Global Economics

China's Torrid Domestic Exchanges


Serious money is definitely back at China's two domestic exchanges in Shanghai and Shenzhen. On July 5, the share price of Bank of China shot up 23% in a $2.5 billion secondary offering on the Shanghai Stock Exchange as investors bet big on the mainland's second biggest lender. Then again, just about every stock has been a winner in Shanghai this year. Its key composite index is up a scorching 40% this year. And over at the Shenzhen Stock Exchange, share prices are up 46%.

That's a stunning performance in a year in which major and emerging market bourses have been shaken by global inflation worries and higher interest rates. It's all the more surprising since both exchanges, for much of their 15-year history, have been viewed as rigged games manipulated by insiders and a dumping ground for dud state-owned companies in need of cash.

Until the Bank of China listing, most big mainland companies generally bypassed local exchanges to list in Hong Kong or on overseas exchanges such as Nasdaq and the New York Stock Exchange. Things were so grim that the benchmark indices at both exchanges actually managed to decline during the first half of this decade, despite China's torrid 10% annual growth rate.

RUSH TO CONVERT. What's different now: financial authorities in Beijing have finally gotten serious about ending government ownership in mainland companies. Reforms launched last August to convert some $200 billion worth of largely nontradable Chinese company shares owned by the government into tradable shares have gone far better than expected.

Some 80% of China-listed companies now have plans to make the conversion. "It has been the great sword of Damocles hanging over the market," says David Wolf, who runs the Beijing-based management advisory firm Wolf Group Asia.

In another market-boosting move, Beijing on July 3 said it would allow Chinese investors to buy shares "on the margin," or with borrowed money from brokerages, starting Aug. 1. Both exchanges still must improve their financial-reporting standards, but some progress is being made. Listed companies at both bourses are now required to disclose semi-annual results, for instance.

"BUY CHINA." Another big plus was the decision by Beijing in early May to lift a yearlong ban on capital raising on local stock markets. Initially, new cash calls will be limited to secondary offerings, private placements, and convertible bond issues, but the government has indicated it will lift the ban on initial public offerings later in the year (see BusinessWeek.com, 5/15/06, "New Life for China's Exchanges").

The moon-shot, first-day performance of Bank of China on the Shanghai Exchange suggests "there is a lot of pent-up demand" for quality companies among mainland investors, as Jing Ulrich, chairman of China equities at JP Morgan (JPM

) says. Indeed, the "buy China" syndrome that has gripped foreign investors has also infected mainland punters.

In late June, the bank attracted a head-spinning $84.6 billion in bids for its share offer. Chinese investors were no doubt impressed by the Bank of China's ease in raising $11.2 billion and the 20% rise in share price since its monster initial public offering in Hong Kong on May 30 (see BusinessWeek.com, 5/31/06, "A Golden Age for China Banks").

ENOUGH DEMAND? Ulrich also points out that the traditional valuation gap between the so-called H-share market in Hong Kong for listed companies based on the mainland and A-shares (yuan-denominated shares traded at domestic exchanges by local investors and government-approved foreign ones) has all but disappeared. Hong Kong-based H-share companies are trading at price-to-earning multiples of about 13 times forecasted 2006 profits vs. about 14 times for big, blue chip A-share companies. Ulrich screens out smaller, less attractive A-share companies to get that number.

What's more, there could be additional secondary offerings in the pipeline for the Shanghai and Shenzhen bourses, analysts say. Companies as diverse as Industrial & Commercial Bank of China, the country's biggest lender, Air China, and Aluminum Corp. of China and are expected to go forward with share offerings. China Mobile (CHL) is another possibility.

The big question going forward is whether there is enough demand for all these new shares, plus the government-owned stock that will eventually come on market at the Shanghai and Shenzhen exchanges—which have a combined market capitalization of roughly $500 billion.

ONCE BITTEN. Optimists such as Ulrich argue yes, given China is home to about $1.9 trillion in household savings. And equities look good compared to the other investment options such as low-yielding bank deposits and the country's overheated property market.

Some observers think both exchanges still have a way to go in building up the kind of credibility needed to attract a mass market of individual investors. Retail investors, says Shaun Rein, managing director of China Market Research Group in Shanghai, "have been burned too much" in the past by share- manipulation schemes.

He thinks the government still has to get a steady stream of quality companies raising capital on the domestic exchanges going forward, which is still not a sure thing given the prestige factor of listing in Hong Kong and foreign exchanges.

INSTITUTIONAL INVESTING ACTION. Still, both exchanges have seen a big pickup in institutional investor participation, thanks to a sizable capital inflow from insurance companies and state pension funds, as well as the arrival of foreign institutional investors such as Goldman Sachs (GS), Citigroup (C

), and JPMorgan.

Around 40-plus foreign brokerages and banks have been approved to invest some $7 billion in the market under the so-called Qualified Foreign Institutional Investor program set up three years back to increase overseas participation in the domestic stock market.

The successful emergence of the Shanghai and Shenzhen as well-regulated and vibrant exchanges is of huge importance to China's larger goal of diversifying its capital markets away from a heavy reliance on bank financing. That's not necessarily what investors are thinking, though, as they flock to China, making it home to some of the hottest stock markets on the planet.

A quick return, of course, is the ultimate motivator when it comes to attracting risk capital. Little wonder China's mainland domestic stock market is the place to be these days.


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