Why China Will Never Have a Wall Street
In good times and bad, Chinese stock markets don’t work. And that's just the way Beijing wants it.
As growth in the United States slows and many European countries head into negative territory, the eyes of the world’s investors are on the next big shoe to drop: Will China, the recent engine of the global economy, fulfill its role of Great Eastern Hope by saving the world from another sharp recession? Given its track record, this concern might seem overdone: Commentators generally agree that China’s economy will continue to grow between 5 and 8 percent a year, far higher than all other major economies. China’s leaders, however, view the decline as a source of great concern — China’s economic growth dropped to 7.6 percent year-on-year in the second quarter, its slowest rate in three years. Their claim to authority has been built on delivering double-digit growth rates that have transformed China into a global economic power; without such growth they see a threat to their "Mandate of Heaven."
Many analysts both inside China and out see this slowdown continuing and argue that China’s development model should shift away from its heavy emphasis on investment and exports to one based more on domestic consumption. Over the past three years China splurged on a decade’s worth of infrastructure projects; the country won’t need any more roads, airports, trains and bridges for a long time. So as global demand for China’s exports slows and such investment projects are finished, the best hope for continued growth is stimulating the Chinese consumer. The poor performance of the country’s stock markets supports such an argument, suggesting why a new development direction is needed and also shedding light on some of the difficulties such a transition would face.
Since 1992, the MSCI China Index, the most broadly referenced indicator of Chinese market performance, is down over 40 percent, while the Shanghai Composite Index has risen only a meager 180 percent. During the same period, China’s GDP has rocketed 1,700 percent. This suggests that China’s listed companies have not been significant drivers of the country’s fantastic growth, and that the capital they have received from investors — some $950 billion from the Hong Kong and domestic markets over the last 20 years — has been seriously misallocated.
The underperformance of China’s listed companies is a direct consequence of Beijing’s deliberately awkward adaptation of Western-style stock markets to a command-type economy. Despite the country’s increasingly first-rate infrastructure and all the other trappings (bankers, investors, regulators, scandals) of development, China’s markets only superficially resemble markets elsewhere. A market is where the ownership of a commodity or service is exchanged, not just where securities can be traded on a daily basis. Chinese stock markets do the latter extremely well, but have nothing to do with the exchange of ownership. At a fundamental level, China’s markets do not price companies and their businesses because its listed companies are not for sale, and never have been. As Liu Hongru, the first head of the securities regulator and the godfather of China’s markets, said in 1992, "The shareholding system is not privatization."
Beijing created its stock markets in the early 1990s because of concern with the poor performance of its state-owned enterprises (SOEs). During the 1980s, private enterprise growth far exceeded that of the SOEs. The government became convinced that adopting the Western capital markets model — diversifying ownership, creating clear corporate structures, and establishing professional legal and audit industries and strong market regulators — would improve SOE management and help them become more competitive both domestically and internationally.
What happened instead was that Beijing excluded non-state companies from the markets and required that absolute ownership control (at least 51 percent) of SOEs remain firmly in the state’s hands. As a result, the stock markets have always been the near-exclusive preserve of the state and its own enterprises (the very recent opening in 2009 of the Shenzhen Exchange to private enterprises notwithstanding). This means that only a minority of a company’s shares trade. The negative repercussions of this arrangement have reverberated far beyond the markets themselves.
Because the state dominates the markets (which it manages and regulates on behalf of companies it owns as the controlling investor), it can channel capital as it likes: An initial public offering (IPO) is fundamentally a bank loan from a state-controlled bank, not the result of a business owner selling a stake in his company to outside investors seeking the highest return on their capital, as we think of in the West. The Chinese government has used this control to create oligopolies and monopolies — the so-called national champions — run by high-ranking political appointees.
In real markets, companies’ attempts to raise capital, as a result, can fail. Not in China! There the government literally sets the price of new shares based on how much funding it needs to raise, then directs other government-controlled entities to invest. Roughly 40 percent of the $9 billion raised in the Shanghai market for the July 2010 IPO of the Agricultural Bank of China, for instance came from other SOEs. This, combined with the more than $13 billion raised on the Hong Kong exchange, helped the bank’s IPO to become on the face of it the largest in the history on any market globally. Another first for China
That’s not how equity markets are supposed to work. Substituting the state for market forces eliminates the fundamental valuation function of the market, turning it into an arena for speculation where the value of a share reflects market liquidity and investor expectations driven by government policy and the latest rumor or suggestion of government intervention, subsidy, or stimulus. Faith in a business strategy, product innovation or the quality of corporate management is secondary to what investors think the government wants. As a result, China’s investors, retail or institutional, lack the capacity to value companies: There is no need. Nor have China’s investment banks (or, for that matter, the government) developed the core competency of analyzing a company and its industry as the basis for equity valuation. The likelihood that a Steve Jobs could raise significant amounts of capital in such markets would depend almost completely on his relationship with the government and not on his innovative vision. China’s premier economist, Wu Jinglian, famously called China’s stock markets "casinos" and a major source of "crony capitalism." If anything, he was too gentle.
Handicapped as they are by government intervention, China’s markets nonetheless represent an important achievement and have played an important role in the country’s transformation. Their existence as national markets mobilizing capital across the country, including Hong Kong, represents one of China’s least-recognized triumphs of reform: Over its thousands of years of history, China has never had national markets of any kind. Markets in China, especially financial ones, have always been fragmented because the country itself was always fragmented despite its seeming unity. This is one of the reasons why, in the 1980s and 1990s, Chinese companies were small, uncompetitive and unknown. Now, 44 Chinese companies appear on the Fortune Global 500 list, and the Industrial and Commercial Bank of China is currently the world’s most valuable banking institution. These national champions could not have been created without the stock markets and international financial techniques.
China’s exchanges have also given Beijing’s reforms the veneer of a modern economy. The Shanghai Stock Exchange began with eight tiny companies in 1990 and now has more than 900; the top 10 companies command a market capitalization of $880 billion. And like markets everywhere they have seen incredible rallies and collapses. From 2005 to 2007 the Shanghai Index rallied from 1,000 points to over 6,000, and the daily traded value of shares surpassed that of all other Asian markets combined, before falling back to near 1,500 in 2008.
To truly reform these markets, the state must exit. China would have to open its markets to private domestic companies and foreign participants and allow the privatization of its SOEs, using a more sophisticated form of control while permitting a full float of company shares. This would create true market capacity for valuing companies, pricing capital and directing it towards those with the best economic returns. In turn, this would contribute to greater economic growth.
If the benefits are so obvious, why won’t China reform its stock markets? The most basic reason is that there has never really been private property in China, except during the 1920s and 30s, when the country was colonized and governed by Western countries. Today’s Chinese government, like those of the emperors before it, believes it owns everything. To allow genuine privatization would be tantamount to handing over vast swaths of the economy to foreigners, and the government — officially still socialist — would lose control domestically. For a group of men whose first instinct is to maintain control at any cost, this just can’t be allowed to happen. Which is why we’d be very surprised if it did.