On November 1st, 2011, Carl E. Walter delivered a lecture titled “Do China’s Stock Markets Matter?” at the U.C. Berkeley School of Law. The lecture addressed the role and significance of stock markets in China, and described the influence of western legal, accounting and financial concepts on the Chinese economic landscape.
Mr. Walter was one of the first students to go to China when the border opened in 1979. He has spent a large part of his career working in the financial sector in China and is a co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise”. After living in China for 20 years, Mr. Walters recently returned to the U.S.
Mr. Walter started his lecture by describing how at the time stock markets were created, China was still very much a centrally planned economy. With no private property, it is not obvious why a country would have a stock market instead of a debt capital market; after all, stock markets are all about trading ownership in companies. Mr. Walter emphasized that the stock market is not a significant part of corporate finance in China (bank loans account for roughly 85% of capital raised). Still, around 2,500 companies currently have listed shares on the Hong Kong, Shanghai or Shenzhen stock markets. Clearly, there must be ‘something’ about stock markets in China that is of interest besides raising capital.
The transformation of state-owned enterprises (“SOEs”) into the western idea of corporations created a whole new political dynamic in China. In the 1970’s, the Chinese economy consisted only of SOEs, which had no legal boundaries with the Chinese State. Everything SOEs produced went straight back to the government. Moreover, SOEs went well beyond mere factories; SOEs had their own schools, hospitals, and courts. Given the pervasiveness of SOEs in Chinese society, when the ability to list companies on an exchange finally emerged the question became what exactly was to be incorporated. In order to list companies, an appropriate legal infrastructure needed to be put in place. This process started with the “ 1992 Standard Opinion”, China’s first body of corporate law.
Over the next five years, from 1993 until 1997, the adoption of securities and corporate laws further allowed SOEs to be transformed into corporations. The incorporation of SOEs meant that the government now became the direct owner of the SOEs rather than just its regulator, and that it was – at least theoretically – possible for SOEs to be owned by private parties. In order to maintain State control, China created different classes of shares based on their owners. “State shares”, at that time, could not be sold.
Bankers played an important role in the transformation of SOEs into “real” companies, for example by describing what companies in the west looked like, in contrast to China’s SOEs. Nevertheless, there were still obstacles to be overcome to transform SOEs into western style corporations. Mr. Walters notes that the valuation of the newly created companies was a major difficulty. In the west, companies that enter the stock or equity market are valuated by comparing them to similar existing companies. But in China, a new company had no private company to compare itself to. An additional obstacle was that the SOEs effectively fulfilled the role of social security in China, and that there was not immediately an alternative system in place.
Another problem was that during the 1990s, China did not have any companies of actual economic scale. Most IPOs were valued at or below $100 million. Moreover, while the rest of the world entered an age of globalization, none of these little Chinese companies were globally competitive. However, this changed in 1997 when Goldman Sachs incorporated the existing small telecom companies and combined them into a new holding company: China Mobile. For this deal, Goldman raised a previously unimaginable amount: $ 4.5 billion. According to Mr. Walter, the operation had a huge and lasting impact on the Chinese economy, especially since it happened concurrently with the streamlining of the government ministries. The elimination of a number of state bureaus caused big companies to suddenly find themselves without a real regulator.
In order to correct this, the State-owned Asset Supervision and Administration Commission (SASAC) was created in 2003. SASAC regulates the parent SOEs, which in turn own the listed corporations. However, SASAC does not have access to the dividend flows that go from the listed entities to the parent group. The enormous amounts of profit generated by the huge oligopolies (in sectors such as airlines, steel companies, telecom, etc.) can stay with the SOEs, which become even more powerful. Based on his research, Mr. Walters estimates that in 2006, 70% of the free float was held by state agencies or entities.
The economic power of SOEs enabled them to become strategic investors, which made huge listings in the domestic and Hong Kong markets possible. For example, last year the Agricultural Bank of China completed the largest IPO in history, raising a staggering $22.1 billion. Mr. Walter tells us that when trading in China, shares are expected to increase significantly the first day (the average first day price jump being 47%, the first day turnover being around 70%). According to Mr. Walter, this phenomenon is caused by the government valuing shares rather than banks or securities companies.
Next, Mr. Walter goes on to describe the Central SAFE investments as an alternative to the SASAC structure. SAFE was set up in 2003 with the goal of having actual control over the boards of directors of listed companies, as opposed to SASAC which deals with parent companies. When SAFE restructured the Chinese banks, it invested in them directly and had a 100% ownership share banks were listed. The benefit of this model, which differs greatly from the SASAC model, is that the profits are not absorbed by the parent companies: between 2004 and last year, $84 billion in cash dividends were paid out to shareholders.
Mr. Walter concluded by drawing a general picture of business in China today. Over the past decades, the Chinese have adopted western legal and accounting concepts to create a new form of company. At this point, government-controlled oligopolies are very powerful, and are competitive on a global stage. The infrastructure is currently in place to have – at least in theory – real privatization in China. Still, some thorny issues remain, for example transparency of companies. Mr. Walters does not foresee any drastic changes in the current system within his lifetime.
A video of the lecture can be viewed here. Mr. Walter’s powerpoint can be downloaded here.
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