands at a 6-year-low, having seen a greater fall than even the overinvested NASDAQ in the US.

The depressed markets make a dramatic - and to naive outside observers, inexplicable - contrast to the sizzling economic numbers China presents year after year, numbers which have not stopped the continuous panic selling of domestic shares. The truth is that most Chinese stocks were overvalued for many years.
What went wrong?
The "Great Bear Market of China" had many causes. China's two baby stock markets were established only in 1992. Disturbingly, a legal charter for the markets emerged only in 1997 - a clue to the uncertainty of officials as they experimented with market-oriented reform measures.

Numerous bull and bear markets have come and gone. During the bull periods, stock prices rose wildly, often reaching price/earning ratios over 60 or even more. Many unprofitable companies had their glory days, as if unprofitability was a minor detail. The party's end was all too predictable. The bear market that began in late 2000 has erased some 50% of the market's value. Chinese investors experienced shock after shock during this period. Many listed companies went virtually bankrupt; hundreds of senior executives were sent to prison; and widespread financial abuses became a daily feast for the Chinese business press.

In this environment, the non-tradable share reform measures struck many investors as an unwelcome, bitter medicine. The non-tradable shares are shares that have been held by various government units as well as legally defined entities. Their sale would bring enormous downward pressure on the markets because the nontradable shares constitute 64% of market value, 74% of which belongs to the state. To countless investors, holding mainland Chinese stocks has become something like holding a falling knife. The resulting exodus of capital has pushed down the markets even further.

A historical background
Why did the government decide to sell the non-tradable shares on the open market? The answer requires a brief history lesson. Prior to the mid-1990s, official China had a different mentality: it was believed that holding a controlling stake in large companies would ensure the government's continued control over these enterprises. This is the reason why 90% of the listed companies are still state-owned.

In fact, between the mid-1950s, when virtually all industrial companies were nationalized, and 1978, when the economic reforms began, essentially all economic activities were government-run. Following the Soviet model, government bureaucrats ran all factories, mines, and shops, with the minor exception of shoe and bike repair shops. Government power expanded along with state economic control, reaching heights unparalleled in China's long history. The stagnation inadvertently created by the state-dominated approach caused China's economy and society to become stuck in the mud for more than 25 years.

It is less well appreciated, however, that the government monopoly created vast problems for the government itself. Power carries responsibility, and Chinese officialdom inevitably faced the quandary that the greater their power became, the more troublesome their responsibilities. Providing life's essentials, jobs, and happiness for 1.3 billion people would be a tall order for even the most efficient organization imaginable, and in the 1970s, China's creaking bureaucracy showed clear signs that it was beginning to buckle under the weight of this self-imposed burden.

The market reform policies that began in 1978 were partly motivated by the need to address this problem, and the dramatic changes that resulted are well known. One of the most noticeable changes was that foreign capitalists and Chinese businessmen were encouraged to play a significant part in the economy, along with the state companies, which continued to exist. The introduction of a stock market in 1992 was widely regarded as a sign that the reforms had become irreversible.

To be sure, there has been enormous economic progress achieved in the reform era; the vast wealth destroyed by the Soviet economic model is quickly being restored. But unresolved issues remain. The most basic issue is this: how to completely transform a government-run economy into a market-oriented one. That issue has brought one fundamental conflict to the fore: the double role being played by the government, as it attempts to be both a "player" and a "referee" in the economy at the same time. This basic conflict of interest tempts countless government officials to utilize excessive government power, left over from the Mao era, for personal gain - and many have failed to rise above the temptation. Nowhere are the effects of the player-referee conflict more visible than in the stock markets.

China's stock market woes - and their cause
Building a stock market with 1,400 listings in a short time is an impressive achievement. But the market has had built-in flaws since day one. In theory, stock markets follow a competitive principle: investors put money into good companies, and not into bad ones, which allows the good companies to grow with the help of investors, while the bad ones die out. In the end, wealth is created. But the Chinese stock markets have hardly followed this rational path so far. In reality, they have run into all sorts of nightmares, with one common cause: continued government domination.

To begin with, the number of companies that want to be listed is hundreds of times greater than the number of listing slots available. Listing rights are controlled by multiple government units, at central, provincial and local levels. This arrangement presents ample opportunities for corruption, and it is hardly surprising that listing rights frequently go to companies whose business qualifications may be less than sound. Furthermore, companies frequently fudge their financial numbers in order to meet listing requirements. While regulatory bodies exist that are theoretically empowered to stop such abuses, in practice they have been too weak to do so.

Once a company is listed, the reward mechanism that should operate is greatly weakened by the prevalence of manipulative practices. There are many sources of "hot money" in the Chinese markets: state-owned banks and state sector companies, for one. "Pumping and dumping" happens in China also: hot-money investors push up weak stocks to sky-high prices by buying in massive quantities, then sell quickly for a fat profit, leaving small investors holding the bag. Regrettably, various investment brokerages have become involved in such practices by making short-term loans to such speculators. Worse still, they sometimes play the game with their clients' money, by promising fat profits to the clients.

The lack of effective regulation has created an "anything-goes" atmosphere around the Chinese financial markets. The manipulators have done well for a long time without getting punished, attracting even more abusers. One "Chinese Enron", De Long, founded by four brothers, was active for many years in this manner: it borrowed heavily and tried to manipulate the stock market. The founders were convinced that their company was "too big to fail", but they were wrong, and De Long collapsed recently, leaving huge uncollectable debts - believed to billions of dollars - for various Chinese banks.

The greatest damage done by the stock market excesses is that they are impeding China's critical goal of transforming and modernizing Chinese companies, both state and private. With capital flowing so freely, the listed companies have little incentive to introduce modern, professional management, to say nothing of transparency and accountability. This problem is exacerbated by the fact that 90% of the listed companies are still controlled by various government entities, making them directly responsible to government officials - not to the market or to investors. Indeed, government officials, being controlling shareholders, can effectively control these businesses through such means as the appointment of key managers. The net effect is to turn market transactions into bureaucratic transactions.

Naturally, financial wrongdoing, in all its multiple forms, is hardly exclusive to China; every country with a stock market has witnessed a certain amount of manipulation and sleaze. Behind the bursting of the Japanese stock bubble, for example, was the widespread practice of cross-holding among banks and their corporate clients, which helped to prevent Japan Inc from having professional, merit-based management. China Inc's key problem - bureaucratic meddling - may be different, but escaping the traps created by past practices will be easy for neither country.

Split-share reform as an aspect of privatization
On the plus side, the atmosphere in China has become more conducive to systemic reform. There is a broad consensus in society that the government should withdraw from the business world and concentrate on the referee role. As such, sales of state assets have picked up recently, not limited to the stock market alone. It is clear that the split share structure reform policy fits these general developments. At the same time, the government entities involved have a huge financial interest in the outcome. Privatizing creates enormous windfalls for them, giving them enormous incentives to do so.

Consequently, Beijing, which sees asset sales as a convenient way to dump troublesome enterprises and generate hard cash at the same time, is actively trying to list more state assets, both within China and overseas. Now, even the "Big Four" state banks - the Industrial and Commercial Bank, the Bank of China, the Construction Bank and the Agricultural Bank - are trying to get listed. But average investors remain worried. Based on past experience, they fear that even needed reforms are just another government ploy to get their money. So, selling government-owned shares, as desirable as it might be in theory, has had the practical effect of pushing the market down even further, and no lower limit is in sight.

Crossing the river by feeling the stones underneath
An old Chinese saying says, "messes are best cleaned up by their makers". Indeed, Beijing is trying to escape a stock market mess of its own creation. The only problem is that the market is nervous. Beijing's solution to these jitters is to carry out the plan gradually over a long period. The government hopes that by proceeding in this manner, large-scale disruptions can be avoided.

So in the immediate term, Beijing has chosen to sell the remaining shares of four companies as an "experiment", which aims to find practical ways to meet the ultimate goal of fully floating the entire market. Beijing is approaching the problem cleverly. The procedure for selling the four stocks is more like a bargaining game between regular investors and the entities holding non-tradable shares. The latter must offer some incentives to the regular shareholders before gaining the ability to trade the shares. Superficially, this seems like a reappearance of the old Chinese game, "pitting people against people". But this time, Beijing wants to act as a neutral arbiter of others' disputes, which represents tremendous progress.

For one of the "experimentally" listed companies, Sany ("Three One") Heavy Industry, the proposal is that the holders of formerly nontradable shares must give both cash incentives and shares to regular shareholders before being permitted to freely trade their holdings. The proposal calls for regular shareholders to get three free shares plus 8 yuan in cash compensation for every 10 formerly nontradable shares sold. The announcement of this proposal caused all the regular shareholders of the company to immediately calculate their gains and losses, and indirectly is causing all investors to do the same thing for their shares. Market reaction to the new plan was positive: Sany and two other "experimental" companies have been trading up smartly for the last several days.

The gradualist approach may work out in the end for the remaining companies. Countless investors now agree that having a fully tradeable stock market is unavoidable, even if some investors will have to pay more for this change than others. Fortunately, the market fundamentals are improving. The top 50 listings in Shanghai had a 2004 price/earnings ratio of about 16, which most global investors would consider reasonable. Many feel that these listings are a good investment already. Undoubtedly, unwinding the government's business stakes is necessary for China to truly move forward. Despite the short-term pain, it will be positive in the end, as the stock market becomes more like a "real" one. The reforms also represent a larger trend: China is embracing international norms with respect to ownership structure, corporate governance and professional management, among other significant things.

The road ahead
The trends are in the right direction, but two basic issues remain to be fully addressed. First, there must be a decisive separation of government interests from the business sphere. The government must irreversibly commit itself to only being a dutiful watchdog, not a market competitor as well. China cannot establish a sustainable, modern economy without this change. Second, all existing state and private-sector companies must be transformed into modern business organizations using up-to-date management methods. Above all, business organizations must be held accountable to law and to their customers.

There is a long road ahead to achieve these goals, but there is no alternative and no shortcut. If the Chinese economic reforms have produced one great lesson so far, it is this: wealth is created by entrepreneurs, laborers and managers, not the government. These groups must have the right environment to succeed, and the entire society is responsible for producing the necessary support for their work. Accordingly, curtailing excessive government power over the economy is nothing less than a necessary goal for the Chinese civilization. In the reform era, China has already taken a giant step forward in this direction, and continued progress is the only way China can achieve its national goals.

George Zhibin Gu, author and business consultant based in China, is the author of a forthcoming book, China's Global Reach: Markets, Multinationals, and Globalization (Haworth Press, Fall 2005).

Copyright (c) 2005 George Zhibin Gu