Lessons of China's Stock Market
George Zhibin Gu
29 June 2005
On the morning of May 9, the employees
of a leading Chinese investment brokerage in Guangdong
returning from the nine-day Labor Holiday were surprised
by an unusual memo from company management. They were
told that tough days were ahead following the government's
announcement that formerly non-tradable shares in Chinese
companies would be allowed to float freely soon. The
managers predicted that the Shanghai stock index could
fall another 15-20%, to the 900-1,000 level perhaps,
as a result of the reform measure.
Sure enough, even though the measure to float non-tradable
shares had long been expected, the immediate reaction
of the market was a sharp dip. By that afternoon, retail
investors were calling the day another "Black Monday".
Both Shanghai and Shenzhen saw a wave of selling, with
the Shenzhen stock index dropping 4% and Shanghai 2.5%.
About two months later, the two markets were still directionless.
The key question on the mind of 71 million Chinese investors
was: where is the bottom? China's stock market, beset
by confusion and worry, now stands at a 8-year-low,
having seen a greater fall than even the overinvested
NASDAQ in the US.
The depressed markets make a dramatic - and to naive
outside observers, inexplicable - contrast to the sizzling
economic numbers China presents year after year, numbers
which have not stopped the continuous panic selling
of domestic shares. The truth is that most Chinese stocks
were overvalued for many years.
What went wrong?
The "Great Bear Market of China"
had many causes. China's two baby stock markets were
established only in 1992. Disturbingly, a legal charter
for the markets emerged only in 1997 - a clue to the
uncertainty of officials as they experimented with market-oriented
Numerous bull and bear markets have come and gone. During
the bull periods, stock prices rose wildly, often reaching
price/earning ratios over 60 or even more. Many unprofitable
companies had their glory days, as if unprofitability
was a minor detail. The party's end was all too predictable.
The bear market that began in late 2000 has erased some
60% of the market's value. Chinese investors experienced
shock after shock during this period. Many listed companies
went virtually bankrupt; hundreds of senior executives
were sent to prison; and widespread financial abuses
became a daily feast for the Chinese business press.
In this environment, the non-tradable share reform measures
struck many investors as an unwelcome, bitter medicine.
The non-tradable shares are shares that have been held
by various government units as well as legally defined
entities. Their sale would bring enormous downward pressure
on the markets because the nontradable shares constitute
64% of market value, 74% of which belongs to the state.
To countless investors, holding mainland Chinese stocks
has become something like holding a falling knife. The
resulting exodus of capital has pushed down the markets
A historical background
Why did the government decide to sell
the non-tradable shares on the open market? The answer
requires a brief history lesson. Prior to the mid-1990s,
official China had a different mentality: it was believed
that holding a controlling stake in large companies
would ensure the government's continued control over
these enterprises. This is the reason why 90% of the
listed companies are still state-owned.
In fact, between the mid-1950s, when virtually all industrial
companies were nationalized, and 1978, when the economic
reforms began, essentially all economic activities were
government-run. Following the Soviet model, government
bureaucrats ran all factories, mines, and shops, with
the minor exception of shoe and bike repair shops. Government
power expanded along with state economic control, reaching
heights unparalleled in China's long history. The stagnation
inadvertently created by the state-dominated approach
caused China's economy and society to become stuck in
the mud for more than 25 years.
It is less well appreciated, however, that the government
monopoly created vast problems for the government itself.
Power carries responsibility, and Chinese officialdom
inevitably faced the quandary that the greater their
power became, the more troublesome their responsibilities.
Providing life's essentials, jobs, and happiness for
1.3 billion people would be a tall order for even the
most efficient organization imaginable, and in the 1970s,
China's creaking bureaucracy showed clear signs that
it was beginning to buckle under the weight of this
The market reform policies that began in 1978 were partly
motivated by the need to address this problem, and the
dramatic changes that resulted are well known. One of
the most noticeable changes was that foreign capitalists
and Chinese businessmen were encouraged to play a significant
part in the economy, along with the state companies,
which continued to exist. The introduction of a stock
market in 1992 was widely regarded as a sign that the
reforms had become irreversible.
To be sure, there has been enormous economic progress
achieved in the reform era; the vast wealth destroyed
by the Soviet economic model is quickly being restored.
But unresolved issues remain. The most basic issue is
this: how to completely transform a government-run economy
into a market-oriented one. That issue has brought one
fundamental conflict to the fore: the double role being
played by the government, as it attempts to be both
a "player" and a "referee" in the
economy at the same time. This basic conflict of interest
tempts countless government officials to utilize excessive
government power, left over from the Mao era, for personal
gain - and many have failed to rise above the temptation.
Nowhere are the effects of the player-referee conflict
more visible than in the stock markets.
China's stock market woes - and their cause
Building a stock market with 1,400
listings in a short time is an impressive achievement.
But the market has had built-in flaws since day one.
In theory, stock markets follow a competitive principle:
investors put money into good companies, and not into
bad ones, which allows the good companies to grow with
the help of investors, while the bad ones die out. In
the end, wealth is created. But the Chinese stock markets
have hardly followed this rational path so far. In reality,
they have run into all sorts of nightmares, with one
common cause: continued government domination.
To begin with, the number of companies that want to
be listed is hundreds of times greater than the number
of listing slots available. Listing rights are controlled
by multiple government units, at central, provincial
and local levels. This arrangement presents ample opportunities
for corruption, and it is hardly surprising that listing
rights frequently go to companies whose business qualifications
may be less than sound. Furthermore, companies frequently
fudge their financial numbers in order to meet listing
requirements. While regulatory bodies exist that are
theoretically empowered to stop such abuses, in practice
they have been too weak to do so.
Once a company is listed, the reward mechanism that
should operate is greatly weakened by the prevalence
of manipulative practices. There are many sources of
"hot money" in the Chinese markets: state-owned
banks and state sector companies, for one. "Pumping
and dumping" happens in China also: hot-money investors
push up weak stocks to sky-high prices by buying in
massive quantities, then sell quickly for a fat profit,
leaving small investors holding the bag. Regrettably,
various investment brokerages have become involved in
such practices by making short-term loans to such speculators.
Worse still, they sometimes play the game with their
clients' money, by promising fat profits to the clients.
The lack of effective regulation has created an "anything-goes"
atmosphere around the Chinese financial markets. The
manipulators have done well for a long time without
getting punished, attracting even more abusers. One
"Chinese Enron", De Long, founded by four
brothers, was active for many years in this manner:
it borrowed heavily and tried to manipulate the stock
market. The founders were convinced that their company
was "too big to fail", but they were wrong,
and De Long collapsed recently, leaving huge uncollectable
debts - believed to billions of dollars - for various
The greatest damage done by the stock market excesses
is that they are impeding China's critical goal of transforming
and modernizing Chinese companies, both state and private.
With capital flowing so freely, the listed companies
have little incentive to introduce modern, professional
management, to say nothing of transparency and accountability.
This problem is exacerbated by the fact that 90% of
the listed companies are still controlled by various
government entities, making them directly responsible
to government officials - not to the market or to investors.
Indeed, government officials, being controlling shareholders,
can effectively control these businesses through such
means as the appointment of key managers. The net effect
is to turn market transactions into bureaucratic transactions.
Naturally, financial wrongdoing, in all its multiple
forms, is hardly exclusive to China; every country with
a stock market has witnessed a certain amount of manipulation
and sleaze. Behind the bursting of the Japanese stock
bubble, for example, was the widespread practice of
cross-holding among banks and their corporate clients,
which helped to prevent Japan Inc from having professional,
merit-based management. China Inc's key problem - bureaucratic
meddling - may be different, but escaping the traps
created by past practices will be easy for neither country.
Split-share reform as an aspect of privatisation
On the plus side, the atmosphere in
China has become more conducive to systemic reform.
There is a broad consensus in society that the government
should withdraw from the business world and concentrate
on the referee role. As such, sales of state assets
have picked up recently, not limited to the stock market
alone. It is clear that the split share structure reform
policy fits these general developments. At the same
time, the government entities involved have a huge financial
interest in the outcome. Privatizing creates enormous
windfalls for them, giving them enormous incentives
to do so.
Consequently, Beijing, which sees asset sales as a convenient
way to dump troublesome enterprises and generate hard
cash at the same time, is actively trying to list more
state assets, both within China and overseas. Now, even
the "Big Four" state banks - the Industrial
and Commercial Bank, the Bank of China, the Construction
Bank and the Agricultural Bank - are trying to get listed.
But average investors remain worried. Based on past
experience, they fear that even needed reforms are just
another government ploy to get their money. So, selling
government-owned shares, as desirable as it might be
in theory, has had the practical effect of pushing the
market down even further, and no lower limit is in sight.
Crossing the river by feeling the stones underneath
An old Chinese saying says, "messes are best
cleaned up by their makers". Indeed, Beijing is
trying to escape a stock market mess of its own creation.
The only problem is that the market is nervous. Beijing's
solution to these jitters is to carry out the plan gradually
over a long period. The government hopes that by proceeding
in this manner, large-scale disruptions can be avoided.
So in the immediate term, Beijing has chosen to sell
the remaining shares of four companies as an "experiment",
which aims to find practical ways to meet the ultimate
goal of fully floating the entire market. Beijing is
approaching the problem cleverly. The procedure for
selling the four stocks is more like a bargaining game
between regular investors and the entities holding non-tradable
shares. The latter must offer some incentives to the
regular shareholders before gaining the ability to trade
the shares. Superficially, this seems like a reappearance
of the old Chinese game, "pitting people against
people". But this time, Beijing wants to act as
a neutral arbiter of others' disputes, which represents
For one of the "experimentally"
listed companies, Sany ("Three One") Heavy
Industry, the proposal is that the holders of formerly
nontradable shares must give both cash incentives and
shares to regular shareholders before being permitted
to freely trade their holdings. The proposal calls for
regular shareholders to get three free shares plus 97
cents in cash compensation for every 10 tradable shares
held. The announcement of this proposal caused all the
regular shareholders of the company to immediately calculate
their gains and losses, and indirectly is causing all
investors to do the same thing for their shares. Market
reaction to the new plan was positive: Sany and two
other "experimental" companies have been trading
up smartly for few days.
Upon it, the government has introduced 42 listings for
the second around of experiment as now. The gradualist
approach may work out in the end for the remaining companies.
Countless investors now agree that having a fully tradeable
stock market is unavoidable, even if some investors
will have to pay more for this change than others. Fortunately,
the market fundamentals are improving. By now the average
listings have a 2004 price/earnings ratio of about 16,
which most global investors would consider reasonable.
Many feel that these listings are a good investment
already. Undoubtedly, unwinding the government's business
stakes is necessary for China to truly move forward.
Despite the short-term pain, it will be positive in
the end, as the stock market becomes more like a "real"
one. The reforms also represent a larger trend: China
is embracing international norms with respect to ownership
structure, corporate governance and professional management,
among other significant things.
The road ahead
The trends are in the right direction, but two basic
issues remain to be fully addressed. First, there must
be a decisive separation of government interests from
the business sphere. The government must irreversibly
commit itself to only being a dutiful watchdog, not
a market competitor as well. China cannot establish
a sustainable, modern economy without this change. Second,
all existing state and private-sector companies must
be transformed into modern business organizations using
up-to-date management methods. Above all, business organizations
must be held accountable to law and to their customers.
There is a long road ahead to achieve these goals, but
there is no alternative and no shortcut. If the Chinese
economic reforms have produced one great lesson so far,
it is this: wealth is created by entrepreneurs, laborers
and managers, not the government. These groups must
have the right environment to succeed, and the entire
society is responsible for producing the necessary support
for their work. Accordingly, curtailing excessive government
power over the economy is nothing less than a necessary
goal for the Chinese civilization. In the reform era,
China has already taken a giant step forward in this
direction, and continued progress is the only way China
can achieve its national goals.
George Zhibin Gu is a business consultant based in China
and is the author of a newly released book, Made in
China: Players and Challengers in the 21st Century (Portuguese
and of a forthcoming book, China's Global Reach: Markets,
Multinationals, and Globalization (www.Trafford.com,
Sept 2005). He can be reached at firstname.lastname@example.org