China's Intent in Stock-Market Reforms Remains Murky
Philip Bowring International Herald Tribune
Tuesday, February 27, 2001
HONG KONG China'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.
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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?
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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, starting Wednesday.
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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.
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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.
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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.
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One possibility now is that the existing B shares will gradually merge with the vastly larger A-share market and pass into history.
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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.
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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.
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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.
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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.
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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 investors.
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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.
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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?
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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.

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