China’s IPO gamble could backfire

A brief rally followed by another tumble would damage China's market-management credibility further. Yet history suggests that is what may happen.

China’s push to reassure investors of the regime’s reformist credentials by swiftly lifting its ban on new company listings could yet backfire.

The moratorium on initial public offerings was imposed in July as part of a massive state-led effort to prop up China’s domestic stock market as shares juggered downwards in disorderly fashion.

The China Securities Regulatory Commission's move on Friday to restart IPOs so soon afterwards has surprised stock market analysts and investors alike as prices still look expensive and divorced from fundamentals.

The benchmark Shanghai Composite index is up 23% since the end of August, despite the latest economic data showing China’s slowdown is deepening, making the administration’s downwardly revised growth target of 6.5% increasingly unreaslistic.

October's data showed China’s exports and imports are contracting, core CPI is at lowest level since April, even the much-touted services sector logged a fall in prices; and the third-quarter earnings of Chinese companies with A-share listings has dropped 13% year-on-year. 

“IPO resumption alone can hardly change the market trend,” Lijuan Du, an analyst at CICC, said in a note this week.

Some analysts have taken the reopening of the IPO spigot to be an attempt by Beijing to return to the vision of President Xi Jinping, which is for markets to play a more decisive role in the economy and boost growth.

“The IPO resumption announced last Friday comes earlier than our expectation. We view this as a strong signal of reform resumption,” Charles Zhou, an analyst at Credit Suisse, said.

However, investor sentiment towards China and Chinese company fundamentals remain fragile after the July market crash wiped $2 trillion off the value of shares in less than a month.

"It is valuation that determines bull and bear market, not IPOs," said Hao Hong, and analyst at BOCOM International this week in a report. Shanghai's stock market is still very expensive relative to Hong Kong-listed stocks he pointed out. 

And worse than mainland China's stock market collapse was the government’s high-handed response, which went beyond using foreign exchange reserves to prop up the market. At one point half of China’s listed stocks were banned from trading and a crackdown on mis-selling ensued – one that has humiliated securities regulators, hedge fund managers, bank executives, and journalists alike.

Ending the emergency market intervention is welcome but without significant complimentary reforms, it puts the reputation of China's regulators at further risk.

To be sure, the regulator is tweaking the IPO process. CSRC will no longer require investors to put money on deposit to participate in an IPO and will allow brokers and issuers to set the IPO price when issuing fewer than 20 million new shares.

That will undoubedly help to smooth out some of the liquidity bottlenecks in China A shares by reducing the amount of funds locked up in interbank markets, as deposits placed in the bank accounts of brokers, once IPOs resume.

JP Morgan estimates the amount of funds locked up in June at Rmb3.5 trillion, equivalent to 8.2% of mainland China's tradable market cap. The IPO of Guotai Junan Securities alone, which raised Rmb30 billion in June and was the largest in five years, locked up Rmb2.35 trillion of capital during the subscription period. 

“This was the deal that broke the market,” according to one senior ECM banker in Hong Kong, citing the frozen funds as the reason for market volatility in June.

A lot of liquidity was also tied up due to the $4.5 billion IPO of Chinese broker Huatai Securities, which drew more than $60 billion in gross demand from institutions, one person familiar with the matter said at the time. 

However China’s A-share market remains overwhelmingly retail investor- and sentiment-driven and as such will continue to be volatile.

Also the CSRC has not provided a timetable for the planned pivotal shift from the IPO approval-based system to the registration system.

A registration system is used in other markets such as in the US and involves companies registering with stock exchanges when they decide to list equities. At the moment the CSRC has to give its approval before a company can IPO in China. 

Market participants hope the switch to registration would reduce corruption, time queuing to go to market and share price spikes on market debuts.  

However that switch requires amendments to the Securities Law and remains some way off.

“Legal revision is a long process and this process has not showed signs of accelerating,” said CICC’s Du.

History lessons

A brief rally followed by another tumble would only add to the doubts of domestic and foreign institutional investors as to the market-management skills of the Chinese authorities. Yet history suggests that is what could happen. 

IPOs have been suspended in China more than six times. In each of these cases, restarting the IPO process triggered short-term rebounds but not sustainable rallies.

If anything, the new supply of listings served to ultimately put an end to bull runs, according to analysts at GF Securities in a report this week. 

Chinese brokers' stocks have also bounced on the first day after an IPO ban was lifted on the last four occasions, mainly due to the hope of renewed IPO fees. After three months, however, their share prices often fell again, noted CICC’s Du.

This time around, Beijing has given the green light to just 28 companies to IPO in the long queue of over 600 companies, which should not be too many for the market to swallow; but more will follow. 

What's more the market’s two biggest shareholders, state entities China Securities Finance and Central Huijin, are among the top-10 biggest shareholders for nearly half of all A-share companies. In the summer they bought en masse, with six-month lockups.

So if market valuations return close to par, they are likely to embark on block sales. Not only will that cap the market's upside, it will also leave a massive overhang of latent selling pressure. 

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