NEWS ANALYSIS China Market Boom Is Raising Questions
Philip Bowring International Herald Tribune
January 02, 2001
Share Structure Gives Foreigners Better Deal
 
HONG KONG The development of China’s stock markets has been dramatic, but these emerging markets badly need a more rational structure, and more equal valuations. Chinese stocks have outperformed most others in the past year, but that has only exacerbated a situation in which Chinese pay several times more than foreign investors for the same assets.
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Since their start a decade ago, the Shanghai and Shenzhen markets have grown to a combined market capitalization of $350 billion. Last year they raised $18 billion from the Chinese public. Throw in the H shares — Hong Kong-listed mainland companies — and ‘‘red chips’’ — Hong Kong-incorporated mainland companies — and the total market value of listed Chinese equities comes to more than $500 billion. This compares with a Hong Kong market capitalization of around $520 billion, of which almost 30 percent is now accounted for by mainland stocks, the most prominent of which is China Mobile Communications Corp.
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The biggest problem for China’s stock market is its fragmentation. The mainland has two separate exchanges, Shanghai and Shenzhen, listing and dealing in A-class shares — those which can only be purchased by locals — and in B-class shares — those reserved for foreigners. The A markets are supposed to merge, but the timetable is uncertain. Meanwhile, Shenzhen in 2001 is to begin with a second board.
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In addition to buying B shares, foreigners wanting to invest in China can buy H-class shares, or the handful of significant mainland companies with listings of their Hong Kong subsidiaries, like China Mobile and China Resources (Holdings) Co. Several of these are also listed in New York. B shares are quoted in U.S. dollars in Shanghai; in Shenzhen, they are quoted in Hong Kong dollars.
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However, the B markets are small and almost moribund, having been overtaken by the larger H-share issues traded in the liquid Hong Kong market.
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The B shares trade at huge discounts to their A counterparts, but the government is of two minds about what to do. The preferred solution would be to merge the two, at the same time allowing foreigners to buy A shares through institutional vehicles such as those Taiwan used when it first opened to foreign portfolio investment. But Beijing is reluctant about allowing trading in shares that could result in capital outflow. As it stands, the types of stock that foreigners can buy are off-limits to locals, in theory, so secondary market trading is in foreign currency and does not affect the exchange rate.
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Currency concerns are only half the problem of bringing foreign and local investors to a single market. The other is valuations. Telecommunications companies apart, international investors give low ratings to mainland stocks. Most H shares trade at price-earnings multiples of eight to 12, whereas A shares routinely trade at multiples of 30 to 40. The gap is even wider after considering the superior accounting practices of foreign-listed companies.
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It makes limited sense for mainland enterprises to raise money offshore when they can get it much cheaper from the A-share market. Nor do companies need foreign exchange: China is awash with reserves and there is no shortage of funds to import equipment. Baoshan Iron & Steel Co. and China Minsheng Banking Corp., two recent A issuers, were massively oversubscribed even though valuations were far above what they could have expected offshore. But Petrochina, listed in Hong Kong and New York during 2000, trades at just eight times earnings and has a 4.2 percent dividend yield.
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The foreign currency listings only make sense from the point of view of prestige, of long-term capital needs, and in terms of the positive impact that foreign listing is assumed to have on corporate governance. The listings, of course, also are much promoted by Western investment banks.
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Under the pressure of this extreme valuation divergence, the barrier between A and H shares has begun to break down. H-share companies such as Huaneng Power International Inc., Tsingtao Brewery Co., Yanzhou Coal Mining Co. and Zhejiang Expressway Co. have recently been allowed to raise money through A-share offerings at prices several times those of their existing H shares. That is beneficial for the holders of H shares but puts the locals at a disadvantage. Meanwhile, the playing field is uneven because A-share companies are not permitted to issue H shares.
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The valuation gap has several causes. H shares may well be underpriced, with foreigners overstating the country risk, particularly for state enterprises enjoying protected franchises. A shares seem overpriced partly because retail investors have as little concept of value as U.S. investors did of dot-coms a year ago. Savers have few outlets other than low-yielding bank deposits, and few institutional intermediaries are there to make professional valuation judgments, so local markets are driven by retail cash flow and sentiment.
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The government is also to blame. It has been anxious to induce a feel-good effect by limiting the supply of new stock. Though more than 1,000 companies are now quoted, most are still controlled by the state, whose shares are unlisted. The government ought to be raising more money through asset sales, but it has given priority to bolstering stock prices. This policy has long-term drawbacks. The government’s ability to use a public offering to discipline state enterprises is reduced, and it becomes ever more difficult for the government to allow prices to fall to rational levels without upsetting investors’ confidence.
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To bring China’s markets closer together, it will not be enough to allow foreigners to buy A shares. They will not buy them if they can get a good spread on H shares at one-third the price. Equally, Chinese companies will not issue H shares if they can sell A shares at triple the price. Market logic also demands that companies have a freer hand in deciding when and where to issue stock.
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Under this scenario, the H- and B-share value gap will gradually wither and foreigners will buy mainland shares just as they now buy, for example, Indian ones. The foreign price for investing in China will rise, and the local investors will get a better deal.

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