An investor watches a screen showing stock market movements at a securities company in Fuyang, Anhui province, on May 29, 2023. Photo: AFP
Opinion
James David Spellman
James David Spellman
China needs drastic reforms to win back investor trust and confidence
Greater transparency, better oversight, fewer controls and an upgrading of market infrastructure are among the unprecedented changes required to lure back foreigners and address citizens’ fears
Reforming China’s securities markets to lure back investors – amid a three-year rout that wiped out US$6 trillion as foreigners ran away – will require unprecedented changes. These range from greater transparency in companies’ financial statements and more rigorous oversight to fewer controls over local ownership.
Those reforms, though, will fail if Beijing’s “common prosperity” policy steps up efforts to sweep away free-market tenets and stifle financial innovation, trends that drove unprecedented growth for over 40 years.
In acknowledging the obstacles and assuring investors that Beijing has a new playbook, the new head of China’s securities watchdog, “Broker Butcher” Wu Qing, says he’s eager to make changes. His pronouncements are among many from top officials trying to turn around an economy beleaguered by a record property downturn, which constitutes a fifth of the economy and is the biggest store of household wealth.
Over the past decade, domestic and foreign investors were willing to overlook regulatory shortcomings, opaque corporate structures, market shenanigans and the risks of party-centric control to benefit from China’s outsize gains. Domestic equity-market capitalisation tripled between 2014 and 2020, accelerating from 2018 after Chinese stocks were added to MSCI indices.
Euphoria turned abruptly into moroseness as the post-Covid recovery floundered. The mature economy’s structural problems became apparent as the debt ratio reached a high – at 286.1 per cent of gross domestic product by December, according to Bloomberg.
Beijing’s almost-three-year crackdown on Big Tech reined in powerful companies and thwarted what would have been the world’s biggest initial public offering. All this added to the chilling effect of a different China emerging under President Xi Jinping.
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The MSCI is removing Chinese companies from its All Country World Index, forcing asset managers to purge these stocks. New foreign direct investment into China fell last year to its lowest in three years. The risk-reward profile has “changed dramatically”, as JP Morgan Chase CEO Jamie Dimon put it recently.
After Dimon’s remarks, the benchmark CSI 300 Index bounced back from a five-year low reached on February 2 to post its longest run of gains since 2018. Despite the rally, however, China’s major equity benchmarks are down 40-50 per cent from their peaks in 2021.
Transparency is high among investors’ demands. While China’s standards adhere to those of the International Accounting Standards Board (IASB) and the country has agreed to allow a US watchdog better access to companies’ auditing processes, investors still view companies’ financial statements with scepticism.
Several key differences exist between Chinese and IASB standards, notably in how certain assets are valued and revenue is recognised. A US agency’s report last year found audits littered with deficiencies. Studies show that greater alignment of China’s standards with those of the IASB could mitigate fraudulent activities.
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Part of the disclosure issue rests with the corporate governance structures commonly used in China. The mounting stress, especially in the property sector, has worsened the situation and demonstrated weaknesses. Ownership structures are highly concentrated and board supervision is weak.
Added to those are problems common in governance at US and European companies, such as the adverse effects of stock options as compensation, which encourage short-sighted decisions. Investors are less tolerant of these issues than during China’s go-go years.
Regulatory oversight must be strengthened to prevent market manipulation, fraud and insider trading. The country’s “highly complex web of banks, nonbanks, shadow banks and competing interests in local and national governments and the party bureaucracy” makes that difficult, according to think tank Breugel.
Risk-management mechanisms need to be more robust to identify and mitigate systemic risks while monitoring margin financing and leverage levels to prevent excessive risk-taking. Blind spots and failures in both coordination and communication among China’s regulatory bodies are part of the problem. Beijing recognised these problems by approving the creation of a new supervisory body a year ago. At a recent press conference, Wu vowed to mete out tough penalties.
Market infrastructure, including trading systems and settlement processes, must be upgraded to enhance efficiency and reduce operational risks. This means bringing more technology into the markets, such as blockchain, to improve transparency and security. Derivatives trading venues need to be modernised. China has partially recognised this with a plan to unify local markets but is hesitant about going too far.
Yet Beijing’s steps have been at cross purposes. New restrictions were imposed on “quant funds”, which use algorithms to carry out trades. That caused a “quant quake” as investors exited. The clampdown on short selling also illustrates how reforms are double-edged swords. While Beijing sees short selling as a reason stocks have been pummelled, it has been an important source of market liquidity and regulation in exposing companies’ wrongdoing.
Above all, China’s fundamentals will bring investors back. Here, the difficulties are rooted in the new phase of the nation’s evolution, a mature economy with less demand and greater social costs as the population ages and the frenzied growth slows – all inevitable trends. The policies of the past, from massive infusions of capital by the government to ownership policies, are barriers to the future.
These times in China underscore the importance of markets’ bedrock: public trust and confidence. Many Chinese who lost their life savings say they won’t buy stocks again. Those fears must also be addressed even as efforts are made to lure back foreign investors. Beijing recognises the urgency but haste makes for mistakes. A more careful balancing of interests and prudence will be the stepping stones ahead.
James David Spellman, a graduate of Oxford University, is principal of Strategic Communications LLC, a consulting firm based in Washington, DC
