Quality and strength define a functioning stock market

PUBLISHED : Wednesday, 29 June, 2005, 12:00am
UPDATED : Wednesday, 29 June, 2005, 12:00am

This week's decision by the mainland's securities regulator to declare all state-owned shares tradable is a step in the right direction after a long period of stasis. However, by itself it will do little to cure the deep malaise that afflicts the country's stock markets.

Since the two stock exchanges were founded in the early 1990s, almost 66 per cent of all the equity of listed companies has been held by state bodies and other so-called 'legal persons' and designated non-tradable.

The resulting shortage of liquid stock was instrumental in driving the A-share markets to giddy heights in 2001.

Fears that Beijing was about to change the rules and sell state shares, flooding the market with new stock, helped drive them down again.

With the market now down 54.5 per cent from its peak, the authorities have finally been prompted to act.

While the state shares are not the only factor depressing A shares - poor corporate governance, opaque company accounts and dishonest brokers have also dragged down prices - investors have increasingly argued that no sustainable recovery is possible unless the overhang is resolved.

Those same investors, however, have been demanding compensation for potential losses if and when the state does sell its shares.

Now, after authorising an initial batch of four companies to negotiate compensation deals with minority shareholders, followed by a second group of 42, the regulator has decided to roll out the same model to the entire market.

Blue chip Baoshan Iron & Steel provides the best example of the shape these deals will take. Yesterday, the company offered minority shareholders 2.2 free shares for every 10 held, with a warrant allowing them to buy one additional share at a fixed price in the future.

At the same time, the company's state-run parent pledged not to sell any of the shares it holds for at least two years.

In the short term, the stock is likely to fall 18 per cent as the market adjusts for the new supply of tradable shares issued to investors. But in the medium term, minority shareholders will do well if the stock makes any subsequent gains over the next two years, before the parent company's lock-up period expires.

Although some observers are likely to grumble about moral hazard and the iniquities of bailouts, the regulator's decision does at least remove one major source of uncertainty deterring investors from buying into the mainland's stock markets.

That will not cure all the ills troubling the markets, however, and it does not mean prices will automatically head higher.

At a price-earnings multiple of 18, the A-share market still looks expensive. By contrast, Hong Kong's H shares trade at just 11 times earnings.

More importantly, the move does nothing to raise the dismal standards of corporate governance among listed companies or to further the development of a long-term domestic institutional investor base to counter China's predominance of lone speculators.

The true purpose of a stock market is twofold: to provide enterprises with a source of long-term capital and to permit savers to invest securely for their future.

Unless the mainland can raise the quality of its listed companies and strengthen its investing institutions, it will continue to lack a properly functioning stock market.