Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
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TABLE 7.5 Top 20 offline investors in the Agricultural Bank of China A-share IPO
Source: ABC public notice, July 8, 2010
Name Value of shares allocated (RMB million)
1 Ping An Life Insurance designated accounts 1,668.6
2 CNOOC Finance Co. proprietary account 1,195.4
2 Shengming Life Insurance Co. designated account 1,195.4
3 People’s Insurance Co. managed accounts 929.3
4 Ping An Insurance Co. proprietary account 896.6
5 China Pacific Insurance Co. managed account 650.5
6 Taikang Life Insurance Co. managed accounts 525.3
7 China Power Finance Co. proprietary account 448.3
8 Xinhua Life Insurance designated account 366.1
8 NSSF designated accounts 335.9
9 CITIC Trust designated account 278.8
10 China Aviation Engineering Finance Co. proprietary account 149.4
10 Deutsche Bank QFII account 149.4
11 Jiashi Top 300 Index Fund 97.6
12 Daiya Bay Nuclear Power Finance Co. proprietary account 92.2
12 Red Tower Securities Co. proprietary account 92.2
13 Boshi Stable Value Fund 83.4
14 Yifang Top 50 Fund 72.2
15 Fuguo Tianyi Value Fund 55.8
15 Jingshun Growth Equity Fund 55.3
ABC’s IPO came in the aftermath of the Great Shanghai Bubble of 2007. From June of that year, the market entered the final stage of its heroic bubble, rising 50 percent in four months to nearly 6,100 points. Many people, caught up in the euphoria, believed the index would easily break 10,000 by year-end. During this period, 17 more companies listed on the Shanghai exchange, including PetroChina, China Shenhua Energy and CCB, and none used the formal strategic-investor route (see Table 7.6). The reason for this is simple: there was no longer any need; the market was full of liquidity and listing success was guaranteed.
TABLE 7.6 IPOs in the closing days of the Great Shanghai Bubble, 2006–2007
Source: Wind Information and author calculations
This is not to say that these IPOs did not attract the small investor. But in almost any market circumstance, the average deposit required to secure an application was far beyond the reach of any normal retail investor. During the mid-2006 to mid-2007 period, the average online “retail” bid was nearly RMB700,000; in the second half of 2007, when strategic investors were no longer needed, it rose to RMB1.2 million on average. During this period, there were more than a million online investors per IPO; PetroChina attracted over four million. So while small investors most certainly came out to help boost the number of applications, they did not account for the bulk of the money put down online: institutions did.
As for the offline tranche, the amounts of money involved could be staggering. For example, in PetroChina’s Shanghai IPO, 484 institutional investors successfully bid for allocations in an offline tranche that accounted for 25 percent of the entire share offer. The smallest successful bid was made by the appliance-maker Haier, which received 2,089 shares and was refunded RMB1.64 million from its lottery deposit. The largest was Ping An Life, which received a total of 119 million shares in a handful of separate accounts and got back RMB93.2 billion (US$11.4 billion) in excess bid deposits. Not far behind was China Life, with over 100 million shares and deposits worth RMB78.5 billion (about US$10 billion) returned. Reviewing the 400-plus names reveals a Who’s Who of China’s top financial and industrial companies, including even the Military Weapons Equipment Group Company (Bingwu Gongsi) of the People’s Liberation Army.
If one of the original goals of creating stock exchanges was, as stated, to ensure the primacy of a socialist economy overseen by the Party, then China’s experience with stocks has succeeded far beyond any reasonable expectation.
Keeping everyone happy: Primary-market performance
In addition to the lottery arrangements that create mass feeding frenzies, the share valuation mechanism set by the CSRC explains the popularity of IPOs in China. Simply put, prices are knowingly set artificially low while demand is set high, with the result that big price jumps on listing day are virtually guaranteed (see Table 7.7). This approach also eliminates underwriting risk so that securities firms need not be concerned that their underwriting fees are so thin. But this all comes at a cost. The pricing process eliminates the need for investors to understand companies and the industries in which they operate to arrive at a judgment as to valuation.
TABLE 7.7 A-share listing-day price performance
Source: Wind Information; author’s calculations; 2010 data through March 31
Note: * represents the amount of shares sold as a percentage of what was allowed to be sold on the first day.
Since the process is dumbed down to a formula, underwriters have never learned how to value companies and price risk. Even worse, the investor population, in whatever category, never became educated as to the values of different companies, the prospects for their shares, or the risks associated with investing. Over time, the result has been that companies became commodities and getting an allocation of shares, any shares, became the sole objective and wildly oversubscribed IPOs were the result. From another angle, what these valuations of China’s National Champions are most certainly not revealing is Chinese management skill, technical innovation, entrepreneurial flair, or the growth of genuine companies. What they do show is the state’s confidence in its own ability that, when push comes to shove, it can manage the market index so that it will go up and the state’s holdings will increase in value. Chinese investors refer to their stock markets as “policy” markets for this very reason: they move on the expectation of government policy changes and not on news of company performance. The fundamental value-creation proposition in China is the government, not its enterprises.
In spite of this, prices play a huge role, although not in valuing the risk related to the business prospects of companies. As mentioned, the CSRC formulas uniformly result in share valuations well below prevailing market demand so that double-digit and triple-digit first-day jumps in prices become par for the course. Put another way, the regulator requires that companies and their underwriters price shares in a completely opposite way to market practice in Western markets. Forced by their ultimate state owner, companies effectively sell their two-yuan shares for one yuan.
From an international perspective, the losses to companies arising from this practice are enormous. As an extreme example, take PetroChina. The company raised RMB67 billion (US$9.2 billion) in its Shanghai IPO and received RMB3.4 trillion (US$462 billion) in subscription deposits. The difference between its actual share price and a market-clearing price based on actual demand is shown in Figure 7.5. As indicated, PetroChina’s cheap pricing meant that it had left RMB45 billion (US$6.2 billion) on the table. Not surprisingly, on its listing, PetroChina’s shares jumped nearly 200 percent, giving it, albeit briefly, a market capitalization of more than US$1 trillion. From a developed-market viewpoint, this was a complete crime. It should have been an even bigger crime in the SASAC’s eyes, given the cheap sell-out of state assets. From the company’s viewpoint, an astute chairman would have wondered why he had just sold 10 percent of his company at half the value attributed to it by the secondary market. To put it another way, he had sold US$16.8 billion of stock for just US$8.9 billion. In an international market, he would, no doubt, have fired his investment bankers outright and then been fired by his board.
FIGURE 7.5 Money left on the table
Source: Wind Information and authors’ calculations
But this money, as shown previously, was hardly lost to the state: it had just been given to those state-owned institutions, the group of “family and friends” that had participated in the prearranged lottery. From this, it seems that IPOs function as a means to redistribute capital among state entities with, possibly, some leakage into the hands of retail investors and mutual-fund holders to smooth things out.
The looking-glass
culture of these markets creates figures such as the chairman of China Shenhua Energy, Chen Biting, who could say without a trace of irony: “The debut price was within expectations, but I am still a wee bit disappointed.”7 His lament was that on the first day of Shenhua’s IPO, its shares jumped only 87 percent, leaving just RMB15 billion on the table for his friends. Such generosity characterized the highs of the 2007 stock bubble and Chen was no doubt looking for a doubling of his company’s share price. If he had been running PetroChina, he would have been much happier, it seems. After all, PetroChina’s chairman, Jiang Jiemin, could look his buddies straight in the eyes, knowing that he had delivered for them and the Party that backed them all up. More importantly, he knew that he could now count on their continued support should he need it.
For those in the central nomenklatura of the Party, there are no independent institutions, only the Party organization and it is indifferent as to which box does what. On the other hand, just think how relieved the two AMC investors in ICBC’s Shanghai IPO must have felt, knowing they had made enough quick money to pay interest on the PBOC and bank bonds.
Whose hot money?: The trading market
The stock market money-machine works best when IPO prices are cheap and there is huge liquidity in the trading market. This environment drives up the prices of “strategic” investments locked up in the hands of the state investor pool. As is the case in the IPO market, this money does not come from retail investors, as the state would have us believe. From roughly 1995 until the present day, the Chinese secondary markets have been dominated by institutional traders; that is, SOEs and state agencies. Their investment decisions move the market index. While much of the evidence is anecdotal, it has been estimated that anywhere up to 20 percent of corporate profits came from stock trading in 2007. The authors themselves once received a call from a recently listed company asking for advice on how to set up an equity trading desk now that management had some cash in hand. Given the ability to achieve a return greater than the bank deposit rate and the ease with which trading can be disguised, why wouldn’t a corporate treasurer look to make some easy money while the market is running hot?
Based though it is on sparse public information, Table 7.8 provides a rough breakdown by types of investors in Chinese A-shares at the end of 2006, just as the market was beginning its historic boom. The market reforms of 2005 notwithstanding, shares owned in various ways by the original state investors remain locked up. As a result, the tradable market capitalization is a known figure and at FY2006 totaled US$405 billion. The figure for domestic mutual funds is published quarterly. The retail number is based on the assumption that half of retail investors invest through mutual funds and half invest directly. If accurate, this would mean that retail investors account for nearly 30 percent of the traded market; this is considered to be a high estimate. The size of total Qualified Foreign Institutional Investor (QFII) quotas is publicly known, although the investment mix is not, and the NSSF and insurance companies at this time had known restrictions as to how much they could invest in shares. The assumption in each of these three cases is that 100 percent of their approved quotas was placed in equities; this yields a US$30 billion estimate. Netting all of these knowable fund sources out of the tradable market means that some 60 percent, or US$245 billion, of the A-share float as of year-end 2006 cannot be linked to identifiable categories of investor.
TABLE 7.8 Investors in China’s stock markets, December 31, 2006
Source: China Economic Quarterly 2007 Q1, p. 11
US$ billion % of Total
Total A-share market capitalization 1,318 100.0
Less: capitalization under three-year lock-up 913 69.3
Tradable market capitalization 405 100.0
Total identifiable institutional investors including: 100 24.7
- Domestic funds (actual number) 60 14.8
- QFII (100% of existing total approved quota) 20 4.9
- Securities companies estimate 10 2.5
- NSSF (100% of approved limit) 5 1.2
- Insurance companies (100% of approved limit) 5 1.2
Estimated retail investors 60 14.8
Estimated other investors including: 245 60.5
- State agencies 115 28.4
- State enterprises 65 16.0
- Large-scale private investors 65 16.0
Who are these unknown investors that own the majority of the A-share float? Almost certainly, they include many overseas Chinese tycoons who have the wherewithal to evade the prohibition on foreign individual investments in A-shares. More interestingly, during the market ramp-up in 2006, many domestic financial reporters believed the market rumor that China’s army and police forces alone had brought onshore upward of US$120 billion and committed it all to stock investments. While this figure is outlandish, it may have been possible that a smaller amount had been repatriated and invested just as the market began its upward move in 2006, resulting in this much higher value. But there can be no doubt that SOEs and government agencies between them must have held some US$180 billion in tradable shares in addition to shares they held subject to a lock-up.
A CASINO OR A SUCCESS, OR BOTH?
It has been nearly two decades since the Shanghai and Shenzhen exchanges were established. Why, if they are still regarded as casinos, have they been so successful? How have they come to be seen as beacons of China’s economic reform and attained such central roles in the country’s economic model? The answer is simple: you can make money from them. These markets are driven by liquidity and speculative forces, given the almost-arbitrary business decisions made by companies influenced more by politics than profit. How can this not be the case when companies are the property of the Party and its families?
Such a market may seem daunting to investors from developed markets, but the Chinese are long accustomed to operating in a No Man’s Land of political interference and contradictory signals. None of this stops them from playing or being played by the market: if you buy a share at RMB10 and sell at RMB15, you do make RMB5. Putting money on deposit with banks or playing the bond market is hardly worth the effort; interest rates are set in favor of state borrowers, not lenders, so they do not provide a real return over the rate of inflation.
In China, the only two ways to make this real return are property and the stock markets. Of the two, the stock markets are preferable since they are more flexible than the property market (not that those with the means cannot play both). The investment measure in stocks may be smaller, but liquidity is substantially better than the property market. In contrast to interest rates, the equity market equivalent, the price-to-earnings (PE) ratio, is free to run as high as the market will take it. In the glory days of the Golden Bull Market from 2006 to 2007, the overall Shanghai PE multiple rallied from 15 to nearly 50 times. With that sort of valuation expansion, the upside is very large indeed.
The Chinese market simply doesn’t have natural stock investors: every body is a speculator. Chinese history and bitter experience teach that life is too volatile and uncertain to take the long-term view. The natural result of this is a market dominated by short-term traders, all dreaming of a quick return. The one natural investor is the state itself and it already owns the National Champions. In contrast, ownership in developed markets is far more diversified; large companies simply do not have dominant shareholders owning more than 50 percent of their shares. For example, the largest shareholder of Switzerland’s biggest banking group, UBS, is the Government Investment Company of Singapore, with less than a seven percent holding. Contrast that with Bank of China: even after its IPO the bank’s largest shareholder, Huijin, still controlled 67.5 percent of the bank’s stock.
Since China’s stock markets, which include Hong Kong, are not places that decide corporate control, the pricing of shares carries little weight when thinking about the whole company simply because it is never for sale. This is why there is no true M&A business in China and most definitely none involving non-state or private enterpri
ses acquiring listed SOEs. Instead, market consolidation is driven by government fiat and is accomplished by mixing listed and unlisted assets at arbitrary valuations. This leaves share prices to simply reflect market liquidity and demand at any given time. The high trading volumes in the market are its most misleading characteristic since they give outside observers the impression that it is a proper market. High volumes lend credibility to the idea that prices are sending a signal about the economy or a company’s prospects. In fact, in China, all that the volume represents is excess liquidity.
All markets are driven by a mixture of factors, including liquidity (how much money is in the system); speculation (the belief in making a profit from market volatility); and economic fundamentals (the underlying business prospects and performance of listed companies). Chinese markets are often seen to be decoupled from the actual economic fundamentals of the country. A rough comparison of simple GDP growth and market performance would certainly show minimal correlation between the two. As long as Chinese A-shares ignore economic fundamentals, the market will always be thought of as a casino and too risky for most investors. Chinese investors, however, instinctively know what they are buying because they think the share price is going up, not because the company that issued the shares is having a great quarter or the economy is having a record year.
Much of the effort over the 1990s to develop the markets was aimed at strengthening this fundamental component by creating or introducing more long-term institutional investors, as in developed markets. The entire domestic mutual-fund business was created by the CSRC in the late 1990s with this in mind. The introduction of foreign investors in 2002 via the QFII facility was another step in this direction. The growing volume of company and economic research from local and foreign brokerage houses is all based on the belief that China’s markets are becoming, or will become, more fundamental and driven from the bottom up.