China ¨C with the main index touching 8 year lows, is this the moment to enter the market? Part III First, thank you all for the comments posted and the healthy discussions that followed. After an historical summary of Chinese stockmarket on Part I and a brief about the regulatory framework and the companies listed on Part II, lets us see today the share categories available and who the investors are. There are six types of share categories available to the investor: 1 - Individual A-shares Shares of Mainland (PRC, not including Hong Kong, Macao or Taiwan) companies traded in Shanghai and Shenzhen that are denominated in renminbi (RMB) and owned by individuals and LPs. They make up about one-third of a typical listed company's equity capital. Foreign nationals and companies may not yet own these shares, though the QFII system (a scheme allowing foreign investors to remit capital into China ¨C avoiding a closed capital account and other restrictions ¨C for the express purpose of trading Mainland securities), allow limited holdings. 2 - Legal Person (LP) shares About a third of every listed firm's equity is sold to domestic institutions (securities companies and SOEs with at least one-non owner) and become LP shares. These can not be traded on the stock market. During late 2000 an active auction market in LP shares developed and sales of LP shares in one-to-one contracts have become popular. 3 - State shares About a third of equity is transferred to state organs, usually to the local bureau of the MOF, though sometimes to other central and local government bureau as well as SOEs wholly owned by the state. The ultimate owner of state shares is the State Council. They are not tradable, though two attempts have now been made to sell and simultaneously convert them into individual shares. A third attempt is now under course. 4 - Individual B-shares Shares of Mainland companies traded in Shanghai and Shenzhen that are denominated in US$ in Shanghai and HK$ in Shenzhen. Only a small number of companies have issued B-shares. Their advantage is that a company can raise hard currency; the disadvantage is that the B-share market is highly illiquid. Initially reserved for foreign investors, domestic individuals and companies quickly found ways of buying them. The market is now open to domestic individuals (though not institutions). 5 - H, N and L shares (commonly known as H-shares) Shares of Mainland-registered companies listed in Hong Kong, New York and London. The State Council has chosen some of its most important and impressive SOEs to list in Hong Kong and elsewhere. These companies are taking advantage of the greater capital available in more developed capital markets, but are forced to undergo more radical restructuring than they would if they listed domestically and are held to higher standards of corporate governance and disclosure. Mainland Chinese firms listed in New York and London are sometimes called N-shares and L-shares (though the term H-shares is also used). 6 - Red-chips Shares of Chinese companies registered overseas and listed abroad (principally in Hong Kong), having substantial Mainland interests and controlled by affiliates or bureaus of the government. Red-chips boomed during the 1990s'. Most now trade below their issuance price. Foreign Investors and Chinese Equity Although the government has been deliberately coy about opening up the stockmarket to foreign capital, it has pursued three other strategies for attracting foreign investment. One, it has tried hard to maximize foreign direct investment (FDI ¨C foreign investment is classified as FDI when it takes an ownership stake in a company) inflows, two it has set up a share market dedicated to foreign investors and three it has been a keen issuer of equity abroad. FDI gives a foreign entity "control" of domestic assets. When exactly control is achieved is a matter of some interpretation. In the United States a foreign entity gaining a 10% stake in a firm qualifies as FDI. In China the investment counts as FDI only when it takes a 25% stake. FDI can take two forms: greenfield investments, in which new capacity is built, or the acquisition of assets of local firms. The second, far less successful, means of attracting foreign capital has been via a special foreigner-only B-share market set up in 1991. However, the B-share market has been a failure for a number of technical and political reasons. Third, China has been able to leverage enough worldwide excitement about its reforms and its future prospects to raise money abroad. By the end of 2002, China had listed 75 companies abroad, mostly in Hong Kong. This three¨Cpronged strategy has had at least one important benefit. Large volumes of foreign capital have been attracted, but with the capital account closed, no volatile portfolio flows out of the country undermined its stockmarket or destabilized its currency. However, China's present policy bears a number of costs. First, attention have been focused on maximizing FDI to the detriment of sorting out the domestic financial system. A look at the country's household savings ¨C some $1b in 2002 ¨C suggests that the problem the economy faces is not lack of capital, but an institutional problem of getting this capital to work. Second, the government has allowed only a few chosen firms ¨C mostly SOEs ¨C access to foreign capital markets, thus channeling foreign funds to its favorite firms, a highly inefficient means of allocating foreign capital. The B-share Market The B-share market, the market in shares denominated in foreign currency which was, at least initially, created exclusively for foreign investors has been a failure. Domestic investors ¨C individuals legally and institutions illegally ¨C now dominate the trading that still exists and ownership. Hampered by low liquidity and poor-quality listed companies, the market never really got off the ground following its creation in 1991 and is now well and truly dead. Since 1993 the government's policy on B-shares has been disorganized, to put it politely. While numerous schemes for developing it have been floated, only a few have been implemented, and then usually badly. In the absence of foreigners, it has been domestic investors, speculating on rumor and hoping to take advantage of the arbitrage opportunities with A-shares, which have kept the market alive, if barely. Domestic investors quickly got involved, particularly in Shenzhen, where they used the passports of friends and relatives resident in Hong Kong to open B-share accounts. Why were they keen when foreign investors were not? Since they can invest mostly anywhere in the world, in any number of financial instruments, foreign investors' appetite for China's poor-quality, illiquid B-shares has been low compare with trapped domestic investors. The discount to A-shares has encouraged domestic investors to buy B-shares in the hope that the CSRC would combine the two markets and their B-shares prices would rise to the same level as A-shares. The central government has made periodic attempts to crack down on domestic investors active in B-shares, but has usually failed, announcing finally in 2001 that individual Chinese could invest legally in the market. They are now trapped and disillusioned. The main issue now facing the CSRC is how to bury it. The H-share Market and Red-chips The government has been keen for companies to issue equity in capital markets overseas, mostly in Hong Kong and United States. Such issues are important: not only do they provide access to deeper markets and therefore more funds, but the companies that do this are important ambassadors abroad for China's industrial reforms. For these reasons, international issues have been mostly reserved for large, strategically important and relatively successful SOEs. In addition to these H-shares, by early 2002 there were also some 60 "red-chips" listed in Hong Kong, companies with their headquarters in Hong Kong but which were controlled by the PRC government, or entities connected to it, and which has their dominant operations located in the Mainland. The advantage of overseas issuance, aside from the funds it provides, has been that it has force these companies to undergo thorough restructuring, to have been audited to international standards and to be disciplined and monitored by, for most of the time at least, a demanding investment community. Outside Hong Kong, the United States has been the favored location for PRC companies escaping abroad. The American Depositary Receipt (ADR) has been a favorite vehicle. An ADR is simply a negotiable instrument, listed in the United States and settled in US dollars, that represents an ownership interest in the shares of a non-American company. Up until June 2002, 31 Mainland companies and at least 9 Hong Kong-registered red chips had issued ADRs in the United States. Please see the continuation on the next post
China ¨C with the main index touching 8 year lows, is this the moment to enter the market? Part III Continued from the previous post The Investors The common image of crowds gazing at the screens in securities brokerages suggests that small investors, most of them pensioners, dominate this market and that institutional investors are only marginally important. It is then easy to explain the high trading volumes and the great volatility of prices. However, closer analysis reveals that individuals are fewer, and institutional investors more numerous and more significant than most accounts suggest. From very early on the market was controlled by institutional investors, whether they were formally registered or not. Small investors are those who are regularly sacrificed in their manipulative schemes. In fact, xishengpin (sacrificial objects) is a phrase commonly used to describe them. Given the dominance of institutional investors, it is clear that it is not the investors who are to blame for the problems of this market, but the regulatory institutions and the listed companies that are on sale. Formal institutional investors include securities companies, investment funds, Trust and Investment Companies (TICs) and insurance funds. Formal institutions also make extensive use of fraudulently opened individual accounts. Informal institutional investors now account for about 50% of market capitalization. Both types of institutions dominate trading and the profits that are made, through their access to huge sums of capital and inside information. The Investors - Individuals Although debatable, the individual share investors active in the market are around 10m, according to industry estimates. It is also a matter of debate what proportion of market capitalization they would be holding, although it is highly unlikely to be more than 30%. Another fallacy is that among individual investors, pensioners dominate. It is the younger professionals, operating from home or working from their rented offices in the securities companies, who dominate the individual trading crowd. They are often extremely sophisticated in their use of computers and trading strategies. They are certainly not fools in need of institutions. For their part, pensioners play the market rather like bingo. Most are not playing with their retirement savings, but are simply spending their days with their friends out of the house. Many of their grown-up children will give them share pocket-money to keep them occupied. The Investors - Securities Companies By the end of 2002 there were some 120 securities companies operating in China. Each securities company operates a number of brokerage branches where investors go to trade shares, watch share prices on large electronic boards and exchange information. Companies were founded by different parts of government or state-owned entities. Most securities companies began life as SOEs, rather than shareholding companies. After the passage of the Company Law in 1994, however, most restructured into limited responsibility or limited liability shareholding companies. Since 2002 a small number of companies have had the majority of their shares bought up by private companies. The present trend is a dispersal of ownership stakes, and with it, perhaps, administrative influence over these firms will be reduced. However, it is not only through state ownership that the government exerts its control over these companies. The appointments of senior managers in the large companies are authorized by party organs within the CSRC and the Central Committee's Financial Work Committee (FWC), a special organ established in 1998 to oversee political work in the financial sector. All large firms operate party committees of which the CEO is usually secretary. However, the influence of the local party and central government is not uniform across the sector. Some firms are more impervious to the influence of CSRC than others, and there is evidence of growing independence. The three main businesses of securities companies are brokering shares, proprietary trading and underwriting. According to industry figures, 40% of the total revenue is generated by brokering shares for clients. Up until 2002 brokerage commissions were fixed by the CSRC at 0.35%. However, many companies have in practice disregarded these rules. It has been practice to reduce this value to attract and retain customers. Proprietary trading is also an important part of the business. A large firm typically makes around 30% of its income from trading shares on its own account. Practices common in Western markets such as fundamental analysis and portfolio investment are only slowly being taken up. Rather, during the 1990s traders at securities companies were engaged in extensive manipulation and insider trading. Often together with a small number of their richer customers, they frequently organized manipulation scams, choosing companies to manipulate, visiting them (often bringing management on board) and then gradually buying up the stock. They would then spread rumors about its great growth prospects and wait for the stock to soar before selling out. While the rich investors dominated the market in the early 1990s, as the securities companies grew in size they took over the mantle of market leaders. It was common practice for cash-strapped securities firms to "borrow" funds from their brokerage customers' accounts. These funds would be used for in-house proprietary trading or would be lent to other customers. A regulation which came into force in January 2002 said that securities companies must keep their customers' share-trading deposits in a completely separate account from their own capital. Another problem is that very porous Chinese firewalls between brokerage and proprietary trading has meant that front-running - when the grocer trades on his own account before the customer's trade is executed, thus taking advantage of any price changes - has also been common. In December 2001 the CSRC found Zhejiang Securities guilty of using 56 individual share accounts to trade the shares of Zhenjiang Qianjiang Biochemical. It was a classic "matched orders" scam. By buying and selling a company's shares between its own accounts, Zhejiang Securities created the illusion of demand for the shares, caused their price to rise and thus encouraged other investors to buy in. It then sold its holdings, making over $5m in profit. Historically, 15-30% of the revenues of a typical securities company have been derived from underwriting initial, rights and secondary share issues. Underwriting fees are set at a mandatory 2.5% of the capital raised. In Hong Kong the fee, set by market players, is also around 2.5%. But in the United States, it is typically much higher, usually around 7%. Everyone in the securities industry knows that China's securities companies are no match for the international investment banks. Their deficiencies range too widely, from their limited size to their restricted scope of business, from their inexperience in a wide range of transactions to their China-centric focus and bureaucratic management styles. Help is now at hand. The CSRC is intent upon nurturing these firms in a variety of ways, and it has the State Council backing to do so. It is intent supporting the consolidation of the sector as well as encouraging individual companies to expand their capital. It is also intent on facilitating the development of other businesses like asset management and venture capital. Please see the continuation on the next post
China ¨C with the main index touching 8 year lows, is this the moment to enter the market? Part III Continued from the previous post The Investors - Investment Funds One priority for many developing countries is to nurture institutional investors at home, because they can have a number of good effects. For one thing, they enable private financial assets to be managed more intelligently than bank deposits, and thus provide one of the few means by which pensions and insurance assets can be grown to cover future needs. Second, there is the competitive effect: these companies intensify competition for financial service providers to improve services for their customers. Third, they can have a healthy influence on listed firms's corporate governance and performance, since funds often buy large enough stakes to make a difference at shareholders' meetings. Since 1997 the CSRC has prioritized the development of the investment fund sector. By December 2002 it had overseen the establishment of some 54 closed-ended investment funds and 17 open-ended funds issued by 19 investment fund management companies. By the end of December 2002 formal investment funds had net assets of over 10% of tradable market capitalization, compared with 50% in the United States. As well as the positive impacts outlined above, this policy has three aims. The first is to draw more investors out of the banks and into the share market so that their capital can be more efficiently allocated. Second, officials want to alter the style of the market from one dominated by short-term speculation to one of long-term, professionally managed investment. A third, more cynical, reason for the governments' support of investment funds is that they provide a means by which senior leaders can potentially shape stockmarket sentiment. There have been two phases of investment fund development in reform China. During the first phase between 1990 and 1997, local governments at the provincial, city and country levels set up some 75 small closed funds with the aim of raising capital for diverse local projects. The funds were badly managed (investing in everything from real estate to light industry), had chaotic governance (many lacked distinct trustees and/or custodians) and were poorly regulated (they fell under PBOC jurisdiction but the capacity of local PBOC branches to supervise them effectively was extremely limited). The second phase began on November 1997. The central government issued new regulations which laid down the legal basis for reinventing the sector, this time under tight CSRC control. These measures stated that all funds had to receive CSRC approval before they could be established, a measure which sidelined local governments. Fund management firms now require only $1.2m in registered capital. The funds themselves must have paid-up capital of over $36m and have a minimum term of five years: 80% of fund assets must be held in securities, 20% in domestic T-bonds, and no direct investments (such as in real estate) are permitted. Another requirement designed to protect investors is that 90% of the funds' returns have to be distributed to investors in the form of dividends. On this footing, the CSRC has overseen the establishment of dozens of new funds and the restructuring of the old ones. The Investors - Privately-raised Funds According to a recent research there are at least 7,000 of these companies operating in Shanghai, Shenzhen and Beijing and probably dozens, if not hundreds, more dotted around the country. On average, each of this last group of companies manages about $18m of funds which are entrusted to it by around 5-50 clients, who are wealthy individuals, non-state firms and SOEs. As a whole, these privately-raised funds are a worthwhile development. For one thing, they increase the number of long-term participants in the share market and so are a force for stability. Moreover, many if these companies are professionally run and highly competitive. The CSRC is now issuing detailed regulations on this sector. It appears likely that the regulator's strategy will be to support the privately-raised funds. The Investors - Insurance Funds Before October 1999, insurance companies were not allowed to invest in shares and were limited to investing their premium income in bank deposits and government bonds. In 1999 the CSRC and the China Insurance Regulatory Commission (CIRC) began allowing insurance companies indirect access to equities. In common with more developed stockmarkets, insurance funds can provide a long-term stable source of demand for shares. And so the CSRC is now working on extending the funds' access not only in terms of investment funds but also in shares directly. Within a few years, insurers should have the autonomy to invest in what they like, subject to standard prudential regulations. The Investors - Pension Funds Another key to growth in the demand for equities will be the development of pension funds. Creating an effective system of old-age insurance is a challenge for any government. In much of Western Europe at present, the challenge for governments is to shift from publicly-funded pay-as-you-go (PAYG) systems (where there is no pension pot, but pensions are paid out of today's pension contributions) to systems where an individual pot is created, managed and then used to pay each individual's pension. Shares are one of the best ways of achieving rates of return above the rate of wage growth over the long term. Thus, in the United States about 60% of pension assets are now invested in equities and the remainder is in fixed-income securities and cash. The challenge for China is greater than that facing Western Europe for two reasons: demographics and the need for reorganization, because of the one-child policy implemented from the mid-1970s, the demographic profile is changing extremely rapidly: China's population is ageing. Since the country is moving from a work unit-based system of welfare, where the factory or government unit provides all the welfare to its employees, including often a pension worth 80% of the final wage, to a national system where pensions are paid out of pooled provincial funds, the institutional work required to make the transition a success is much greater. The three-pillar pension system currently being put into place raises its funds from employees, employers and the state through: a defined-benefit "public" pillar paid for by a payroll tax drawn from enterprise revenues; a mandatory-funded, defined-contribution pillar for each worker paid for by a payroll tax with contributions from both enterprise and employee; a voluntary supplementary scheme managed by the employer or an insurance company. The scheme is being rolled out at provincial level, but many of the poorer provinces, especially in the rust-belt of northeast China, are already running large deficits. The development of a government-run pension scheme will increase the demand for equities over the long term and also bodes well for the quality of regulation. The National Social Security Fund (NSSF) and the provincial pension funds have a mandate to derive a steady income stream from their assets and conservatively manage their investment risks. They cannot afford to copy the high-risk speculative trading strategies of the securities companies, investment funds and informal institutions common in the 1990s. While previously the government has been only the seller of equity, now, in order to create an effective asset management system through which to meet its social liabilities, the government's own fund managers will have to become purchasers of, and investors in, equity. For this, the government will require the sort of things that any other investor requires: good-quality listed companies, tough regulatory enforcement practices, reliable financial accounts, more transparency in the regulatory process, a judiciary able to enforce ownership rights and, eventually, effective supervision of the regulator itself. In other words, pension development presages a shift in the incentives facing the government, and should also therefore mean a change in how the market is regulated. To be continued...
To put things into perspective, some overseas institutions entered China recently. Bill Gates Foundation recently invested in China equity markets heavily. But they refused to disclose what they buy. The last week's Barron mentioned that many hedge funds opened offices in China. Unfortunately, much of the information in China is passed by mouth and not accessible from outside, which makes trading from US almost impossible.
What are the Chinese property laws like?The Russian ones are frightening and will stop Russia taking off until citizens get some type of security of ownership.What's it like in China?
If I understand it correctly, chinese law only allow foreigners to buy B-shares, which right now trades at a discount to the A-shares.
Foreigners can buy property in the major cities quite easily. Foreigners can't buy A shares but can buy the B-shares. Not all A shares have a B share equivalent. Most B-shares are trading at a discount to A shares by as much as 70%. Similarly for the H shares which are listed in Hong Kong, most of these are trading at substantial discounts to the A shares.
Thanks Steve. What does this mean to the "B and H" shares ? Are they well priced or seriuosly undervalued ? (Excuse me if this was made clear earlier in this thread, but didn't have time to read the share descriptions.)