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ZT: A Banner Year for China's Stock Markets

http://www.businessweek.com/globalbiz/content/dec2006/gb20061226_389013.htm?chan=globalbiz_asia_today%27s+top+story

Programs to eliminate non-tradable shares are part of what brought retail investors back to the mainland bourses. The Shanghai index is up 122%

by Frederik Balfour

About the time that executives at HSBC Holdings in Britain were opening their Christmas stockings on Dec. 25, markets in Shanghai were closing—with shares in ICBC, or International & Commercial Bank of China, ending the day up 9.9%. That was enough to drive up ICBC's market capitalization to $214.2 billion, in the process unseating HSBC to become the world's third largest lender by market value behind Citigroup (C) and Bank of America (BAC). On Dec. 26 its shares climbed another 5.8%.

That performance has helped drive the Shanghai Composite to a record closing high. The index is up a whopping 122% in dollar terms this year, while the smaller Shenzhen exchange is up 101%. The combined market capitalizations of Shanghai and the smaller Shenzhen Exchange now total $815 billion.

"2006 has just been amazing," says Joseph Ho, head of i-Shares for Asia Pacific, a family of exchange traded funds (ETFs) owned by Barclays. He manages an ETF based on the China A-share market that was launched at $25 million in November, 2004, and had grown to $748 million at the end of last year. Today the Hong Kong-listed fund, which is open to foreigners, is worth $1.6 billion.
The Shadow of Non-Tradables

The amazing thing about this red-hot performance is that it comes on the back of a five year slump when Chinese equities were dead in the water. Indeed, for much of their 16-year history, China's Shanghai and Shenzhen stock markets were regarded as little more than casinos and dumping grounds for dud, state-owned companies in need of cash. Insider trading was rampant, and the brokerage industry was plagued by successive scandals and bankruptcies.

What's more, uncertainty over what would happen if the government ever released large chunks of non-tradable shares cast a pall over markets. The fear that two-thirds of the shares held by state-owned enterprises might be unceremoniously dumped onto the market had kept potential investors on the sidelines, helping to contribute to the five-year market slide.

It wasn't until August, 2005, that the clouds began to part. A pilot program that compensated minority shareholders when the release of non-tradable shares diluted their stock holdings was deemed successful enough to be extended to all companies.
High-Quality IPOs

By January the program was a proven success, and retail investors started to wade back into the market. Then things really took off in May. That's when regulators resumed initial public offerings that had been put on ice for 12 months while a scheme was introduced to make previously non-tradable shares tradable. Before the rule change, non-tradable shares—which were held by state-owned enterprises and other government bodies—accounted for between 60% and 70% of the stock in most listed companies. As a result, minority shareholders had no power to influence company decisions.

The elimination of non-tradable shares made the mainland exchanges much more attractive to investors. More importantly, the quality of companies in the IPO pipeline was unlike anything local investors had seen before. Previously China's most attractive companies bypassed local bourses in favor of listing in Hong Kong or New York. Now, for the first time, Chinese investors were getting the chance to buy into blue chip companies. The results have been overwhelming.

In October ICBC raised about $5.95 billion on the mainland as part of its $21.9 billion dual listing on Shanghai and Hong Kong. Other high flyers since their listing include Guangshen Railway, Datang International Power Generation, and Bank of China.

Stratospheric Gains Over?

And the parade of new listings is expected to continue for some time. China Life Insurance Company (LFO), which already trades on Hong Kong and New York, is expected to raise more than $3.6 billion in its debut early in 2007, and Bank of Communications and Aluminum of China or Chalco, (ACH) have announced plans to sell shares in Shanghai to raise billions more.

Still, investors looking to replicate this year's stratospheric gains might be disappointed in 2007. "We have concerns about the A-share market, that it's up 100% this year," says Jonathan Anderson, UBS chief economist for Asia in Hong Kong, who notes that at the beginning of the year A shares were trading at a significant discount to H shares, or shares of mainland companies listed in Hong Kong. "But now, looking at 100% gains, it's hard to say anything is undervalued in China."

However one appeal of China's stock markets is that China's closed capital account insulates them from external shocks that leave other emerging markets vulnerable. Total foreign participation in the Chinese bourses under the Qualified Institutional Investor Program, a scheme which allows foreign institutional investors to buy Chinese A shares, which are otherwise restricted, has a quota of just over $9 billion, a small fraction of the $815 billion combined market capitalization of Shanghai and Shenzhen.
Tapping Into Chinese Savings

"The beauty of the market is it does not need foreign liquidity and has controls on capital inflows—unlike Thailand," says Frank Gong, head of China research at JP Morgan, referring to the meltdown in Bangkok on Dec. 19 when authorities tried to curb foreign inflows

With some $4 trillion of savings sloshing around in China, chances are money will continue to find its way to the stock market. Much of that could flow into mutual funds, which have also had a banner year. Harvest Fund Management, a Beijing-based manager partly owned by Deutsche Bank, raised $5.1 billion in a single day in December for its new equity fund, reportedly attracting one million new customers.

But despite the increase in institutional investors—they now account for the lion's share of the market—it would be premature to say China's bourses have come of age. For one thing, short selling is not allowed, and the absence of derivatives makes hedging impossible. However Shanghai is expected to introduce stock index futures and equity warranties early next year.