Professor Franklin Allen, Director of the Brevan Howard Centre for Financial Analysis, discusses the Chinese stock market and its unique challenges.
Not only is the Chinese economy the largest in the world with regards to Purchasing Power Parity (PPP), but it has also been the fastest growing large economy for the past three decades. Unsurprisingly then, the Chinese stock market is now the second largest in the world. Despite this, China’s domestic market is underperforming. Research I have conducted, alongside colleagues from Shanghai Jiao Tong University, suggests that this is due to a number of factors, namely regulatory restrictions.
The Chinese economy has grown rapidly: in 1980, China’s GDP was less than 10% of that of the US, but by the end of 2014, China had become the largest economy in the world (in PPP terms). In fact, as long as it maintains an average growth rate of at least twice that of the US, it will have doubled the US GDP by around 2035.
Since launching in 1990, the Chinese stock market has grown fast, and now has more than 2,300 firms listed within the two exchanges: the Shanghai Stock Exchange and the Shenzhen Stock Exchange. As of the end of 2014, the Chinese A-share (domestic) market was the second largest in the world in terms of total market capitalization, trailing only the US equity markets. However, despite the huge growth in China’s economy and the rapid evolution of the stock market, investors in the domestic market haven’t been profiting.
Our study examined the reasons for this disconnect between economic growth and stock market performance. We compared Chinese firms listed in the domestic A-share market and those listed overseas, as well as unlisted firms in China. We also compared the performance of the Chinese market and listed firms with those of other large developing economies (India and Brazil), and large developed economies (US and Japan), among others.
Between 2000–2014 we found that China’s domestic market and its listed firms underperformed other markets and listed firms from developed and emerging countries, and underperformed unlisted firms. However, Chinese firms listed overseas – especially in Hong Kong – performed much better.
Why is this important?
Within the Chinese market, the banking sector has been crucial in providing financing for firms and promoting the impressive economic growth in recent years. But without a high performing stock market, disproportionate investments into other saving vehicles, such as the real estate sector, have led to many costly distortions in the economy. The stock market provides a vital source of funding for China’s growing consumption and services, as well as hi-tech industries – the main driver for China’s continuing economic growth. It’s also important for savers to achieve adequate returns in order to retire with sufficient financial resources. Addressing its efficiency and performance is therefore necessary for China’s financial system.
So what’s the problem?
Our research investigated the Initial Public Offering (IPO) and delisting mechanisms and found that these unfairly inhibit successful firms from entering the market, as well as preventing unsuccessful firms from leaving. We also found that due to this, the firms that are listed are not representative of the Chinese economy.
Each IPO must be approved by the China Securities Regulation Commission (CSRC), which sets high financial and administrative hurdles for entry into the market. Each IPO must be approved by the CSRC, and in earlier years this meant an annual quota for different regions across the nation. Firms must also show profits in three consecutive years leading up to the IPO application year, among other explicit financial requirements, to satisfy listing standards set by the CSRC.
Our research found that there was a significant drop in value amongst Chinese firms post IPO. While this occurs in other countries’ markets, the effect is much more pronounced in China. It seems that the stringent listing requirements cause firms to distort their activities to such an extent that it harms their long-term performance.
Once listed, firms are rarely delisted in China. However, the ‘shell’ of a listed firm is still considered valuable because of the difficult listing process. Hence, problematic IPO and delisting processes exacerbate the adverse selection of firms entering and exiting the market. This adversely affects economic growth. Essentially, the best-performing firms within an industry are not always selected to enter the A-share market, or don’t apply in the first place in anticipation of these issues.
We also found that there were much higher levels of investment in Chinese firms compared to listed firms from the US, Japan, India and Brazil. However, Chinese firms generated lower net cash flows, which implies low investment efficiency. Lower cash flows are associated with more related-party transactions for Chinese firms, indicating deficiencies in corporate governance. In fact, investors in the market earned zero return in real terms, and the cumulative return of the market is much lower than that of five-year bank deposits, or even three- and five-year government bonds in China.
This all affects the efficiency of the market, and discourages Chinese firms from entering the market in the first place. Indeed, arguably the three most well-known Chinese companies, privately owned internet giants ‘BAT’ – Baidu, Alibaba and Tencent – are all publicly listed, but none are listed in the domestic market. Companies like these prefer to be invested overseas in markets with better rules and, compounding the issue, Chinese investors have limited access to these markets – and so are missing out on the impressive returns these companies are generating.
Our main recommendation is with regards to policy: the CSRC should substantially lower the financial hurdle for IPO, and encourage more privately owned firms, especially those from growth industries, to enter the market. Incidentally, the CSRC has realised this and is undergoing an important reform: shifting the IPO process from an administrative procedure controlled by the CSRC to one that is controlled by the stock exchanges and monitored by the market. This would improve the quality of the mix of firms listed in the market and, alongside a tightening of the rules for delisting poor-performing firms, should increase market efficiency. Continuing efforts in improving corporate governance will enhance investment efficiency.
Moving towards a more market-oriented process – along with corporate governance, IPO reforms and better enforcement of the delisting process – can improve the mixture of firms in the market and resource allocation, and increase returns to shareholders. If these reforms are put in place, the future of the share market will look a lot more attractive to individual and institutional investors both domestic and international, providing the potential for great investment opportunities and positive returns, and a better use of resources. Furthermore, if the Chinese domestic market is better performing, it will have a similarly positive effect on the global economy.