HONG KONG - After five years of declines
on almost non-existent volume, China's B-shares -
shares in Chinese companies whose sale is
officially limited to foreigners - finally seem to
be back in favor. As of January 25, the Shanghai B-share index
was up 40% year-to-date while its Shenzhen
counterpart had risen 26%. Combined average daily
turnover in the two markets rose from US$12.9
million in December to $83.2 million in the first three
weeks
of January. And B-share new account openings have
quadrupled since the start of the year.
Ironically, all this excitement in the
historically soporific B-share market has been
generated by speculation that the B-shares may be
phased out, possibly starting some time this year,
either through conversion to A-shares or to Hong Kong-listed
H-shares. The former possibility is the most
probable and certainly the most interesting to
investors.
A- and B-shares are identical
in all respects but one - the former are settled
in local currency while settlement for the latter
is done in either Hong Kong dollars (in Shenzhen)
or US dollars (in Shanghai). Nevertheless, for
most of the 110-odd companies with listed
B-shares, the A-share is at a large premium,
implying big gains for B-share holders were the
two asset classes to merge. (There is only one
company whose B-share trades at a premium to its
A-share - Shenzhen-listed property developer China
Vanke.)
The B-share discount has always
been something of a mystery. When the B-shares
were introduced in the early 1990s, ownership was
officially limited to foreigners, though in
practice locals trading through nominee accounts
usually seemed to account for the majority of
transactions. In those days, it was possible to
believe that the discount might be the result of
differences in expected returns between those with
market access and those without. In fact,
researchers at the US Federal Reserve concluded in
a 1998 paper that a 4% expected return
differential would be enough to explain the higher
A-share prices.
Alternatively, it was
often suggested that the discount was due to poor
liquidity, B-share trading volumes typically being
only a fraction of those of the corresponding
A-shares. Of course this only begged the question
of why there was so little trading in the first
place. The most likely explanation seemed to be
that most of the B-shares had been initially
placed out to foreign institutional investors who
used buy and hold strategies and had long time
horizons.
In 2001, however, the mystery
deepened when the B-share market was officially
opened to local investors. This policy change
initially resulted in a dramatic narrowing of the
price gap between the two classes of shares as
B-share prices skyrocketed, with the average
(market capitalization weighted) discount falling
from pre-reform levels as high as 80% to the
30-40% range. From February 19, 2001, when the
reform took effect, to June 1, 2001, the Shanghai
and Shenzhen B-share indices rose 2.9 and 3.5
times, respectively. Average daily turnover
increased to previously unheard of levels, rising
from a combined $34 million for the two exchanges
in 2000 to $633 million during the period from
March 1 to June 1, 2001.
In the second
half of 2001, however, the B-share indices fell
sharply along with the rest of the market after
the announcement of a plan to list
state-enterprise shares. The decline continued
almost without interruption until the end of last
year. Even with January's gains, Shanghai B-shares
have lost almost two-thirds of their value from
the 2001 peak, while the Shenzhen B-shares are
down 45%.
Most interestingly, average
discounts to the corresponding A-shares have
remained in the same 30-40% range reached in
mid-2001. In the first half of that year, about
90% of large foreign B-share holders reduced their
holdings, with the average reduction in excess of
40%. This makes developments since that time truly
mysterious. After such a big transfer from
foreigners to locals, it is hard to see how there
can continue to be such large B-share discounts.
After all, there can hardly be an expected return
differential between investors in the two classes
of shares when these investors are in fact the
same people.
Another puzzle is that by
2002, average daily volumes had fallen back to the
anemic levels of the pre-reform period. The
opening of the market to local retail punters
should have resulted in much higher turnover but
somehow, with the exception of a few months in
2001, this hasn't happened.
By now, the
B-share markets have become almost completely
irrelevant; some would even describe them as an
embarrassment. Their combined market
capitalization is only about $10 billion (about
60% of this in Shenzhen), less than 10% of that of
the listed A-shares, and they have long since
ceased to play any significant role in raising
capital for Chinese companies. In fact, there have
been no new B-shares listed since 2001.
But it is this very irrelevance that has
suddenly revived interest in them. With the
expansion of the Qualified Foreign Institutional
Investor (QFII) program, which allows foreign
portfolio investment in A-shares, and new rules
allowing strategic foreign investors to buy
A-shares even without a QFII quota, many now
believe that there is no longer any reason for the
B-shares to continue to exist. This idea gained
additional currency in mid-January when Zhou
Qinye, executive vice president of the Shanghai
Stock Exchange, expressed the view that trial
B-share conversions of some type could conceivably
start before the end of this year. His comments
led to a veritable feeding frenzy as investors
became convinced that the long-awaited conversion
to some other type of asset must finally be at
hand.
Exactly how the B-shares might
eventually be eliminated is an important question
for anyone seeking to profit from such an
eventuality. None of the proposals now being
suggested would be entirely straightforward to
implement.
If B-shares are converted
directly into A-shares, it is not clear how
shareholders will convert the local currency they
get when they sell. Converting B-shares to Hong
Kong-listed H-shares is only an option for
companies that can meet the Hong Kong listing
requirements, and in any case seems less
interesting from the B-share holder's point of
view. Historically, H-shares have traded at
discounts to their corresponding A-shares and,
particularly in the case of the smaller B-share
companies, liquidity in Hong Kong might continue
to be poor.
If there are trial programs
this year, many believe they are most likely to
involve buybacks by major shareholders such as the
state-owned parents of listed companies. This
option also implies a conversion to A-shares;
otherwise the goal of eliminating the B-shares
would not have been achieved as the purchasers
would continue to hold them. But in this case the
conversion would be done by large Chinese
corporates, for whom the associated problem of
converting local currency into US or Hong Kong
dollars is likely to be less of an issue than it
would be for minority shareholders.
As
long as there is a B-share discount, such buybacks
make sense from the major shareholder's point of
view, providing that the purchase can be financed
by selling A-shares. Here the question is simply
one of how the financing would be arranged. The
amounts involved would be large relative to the
size of the listed companies. B-shares account for
34% of the capital of the average issuer.
But things might be even better if
the B-shares continue to exist. There is
now considerably more foreign demand for A-shares
than there is supply of the QFII quota foreigners
need to buy them. This can easily be seen from the
20% premium to net asset value (NAV, or assets
minus liabilities) people are now paying for the
Hong Kong-listed FTSE Xinhua Index tracker fund,
which tracks an index of 50 big-cap A-shares. If
some of this excess demand were to flow into the
B-share markets, the B-share discount might well
become a B-share premium. The prospect of
conversion to A-shares would then be quite
unwelcome.
For A-share bulls, the B-shares
must be starting to look like something of a
no-brainer. Conversion to A-shares, whether done
by major shareholders after buybacks or in some
other way, seems the most likely scenario in the
long run. This would be consistent with the
regulators' present policy of eliminating the
differences among the various classes of Chinese
shares (eg through converting the state's
untradable holdings into A-shares). But even if
this does not happen soon, foreigners without QFII
quota can still be expected to get on board.
Either way, the B-shares can easily continue to
outperform.
Mark A DeWeaver,
PhD, worked as a research analyst in Shenzhen from
1991-95, first for W I Carr and later for
Peregrine Brokerage. He manages Quantrarian Asia
Hedge (www.quantrarian.com), a fund that invests
in Asian equities, and can be reached atdeweaver@quantrarian.com.
(Copyright 2006 Mark A DeWeaver. Used
by permission.)
