Virtual China Stock Market Guide

The stock markets of China are a case study in paradox: capitalist bastions in a communist state. There are two main kinds of shares: A-shares for the Chinese, B-shares for foreigners. The B-share market, meant to attract foreign capital, is so opaque and illiquid and inefficient that few foreigners are interested. In the A-share market, still an oddity in a country where government loans are the royal road to finance, the biggest group of investors are workers laid off from bankrupt state-owned enterprises.

It hardly seems the picture of a place where an honest investment dollar could be made, either right now or anytime soon.

And yet, and yet.

Considering where they began - which was non-existent only eight years ago - the stock markets of China have come a long way. The Chinese government, increasingly Communist in name only, has without question made tremendous and sincere efforts to create a stock market that will eventually become a true engine to a capitalist-style economy.

Since China's two main stock markets, in Shanghai and Shenzhen, were started in 1991 and 1992, respectively, Beijing has taken a rather arms length approach toward their development. Perhaps because of the ideological freight borne by the very idea of stock markets, Beijing's top leaders have never explicitly made their nurturance a priority. Stock market reform has thus often seemed an afterthought in comparison to the other great economic reforms underway in China such as those elsewhere in the financial system, the state-owned sector, and in the government bureaucracy itself. The equity market has lurched forward from crisis to crisis with mid-level functionaries creating ad hoc solutions without the benefit of top-level directives. Frantic bouts of retail speculation, endless insider trading, and government intervention to stop the slide of state-owned company shares have marked the market's formative years. It has hardly been a confidence-inspiring performance for would-be investors, especially foreign ones.

Yet the general direction of the changes have been towards greater supervision, less direct intervention, and more transparency, especially over the past year. In 1998, a regulatory body patterned after the Securities & Exchange Commission in New York, the China Securities Regulatory Committee (CSRC) was approved as the country's sole market supervisory agency. This year another new law was enacted allowing private companies to sell shares on the market; previously only state-owned enterprises were allowed to list shares. And on July 1, China's legislature enacted the country's first comprehensive national securities law. Six years in the making, the law sets higher standards in nearly every important category of stock market operation, from IPO approval and corporate disclosure to the control of fraud and insider trading. On the same day, Beijing gave the strongest signal yet it was determined to make these new laws stick: the co-chairmen of a Shanghai manufacturing company, Dongfang Boiler, were sentenced to death for selling shares ahead of their company's initial public offering, netting them each a quarter of a million dollars in profit.

A Brief History
Once upon a time, which is to say before the Communists took power, Shanghai boasted a world-famous stock market, the world's third largest after New York and London. Patronized by a legendary cast of hustlers and tycoons of international trade, the stock market building stood at the head of the Bund, Shanghai's financial district, a mile-long promenade of grand neo-classical banks and brokerages that rivaled any of the great financial streets of Europe or the United States.

A symbol of Western capitalism, the stock market was shut down by Mao in 1949 along with all the international banks and brokerages on the Bund.

In the 1980s, as Deng Xiao Ping's economic reforms began to take root across the country, China began to experiment slowly, slowly, with stocks as a method of fundraising. The first real step was in 1984, when 11 state-owned enterprises became "shareholding enterprises." Instead of calling the process "privatization," with its overtones of "rightist" and "capitalist roader," the Chinese word gufenhua, for "shareholder transformation," was used. Still, throughout the 1980s, most of the real market action was in bonds - domestic corporate bonds and treasuries. Less tainted ideologically than stocks, bond markets, beginning in 1986, were established in the major cities of the East and South such as Shanghai, Beijing, Tianjin, Shenyang, Harbin and Guangzhou. By 1996, average daily trading in bonds had reached RMB200 million (US$24.4 million) a month in these markets.

By the late 1980s a handful more state-owned companies had experienced gufenhua and their investors had taken note of an interesting fact: the dividends on some of the stocks outstripped the yields available on bank savings accounts. A few issues skyrocketed to more than 800 percent times their issue price. Interest was, to say the least, piqued.

China's two officially sanctioned stock markets, in Shanghai and Shenzhen, were opened in 1990 and 1991, respectively. From the beginning these two markets had their own distinctive personalities. In Shanghai, the listed companies are mainly large state-owned enterprises; the Shanghai market's performance is therefore sometimes seen as an indicator of China's domestic economy. The Shenzhen exchange is by contrast populated by manufacturing and export companies doing business with nearby Hong Kong, so is sometimes read as a sign of health in that sector.

There are seven types of China shares:

• State Shares - Shares owned by the state.
• Legal Person Shares - Shares owned by companies or institutions.
• A-shares - May be owned only by Chinese ("individual shares").
• B-shares - May be owned only by foreigners ("RMB-denominated special shares").
• H-shares - Shares in Chinese companies that are traded on the Stock Exchange of Hong Kong ("Hang Seng China Enterprise Shares")
• Red Chips - Shares in Hong Kong companies that are traded in Hong Kong but derive most of their profit from business in mainland China ("Hang Seng China-Affiliated Shares")
• N-shares - American Depositary Receipts (ADR's), issued by Chinese companies, that trade on the New York Stock Exchange.

Of this group, the last four are ways that foreigners may invest in China.

The B-Shares
The B-share market is an odd little thing. Dreamed up as a way to attract foreign currency to cash-strapped Chinese firms, it has defied all attempts to make it more palatable to foreign investors.

In their seven years of existence, the B shares of Shanghai and Shenzhen have lost 25% of their value, compared to an increase of 160% in the A-shares during the same period.

It's not that only the B-share market has seen volatility and scandal during that period. The A-share market has also careened wildly on both sides of the breakeven line. On the whole, however, the government has shown far more interest in developing the market for A-shares.

In the past three years especially, the authorities have many times announced their intentions to revive the flagging B-share market. In the meantime, they have taken actual steps to ensure that money is put into the A-shares. In the last week of May, 1999, alone, the A-share market rose 20% after nine state-run securities companies were allowed to issue additional shares, and dozens of state-run banks, brokerages, and investment funds shifted millions of dollars from government bond funds into the stocks.

As of September 1999, on the Shanghai stock exchange there were 103 Chinese companies selling B-shares worth US$4.37 billion; by contrast, XX companies sell A-shares worth US$XX billion. On the Shenzhen stock exchange, XX companies sold B-shares worth XX, while XX companies sold A-shares worth $XX.

There are many reasons why foreign investors haven't taken to B-shares.

First, the market is so small it's just not worth the time and trouble for institutional investors to get involved. In 1995, the market capitalization of the Shanghai and Shenzhen markets combined was $42 billion, compared to the $6.8 trillion total worth of equity markets in the U.S.; the average daily trading volume in China's markets was a mere $6.9 million, compared to $22.8 billion in the U.S. stock markets.

The lack of institutional interest in the B-share market leads to a lack of liquidity, with many shares not trading for days or weeks at a time. In addition, the market is highly inefficient, with trades taken by foreign brokers often taking several days to complete. Prices are quoted in renminbi, and currency restrictions add a greater-than-average foreign exchange risk.

The biggest problem, though, is lack of transparency. Reporting requirements for listed companies in China are far less complete and rigorous than in the stock markets of the developed world.

As a result, investors in China shares are highly vulnerable to frequent rude shocks. In 1995, for example, investors in one of China's few well-known brand name companies, the Tsingdao Brewery, fled the stock the company was reported to have lent US$70 million to companies at rates of nearly 20%. That money, most of it raised in a stock offering, was supposed to have been spent on new breweries.

A theory that some B-share investors nurture is that at some point in the future, perhaps when the renminbi is made convertible, or perhaps when the authorities are simply unwilling any longer to tolerate the annoyance of maintaining such a consistently wretched market, it will be merged with the A-shares, thus causing an immediate upward shift in B-share values.

But who's to say that upward shift, if it ever happens, will be into profitable territory? To all appearances, the B-shares are something the authorities in China consider only after they've expended their best efforts to keep the A-shares afloat. But who would want to invest in an afterthought?

Red Chips
A more tempting China investment play than B-shares, because it allows the foreign investor to see Chinese companies through the more transparent lens of the Hong Kong stock market, are the so-called "red chips."

In the early 1990s, some of China's giant state-owned enterprises started raising money via an interesting slight of hand: they would buy small or inactive Hong Kong companies, shift assets into that company, and sell shares on the Hong Kong Stock Exchange.

In the months leading up to the Hong Kong handover in July 1997, red chips were seen as a symbol of the inevitable integration of the Hong Kong and mainland Chinese economies. Many investors believed the Chinese government would never allow this transition to fail - nor any red chip to go bust - and a veritable fervor for red chip stocks thus gripped the colony.

Chinese companies like CITIC Pacific, Shanghai Industrial, China Resources Enterprises and Ng Fung Hong raised more than $2.4 billion in share sales in Hong Kong. Price earnings ratios soared. Beijing Enterprises, a company said to be in line for bargain basement prices for choice Beijing municipal property, soared 60% in a four-month period with a PE of 90.

By January, five months after Hong Kong became part of China, the red chip party was definitively over. Sparked by the default of a red chip company, Xin Hua Estates, to buy 11 stories in a Hong Kong skyscraper, virtually all of the red chips plummeted, dropping 40 percent compared to a 17 percent decline among other Hong Kong shares. Beijing Enterprise's stock fell 60 percent during the period.

Confidence in the red chip sectors was shaken even further in the following year, when GITIC, the investment branch of Guangdong province and one of the biggest of Hong Kong's red chips, went bankrupt, prompting foreign investors to place $4.1 billion in claims against the company.

H-Shares
Another category of China stock, frequently confused with red chips, are H-shares, or stocks in mainland Chinese companies that trade in Hong Kong. Investors interested in red chips are usually interested in H-shares too, and for the same reason: the greater transparency and liquidity afforded by their listing on the Hong Kong stock exchange.

N-Shares (ADR's)
The best bet for foreign investors with their eyes on China is probably the so-called "N-shares," or shares in Chinese companies that trade in the form of American Depositary Receipts, especially those listed on the New York Stock Exchange. China lets only its best managed and most profitable companies list shares on the global stage of the NYSE. The corporate disclosure for these companies is incomparably better than that available for the B-shares (and it's in English, too), and also much better than is available through the Hong Kong stock exchange for the red chips and H-shares.

Nine Chinese companies are listed on the NYSE: Beijing Yanhua Petrochemical Co.; China Eastern Airlines Corp.; China Southern Airlines; Guangshen Railway Co.; Huaneng Power International Co.; Jilin Chemical Industrial Co.; Shandong Huaneng Power Development; Yanahou Coal Mining Co.; and Shanghai Petrochemical Co.

Another 19 N-shares are traded over-the-counter.

Useful Links:
The Shenzhen Stock Exchange: All Listed Shares

The Shanghai Stock Exchange: All Listed Shares

The Red Chips (Hang Seng China-Affiliated Stocks)

The H-Shares (Hang Seng China Enterprise Stocks)

The N-Shares (NYSE and OTC American Depositary Receipts)