KONGChina's decision to allow local investors to buy stocks that in
theory have been reserved for foreigners raises more questions than it answers
about the future shape of the securities industry.
Is this a minor adjustment to reality? Or
is it the start of a major revamp that has huge implications for foreign
portfolio-investment in China? Could the move ultimately raise the entry price
for foreign investors, increase the importance of the Shanghai market and
threaten the role of overseas-listed shares in mainland companies, which have
become so important to the Hong Kong stock market?
The announcement last week left unclear
the intentions of Chinese securities regulators as they prepare the country's
fledgling markets for the changes that will inevitably result from membership in
the World Trade Organization. Beijing said that it would allow Chinese to buy
so-called B shares, which are denominated in Hong Kong and U.S. dollars,
In a parallel decision that garnered
fewer headlines but that may be more influential in the long run, the regulators
also decided to abolish the quota system for issuing A shares, which are
reserved for residents. The quotas had prevented most private companies from
listing their shares. The elimination of that regulatory barrier should improve
the quality and quantity of issues and bring more consistency to China's
fragmented stock markets, in which valuations vary widely.
The B-share decision might be seen as
little more than a tidying-up operation. The B shares are a small and hitherto
illiquid market. Total market capitalization of the 114 B shares listed in
Shanghai (where they trade in U.S. dollars) and Shenzhen (where they trade in
Hong Kong dollars) is around $6 billion.
Most of the scant turnover in these
issues has long been conducted by local investors with dollar accounts.
Foreigners have been little interested because of the small size and generally
poor quality of the B companies.
One possibility now is that the existing
B shares will gradually merge with the vastly larger A-share market and pass
Eighty-seven of the 114 B companies
already have A listings as well. With the abolition of the quota system for A
shares, the remainder should logically follow suit, given that, on average, A
shares trade at four times the valuation of B shares. B-share prices would rise,
but not much else would change. The move would have the secondary effect of
finding a home for some of the $75 billion in foreign-currency deposits held by
households in China.
The next question is whether China's
authorities intend in the future to allow similar local purchases of H shares by
mainlanders. Prices of H shares, Hong Kong-listed mainland companies that
include giants such as PetroChina Company Ltd., leaped by an average of 10
percent last week in response to the B-share announcement. They are underpinned
by low price-to-earnings ratios and improving earnings prospects. Some companies
with H listings have also recently benefited existing shareholders by issuing A
shares at several times the price of the H shares. In the case of Dongfang
Electric Corp., for example, the price-to-earnings ratio of the money-losing
company's A shares is 17 times that of its H shares.
Though a system of arbitrage between A
and H shares is badly needed, it is questionable whether the authorities will
consider allowing H-share investment by locals. The market is much bigger than
for B shares, thus the potential outflow of foreign exchange is greater. Being
outside the mainland, the H-share markets are beyond Beijing's direct control
and would require allowing Chinese residents to set up foreign-currency accounts
offshore. Such a step toward full capital-account convertibility seems unlikely
in the foreseeable future.
The H-share market has been quite
successful in attracting foreign portfolio capital and in the process raising
standards of corporate governance. However, the valuation gap suggests it is not
the most effective way to bring in foreign capital.
What are the alternatives? One idea has
long been to create an institutional mechanism to allow foreigners to purchase A
shares on a regulated basis, as happened when Taiwan first opened to portfolio
China still fears that this could lead to
destabilizing foreign-exchange flows. In any case, at current A-share
valuations, foreign investment would be limited.
But why not revive the B-share market for
foreigners as well as locals by allowing some large and attractive companies to
issue B shares in Shanghai rather than H shares in Hong Kong and New York?
That way, foreign capital could be
attracted to mainland markets but in a controlled manner. With B shares now open
to local investors, it would also eliminate the discrepancy between what Chinese
and foreigners pay for the same shares, in the process raising the entry price
for foreigners. It would be more attractive for local companies that like the
prestige of foreign investment but dislike the low pricing of H-share issues
compared to A shares. It is not clear whether Beijing is thinking along these
lines, but the possibility exists.