Domestic Chinese A-shares reached their high in the middle of 2001 and have followed a downward trend ever since. It is puzzling to many investors why the Chinese stock market could lose more than half of its value since 2001 while the Chinese economy continues to experience massive growth. One major trigger for this protracted bear market was the announcement by Zhou Xiaochuan, the then chairman of the China Securities Regulatory Commission (CSRC), in relation to the non-tradable share reform (the floating of previously state owned shares onto the market). The stock market’s interpretation was that the government would allow full floating of non-tradable shares without any compensation to existing public A-share holders. Fearing an imminent liquidity drain, the market took a nosedive.
Non-tradable shares in China account for around 65 per cent of total issued shares and consist mainly of state-owned and legal person shares. The original rationale for the large number of non-tradable shares was to ensure that state-owned enterprises would not fall into the hands of private or foreign parties.
The government promised at one time that these shares would never be sold in the open market and could only be transferred outside the market through private negotiations. Such commitments lent a tremendous boost to market speculation and company fundamentals were often deemed as useless numbers. As a result, listed companies themselves cared less about improving their management. Various levels of government entities controlled these companies and had power over the appointment of key managers, thus making management responsible not to the investors, but to bureaucratic powers.
This situation was clearly at odds with the government’s original intention of transforming and modernising Chinese companies through stock market listing. From a practical perspective, the long-term depressed nature of the market also made it very difficult to bring new IPOs to the market. To float the non-tradable shares appeared more and more crucial to improve the health of the Chinese financial system and in May 2005, the government finally made the decision to clear this large overhang.
Restructuring progress
The complexity of this legacy issue appears daunting even to domestic Chinese investors. Plenty of debate and feasibility studies on the non-tradable share reform were undertaken, all concentrating on how to compensate the public A-share holders who bought the shares at higher prices. To test the water, the government released a general guideline for the reform in early May 2005, with four companies selected for the pilot programme.
The general guideline was for the non-tradable shareholders to give for free a portion of their holdings to public A-share holders plus the issuance of a commitment not to sell a certain percentage of their shares in the first few years. Actual details of compensation packages are left with individual companies and are subject to tradable shareholders’ approval. The first company to complete the share reform was Sany Heavy Industry, whose public A-share investors received 3.5 shares and 8 RMB cash for every 10 A-shares held. The major non-tradable shareholder also pledged not to sell any of their remaining shares in the market for the first two years and no more than 10 per cent of the total share capital in the third year. The average compensation for the first four companies was 3.26 shares for every 10 tradable A-shares, with one company’s proposal rejected by public A-share shareholders.
In the ensuing month, another 42 companies covering a much broader spectrum of industry sectors proceeded with reforms. The average ratio was 3.3 shares for every 10 A-shares. The second batch of proposals involved more complementary methods, such as call or put warrants, guarantee of share buy-backs at a certain price, and a partial cancellation or ‘reduction’ of non-tradable shares. The proposals were well received by the market and none was rejected.
With the successful conclusion of the first two batches, the government released an official set of detailed guidelines in late August 2005 that would apply to all A-share companies, which had yet to go through the exercise. To date, a total of 293 companies have made their proposals on their non-tradable share reform. For those that have already finished the reform, a prefix of ‘G’ is put in front of their stock names and so far, there are 153 such ‘G’ stocks.
Short and long-term market impact
When the pilot programme for the first batch was introduced, the A-share market took it fairly negatively as investors had for a long time equated the non-tradable share reform to government selling out state shares in the market. The drastic reaction of the market took the authorities by surprise. However, they went ahead with the programme, putting forward the second batch of 42 companies. This strong determination convinced the market that the government is serious to sort out the problems, and that it is eager to cooperate with public A-share investors rather than fight against them.
It has been a volatile time for the market in the past few months due to the non-tradable share reform, which was accompanied by investors’ ‘treasure-hunting’ for possible future reform candidates. For those shares that completed the reform, the G shares, performance so far has been poor and some G shares even dropped below their pre-reform levels despite the fact that there were no material changes in the shares’ fundamentals. This is a typical reflection of the inefficiency in the China stock market. Investors are just too short-term driven: after the reform, they simply dump the stock and shift their attention to other reform candidates. APS, as a long-term investor, however sees value emerging among some of these stocks that have gone out of favour in the market.
To complete the share reform for all the listed companies, some key issues still have to be tackled. For example, whether the majority state shareholders are willing to offer compensation packages up to the market average, how companies with diversified shareholdings participate in the reform and many other issues. At the current speed of around 20 stocks per week, one would expect almost all the stocks to complete their non-tradable reforms by the end of 2006. Before that, the compensation packages will remain a key consideration for the market in the short term.
In the long run, we take the reform as fairly positive and see multiple benefits to investors. First of all, it realigns the interests of the companies to those of the minority shareholders and restores market confidence. The stock market has been the government’s platform to bail out heavily burdened state owned enterprise (SOE) or to complement its political directives for far too long. The return on the raised capital was often so dismal that investors almost gave up on investing in stocks. After the reform, state shares will ultimately become tradable and their market price can then be used to assess the management’s performance, rather than the net asset value (NAV) used in the past.
Secondly, the reform will create more flexibility in introducing foreign investors. These long-term strategic investors have modernised management and introduced industrial expertise which was sometimes lacking. The Qualified Foreign Institutional Investor (QFII) scheme introduced in November 2002 by the CSRC was a good step to start bringing in more foreign investors. The quota for QFII, however, has been very tight so far and the share reform now under way would offer a broader avenue for foreign strategic investor to invest in domestic listed companies.
Thirdly, by making all the shares tradable, the government can accelerate the pace of industry consolidation. China is probably the country with the broadest spectrum of industries, be it textile, chemical, machinery, or semiconductor, yet few companies are really internationally competitive. One pivotal reason is that many industries are far too fragmented with no clear leader. Local governments are reluctant to sell out their stakes in uncompetitive companies because of the deep tradability discount you have to offer to potential buyers. Once these shares can be freely transferred in the open market, we expect M&A activities to pick up and market forces will seed out the weak ones and make the strong ones stronger, thus creating better return to investors and improving the overall efficiency of the Chinese economy.
Overall, the reform will improve the health of the whole financial system through a more balanced direct and indirect financing. As the stock market becomes more liberalised, more companies will choose to go public and China’s over-reliance on bank loans would be reduced. This in turn is likely to further support China’s current rapid GDP growth and reduce vulnerability to outside risks. It is expected that the share reform programme will be concluded on a high note and investors will see a much healthier stock market in China, which preludes an era in which equity investors are able to enjoy more of the Chinese sizzling economic success.
Tan Kong Yam is chief investment strategist at APS Asset Management Pte Ltd.
Disclaimer: Past performance and any forecasts made are not necessarily indicative of future performance.
