Are China A-shares due to drop off a cliff?

Ironically, reforms such as the QFII scheme are causing the stock markets to wilt. The government must act fast to replace incumbent listed companies with better ones if the markets to regain some vibrancy.

The news that the Chinese government has finally giving the green light for the Qualified Foreign Institutional Investor scheme after months, if not years, of debate, is striking. This is especially so put in the context of the far-reaching laws passed in the last couple of months. These finally open up previously non-tradable state shares to mergers and acquisitions by both domestic and foreign companies. Hence the historic acquisition of a 20% stake in the Shenzhen Development Bank by Newbridge Capital and the investment in Ping An insurance company by HSBC.

Whether the latest QFII move is a good-bye gift from premier Zhu Rongji, a sign of the growing power of the reformist China Securities Regulatory Commission, or a consensus move rushed through before the present generation of leaders hand in their swords at the ongoing 16th Party Congress, the market reaction has been tepid. In fact, the Shanghai and Shenzhen stock markets have edged steadily down since the news came out last week and are down almost 10% since early September.

This might come as a shock to observers, since the move implies that new money will arrive into the stock markets, at least from those foreign investors with the deep pockets. But they risk investing in a market plagued by poor companies, inexperienced regulators and weak institutional investors.

Many experts have already said the net effect of the move will be limited by Chinese regulators keen to preserve their financial systems from destabilizingly large inflows and by wary foreign investors. A Goldman Sachs estimate puts the inflows at a $3 billion - $5 billion over the next 24 months, quite puny compared to the market's total capitalization around $500 billion.

But more significantly, what the move shows domestic investors is that the ongoing marketization of the stock markets will sooner or later result in yields which are more in line with the true picture of listed companies. These will be considerably lower than they are now.

It is important to repeat that the predominantly state-owned companies were not listed necessarily on their financial merits but on connections to the local governments, in turn awarded a quota of shares that could be listed. They were often loss making, inefficient and over-manned. The aim of listing was simply to raise cash, often to re-invest in real estate or even the stock market itself. Investors made money though capital gains, since dividend pay-outs were rare and voting rights none-existent.

"But people are now worried that QFII signals the ongoing marketization of the economy," says one local analyst. "This will gradually reverse the previous government-sponsored bull market, and inexorably will depress values."

Price to earnings ratios are famously high at around 40 times, compared to under 20 in Hong Kong.

The domestic bourses are rooted in Zhu Rongji's envious look at the Nasdaq in the early 1990s and the 'wealth effect' the Internet bubble was triggering in the US. He was confident he could do just as well and gave the stock markets his blessing to start one of the most outrageous bull markets in history.

With a government trailing, as always, behind the forces it helped unleash, the stock markets rapidly become not just a casino, in the famous words of one top government bureaucrat, but a crooked one at that, dominated by a vast and underground funds management industry. The players, known by the Chinese slang word for 'banker' in a card game, promised large, guaranteed returns. They ramped up stocks partly by working in collusion with the securities houses, and partly by relying on the difficulty the government had in slowing the bull market down, as well as the almost complete absence of institutional investors.

That has begun to change this year. Mainly because, along with the support of the central government, the China Securities and Regulatory Commission has begun to show its teeth. Led by a crusading army of bright and idealistic, often overseas-educated returnees, the CSRC has moved rapidly towards becoming a force to be reckoned with.

Yet the de-listing of companies the CSRC initiated, most famously with Narcissus last year, and the fines and prison sentences handed out in increasing numbers this year, has enraged market manipulators. This has led to an insidious whispering campaign against the reformers, whose reforms were categorized in various ways as "foreign" or even "unpatriotic".

The CSRC was helped by a rapid development of the local business press. Magazines like Caijing set up by a remarkable returnee, Wang Boming's New Fortune, and newspapers like 21st Century Business Herald grew in professionalism and, especially Caijing, were often the first to expose wrongdoings.

Still, it looks as if the reformers are winning. Shortcomings are gradually being reformed and in the long-term it will be of tremendous value to China's economic development.

But in the short to medium term the model of the earlier, policy-driven stock market will be comprehensively destroyed. To prevent the slide of in the A-share market (down 29% from last year's highs) becoming a route, the government has a new challenge.

It must encourage a new crop of profitable companies to replace the incumbent dinosaurs. The candidates for that post are numerous - the private sector is full of them. Now that the Party has officially declared its support for the private sector in terms stronger than ever at the Congress, it needs to allow private companies to rapidly access the stock markets they have been deprived of for so long. If the reforms bite too hard before investors see some gains, they might be reluctant to back further reforms. And the last thing the government needs is to enrage the 35 million small investors who like to play the markets.

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