Regulatory changes arenÆt always bad

Western fund managers donÆt like recent government moves to perk up the A-share market, but Chinese observers argue the trend is right.
ôThis is a complete step backward for the market and shows how all the fine words of the past few years were all hot air,ö is how Fraser Howie, CLSAÆs China capital markets specialist, characterised recent moves by the Chinese government to revive the flagging stockmarket.

Mixing metaphors as boldly as he invariably criticises the governmentÆs policies, Howie is referring to the regulatorÆs decision to make companies sell large quantities of shares through block trades, rather than trickle them out directly into the secondary market, and thereby affect the share price. Indeed, the rule was not there two years ago when the regulations were first discussed and sceptics see this as a move by the authorities to slow the share sell-down in order to minimise the effect on prices.

Or take this from a top Western fund manager in Shanghai on the governmentÆs decision to cut stamp duty to 1% from 3%: ôItÆs inviting speculators back into the market. ItÆs a reversal of the governmentÆs announcements earlier this year that it would improve corporate governance in the markets,ö he says.

Chinese bankers arenÆt convinced. ôMany of the investors are young and inexperienced. Why should they lose all their money, while more experienced investors are protected? Western observers have a history of criticising Chinese stockmarket policies, but we seem to muddle along somehow,ö says a Chinese banker.

You can understand the government regulators getting worried. The A-share market has had a wild ride during the past 15 months. The Shanghai A-share index rose to 6,395 points in mid-October last year, before collapsing to 3,247 in April. After the government measures were announced in early May the index put on 1,000 points, but since then has fallen again and on Tuesday closed at 3,172 points.

The Chinese market is no thing of beauty, but then its past has made its evolution rather difficult. On the whole, however, the stockmarket is doing a fantastic job in dragging the government towards a more capitalist mindset.

ôWhen the government was looking at raising money in the 1990s, given the large number of poorly performing state-owned companies, it was drawn to the Western idea of floating companies on the stockmarket and raising money. Since the free float would be so small, the government was confident it would still keep control,ö says one observer.

But the government was creating a powerful beast, which quickly took on a life of its own. After many Chinese took up share trading with enthusiasm, it became difficult for the government to allow the extreme abuses that defined the market in its early stages to continue û the political stakes had become too high, which is why the government allowed newspapers to extensively cover the Black Curtain Scandal in 2002, a fund management/price rigging scandal. That proved a pivotal point. Corporate governance regulations were tightened considerably, even if standards still lag those of many Western markets.

Another instance of the government being forced to cede control was related to the deliberately tiny free float. Regulators woke up to the fact that the non-tradable government shares, around two-thirds of the market, were weighing down prices. The fear was that if government shares were ever sold down, they would depress the market. The fact that the government had not announced any intention of selling down the shares was irrelevant. Just the possibility put a cloud on the market.

When, in 2003-2004, the government decided to tackle the problem once and for all by explicitly allowing the shares to be traded, and by stipulating a sell-down schedule, investors were spooked and deserted the market in droves. It was only in 2006 that the market finally recovered, and roared, before again tapering off at the end of 2007. In other words, the governmentÆs policy, roughly speaking, was effective, at the cost of drawing out the sell-down over several years. The market had become more capitalistic, and minority shareholder interests started to be more closely aligned with the interests of the majority shareholders.

Meanwhile, the stamp duty has become a battleground between those who want the market to become Westernised and those who see China as successfully adopting a pragmatic course. ôThe problem with the government cutting the stamp duty after the market falls below a certain level is that it encourages speculators. Speculators are not encouraged by the actual fall in the stamp duty, they are encouraged by the governmentÆs intervention,ö says the Western fund manager.

He carries on: ôIf speculators believe that itÆs government policy which dominates the market rather than market fundamentals, they will buy any stock, even bad stocks, in the expectation that the government will bail out the market regardless as soon as the index dips below 4,000 points. When those speculators start buying rubbish stocks, normal fund managers have to buy them as well, or risk underperforming the index.ö

This is a fair point, even the pro-government bankers concede. But in the short-term, protecting investors who have made major losses is more important than pandering to free-market shibboleth, they insist.

Shanghai-based Haitong Securities strategist Chen Jiutong points out that the reduction of the stamp duty should be viewed in two ways. First, transaction costs are phenomenally high in China.

ôThe stamp duty is high by international standards, especially when you combine it with other brokerage fees,ö says Chen. ôTotal profits on the A-share market in 2007 amounted to Rmb947 billion ($135.5 billion), while the stamp duty amounted to Rmb200 billion. In other words, the stamp duty is the equivalent of 21% of the profit of A-share companies. If you add commission and other fees, then transaction costs are actually rather high.ö

This is an astonishing statistic and suggests that Chinese stamp duties are probably among the highest in the world. It also makes the cutting of commissions appear far more defensible.

Nor does Chen believe that the A-share market is an out-of-control speculatorsÆ market. ôThe sharp upswing in share prices is not due to speculators or to the stamp duty, although they are contributors. More important is the fact that investors simply donÆt have sufficient channels of investment, which means that huge volumes of money pour into the securities market. Further, there are signs that inflation is picking up in the Chinese economy, which means fewer people want to hold cash,ö he says. Indeed, Chen is pointing to the tendency of assets to go up during periods of inflation.

From an earnings point of view, the outlook for A-share companies is not unfavourable. Haitong Securities estimates that earnings for listed companies will increase by 32% in 2008 and 22% in 2009, compared with increases of 27% and 55% in 2007 and 2006 respectively. ChinaÆs stockmarket has moved away from the many provincial state-owned companies which were listed in the past. ôNow we see large size state-owned enterprises run by the central government being listed. Therefore, the index is becoming more representative of the Chinese economy,ö he notes.

Charles Dumas of Lombard Street Research agrees that Chinese stocks can be viewed as a buy, even assuming half the earnings are fabricated. öSuppose the true P/E ratio is not 40 to 50, but a massive 100, then the earnings yield is 1%. Adding in ChinaÆs GDP growth rate of 9.7% implies that the all-in potential yield of Chinese stocks would be in double figures, once any dividend yield is added,ö he says.

Nobody could argue ChinaÆs stockmarket is perfect. But it is under constant evolution and the latest changes were probably necessary. A stockmarketÆs ultimate function is to facilitate the generation of wealth. If it fails to do that, you could close it down. But a better solution is to put the patient on life support and plan for a healthier lifestyle in the future. And thatÆs what the Chinese government has done.

This story was first published in the June issue of FinanceAsia magazine.
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