Stocks or real estate for China's middle class?
By Min Xu

China is one of the most savings-oriented nations in the world: total personal savings deposits amount to over 12 trillion yuan (US$1.48 trillion), or around 50% of income. For thousands of years people have been accustomed to putting money under the mattress, and the intermediating role of a banking system has been well suited to the traditional, conservative mentality of saving at a risk-free rate for the future. This mentality, however, is rapidly changing.

The low savings deposit rates - the one-year deposit rate is now 2.25% and the five-year rate is 3.60% - give those who are profit-oriented an incentive to explore alternative investment channels. In addition, a middle class growing in affluence has emerged over recent years, especially in rapidly developing coastal cities. It is estimated that 66% of all savings deposits are controlled by only 10% of domestic depositors. These higher net-worth individuals espouse the same consumerism pervasive in more developed countries, and are avid endorsers of Deng Xiaoping's famous expression "to be rich is glorious". They aspire to the best cell phones, luxury brand clothing and accessories, automobiles, and high-end homes. They are no longer satisfied with collecting paltry interest on their bank savings and are hungry for positive real returns on their assets.

Since the general population is still largely prohibited from exchanging yuan into foreign currencies, the domestic stock market and the property market have become the two most viable options for investments. Unfortunately, given the nascence of both these markets, individual investors lack the sophistication of those in more developed countries. Their investment horizon is typically short; they often do not fully understand the product or company they have invested in; and a "buy-and-trade" strategy is often preferred to a "buy-and-hold" strategy. These investors tend to follow the bandwagon while making investment decisions, participating previously in the 1999-2001 stock market bubble and more recently in the property market bubble.

Over the past four years, the stock market and real estate market in China have gone in completely opposite directions. Despite robust growth in the economy, the market capitalization of stocks trading on the Shanghai and Shenzhen stock exchanges - China's two stock exchanges with over 1,400 listed companies - has tumbled 45-55% from their peak levels in 2001. The distressed stock market is the result of the following factors: poor performance of state-owned companies listed on the exchanges, a lack of information transparency and a sound legal infrastructure for the securities market, and a significant erosion of confidence among unsophisticated retail investors who suffered substantial capital losses.

The real estate market, on the other hand, has flourished. The property market in Shanghai, one of the hottest in China, grew 60% in 2004 over the 2003 level, while housing prices have increased 200% over the last two years. This was partially an adjustment of the imbalance between supply and demand in populated cities such as Shanghai. Even more importantly, the expansion of the real estate sector was fueled by commercial banks' lenient lending policy to developers and individual housing purchasers as well as speculative buying and trading activities. Despite numerous government measures introduced since 2004 to cool down the property market, the real estate selling price in China is still expected to grow 8.3% year-on-year in 2005, according to the National Bureau of Statistics (NBS).

The government's intention in cooling down the housing market is twofold: first, to prevent a hard landing, and second, to direct capital from the property market into the stock market. So far, there is little evidence that the latter shift will materialize. According to a poll of 2,700 small investors released by Huading Market Survey Corporation in July 2005, 85% of the investors had lost money in the stock market since the beginning of 2005, and only 3% intended to invest in equities within the next year.

The stock market
The Shanghai and Shenzhen Stock Exchanges were founded in 1990 and 1991, respectively. Publicly traded shares received an overwhelmingly positive response from small domestic investors, who perceived the stock market as a far superior alternative compared to savings accounts generating miniscule returns. The lack of alternative investment options and extreme enthusiasm among unsophisticated investors helped drive the equity market to untenable levels.

Between 1998 and 2000, the market capitalization of tradable shares on the two stock exchanges almost tripled from 574 billion yuan to 1.61 trillion yuan, even though the total number of listed companies only increased moderately from 931 to 1,171. The average price/earnings (P/E) ratio of A-shares - targeted toward domestic investors - on the Shanghai Stock Exchange increased from 34.4 to 59.1 over the same period. Analogous to the Internet bubble in the US in the late 1990s, this level of overheating in the Chinese equity market was clearly unsustainable. Furthermore, until 2000, the majority of listed companies were selected via a quota system, whereby provincial governments negotiated the quota for the region with the China Securities Regulatory Commission (CSRC), elected the companies they would like to support, and submitted information about potential candidates for approval. This process, tightly controlled by administrative authorities and highly lacking in transparency, has contributed to the poor quality of many companies listed on the exchanges. Investors, who once swarmed the flourishing stock market, were disillusioned by the exposure of fraud and material financial misrepresentation in listed companies.

In April 2001, the share price bubble burst, due to the combination of the government's announcement of plans to float state-owned shares in the market and the uncovering of significant fraud in listed companies. This yielded substantial losses for investors, who have never quite recovered their confidence in the equity market since then. The market value of tradable shares listed on the two exchanges declined from 1.61 trillion yuan at the end of 2000 to 1.17 trillion yuan at the end of 2004, even though the number of listed companies increased from 1,171 to 1,372 over the same period. The total market value of shares resumed its decline in 2005, to 990 billion yuan.

Currently, the total market capitalization of publicly traded companies amounts to 3.2 trillion yuan, of which only 31%, or 990 billion yuan, is attributable to tradable shares. The remaining shares are non-tradable, largely held by the government. On April 19, the Chinese government announced, for the second time, plans to float state-owned shares in public companies in order to fund its social security system. The government had first attempted this program in June 2001, yet revoked its plans after share prices plunged 30% in three months.

The split share structure reform program is to be implemented in three stages. Four companies were selected for the first stage of the program, each of which was required to negotiate a compensation plan for shareholders of the tradable securities. To date, three of the four firms' split-share reform plans have been approved by the majority (at least two-thirds of voting rights) of holders of tradable shares, whereas one firm's plan was rejected. The second stage of the program involves 42 companies, including some of the largest SOEs such as Baosteel, Yangtze Electric Power, and CITIC Securities. Many of these companies have already unveiled their compensation plans - typically two to three bonus shares for every 10 tradable shares held, although some firms have adopted more complex proposals involving instruments such as warrants. Should the first two stages of the program succeed, the government will then proceed to deal with state-owned shares in the remaining companies on the stock exchanges. All new IPOs and secondary stock offerings of listed companies are suspended until further notice.

Even though existing owners of tradable shares will be given compensation in the form of stock or cash, the payout is nevertheless insufficient to offset the dilution in value from the flotation of state-owned shares. As a result, stock prices resumed their decline on the exchanges following the announcement of the reform program. The approval of the plans by shareholders despite the meager compensation may be attributable to the pressure imposed on fund management firms, who together hold about 22% of the total market value of tradable shares, according to Xinhua estimates. They were instructed to "look at the difficulty the Chinese stock market is experiencing from a rational perspective" in a meeting with Shang Fulin, chairman of the CSRC on June 5.

In an effort to salvage the depressed stock market, the Chinese government implemented a series of measures to stimulate demand, including the following: