China's stock market reforms deepen

Government sends a clear signal to critics with plan to broaden reform to 42 more companies.

The China Securities Regulatory Commission's (CSRC) recent decision that 42 companies will be added to the original four companies selected for share holding reforms has sent a powerful message to its critics. The mainland media has pointed out that the inclusion of Bao Steel and Changjiang Three Gorges Electric Power Corporation -two major domestic blue chips - is especially significant.

The companies are under the direct supervision of the central government unlike the previous four companies, which have a high number of private and provincial government shareholders.

As one fund manager comments, "Now reforms are moving from the rather small sized companies in the first batch to these 'pillar companies,' the market can be sure the government is serious about reform."

All 42 companies - comprising large, provincial government owned companies, private companies and 10 counters from the small and medium enterprise board in Shenzhen - are to see their non-tradable, government shares converted into tradable shares. The Chinese stock market has been hamstrung by the existence of two classes of shares, tradable and non-tradable, which respond to different incentives.

For example, management rarely give much thought about dilution since they enjoy such a high concentration of ownership (almost 70% on average). This therefore results in frequent and regular secondary stock issuance.

The cash raised increases the company's net asset value, which is the benchmark used by the government to judge the performance of its officials. But it means that share price performance is unimportant and leaves stock investors, both retail and institutional, out in the cold.

But observers are still concerned that like the first batch, the present batch does not really represent a genuine cross section of China's stock market. This because the 42 have a decent track record and profitability level, while hundreds of listed companies do not.

The question is what happens to these companies when the reforms get rolled out on an even wider scale. Many of the listed companies have parent companies in bad financial shape that may not be able to pay the A-share investors the necessary compensation for the privilege of converting their shareholding into tradable shares.

The risk for existing A-share investors is that the parent company will sell off old shares, thereby dragging down the price of the shares in the secondary market. Another question mark is what happens to foreign investors who have invested in Chinese companies?

Many companies have also become major shareholders by buying up government shares at a price close to the A-share price. Should they now have to compensate A-share investors?

Another stumbling block could be the State Asset Administration and Supervision Commission (SASAC), the powerful ministry, which oversees the core 160 giant SOEs viewed as the final guardians of government control over the economy. Allowing full convertibility of shares will weaken state ownership.

One way A-share investors can be rewarded for permitting conversion is by giving them free shares via a rights issue. SASAC is facing pressure to go along with this despite a reluctance born out of reduced ownership and transfer of the reform initiative to the CSRC.

Some additional reform pressure may have been generated by the recent poor performance of Shenhua Coal, which listed on the Hong Kong Stock Exchange earlier this month and is now trading below its IPO price.

Some might argue that SASAC is not accomplishing its mission of safeguarding state assets. It was set up two years ago precisely to reverse losses resulting from the government's helter-skelter de-facto privatization process.

It was hoped that better domestic capital markets would enable domestic investors to access the best stocks and the state to charge a higher price. Chinese investors have hitherto not been able to buy the best stocks, which generally go abroad, due to concerns that the industrial giants would suck up all the liquidity in the market.

Mainland commentators now say that much depends on the attitude of SASAC's 'reasonable men'. Unless they come onboard, it is possible the ministry could still sabotage the reforms by delaying the approval process.

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