China looks for capital ideas

In order to finance its social security and pension deficit, the Chinese government is pondering how to divest itself of its enormous holdings in state companies.

One solution is the creation of a gigantic fund, modeled on the Hong Kong Tracker fund. To increase demand and prevent a slump in the share price, it could open the domestic A share markets, so far strictly off limits, to foreign investors, as well as expand its domestic institutional investor base. This would make the B share market, the foreign currency market open to foreigners, obsolete.

Under China's capital markets reform program and under pressure from its accession to the WTO, foreign experts believe that it is important for the government to downsize its economic stake in the country's corporate sector. Although China's stock markets' market cap is $450 billion, two thirds of this is comprised of non-tradable shares held by the state.

"Only by selling its shares and increasing the free float", says Chi Lo, Chief Economist at Standard Chartered Bank, Hong Kong, "will investors, foreign ones especially, feel confident that they are capable of having an influence on how the firm is run." He adds that there is no incentive to invest in a company if the state, which holds an average 70% of the shares in the China's SOEs, can outvote any changes proposed by new investors.

The CSRC (China Securities Regulatory Commission) has responded to comments such as these and said in July this year that the government intends to gradually reduce its holdings to 51%. Previously, retaining control of ChinaÆs companies through high shareholdings had been the governmentÆs priority.

In order to prevent a price crash in the A share market, the government is also encouraging the creation of a domestic institutional investor base. Bigger insurance and pension fund companies could soak up the new shares put on the market by the government which the retail investor base is too small to absorb. So far the institutional investor base is small, with just 25 funds, managing Rmb50 billion of assets. However, the funds were encouraged last year by the decision to permit insurance companies to invest up to 15% of their assets into the stock markets. Up till then, they had been restricted to government bonds.

The expanded institutional base should then be able to generate returns which could pay for the social security and the huge pension deficit of the country, on top of generating capital gains from the sale of the shares. This would remove the burden from the SOEs, so far the main structure for protecting the population.

Historically, the institutional investor base has been dwarfed by retail investors, who have opened up some 50 million accounts throughout the country.

Together with developing the domestic investor base, the government is tinkering with the idea of opening up the A share market to foreigners. ôThe money that foreign institutions would bring in would act as a walking stick

for SOEs to recapitalize themselves as they prepare to face the competition brought by entrance to the WTO,ö says Stephen Green, a China securities specialist at the London School of Economics. While the government is concerned about capital volatility, it could get around this by using the Qualified Foreign Institutional Investor (QFII) model used in Taiwan. This is a way of selecting good long-term investors and limiting their input into the economy.

The effect of this on the B share market û which are shares designed exclusively for foreigners û has been a spike in their share price. Were the A share market open to foreigners there would be no need for the B share market and they could be converted into A shares. This would benefit the holders of B shares as these shares are trading at discounts of an average of 50% to the A shares. P/E ratios on the B share market are around 15, compared to 60 in the A share market.

The B share market, opened in 1992 to attract foreign funds, but has been in the doldrums for several years. In effect, it has been superseded by the Hong Kong H share and New York ADR market as sources of foreign capital. Henry Wu an analyst at UBS Warburg, Shanghai, points out that the B share market is just 4% of total market cap, and highly illiquid. Furthermore, IPOs, at an average of $20 million to $30 million are too small to attract foreign institutional investors.

ôB shares are dead, it is just a question of how to bury themö, says the London School of EconomicsÆ Green. Still, some five companies have listed on the B share market in the last 24 months, says Xue Lan, a B share specialist at China Securities, Beijing. ôBut this is not directly related to the recent better performance of the B share market,ö she says. ôIn fact, these companies started the listing procedure some time ago û in several cases, two to three years ago. But permission has only just come through.ö Companies originally turned to the B share market because it was exempt from the quota system that controlled the A share market until last year. Under the quota system, the central government determined the number of shares which could be issued on a company by company, province by province basis.

Since the quota system was abolished earlier this year the trend is for the CSRC to adopt market oriented criteria for listing companies on both the A and B share markets, although some sources say that in their efforts to get things right the process has become even slower. But the consensus is that the CSRC, by getting rid of the quota system, has deprived local governments of listing companies they had a vested interest in, thereby ensuring that the companies that are selected are more efficient.

This ought to be a good thing.