Last rites called for B shares

Despite B shares'' spectacular performance of late, their very future is in doubt.

China's B shares are back in the headlines. The B-share indices in Shanghai and Shenzhen have soared to record highs in the past month on the back of growing speculation about market reforms. The rumour mill contends that China's B-share markets will be opened to mainlanders, through joint-venture mutual funds; A-share and B-share markets will merge; and the Shanghai and Shenzhen stock exchanges are set to combine. But some fund managers believe B shares' days are numbered.

B shares, or foreigner-only stocks, are designed to raise foreign investment for cash-strapped Chinese firms; locals are only permitted to trade A shares. But according to China Securities, a mainland newspaper, more than two-thirds of all B-share accounts are owned by mainlanders trading through local securities firms. The biggest problem for the B-share markets, however, is their illiquidity. Institutional investors have been turning away from the markets due to their low transparency, inefficiency and the poor quality of the companies listed.

The Chinese authorities have repeatedly pledged to clean up the B-share markets in the past eight years. And it's certainly not the first time that rumours of a merger between the A-share and B-share markets have caught fire. But just how seriously can they be taken this time?

Good news travels fast

The speculation has certainly been good news for mainland investors. In a land where few investors understand value investing, even in a market as illiquid as that of B shares, the scope for liquidity-driven trades is causing volatility, says one foreign manager in Shanghai. It certainly says a lot about the quality of investors in the B-share markets that none of the top 10 players is a foreign bank.

The B-share markets have 108 companies with a combined capitalization of about $4 billion and an average daily turnover of around $33 million. In contrast, there are 912 companies listed on the Shanghai and Shenzhen A-share markets with a total capitalization of about $344 billion.

As more than 90 companies on the B-share markets are also listed on the A-share markets, a merger seems on the surface to be a viable option. But such a move would hinge on the yuan being made fully convertible. And a deregulated yuan at this stage is said to be "unthinkable", according to one foreign fund manager, who has held a private conversation with Zhao Xiaochuan, chairman of the China Securities and Regulatory Committee (CSRC).

Rumours of a merger of the B-share and A-share markets may be based on expectations that China will combine its Shanghai and Shenzhen stock exchanges. According to fund managers, this is a more realistic priority for the government.

A unified exchange would boost liquidity, standardize regulations and improve market depth. But the CSRC is also said to be considering the introduction of capital control measures similar to Taiwan's QFII (qualified foreign institutional investor) system. This would be the nail in the coffin for B shares.

Are capital controls on the way?

Taiwan introduced capital controls in 1991, when its investment market was in infancy, to protect against fluctuations in the financial market caused by a large influx of foreign capital. Fund managers agree that the measure has been a success. QFIIs can only remit $1.2 billion into the country in any given year. There is also a 50% ceiling on total foreign ownership in a listed company, which is scheduled to be raised to 100% in June 2001.

According to a fund manager in Shanghai, whose company pulled out from the B-share markets last year out of frustration with the markets' shortcomings, a capital control system would divert what's left of the institutional money from B shares to A shares.

The only real chance of survival for the B-share markets is an improvement in the quality of the companies listed. But the prospects of this are slim.

Has the lesson been learned?

Chen Ji, a spokesman for the Shanghai Stock Exchange, says Shenzhen's stock trading is likely to be moved to Shanghai if the exchanges are merged, and a secondary board will be established in Shenzhen for tech companies and smaller firms.

If the Chinese government has learned anything from the B-share experience, it will intervene less in the new board and let market forces play a bigger role. As the Shanghai fund manager points out, the B-share markets had some quality listings when they were first established. But when the government started to offload bad quality state-owned enterprises onto the B board, the flow of institutional money was staunched. Allegations of corruption surrounding listing selections further diminished the chances of B shares becoming a major index.

As things stand, only the ultimate optimist would have faith in the B-share markets' ability to compete with the new tech board for quality companies. The verdict of the Shanghai fund manager on the future of B shares? "It's basically dead."