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Raging Growth And Rickety Bourses


If the mainland is to wean itself from the simple bank loans that now finance almost all investment, it must have fully developed bond and stock markets. But for most of their 14-year history, the Shenzhen and Shanghai stock exchanges have been unworthy of the name. Originally designed to enrich the stakeholders of privatized state companies, the bourses have become littered with small local companies with suspect financial statements and shares that are sold by often-corrupt brokers who allegedly make their money by manipulating prices.

China's latest IPO is further evidence of how discredited the markets are: When it has its big initial public offering in late October, China Construction Bank will eschew the mainland exchanges in favor of a listing in Hong Kong. Others list in London and New York. And it's no wonder most investors have fled the Shanghai and Shenzhen bourses, which hit eight-year lows in June, though they have since rebounded. "Average p-e ratios have fallen from about 60 times earnings in 2001 to 15 now," says Fang Xinghai, deputy chief executive of the Shanghai Stock Exchange. "The small investor is at a loss."

Now the government is finally taking action. Step one is to sell off the state's stakes. Two-thirds of the combined $406 billion market capitalization of the nearly 1,400 companies now listed in China is held by government departments and state-linked companies. Dumping those shares on the market will drive prices down initially, so the government will compensate holders of the local-currency "A" shares that make up most of the market with cash, warrants, and additional shares. It tested the program four months ago by selling off government holdings in 46 companies. After initial market turbulence, the pilot program went smoothly, and the local stock markets have recovered 10% of their value since June.

Gradually the compensation program will be extended to the rest of the market. "This removes a huge cloud of uncertainty," says Tian Rencan, chief executive of joint venture fund-management firm Fortis Haitong Investment Management Co. Just as important, once shares in mainland-listed companies are more widely held, public shareholders can demand better corporate governance. "With more shares in the free float, that will mean more rational investors, more vigilance, and a bigger voice in shareholder meetings," says Nicole Yuen, who oversees the $800 million Swiss bank UBS () has invested in the "A" share market for its clients through China's Qualified Foreign Institutional Investors program.

Meanwhile, the government has begun to tackle the problem of brokerages, many of which are bankrupt after paying investors guaranteed returns and losing money on their own share trading. In September the government, which had kept many brokers alive through bailouts, announced that it will create a fund to protect investors against brokerages that go bust. Here, too, Beijing wants foreign investors to help. It just gave UBS the nod to pay as much as $210 million for a 20% stake in state-owned Beijing Securities.

The government also has a plan to revamp the rules that determine which companies can list in Shenzhen and Shanghai. Those regulations historically have favored companies with political connections. The result: "Chinese residents haven't gotten the chance to invest in their best businesses," says Malcolm Wood, a regional strategist for Morgan Stanley (). Now the China Securities Regulatory Commission has made the process more transparent, allowing more deserving companies to come to market.

Still, the reforms are a work in progress. The government, for instance, has failed to clearly define the terms of the program for compensating shareholders, which has led to speculative buying of companies expected to offer generous payouts. "Some market players see this as a once-in-a-lifetime opportunity to get free compensation," says Tina So, chief investment officer at BOC International Investment Managers in Shanghai.

China clearly has a long way to go before its markets measure up to international standards. For now, "it's not working," says Hong Liang, senior China economist at Goldman Sachs Group Inc (). "The share prices don't tell us anything about China's impressive macro-expansion." Officials will know they have made progress when the bourses and the economy are finally connected.

By Frederik Balfour in Shanghai and Brian Bremner in Beijing


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