China Syndrome V

After the death of Mao, a capitalist gained control of the communist party: Deng Xiaoping. In the 1980’s, as the head of China’s Communist Party and thus the de facto leader of the People’s Republic of China, Deng inherited a country in economic chaos and cultural confusion. In the name of “progress,” the political system had subjected hundreds of millions of people to the trials of the Great Leap Forward and the Cultural Revolution. A new genre of literature, aptly coined “scar literature,” emerged, which portrayed the emotional and psychological wounds inflicted by the Great Leap Forward and the Cultural Revolution. The Chinese were poor, tired, and disillusioned. Deng Xiaoping recognized China’s salvation not in increased government control but in liberal economic reforms. Theoretical communism, Deng could clearly see, was failing worldwide. Nonetheless, it is remarkable that Deng courageously chose to muddle economic and political concepts to coax his own Party on to the path of self-inflicted destruction. Indeed, his view of what good government entails can be summed up by the metaphor he coined, “It doesn’t matter whether it’s a black cat or a white cat; so long as it catches mice, it is a good cat.” That cat as it turned out, was capitalism, prosperity its prey.

Even a quick look at the world in the 1980’s confirmed that countries that had embraced certain tenets of capitalism and globalization were doing well. By permitting competition, allowing low-tariff imports of raw materials and intermediate goods, and encouraging exports through realistic currency values, South Korea, Taiwan, Hong Kong and Singapore, commonly called the Asian Tigers, had evolved into successful market economies. Equally booming was Japan’s economy. In stark contrast, the USSR was in turmoil, and North Korea was defaulting on loans and experiencing output declines of four percent a year while Cuba was surviving only by the support of others. For Deng, the economic picture was becoming clear: capitalist countries were ascendant. To achieve his goals of reform, Deng promoted market modernization and played down the ideology of class struggle. Market innovation started from the countryside. Under regulation called “house responsibility system,” the central government allowed farm families to engage in private enterprise with surplus yields, previously illegal in the Communist state. This incentive-based system worked, bringing in record harvests in 1982, 1983, and 1984 for grain, cotton, and other crops. Furthermore, it encouraged farmers to be entrepreneurs in other aspects of their lives. Private markets emerged, and rural towns became centers of commerce and trade. In fact, these rural businesses became the fastest growing sector of China’s economy, growing at a rate of 20 to 30 percent per year. In January of 1983, the People’s Daily declared, “The people’s commune in the old sense no longer exists.” By 1987 over half the rural economy consisted of nonagricultural activities. Villages were prospering.

Meanwhile, the necessary reforms in the cities made life more difficult for many urban dwellers used to the communal system. Communism guaranteed jobs for life, essentially free lunch for life. The government made efforts to deregulate the labor markets, ending the “iron rice bowl” of guaranteed employment in 1981 and encouraging the unemployed to start small businesses such as restaurants and hair salons. Even so, productivity growth and increasing domestic demand for goods led to rapid inflation. The unemployed fell on hard times. The government’s proposed solution was bonuses, which it financed by printing money and thus exacerbating the inflation all the more. By 1988 China was experiencing the worst inflation since the founding of the Communist state, reaching a scorching 26 percent. Sensing growing unease in the cities, the government tried to tame inflation by slowing growth— cutting oil and coal production, capital construction, and defense spending. This sudden contraction in the economy, however, caused prices of grain to fluctuate, as demand dwindled and supply remained high, angering rural farmers. Meanwhile, urban workers continued to be laid off. Adding fuel to the fire, government corruption stirred public discontent. Some corrupt Party members, lured by easy money, took advantage of the darker side of free enterprise taking root throughout China. In 1987, some 150,000 Party members were punished for corruption or abuse of authority. The Party dismissed over 25,000 of these alleged abusers. Half of all enterprises and 80% of individual entrepreneurs were avoiding taxes. Children and relatives of Party leaders used special contacts to monopolize control of companies. In 1989, a disenfranchised urban class, a slowing economy, and mounting inflation, mixed with an impression of government ineptitude, led to tragedy in Tiananmen Square.

Viewed from another perspective, the masses had grown impatient with the fragile process of economic reform. The farmers had tasted capitalism, and wanted to hold on to it, desperately. The city dwellers had eyed the improvements in the rural countryside with envy. They demanded more of the government, too much and all at once.

Deng’s authorization of military force seared the image of hapless, dissatisfied students pitched against a brutal regime into television sets and memories the world over: How could such a brutal government ever hope to emerge on the world’s economic stage?

At least in the short run, Tiananmen Square impeded democracy more than it promoted it. Following the spring of 1989, Beijing embraced self-preservation at the expense of further reform. Zhao Ziyang, a key official responsible for much of the economic progress during the 1980s, was fired for allowing the escalation that led to Tiananmen. Deng’s image suffered immensely, both domestically and internationally. The Party began to censor communications technology more than ever. As fax technology played such a key role in uniting international dissidents with students in the logistical planning of the Tiananmen Square protests, the Party became especially wary of communication with the outside world—cautiousness evident even today with how the Party is dealing with companies such as Google and Internet bloggers. China's Ministry of Public Security employs more than 30,000 people to monitor the Internet for anti-government ideas. This suspicion has hampered China’s emergence into the world’s economy, an economy increasingly dependent on electronic exchanges and instant communication. Additionally, the success of the government military retaliation and the sustained unity of the Communist Party through the ordeal made the Party confident that suppression by force could be used. This precedent became the model for how the Party would respond to the formation of the Chinese Democratic Party in 1998 and the religious cult Falun Gong, which emerged in 1999.

Despite the setbacks, under the leadership of Deng’s successors, Jiang Zemin and Hu Jintao, the national transformation continued. In 2000, the US Congress approved permanent-normal-trade-relations (PNTR) status with China. In December of 2001, after fifteen years of negotiation, China joined the World Trade Organization. Formerly known as the General Agreement on Tariffs and Trade, the WTO aims to increase trade among its member nations by reducing trade barriers such as tariffs and quotas. To gain membership China had to make tariff reductions on information technology products, chemicals, automobiles, wood, paper products, and many agricultural goods. By 2003, China’s economy was growing close to 10 percent per year. It had become an economic powerhouse and a major force in world diplomacy. The average per capita income reached US$1,200, creating a middle class by purchasing parity standards, of 470 million people. This population is the largest middle class in any country in the world and it is still growing today. An excellent illustration of China’s growth is its market for cars. Car sales in China are increasing at an annual rate of more than 50 percent. In the first quarter or 2003, Volkswagen sold more vehicles in China than it did in Germany. In a trend that might make Mao roll in his grave, General Motors sells luxury Buick sedans to Communist Party officials and executives. With China emphasizing roads rather than railways to open its western frontier, the market for trucks and buses will only increase. China already accounts for a quarter of the worldwide demand for trucks. Another way to measure China’s economic growth is oil consumption. A net exporter as recently as 1993, China is now the fastest growing consumer of oil in the world. The International Energy Agency in Paris estimates that by 2030 China will import as much oil as the United States does now. To reduce its dependence on the Middle East, the central government has increased efforts to find oil and natural gas along China’s continental shelf. In the deserts of the western Xinjiang province a consortium of domestic and foreign energy companies is spending $3.3 billion to develop gas fields and another $5.2 billion for a pipeline from Xinjiang to Shanghai. Agreements have been made with Australia, Indonesia, and Russia to obtain oil and natural gas, and in 2003 China’s offshore oil company CNOOC announced it would buy a $615 million stake in an immense oil field in the Caspian Sea. While some might argue that Deng Xiaoping followed the economic models and reforms of the Asian Tigers and Japan a couple of decades too late, China has had the chance to learn much from the mistakes made by its Asian neighbors. When the Asian financial crisis in 1997 brought recession to Asia and the world economy at large, China’s growth was hardly affected. The tigers including Indonesia, South Korea, and Thailand experienced sharp reductions in values of currencies, stock markets, and other asset prices. Millions of people fell below the poverty line from 1997 to 1998 as businesses collapsed and fortunes were wiped out. Political upheaval followed as Suharto of Indonesia and Chavalit Yongchaiyudh of Thailand resigned. Anti-Western sentiment peaked and the International Monetary Fund heavily criticized.

This stability in China was due to China’s 1994 pegging of the renminbi to the dollar in order to signal a commitment to a non-inflationary monetary and fiscal policy. China’s growth in the ensuing period, therefore, was not due to artificial exchange rate devaluations, but due to painfully cultivated domestic demand. The Tigers, meanwhile, aggressively devalued their currency to increase exports to drive the economy, inviting currency speculation that fed the crisis. Somewhat hypocritically, while the United States applauded China for its 1994 decision to peg the renminbi to the dollar, the United States now accuses China of keeping exchange rates artificially low. In recent years, the US has urged China to abolish the peg which America so heartedly encouraged only a few years before. Interestingly, China now has a trade surplus with the US, but a trade deficit with nearly everyone else, including high cost countries like Japan and Germany. The US trade deficit is perhaps more our own fault than that of the Chinese. Foreign investors also complain that China’s multilayered stock market, with some stocks restricted to ownership only by Chinese nationals, presents an illiquid, opaque market for foreign stockholders. Yet once again, the system has been partly deliberate; the Asian Financial Crises of 1997 provided a cautionary tale whether correct or not. Instead of caving into political pressure, China has fashioned policies and market reforms that are retractable and testable. After all, it was Deng Xiaoping who coined another phrase: Crossing the river by feeling the stones in front of you.

-China’s Stock Market

The Chinese have long been capitalists. In fact, Chinese companies have issued public shares since the mid nineteenth century. The market for securities trading in Shanghai began in the late 1860s. In June 1866 a list of thirteen companies, including the Hong Kong & Shanghai Banking Corporation, appeared in a local newspaper under the ‘Shares and Stocks’ section.

In 1891, during a boom in mining shares, foreign businessmen founded the Shanghai Share Broker’s Association, China’s first stock exchange. In 1904 the Association applied for registration in Hong Kong and was renamed the Shanghai Stock Exchange. Soon after brokers broke with the Exchange over a dispute about commissions. These brokers formed another Shanghai Sharebrokers’ Association in 1909, but in 1929 the two markets combined operating under the name of the Shanghai Stock Exchange. This stock exchange became the biggest by market capitalization in all of Asia before coming to an abrupt halt on December 8, 1941 when the Japanese invaded Shanghai. For the next few decades, under Mao’s rule, public exchanges were forbidden until reform took place under Deng Xiaoping. In the late 1980’s when the government purposefully contracted the economy to curb runaway inflation by tightening the money supply, Shenzhen and Shanghai firms issued shares to raise much-needed capital. The Industrial and Commercial Bank of China established a small trading counter in 1986. The economic need for a stock market exchange was obvious, but ideological concerns—the stock market, after all, is probably the most recognized mechanism of capitalism—caused the government to stall. However, when overseas Hong Kong Chinese agreed to help develop a viable and structured stock market, the government caved in to economic pressures and helped design two stock exchanges—one in Shanghai and another in Shenzhen. Shenzhen is another example of Deng’s practical approach. Thirty years ago it was a village bordering the economic powerhouse in the Hong Kong territories which served as a gateway to China. Deng decided China should develop its own gateways and the economic and population boom in the Pearl River Delta has been staggering ever since. Shenzhen now has one of China’s two stock exchanges and about six million people. The Shanghai Stock Exchange and Shenzhen Stock Exchange both commenced operations in December of 1990. When they opened, thousands of Chinese waited days in lines to buy shares.

Deng Xiaoping visited Shenzhen in 1992 and put to rest any remaining ideological concerns, announcing, "It’ll take careful study to determine whether stocks and the stock market are good for socialism or not. This also means that we must first try it out!” “Stock fever” to permeated the streets. Over the past decade and a half, the two exchanges have developed different characteristics. Many of the large, state-owned companies listed on the Shanghai Stock Exchange, while the Shenzhen Stock Exchange has lists more export-oriented companies, joint ventures, and younger companies. Initially the government intended the Shenzhen Stock Exchange to be the primary board to compete with Hong Kong across the border, but since 1992, the Shanghai Stock Exchange has become many times more active. In the future, it is conceivable that the two exchanges may merge. Australia had seven exchanges for more than 100 years until 1987, and Hong Kong had four exchanges from 1969 to 1986. Both countries now have only one exchange each. Europe is also in the process of consolidation as alliances and partnerships form due to the emergence of the Euro. In addition to the Shanghai and Shenzhen Exchanges, China also has nationwide over the counter systems. The first is a computerized trading system called STAQ, the Securities Trading Automated Quotations system, modeled on the U.S. NASDAQ system. The STAQ system is the world's largest computerized trading system, as ranked by number of computer outlets. The second is the National Electronic Trading System (NET), which trades shares owned by state-owned enterprises and T-bonds. Regulatory organizations for the markets in China include the China Securities Regulatory Commission, roughly equivalent to our Securities and Exchange Commission.

-A Stock Market with “Chinese Characteristics”

Many say that the “Asian way” is to open the economy in such a way that all citizens have a stake in the economy’s wellbeing. The structure of equity ownership in China is a perfect illustration of this way of thinking. Just as the Chinese describe their mixed economy as “Socialism with Chinese characteristics,” the Chinese also developed their stock market to reflect this philosophy.

-The Split-Share System: A-Shares, B-Shares, and Foreign Listings.

A-Shares: The Chinese developed a split-share system to prevent foreigners from prematurely speculating with their companies, acquiring the companies outright, or otherwise manipulating the markets. A staggered approach allows a company to issue classes of shares to domestic investors and foreign investors separately. A company issues A-shares to raise capital from domestic investors exclusively (although recent rules allow Qualified Foreign Institutional Investors to bid for licenses and invest in A-shares). The shares are listed on either the Shanghai or Shenzhen Exchanges. They are not open to individual foreigners and accounts are denominated in renminbi not freely convertible to any international currencies. B-Shares: Before February of 2001, B-shares were exclusively issued to foreigners. These shares are also listed on the Shanghai or Shenzhen Exchanges, but the accounts are denominated in Hong Kong dollars or U.S. dollars. The aggregate market value of B-shares is less than 5% of the A-share market’s value. The long-term performance of the B-share market also lags far behind the A-share market, even when the same company issues A-shares and B-shares with identical voting and dividend rights. A-shares tended to trade at a great premium in the past, selling on average 420% higher than a B-share counterpart from the period 1993-2000. One reason, somewhat ironically considering the reasons for the development of the split share structure, is that domestic investors in China tend to speculate more actively in stocks than foreign investors, as evidenced by the high rates of turnover (500% per year for A-shares versus 200% per year for B-shares). Another reason for the premium is that some foreigners may view the split-share system with suspicion, and discounting shares labeled “foreigners only.” The presence of such a large domestic share premium is quite different from many emerging and developed markets where domestic shares often sell at the discount. In countries as diverse as the Philippines, Thailand, and Switzerland, domestic shares sometimes sell at a discount.

In February of 2001, the government opened up B shares to domestic investors, in an attempt to rescue what had become a stagnant market. When Beijing decreed that Chinese citizens could buy Class B-shares if they could show proof that they were starting the account for a foreigner, money poured into the country through wire transfers to residents from friends and relatives abroad. When the markets opened, buyers far outnumbered sellers. More than three-quarters of the stocks jumped their 10 percent daily limit, many on the turnover of a single share.

However, even after the rule change, capital controls continue to restrict the acquisition of B-shares by Chinese residents. Since Chinese citizens have limited access to foreign capital, the relaxation of restrictions on B-shares by domestic investors did not eliminate the premium entirely. B-shares remain the only way foreigners can freely invest in shares within China; most Chinese companies have not issued B shares anticipating that the restrictions on open investment by foreigners within China is on the not-too-distant horizon. For example, there are recurrent stories that B-shares will be eliminated perhaps by converting them into A-shares. In the meantime B-shares remain the only way for individual foreigners to buy shares on mainland stock exchanges. -Foreign Listings There are two ways Chinese companies can list abroad. First, companies can apply directly to the foreign exchange. In 1999, China.com listed on the NASDAQ, as did Sina.com. In October of 2006, China Construction Bank Corporation became the first of the Big Four state-owned banks to list offshore in this manner, with a US$9.2 billion Hong Kong initial public offering. The largest of the Big Four, Industrial and Commercial Bank of China, executed a $21 billion dual listing on both the Hong Kong Stock Exchange and Shanghai Stock Exchange in October of 2006. The Bank of China has A-shares on the Shanghai board as well as the Hong Kong board. China Construction Bank is currently solely listed in Hong Kong. The Agricultural Bank of China is the second biggest bank in China by assets, and is not yet publicly traded anywhere. Many international exchanges are eager to attract business and publicity from Chinese company listings, and the London Stock Exchange announced in late 2006 that it would step up its efforts to attract listings from Chinese companies. Another way that a Chinese company can list abroad is to sell shares from an initial issue on a Mainland or Hong Kong exchange to an investment bank, which then will act as the intermediary and underwrite American Depository Receipts (ADR) or Global Depository Shares (GDS) on a foreign exchange against their holdings of the original listing. Regardless of the method chosen by the company, H, N, L, and S shares describe shares listed in Hong Kong, New York, London, and Singapore, respectively. While only foreign institutional investors and a limited number of qualified individuals can invest in the A-share markets in China directly, many of China's best companies list shares abroad. Shares listed outside China are freely open to all foreigners. This archaic system has grown for historic – if irrational – reasons but now has some absurdities. An individual foreigner would be prohibited from buying A-shares in a company listed in China, but could buy B, H, L, N, or S shares in the same company. Over 14% of Singapore's listings are Chinese companies. As of 2006, there were 33 Chinese ADRs trading on the NASDAQ, the main Over the Counter system in America and 16 Chinese ADRs trading on the New York Stock Exchange. There are thousands of many more obscure companies, frequently penny stocks, that don't meet NASDAQ's listing requirements. These companies trade separately, often with their prices listed only once daily, on the OTC Bulletin Board (OTCBB) or, pink sheets, a daily publication complied by the National Quotation Bureau containing price quotations for OTC stocks.

-Domestic Exchanges

As of the September 2006, 1,377 companies were listed on the two exchanges, with total market capitalization of 3.2 trillion renminbi, or US$400 billion. From 1991 to 2005, companies raised over $1.2 trillion renminbi, or US$150 billion on the two exchanges. While the number of companies listed on the Shanghai Stock Exchange continues to grow, the Shenzhen Stock Exchange seems to have lost its appeal to companies since 2000, with no particular reason. We will see whether this trend continues, and whether the boards show signs that they might merge. In May of 2005, the Chinese government imposed an Initial Public Offering [IPO] ban to reevaluate market conditions. The ban was subsequently lifted in May of 2006. Most of the subsequent initial sales of shares have been on the Shanghai Exchange at least partially because they have been larger, well-established companies. Interestingly enough, Chinese domestic investors bear the brunt of the risk in China’s developing market. Until a few years ago, China would not allow its citizens to exchange renminbi for foreign currencies. The only foreign currency that domestic investors could legally obtain was money sent back from overseas relatives or friends. Furthermore, many of China’s more mature and profitable “blue-chip companies” are not available to domestic investors as they are listed on overseas exchanges. Although foreign listing is a common practice for companies in countries such as South Africa and Israel, overseas listings by Chinese companies far outstrips that of any other country. China Mobile, China Unicom, CNOOC, and Legend are all leading Chinese companies as well as components of Hong Kong Stock Exchange’s Hang Sang Index. Yet while Mainland Chinese are the customers, suppliers, producers, and even employees of these companies, they are barred from investing in them. The Chinese government regulates initial public offerings on all its exchanges. The government sets the quota for new listings each year, selects the qualified companies based on provincial and sector allocation, and until 2001, even determined where the new stocks would list. China is the only country in which the government controls the size of the stock market, the pace of issue and the allocation to exchanges. Also, under China’s current laws, no company is allowed to list without three years of continuous profitability – a much more conservative policy than in the US and elsewhere. Like Japan, China’s stock market leans heavily towards the industrial sector, with many manufacturing-oriented companies. Based on the Dow Jones Global Classification Standard, as of June 2005, the industrial sector, one of ten economic sectors, represents about 20% of the Dow Jones China Index, much more than the Dow Jones World Index’s allocation of 11%. Other sectors with strong manufacturing ties also have significant representation in China’s stock market. The industrial, basic Materials, consumer Cyclical and consumer noncyclical sectors combined cover more than 70% of the broad index’s market capitalization. At the global level, those same sectors only account for about 36% of the Dow Jones World Index. China echoes its nicknames as the “World’s Factory” and the “Global Manufacturer” on stock markets too. By contrast, sectors representing a significant portion of the global market, such as financial, information technology, and healthcare, are underweight in China on Mainland exchanges, comprising of 7%, 2.8%, and 0.2% respectively. It is important to remember, however, that these weights are somewhat misrepresentative due to government listing decisions. China Mobile and China Unicom are both listed and traded in Hong Kong only. As a result, Hong Kong is heavily overweight in telecommunication stocks at 22.6%, while China’s telecommunications sector represents only 0.2% of its market. Likewise, CNOOC and Legend Holdings, leading companies in the energy and technology sectors, are only listed in Hong Kong, skewing the representation of the sectors in both markets. -Floating Non-Tradable Shares Besides the split-share system, another feature of the Chinese stock market are non-tradable shares. Every stock market in the world has non-tradable shares such as company cross-holdings, government-owned shares, and private holdings. According to the Dow Jones World Index, about 14% of all the shares issued in the world are non-tradable. Among seven developed markets, the UK has the highest free-float ratio at 95.1% while Hong Kong has the lowest at 48.5%. The US has a free float ratio of 93.9%. Generally speaking, stock markets in Asia such as Hong Kong and Singapore tend to have relatively low free-float ratios—probably due to cultural and historical reasons. An announced plan to reduce government ownership in July 2001 triggered a 45% market crash. Faced with an explosion of available shares, any market is at risk of a collapse. For example, if all family-owned shares were put on the market in Hong Kong, float shares would almost double, a wave the Hong Kong market would find hard to bear. The Tracker Fund of Hong Kong, the first exchange-traded fund (ETF) in the Asia Pacific was originally created as a vehicle for the Hong Kong government to unload the shares it bought during the financial turmoil in 1998 to maintain market stability. Since its launch in November 1999, the Hong Kong market always drops significantly before its quarterly issuance.China has made significant progress in floating non-tradable shares in a reasonable manner. While only about 150 companies on the Shanghai Stock Exchange and about 130 companies on the Shenzhen Stock Exchange can be considered free of government ownership, since May of 2005, batches of companies have been scheduled to float non-tradeable shares through a series of orchestrated negotiations between the state and current share holders. As of mid 2006, less than 50% of shares are state-owned, a dramatic improvement considering that in January of 2002, the state owned 78% of equity shares.