Capital Markets

The Truth About China’s Stock Market

Officials in the PRC are making lots of noise about the success of their local exchanges. A case of capitalist propaganda?
Stephen GreenOctober 26, 2001

In May, the official market capitalization (MC) of China’s stock market, the Shanghai and Shenzhen Stock Exchanges combined, hit 5.27 trillion renminbi (US$636 billion) — the first time the figure became higher than that of Hong Kong. Suddenly, China boasted Asia’s second-largest share market. Tokyo shivered.

In fact, all was not what it seemed. The government’s MC statistic included shares owned by the state, the so-called state and legal-person shares. Such nontradable equity accounts for about 65 percent of the total. In its calculations, the government valued these shares at market prices and included them in its figure. This is more than a little shifty.

Since there is no market in nontradable shares, no value can really be given to them. In cases where these shares are sold — and this has begun to happen — they raise only 20 to 30 percent of the market price. Sales of these shares have caused valuations for tradable shares to fall.

A more accurate MC statistic would include only tradable shares, and would put China’s stock market in third place in Asia with an MC of around 1.84 trillion renminbi (US$222 billion). Far from the stock market being worth some 50 percent of GDP, as the government claims, the actual figure is nearer 20 percent. Developed share markets commonly reach a capitalization of more than 150 percent of their country’s GDP.

More Myths

The second myth about China’s stock market is that it is dominated by small investors. The China Securities Regulatory Commission (CSRC) claims there are more than 60 million of them. In reality, there are probably fewer than one-sixth that number.

Several factors complicate the CSRC’s arithmetic, stemming from the fact that the regulator counts investors by tallying share accounts. First, a single investor often holds two accounts perfectly legally. Investors can hold one at each stock exchange. But this duplication is not discounted in the official figure.

Second, many accounts were opened by investors who have now lost both money and interest in speculating in shares, and whose accounts are now inactive. Third, millions of accounts were opened just to buy shares at IPOs to profit from the rise in prices once the shares are listed. But many of these shareholders do not trade in the secondary market.

Last, and most serious, more than 30 million accounts are simply fake, having been opened using false names. Until a few months ago, individuals could open an account without showing an ID card. Many large investors, including securities companies, each operate thousands of fake accounts to purchase massive chunks of IPO shares and manipulate share prices. Selling shares between one’s accounts increases trading volume and creates the impression of widespread demand. This practice is called matching orders. It is difficult to catch people at it, and almost impossible to prove. According to one regulator in Shenzhen, this practice is “still very, very common,” despite some efforts by the CSRC to crack down.

Adjusting for duplicate, inactive, and fraudulent share accounts, one might generously estimate that China has around 6 million to 9 million active individual investors. That is a lot of people, certainly. But it is only 0.5 percent of the total population, and only 3 percent of the country’s approximately 200 million urbanites. Trading is not a common activity.

Quiet Giants

So what is moving China’s markets if it lacks small investors? Everyone knows that institutional investors in China are thin on the ground, right? Wrong. While China’s formal institutional investment sector is tiny, recent research by Xia Bin, a senior official at the People’s Bank of China, revealed a huge number of informal funds active in the market. Since 1997, hundreds of “financial management” and “financial trust” companies quietly moved into asset management. They each manage the money of 5 to 50 clients, both rich individuals and firms (including many state-owned enterprises), and invest mostly in shares. There are at least 7,000 of these asset management companies operating in Shanghai, Shenzhen, and Beijing, and probably hundreds more dotted around the country. Most of them offer returns of above 10 percent, and some up to 50 percent — well above the one-year bank- deposit rate of 2.25 percent. Such funds are known as simu jijin, or privately raised funds.

Of the companies Xia’s team contacted, 77 percent declined to say how much money they looked after. Another 15 percent claimed to manage between 100 million to 200 million renminbi (US$12 million to US$24 million) and the rest, over 200 million renminbi. Xia estimates that the average amount managed by such companies is 150 million renminbi (US$18 million).

Securities companies also conduct asset management informally. “It’s neither legal or illegal. The CSRC has yet to issue rules,” says one manager of a Shenzhen securities company. The amount of funds handled by securities firms is unknown. One exception is Nanfang Securities, which is said to have at least 10 billion renminbi (US$1.2 billion) under management.

According to Xia, it is likely that securities companies manage about 200 billion renminbi (US$24 billion) altogether. Combined with a conservative estimate of informal asset- management companies’ funds, that total reaches 700  billion renminbi (US$980 billion), about 40 percent of tradable market capitalization. Add the money managed by China’s formal investment funds, and the total nears 50 percent, which is similar to that in the United States. Small investors do not dominate this market. Institutions already do.

Regulating Fantasy

Many analysts blame the ills of China’s stock market on the (imaginary) 60 million small investors, claiming that such investors are rabid speculators and that their quick profit-trading strategies cause prices to be volatile. If only, these analysts say, there were more institutional investors. After all, they add, institutions do research, build share portfolios, have the patience to wait for dividend returns, and invest for the long term. The government has responded to these claims with efforts to boost the formal institution sector.

The evidence, however, suggests that the basic problem is not the customers but the product. China’s investors may be an undereducated lot, but they are not fools. Their behavior is entirely rational. Bank interest rates are kept artificially low, and given few other options for investment, a few people choose to invest in shares. But since less than one-half of China’s listed companies have decent businesses, fewer pay dividends, and large investors commonly manipulate shares, it pays to invest for the short term.

Institutions, both formal and informal, face exactly the same incentives. If long-term investment and portfolios paid off, informal funds would be using them already. But they do not. Indeed, a share- manipulation scandal last year involving Boshi Fund Management and a number of other investment funds showed that creating institutional investors does little to mature the market.

While financial institutions in more-developed Western markets have an incentive to hold long-term stakes in companies because they can influence management, financial institutions in China can hold only limited sway — 65 percent of a company’s shares cannot be purchased. Even the largest fund is not in a position to pressure the management of a company whose shares it owns. So financial institutions invest for the short term, too, and use their superior capital and inside information to manipulate share prices.

If company reports were trustworthy, if companies paid dividends, if listed companies were actually privatized, and if the CSRC regulated the market properly, individuals and institutions would invest, rather than speculate. The lesson for the CSRC is simple. It should concentrate on sorting out the supply side — the companies that are listed. The demand side, the speculators and investors, require regulation but not active management. Institutions would then invest for the long term and bring stability to the market.

Getting Tough

If China really wants a viable stock market, regulators need to implement the following:

  • The China Securities and Regulatory Commission (CSRC) should toughen up listing standards, open up the Shanghai Stock Exchange to private companies, and be tougher on those who abuse the system.
  • The State Council should continue — and extend — its policy of selling off state shares. Companies issuing shares must now also sell enough state shares to contribute 10 percent of total revenues raised to the government’s pension funds. This is good for the market.
  • The 60 million- odd individual share accounts need to be re-registered. This is a huge logistical task, but it is the only effective means of eliminating matched orders.
  • The CSRC should establish a simple set of prudential rules and allow anyone that meets them to run a fund.

This story was orginally published in Business China, a publication of the Economist Intelligence Unit. For more coverage of corporate finance in Asia, visit CFO Asia (