China remains the only communist country in the world to create stock exchanges. However, Beijing's often-contradictory approach to their development has created a government-mandated hierarchy that favours some kinds of shareholders over others. Individuals holding domestically listed Chinese public shares, or A shares, for example, claim different treatment from state-owned units holding legal-person, or C, shares. Hong Kong-listed H-share companies, meanwhile, often enjoy preferential policies unavailable to A-share firms. Such a compartmentalised shares structure has led some to describe China's capital market as 'one market, two systems'. Nowhere has this ladder of privilege more sidelined investor interest - and scorched market liquidity in the process - than in markets for B shares, or domestically listed foreign-person shares. The two B-share markets - in Shanghai, which denominates B shares in US dollars, and Shenzhen, which denominates B shares in HK dollars - were established with an eye to tapping foreign enthusiasm to participate in the mainland's double-digit economic growth. Following seven years of 'market experimentation', however, each is hovering at historic lows, with share prices shrinking by more than 60 per cent of their values of more than one year ago. Shanghai B-share market capitalisation fell to US$1.7 billion during the first half of the year, compared to $3 billion one year earlier. The story in Shenzhen was much the same, with market capitalisation sinking to $1.9 billion from $3 billion. Investors, analysts and fund managers agree the miserable B-share performance is traceable to a single cause: liquidity. 'Turnover in B shares is small and investors simply prefer to increase their exposure in a more liquid market,' explained Paul Lau, China fund manager for Daiwa International Capital Management (Hong Kong). Indeed, the B-share markets this year have virtually come to a standstill. Average daily turnover in Shanghai's B-share market plunged to $3.7 million during the second quarter - compared with $882.6 million in the A-share market - down 80 per cent from the average $15 million daily turnover one year earlier. During the same period, average daily turnover in the Shenzhen B-share market stood at $3.2 million, compared with $813.2 million for the bourse's A-share market. According to Mr Lau, individual foreign investors have abandoned the mainland markets, while institutional investors have turned to Hong Kong, where the variety and types of available vehicles in the form of red chips and H shares are better. Much of that has to do with share capitalisation. Although B shares were launched with the intention of raising foreign funds to assist in the restructuring of medium and large state-owned firms, they remain by and large small-cap counters. Over the history of the B-share market, only eight Shanghai stocks and 10 Shenzhen stocks of 106 listed companies raised more than $50 million at their initial public offering. Despite repeated calls by regulators to boost the market through the floatation of large, liquid conglomerates, the markets remain dominated by narrowly focused, retail-orientated companies, without the diversification of their Hong Kong counterparts. Market liquidity, in fact, is set to sink lower as domestic B-share traders are driven further from the B-share markets, the result of a People's Bank of China (PBOC) and State Administration of Foreign Exchange (SAFE) campaign launched this summer to crack down on illegal foreign-exchange dealings. That was underscored by a joint PBOC and SAFE decision to bring all authorised swap centres under the supervision of the national foreign-exchange trading centre and shut down all unofficial ones. Although technically prohibited from buying and selling foreign-currency-denominated stocks, domestic participants historically have driven B-share trading. Beijing's rationale for keeping locals out of the market was to prevent currency flight by mainland residents buying B shares and then remitting foreign exchange offshore. However, the State Council also ruled that Chinese living overseas remitting money inwards were permitted to trade in B shares, thus creating conditions whereby local traders opened accounts in the names of overseas relatives and friends. Their aim, of course, was speculative profit-making, primarily by exploiting the tremendous price differentials between companies that listed both A shares and B shares. A shares are traded 35 to 40 times price-earnings ratios, compared with 10 times for B shares. Regulators and fund managers agree that, with B-share markets hovering at such unsustainable levels, new market-boosting measures are required. What form those measures will take, however, remains murky. Jim Lam, chief representative for ABN Amro Asia in Shanghai, said that in the meanwhile the government should consider listing more dynamic firms, particularly non-state companies, in B-share markets. 'If you look at what [has been slated for listing], none are investible,' Mr Lam said. 'They are outdated industrial companies in sectors suffering huge oversupplies.' One solution - often floated but unlikely as long as the renminbi remains non-convertible on the capital account - would be unification of the B-share and the A-share markets. A more comprehensive solution is offered by mainland stock market scholar Chengxi Yao, who has called for consolidation of share structure based on 'economic rationale'. Ms Yao argues state shares, state-owned legal-person shares, Chinese public shares and employee shares should be unified into a single Chinese domestic capital share. That, she said, would end the current hierarchy of investors, with each and every share of stock having 'the same rights, interests and obligations'. Individual foreign investors have abandoned the mainland markets, while institutional investors have turned to Hong Kong
