When it announced new stock listing rules over the weekend, the Chinese securities regulator was trying to end a decade of underachievement.
The best economic growth story of the 21st century has been a poor investment play. While its gross domestic product has shot up, China’s equity market has languished.
Part of the blame has been an initial public offering system that consistently overprices shares, to the benefit of newly listed companies and their underwriters. Those buying into IPOs on their first day of trading have lost money, and the mass of ordinary investors in China has slowly lost confidence in stocks.
More pre-listing disclosures and greater institutional participation in pricing — the reforms detailed on Sunday — should add some stability to China’s casino-like markets. Guo Shuqing, the reformist who was appointed securities regulator six months ago, has also tried to limit insider trading.
But he is fighting a paradox seen throughout emerging markets and typified by China: high gross domestic product growth often goes hand-in-hand with lousy stock returns.
“Companies raising money, not investors, have done well off the stock market. The vast majority of investors have had no way to profit,” says Ye Tan, a financial commentator.
If China’s GDP were a security you could buy, it would have delivered strong returns. The value of China’s annual output nearly quintupled from 2000 to 2011, which would have made it one of the best investments in the world.
But GDP is not a security. The Shanghai Composite Index, something you can invest in, has a much weaker record. It rose about 46 per cent over the past decade, barely keeping pace with inflation. How can China’s growth have been so fast and its stocks so sluggish?
The first thing to note is that China is far from an aberration. GDP is crucial to understanding economic performance, but it has proven a bad predictor of equity returns. As Jay Ritter of the University of Florida and other economists have documented, there is no stable relationship between GDP and stock performance.
China illustrates two key reasons why fast-growing countries often disappoint investors.
First, there is a simple question of maturity. China’s stock market was established only two decades ago, so it would have been extremely surprising if it had behaved like long-established bourses in developed economies. Many of the biggest components of the Shanghai Composite Index, including the top banks, listed after 2005.
Moreover, there has been a steady dilution of existing investors as China has reformed state-owned companies by gradually “unlocking” their shares for trading. The portion of tradable shares in China has risen from about 30 per cent of listed companies a decade ago to 70 percent.
“The objective in establishing the stock market was to give state-owned companies a way to escape their difficulties. It was only after the late 1990s that thought was given to protecting investors’ interests, and this transformation is not yet complete,” says Zhao Xijun, a professor at People’s University.
The second factor, as in other developing countries, is the market’s legal and political backdrop. This is much harder to change. The corrosive influence of insider trading was highlighted in a 2002 study of China’s stock market by Dow Jones Indexes. It showed that the vast bulk of the gains over the previous decade had occurred on 10 specific trading days when stocks jumped.
The inference was that only investors who possessed critical information – often linked to state policy announcements – were able to make money. Everyone else was just along for the ride. Although China has taken steps to clean up its markets since then, insider trading remains pervasive. Mr Guo has launched yet another crackdown.
Investors are by now familiar with the immaturity and the insider trading in the Chinese market. After the disappointing performance of the past decade, it is clear that negatives are more fully priced in. The ratio of Chinese share prices to last year’s earnings is near a historic low at 14.7, about the same as in the US.
As Mr Guo continues his reform drive – bringing more institutional money into the market, adjusting the IPO pricing system, implementing easier delisting rules and more – the maturation of the Chinese stock market could be argued to be accelerating.
Geoff Lewis, head of investment services with JPMorgan Asset Management in Hong Kong, says Chinese shares are approaching a point where they can be assessed like those in other markets.
“Your view on China should be whether you think it will be a soft landing or a hard landing. I don’t think it should be related to structural overhangs or market imperfections,” he says. If economic performance does start determining investment performance, it would indeed be a new departure for Chinese stocks.