china syndrome....
China's $600 billion casino
Justin Doebele, Forbes Global, 10.01.01
Can it become a stock market?
Guangxia (Yinchuan) Enterprise, a diversified biochemical company, was once a darling of the Shenzhen stock exchange, one of China's two stock markets. Its shares climbed from a price of about 50 cents at the time of its listing in 1994 to roughly $4.50 in May 2001, buoyed by five years of rising profits.
Then Caijing, a local muckraking magazine, revealed in August that the Ningxia-based company had fabricated some $90 million in earnings over the past two years, wiping out its entire reported profit of $50 million in 2000. Figures for exports, sales and production were also bogus. A deputy chairman of the company resigned, and a full investigation is under way by regulators.
This is a typical tale of woe from the Shenzhen exchange. And China's other exchange in Shanghai has similar travails. Wu Jinglian, a Chinese economist, voiced the opinion of many when he said on the state-owned TV in January: "The stock markets [in China] are worse than casinos, because even casinos have rules."
China's two stock exchanges could be dismissed as irrelevancies were it not for the fact that their combined market capitalization now exceeds $600 billion. An impressive figure given the fact that Shanghai's exchange is only 11 years old and Shenzhen's 10. This gives China the ninth-largest stock market in the world, not including Hong Kong's.
Size counts. In August, China Petroleum & Chemical (Sinopec) issued $1.4 billion of shares in the Shanghai stock market. "In three to four years, China could start to raise all the capital it needs inside its own markets," says Joe Zhang, head of China research at ubs Warburg in Hong Kong. In 2000 China raised $21 billion in overseas capital markets but only $1.4 billion so far this year. By contrast, $11 billion was raised inside China this year.
China's market is now No. 2 in Asia behind Japan, with one fifth its market cap. (Hong Kong is third, with $525 billion.) The gap between China and Japan could close rapidly. "If we continue along our present route and assuming that Japan doesn't reinvent itself, we're likely to surpass Japan as the world's second-biggest market in ten years," says Anthony Neoh, an adviser to the China Securities Regulatory Commission and formerly chairman of Hong Kong's Securities & Futures Commission.
This is not as far-fetched as it might seem. Many believe that China's economy, now $1.2 trillion, will continue to grow by 8% or so a year, thus doubling in size every decade. If China's stock market expands along with the economy, it will merely be reclaiming the primacy it held before World War II, when the Shanghai bourse was one of the world's biggest capital markets.
The market then was a den of double-dealing. The main difference is that the Communist Party is now responsible for any skimming off of the cream. There are 1,200 listed companies in China, and nine in ten of those are majority-owned by the state. Until March of last year, party bosses in the provinces decided which of these enterprises could list their shares. Newly listed shares used to double or triple in value on the first day of the IPO. Until a few years ago, these profits were often pocketed by insiders close to the party. And there was plenty of gravy: For the past 11 years, China has given birth to a public company every two working days.
And the IPO is but the first sip. "Insider trading is a common practice," says Jingzhou Tao, a corporate lawyer with Coudert Brothers in Beijing. "There's widespread creative accounting, and there are suspicious related-party transactions. It makes people afraid to invest." But who is going to blow the whistle when all 100 securities companies in China are state-owned?
The China Securities Regulatory Commission (CSRC), that's who. Given that the commission was produced by the very system that spawns corruption, it's a shock to discover that CSRC is not only trying to turn the casino into a stock market but is also making some headway. Since early last year it has:
• Changed the way companies are chosen to be listed. Since March last year, China's 33 authorized underwriters, instead of provincial governments, have competed to select companies and take them public.
• Delisted two companies that lost money three years in a row (and vows that many more will be delisted soon). In the past, the stock of a company in poor financial shape was placed on a watch list for delisting, where they often became the focus of speculation because investors assumed they would be bailed out.
• Required all listed companies to have two independent directors by June 2002, to rise to one third of the board by June 2003. Before this rule, introduced in August, companies didn't have to appoint outside directors.
• Told all listed companies to begin issuing quarterly financial reports from next year (only semiannual unaudited reports have been required). The commission has also said that all listed financial firms must be audited by a "big five" accounting firm.
• Begun an investigation in August of Sanjiu Enterprises, formerly owned by the People's Liberation Army, for misappropriation of about $300 million in funds. The company is famous in China for its 999 brand of drugs. Expect more such well-connected companies to be scrutinized by the commission.
"You can't just have rules. You need to enforce them robustly," says Laura Cha, one of four vice-chairmen at the securities commission. Cha was formerly second-in-command of Hong Kong's Securities & Futures Commission. She is one of a series of well-regarded hires made by Zhou Xiaochuan, who was appointed by Premier Zhu Rongji to chair the CSRC in February 2000.
Zhou has impeccable credentials for the job. He has written ten academic books extolling economic reform, and he helped set up China's first investment bank and first investment-management company. "Zhou is one of China's leading reformers," says Nicholas Lardy of the Brookings Institution in Washington, D.C.
Zhou's deputy is Gao Xiqing, nicknamed Typhoon Gao by the press, because of his fastpaced work habits. Gao, who was a corporate lawyer in New York, cowrote a letter to China's central government in 1988 calling for the establishment of a stock market. He returned to China three months later to help set one up and has been involved in it ever since.
Before Zhou's appointment, the CSRC was slowly developing from a toothless government agency, established in 1992. Zhou accelerated the process of reform and curbed the economic autonomy of the provincial governments. He has required many of the 1,000 commission employees who work outside Beijing (another 300 are in the capital) to move regularly from one province to another. And he's made them answerable to him in Beijing. "The stock markets are in puberty--lots of growing pains," says economist Dong Tao of Credit Suisse First Boston in Hong Kong. "But China is trying to impose discipline on the markets."
If many party officials benefited from the old way of doing things, why was the securities commission revamped? For the same reason that China is joining the World Trade Organization. The communists need to modernize the economy to have any hope of clinging to power.
And there's no doubt of the urgent need to improve the efficiency of the capital markets. The Chinese are avid savers (37% of GDP is saved), yet there are few things in which to invest the $845 billion pool of household savings: bank deposits yielding 1.8% after tax, government bonds paying not much more or stocks. Local Chinese investors account for 90% of the $2.5 billion daily average turnover of the stock markets, and because of the paucity of reliable information, they tend to buy and sell on rumor. In October last year, Caijing magazine leaked a report by the Shanghai exchange that as many as 140 stocks were manipulated by brokers between August 1999 and April 2000.
Few of China's 40 million shareholders bother to ask questions about the stocks they buy. "Many investors don't care as long as prices are going up," says Fang Xinghai, a former senior executive at Galaxy Securities, China's largest brokerage. At least they've bet the right way. The two markets have each grown in valuation at a compound average annual rate of 21% over the past five years.
This impressive performance probably owes more to there being too few stocks relative to demand (despite the flood of new listings) than to the marvelous quality of the listed companies, although 8% annual GDP growth helps.
Tales of stock swindles are being given more attention in the business press, and individual investors are starting to raise a stink when they believe they have been defrauded. A group of at least 350 investors is preparing China's first class-action lawsuit this month, in civil court in Beijing, against a group of brokerages and a listed company, Yorkpoint Science & Technology, for allegedly defrauding them of a reported $54 million in transactions involving Yorkpoint's stock.
Another straw in the wind: China's securities commission authorized the launch of the first open-ended mutual fund in September by Huaan Fund Management, with JP Morgan Chase's JF Asset Management as adviser to the fund. "Chinese can now give their money to a professional investor," says Blair Pickerell, chairman of JF Funds. As additional mutual funds are introduced, the standard of securities analysis is likely to rise.
Foreign investors may get a chance to play soon, too. Neoh says that the CSRC wants to develop a system similar to Taiwan's qualified foreign institutional investor regulations, allowing large investors to invest preset amounts under strict rules in Chinese stocks.
But without an increase in the number of listings, the advent of mutual funds could merely increase the amount of money chasing a limited number of stocks. At the moment only about a hundred listings are not state-owned companies, a tiny number considering that sector companies account for at least $480 billion of China's annual output.
The securities commission attempted to find one way around the problem by preparing for the establishment in Shenzhen this year of a Nasdaq-like market that would have listed many private-sector companies. A roster of about 300 companies was drawn up for listing. But the plan was postponed indefinitely by Beijing after the slump on Nasdaq.
The CSRC now vows to focus on three areas: encouraging small investors to sue when defrauded, possibly in class-action suits; ensuring that all listed companies--not just financial firms--adopt better accounting standards; and "enforcement, enforcement and enforcement," says Cha.
The securities commission must move fast. "The private sector has grown to a size where it needs to be able to finance its operations through the capital markets," says Tim Condon, the chief economist of ING Barings in Hong Kong.
With Beijing's continued support, the commission has a good chance of keeping up the pace of change. "The country is committed to reform of the financial sector," says Neoh.
China's stock market may eventually be a good place in which widows and orphans can invest. If so, they will have Zhou and his regulators to thank.
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