How an international board will free up China's stock market

Bourses headed for better times as economic confidence improves

After a roller-coaster year, China's equity market closed with cautious optimism not seen since 2007.

The Shanghai Composite Index had a small gain with year-to-date return of 3.17% (as of Dec 31). This is a considerable improvement since the market slipped in late November when the index stood at less than one-third of an index peak of 6124 in October 2007.

The recent performance, however, still compares rather poorly with market indexes from important economies in the world. The S&P index, the FTSE, Nikkei, and Hong Kong's Hang Seng indexes all ended the year with a strong year-to-date return in spite of lackluster overall economic performances.

Though China's recent performance doesn't stack up to its standards from previous years, its macroeconomic performance remains robust relative to emerging market peers as well as major advanced economies such as the United States, the European Union and Japan. The contrast between China's GDP growth and its stock market returns raises questions as to why China's share market is not a reflection of its economic fundamentals.

China's stock market performance has shown little relevance to its economic performance over the last two decades. From 1992, when the stock market was first established in Shenzhen, until 2012, China has grown at an annual rate of around 10 percent, but its stock market performance has been extremely volatile. The stock market has been affected little by the country's long-term growth potential and more by its regulatory policies, the lack of forceful enforcement of securities laws and regulations, as well as the vicissitudes of short-term macroeconomic policies.

One of the main objectives of China's stock market in the early 1990s was intended to help promote reforms in state-owned enterprises and reduce their debt. Through incorporation, the government could help enhance the governance of SOEs. By relinquishing a portion of ownership, the State could secure necessary funding, mostly from the retail investors, to mitigate the debt burden of SOEs.

Though it has helped to relieve the debt of small- and medium-sized SOEs and played an important role in helping to revitalize China's SOEs, it has also created important institutional impediments that may have prevented the market from becoming a market for investors to generate long-term wealth.

For example, a requirement that SOEs must allow less than 20 percent of its shares to be listed suggests that the majority of the shares are still within State hands. Listed firms can thus decide how much to pay out as investors' dividends. In most cases, dividends are not paid out.

The lack of institutional investors also makes the dividend policy even less likely to be enforced. With little investor protection and selective enforcement of securities laws and regulations, China's stock market has become a haven for speculators rather than a place for long-term investment. Some say the Chinese stock market is worse than a casino.

Other than these institutional shortcomings, alternative channels of investment have opened up for Chinese property investors. These investors have made the stock market a more attractive place to invest their savings.

The private property market has taken off after the late 1990s. If one were to invest 100 yuan ($16; 12 euros) in China's property market in 2000, the average return by 2012 would have been at around 285 percent. The same amount of money invested in a bank would have yielded a return of 139 percent, while the same amount of money invested in the stock market would have yielded 135 percent.

As such, the Chinese stock market has offered the lowest returns for Chinese investors over a long period of time.

The fear of Chinese retail investors losing interest in the stock market has forced regulators to strengthen its capability to protect investors. Indeed, progress has been made. The China Securities Regulatory Commission has enacted a slew of new and important regulatory changes to protect investors.

Of particular note, the CSRC has issued a guidance to force listed companies to pay dividends to investors; it has become tougher in cracking down on insider trading; it has strengthened the importance of information disclosure before a company's initial public offering; it has improved the mechanism to delist firms that are no longer fit to be traded on the market; and it has enlarged the quota of qualified foreign institutional investors to around $80 billion (60 billion euros) from the previous quota of around $30 billion. It also encourages China's own pension and housing provident funds to invest in the stock market.

These measures are laudable, suggesting the Chinese stock regulator is now serious in strengthening the rights of investors. But one should not have high expectations for rapid improvements because an institutional evolution usually endogenous goes hand-in-hand to the level of a country's economic development.

For example, the 2012 Corruption Perception Index published by the Transparency International ranks China at 80 among the 176 countries and economic entities surveyed. This implies that the new CSRC measures will only have a limited impact in helping improve the protection of investor rights as long as the overall quality of China's institutional and legal framework remains poor relative to advanced economies.

To defy the slowly evolving institutional environment, what the CSRC could do is further open the Chinese stock market by not only allowing international investors to bring capital to China's stock exchange via the QFII stimulus scheme, but also allow multinational firms already operating in China to become listed on the Shanghai Stock Exchange. An international board in the Shanghai Stock Exchange has indeed been discussed over the last couple years and it appears that the Shanghai Stock Exchange has been technically prepared for such a launch for some time.

There are important benefits to allow those leading multinational firms to become listed in China.

First, those firms will offer investment opportunities for Chinese investors because some are the cream of the crop among global firms.

Second, they can help set high standards for disclosing information because they have already been listed in key stock markets around the world where information disclosure is much more stringent than in the Chinese market.

Third, their listing in the Shanghai Stock Exchange will also reduce capital inflow to China as they no longer have to bring in capital from abroad for their Chinese business expansion.

Finally, their appearance in China's stock market will also make the Shanghai Stock Exchange a truly international exchange. This will also help boost Shanghai's status to become an international financial center.

Some fear that allowing multinational companies to garner listings in China could divert market liquidity, leading to an even lower Shanghai Composite Stock Index.

But one must understand where Chinese residents allocate their assets across different asset classes such as bank deposits, the stock market and the property market.

At this stage, Chinese residents still put much of their wealth in bank deposits and in the property market with considerably less in the stock market.

If the stock market offers a good return on investments, there could be more funds flowing from the bank deposits to the stock market. Therefore, the fear of liquidity diversion is exaggerated.

So what will be in store for China's stock market in 2013? There are some favorable initial conditions indicating that China's stock market could improve.

There is more confidence in China's economy after a successful political transition. With the economic rebound in the fourth quarter of 2012, the fear of a hard landing is diminishing. Meanwhile, the economy has gone through a rapid de-stocking process and enterprise profitability has returned.

Second, the stock market valuation in terms of the price and earnings ratio may have reached the bottom. Optimism in China's rebounding growth suggests the future earnings capacity of listed firms will only increase. This will then boost share prices.

Third, more capital flows will return to China as the major central banks in the world are still engaging in various forms of qualitative easing. Ample global liquidity conditions will certainly favor growing emerging economies. These positive domestic and external conditions, if supported by greater access to China's stock market for multinational firms, could create a strong stock market in 2013.

The author is the chief economist for Greater China with Australia and New Zealand Banking Group.

(China Daily 01/04/2013 page15)