China in Transition

Capital Markets after the Reforms of Non-tradable Shares

Chi Hung KWAN
Consulting Fellow, RIETI

The reforms of non-tradable shares launched in the spring of 2005 are seeing success, with more than 90% of listed companies implementing the new measures. During this time, the Shanghai Composite Index, which temporarily fell below the 1,000-point level on June 6, 2005, was approaching the 3,000-point level as of late January 2007. Rising stock prices, together with the resumption of initial public offerings in June 2006, have boosted the combined total market capitalization of the Shanghai and Shenzhen stock markets to over $1 trillion, three times its pre-reform level. The reforms of non-tradable shares have not only brought about an expansion of the size of China's stock markets, they are also expected to lead to a change in "quality," and China's capital markets are now on the threshold of a new period of growth.

Strengthening the functions of China's capital markets

Capital markets have three basic functions - fund procurement, investment, and efficient resource allocation. Prior to the start of the reforms of non-tradable shares, when regulations prevented the trading of two-thirds of all shares, those holding tradable shares sought capital gains through a rise in share prices, while non-tradable shareholders were active in increasing net assets. At the same time, because those who held tradable shares could only be resigned to the position of minority shareholder, they could not oversee and evaluate management, which was appointed by majority shareholders. As a result, speculative activity was so rife in China's stock markets that some economists criticized them as "casinos," and they could not sufficiently fulfill their fundamental roles.

This situation is changing through the reforms of non-tradable shares, and a price mechanism that reflects supply and demand in the market is starting to kick in. In mature capital markets, stock prices, which are signals from the market, guide investment flows to profit-making companies, while firms that perform poorly are abandoned by the market and forced to exit. Funds are efficiently allocated through this sort of "good money drives out bad" mechanism. In China also, the ongoing capital market reforms are likely to bring benefits to both investors and borrowers through boosting investment efficiency.

Improvement of corporate governance will encourage efficient resource allocation

The more efficient allocation of resources that accompanies the reforms of non-tradable shares will be realized through improving the corporate governance of listed companies. First, by resolving the problem of non-tradable shares, the tendency for shares to be concentrated among large shareholders is being corrected, and companies are increasingly being exposed to the pressures of possible takeovers. Companies with poor performance and thus falling share prices will be bought out, and the current management team may be sacked. Managers who feel threatened by such a scenario will strive to maximize corporate value in order to protect themselves, and therefore make best efforts to manage their companies. Aiming at facilitating mergers and acquisitions (M&As), the "Measures of Administration of Acquisition of Listed Companies" took effect on September 1, 2006, followed by the Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors" on September 8. As a result, M&As through takeover bids are expected to gather steam.

At the same time, through these reforms, state-owned enterprises have become able to increase incentives for management by offering stock options. Also, because major shareholders, like minority shareholders, now have a strong interest in raising share prices, they take greater pains selecting and overseeing management. Furthermore, through the success of the reforms of non-tradable shares, the path toward the privatization of large state-owned enterprises has now been cleared in such a way to float state-owned shares on the stock market. Privatization should, as alongside with the abovementioned factors such as M&A pressures, should increase corporate value and thus boost share prices through better corporate governance. Indeed, the recent rise in stock prices in China reflects this sort of expectation.

Investors increasing both at home and abroad

While stocks have become more and more attractive for investors, a series of rules related to securities issuance and trading, the exit of companies from the market, information disclosure, and M&As, in addition to the "Company Law" and the "Securities Law," are also coming on stream. Against this backdrop, moves are accelerating for institutional investors, including foreign ones, to actively enter the market. In a mature market led by institutional investors, investments are expected to be made rationally, and excessive speculation can be suppressed.

Meanwhile, China's stock markets are undergoing a transformation from a semi-closed state to one of openness. If the healthiness of its capital markets can be secured through such means as the establishment of a legal framework and stronger monitoring, opening domestic stocks to foreign investors as a target for investment - which would mean the liberalization of capital movement - would be accelerated. In fact, the investment quotas assigned to qualified foreign institutional investors (QFII) have been gradually expanded. For foreign investors also, it becomes possible to share the fruits of China's economic development by investing in its securities markets.

Market's increasing role as a place to procure funds

Prior to the reforms, amid a protracted slump in share prices, the stock markets rarely fulfilled their role as a place to procure funds, but the situation has changed dramatically through the reforms. Initial public offerings (IPOs), which had been temporarily suspended with the start of the reforms of non-tradable shares, were resumed in June 2006, and large-scale IPOs, such as that of the Industrial and Commerce Bank of China, are being launched one after another. Their scale topped 100 billion yuan in the first six months alone, and is projected to surpass Hong Kong and reach the 200 billion-yuan mark in 2007.

IPOs and post-IPO fund raising had been thought to be negative factors for stock prices as they increase supply relative to demand in the market. However, the experience of these reforms suggests that if the procured funds are used efficiently, stock prices can actually rise. State-owned shares are to be gradually released in the future, but as long as this is a part of the privatization process that aims at improving corporate governance, it is unlikely to have a negatively impact on stock prices.

January 29, 2007

January 29, 2007