China's stock markets have become something of a joke in the past two years. Constantly testing new lows, and seemingly impervious to government reform efforts, many wonder when the slide will stop.
The latest reforms seem to have only made things worse, with the A-share market plunging to eight- year lows. To many observers, that proves the reforms are wrong. After all, is it not axiomatic that reforms that cause the market to drop are undesirable?
Recall that four small but profitable test companies owned by a mixture of private investors and local provincial governments have been chosen to pioneer the conversion of previously un-tradable state shares into fully tradable A-shares.
Around two-thirds of China's stock market cap consists of these non-tradable shares. Hitherto, the listed shares traded on the assumption that the non-tradable shares would never be released onto the market. Converting them to tradable shares has caused fears that supply will exceed demand.
When the government announced that it was extending the reforms to larger, centrally-owned SOEs at the end June, the market dropped to new lows.
A good deal of frustration and blame has therefore been leveled at China's stock market regulator, the China Securities and Regulatory Commission.
"These are the same people who failed on the past two occasions they tried to reform the share market," says one well-known A-share investor in Hong Kong. It's a human resources problem."
But another fund manager gives quite a different view, maintaining that it is absurd to regard the reaction of China's stock market to the reforms as a credible barometer of their efficiency.
"A-share investors have benefited from the markets as they were historically. But recently they've become scared of the prospect of genuine market reform," he says.
According to this fund manager, the investors currently resisting government reform efforts by dumping stocks, should be grateful for the run they have had since the go-go years of the 1990s.
He has a point. Too much should not be read into the decline of the A-share market. It is more accurate to think of the A share market as a slowly collapsing Ponzi scheme than as a 'market' rewarding efficiency and punishing waste.
Indeed, how can a stock market be called a proper market when one HSBC fund manager estimates that 400 companies (out of 1400) should be immediately de-listed?
Remember the Chinese stock market was invented in the 1990s to provide a symbol of China's economic modernization. It was also a symbol of Shanghai's desire to emulate Hong Kong.
The mis-development of the stock market shows that both these goals are a long way from being met.
Until the CSRC put a stop to the worst practices, stocks were not listed on merit but based on provincial quotas. Local governments usually listed the very worst of the state-owned companies they controlled, in order to get China's investors to pick up the bill for recapitalizing them, rather than they themselves.
These companies are known as 'trash companies' in China and there are far too many of them. The mechanism for delisting them is highly ineffective. Instead, weak companies are put in special categories and trading in them is limited. Corporate governance is still very weak, although generally considered better than a few years ago.
Even under the reformed listing process, even the most successful private companies find it almost impossible to benefit from the capital markets.
Or take the habit listed companies have of endless share issuance, at a steep discount to the market price. That is because any money raised in this manner increases the company's net asset value. The fact that it also dilutes minority shareholders and inexorably drags down the company's share price is of no consequence to the state-appointed managers: It is not the yardstick they are measured by.
The problem is that in China two unrelated standards exist for valuing companies. The first is the legal, official one (net asset value), and the second is the market price of shares. But so far, despite efforts of the CSRC, the market price of the shares is still the lesser yardstick, with little legal weight.
Using the net asset value has other consequences. The government cannot simply write off the state-owned shares. The law does not permit the destruction of state assets, which, after all, belong to the people.
Alien to western investors, the concept of state assets belonging to the people is still profoundly resonant in China.
Still, investors did not worry too much about the market's stranger features. With the Chinese government keen to repeat the wealth effect of the US stock market, retail investors believed the market had a government guarantee. They piled in, driving the composite index up to 3,000 points, compared to the 1100 points it is hovering at now.
Investors were not just piling in because the market was going up. They also had lots of bonus features to incentivize them, features whose very existence strengthened their belief the government would not allow them to lose money.
The under-pricing of IPOs, with price/earnings levels set by fiat way below the prevailing secondary market price, were even better than the popular sports lottery. In the stock market, assuming you got allocated shares, you were bound to make money. The only gambling element was whether you got a share allocation.
So it is natural that the 'market' has resisted the reform efforts introduced by the CSRC.
In fact, of course it is not a market. A-share investors are just as much a special interest group in need of dismantling as the companies themselves.
Investors should prepare themselves for much steeper falls yet. With the A-share bubble already severely deflated, the government has little to lose by pressing on with further change.
And eventually, the good companies in the market will enjoy the same rewards as the trial companies. Note that three out of the four test companies saw their shares go up on the back of the reforms.