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The Volatile Chinese Stock Market: IPOs and Banking Reforms

China’s IPO market resumes after a year-long halt due to an extended bear market. What can we expect next?

In June, China ended a year-long government freeze on initial public offerings (IPOs). The government allowed the Bank of China and other financial institutions to issue stocks. Why? What are the short-term and long-term effects of this decision on the Chinese markets?

China’s stock market is still in its infancy, heavily influenced by government policies. Its market capitalization is only 3 trillion yuan (US$375 billion), which is about one-third of Hong Kong’s stock market, and 3 percent of the U.S. stock market. The Chinese stock market is out of proportion with the country’s economic development—it is too small relative to the economy. In 2005, the total stock value was only 16 percent of the GDP. By comparison, Hong Kong’s stock value is 600 percent of its GDP. Not only is the stock market small, but also bad risks account for a large portion of the companies listed. In addition, two-thirds of the stocks are not tradable. With both a high saving rate and scarce opportunities for financial investments, China abounds with strong stock speculation—in addition to a lack of investment knowledge and strategy. Consequently, a basic feature of the market is high volatility.

Although China has maintained high GDP growth in recent years, the performance of its A-share market has been disappointing. China’s A-shares entered a bear market in June 2001. Then, within four years, the Shanghai Stock Exchange index dropped from 2,200 to around 1,000. Afterward, for an entire year, China’s stock market did not see any IPOs. The market, however, saw some improvement.

Is it true that if there is no new stock for one year, the stock market will not drop? For lack of alternative investment opportunities, and because there are not many stocks to choose from, the stock market is pushed up by excessive demand. According to financial analysts, the main reason China suspended IPOs was the fact that the stock market had continued declining, the government feared that introducing new stocks would trigger massive selling of bad stocks to buy new ones, and that it would lead the already fragile market to a crash.

The immaturity of China’s stock market and the situation of the country’s financial institutions are directly correlated. China’s A-share market has only 15 years of history. Looking at the companies that offer stock, we see a very irrational structure. Take financial stocks, for example. Compared with developed countries, there are only a few financial stocks listed on China’s stock market. The financial content of the market is grossly disproportionate to its role in the national economy—the industry structure of the stock-offering companies is badly out of balance.

Financial stocks are very important to all the major stock markets in the world. Why are there so few financial institutions listed on the Chinese stock market? Isn’t it better if more financial institutions are seen on the market? The reason is that both the communist government and the banks know that, among all the industries, the financial industry is the least stable and the most dangerous. That’s why over these past years, not many financial companies have been added to the stock market—for fear that people would reject the stocks. Everyone knows that Chinese banks have too many bad debts and are high risk. Yet why is the Bank of China suddenly allowed to issue an IPO? This is due to several factors.{mospagebreak}

International experience tells us that as an economy develops and grows, financial institutions are the biggest winners. As China’s economy continues to grow, many investors view China’s banking industry as a profitable avenue. In the past two years, many foreign investors have purchased shares in China’s financial institutions. Why do they take the risk, knowing that Chinese banks are high risk and have had many bad debts? Because if they don’t, they may lose the opportunity to make big money; in the eyes of the investors, that scenario is also a risk. So when investors weigh the two risks, they are gambling. Which risk is higher? They wish to see this scenario: Economic development brings more profit to the Chinese banking industry, and bank management will improve, which will give banks new market and profit. Maybe the investors believe that Chinese people’s diligence and the current structure will somehow have a better chance for making money than bankruptcy. Of course, they also are clearly aware of their risks: If the bad debts are not resolved, the accumulative effect will trigger a financial crisis, in which case, they will lose all their money. According to Chinese official statistics, the bad debt rates in Chinese banks were down in the past two years. Although most foreign investors don’t trust the official statistics on bad debts, when they keep reading these numbers for a long time, they really would rather believe in them; the numbers make them feel better.

On the other hand, Chinese people’s saving rate is 40 to 50 percent. Chinese people have a total of 30 trillion yuan (US$3.75 trillion) saved in banks. To most people, interest rates on their deposits are too low, yet housing prices are beyond their reach. The return on stock investment is generally higher than the bank interest. This in part explains why in the first several months of 2006 when the global stock markets were doing poorly, the Chinese stock markets were buoyant. As a matter of fact, China’s stock markets gained about 40 percent in the first half of 2006, continuing a rebound from its eight-year low in mid 2005.

When the demand for stocks far exceeded the supply, the China Securities Regulatory Commission re-opened the market for IPOs. Obviously, whichever companies got selected for IPOs got the premium. After a year of pause, the Bank of China got the approval for listing on the stock market. The bonus it received was even bigger. This is a good time to list some financial institutions on the market, and investors may accept them. From another perspective, this decision could also add some excitement to the banking industry, and may even lead to further reforms. As far as the listing banks are concerned, they can get immediate cash and raise their capital, which naturally reduces their risks. In fact, selling bank stocks allows the government to transfer some risks to the investors—especially with new stock owners. The more stock the investors buy, the more money the bank has and the safer the bank becomes. On the other hand, some problematic banks may actually turn for the better as a result of foreign owners’ involvement in the bank’s management and restructuring. This somehow may resolve the big headache of the Chinese financial system. Why not give it a try?{mospagebreak}

Everyone knows that Chinese banks have many problems, and they should reform. Everyone also knows that it is difficult to initiate such financial reform, and the resistance is strong. Banking is vital for an economy. It has a far-reaching effect on the society; non-performing loans (NPLs) are a big issue already, and financial crisis could erupt any time. Since 1999, the Chinese communist government has repeatedly helped the four major banks write off their bad debts and has injected several hundred billion U.S. dollars into the banks. However, these measures did not fundamentally solve the problem. On the contrary, in the beginning of May 2006, Ernest & Young concluded in a report that the total amount of NPLs in China’s banking system is as high as US$900 billion. Although the report was eventually recalled under pressure, China could no longer hide its bad debt issue from the international community.

A recent speech by Premier Wen Jiabao confirmed the seriousness of China’s financial situation. Premier Wen said, "Massive financial corruption cases happen every day." Given this situation, everyone now agrees to bank reform. How can it be accomplished, then? Implementing reform in a bank is different from reforming a company. When it doesn’t work, we just close the company—but the collapse of a bank could trigger large-scale social unrest. Who dares to take the responsibility? In addition, there are so many bad loans. Taxpayers’ money cannot be used to fill the holes in the banks indefinitely. The people will not allow their money to be used like this, either. And it’s no use for officials to issue warnings like "no next time" and then take no action. Otherwise, banks learn quickly that they can count on the government to bail them out again, and they will most certainly get into the same situation next time.

It looks like maintaining status quo is not acceptable, so the strategy becomes: "Let’s do IPO!" Selling bank stocks can raise capital. Let the market be the judge and the driving force. Last year, two banks in China issued IPOs, and their stocks since day one have been on the rise. After its success in the Hong Kong market, the Bank of China issued A-shares in the Chinese stock market. Its stock prices surged on the IPO day.

However, how many IPOs can the market absorb now? Recently the China Securities Regulatory Commission was preparing for a new batch of IPOs. The information leaked out, and the market responded violently. On June 7, the Shanghai stock market index dropped 5.3 percent, which is the largest daily drop in the past four years. Subsequently, the Shanghai stock index plummeted another 4.8 percent on July 13 as a result of the news that the Industrial and Commercial Bank of China and the Datong-Qinhuangdao Railroad plan to issue IPOs on the Shanghai Stock Exchange. China’s stock market is small and volatile. Although Chinese people have huge savings reserves, with the country’s very fragile social welfare, medical care, insurance and pension plans, most Chinese cannot afford the risks of the volatile stock market.{mospagebreak}

In addition, before the end of this year, the stocks of 201 companies will come out of their IPO locked-in period, and 76 billion yuan (USD $9.5 billion) of non-tradable shares may now enter the secondary market. As a result, China’s stock markets will experience jitters in the second half of the year. Under such circumstances, companies that issue IPOs may not have the same luck as the Bank of China. Chances are that the popularity of new stocks won’t last long. As a matter of fact, while this article was being finished, news came that Air China cut its IPO size by 39 percent due to signs of weak interest in a domestic offering.

Dr. Tianlun Jian is a Senior Economist at Eaton Corporation. After he received his Ph.D. in Economics from Boston University, Dr. Jian joined Harvard University as a Research Associate and published research papers on China and India. Dr. Jian also worked in the People’s Bank of China and participated in the reforms on the RMB foreign exchange system and foreign investment policies