How an international board will free up China's stock market

The fear of Chinese retail investors losing interest in the stock market has forced regulators to strengthen its capability to protect investors. Indeed, progress has been made. The China Securities Regulatory Commission has enacted a slew of new and important regulatory changes to protect investors.

Of particular note, the CSRC has issued a guidance to force listed companies to pay dividends to investors; it has become tougher in cracking down on insider trading; it has strengthened the importance of information disclosure before a company's initial public offering; it has improved the mechanism to delist firms that are no longer fit to be traded on the market; and it has enlarged the quota of qualified foreign institutional investors to around $80 billion (60 billion euros) from the previous quota of around $30 billion. It also encourages China's own pension and housing provident funds to invest in the stock market.

These measures are laudable, suggesting the Chinese stock regulator is now serious in strengthening the rights of investors. But one should not have high expectations for rapid improvements because an institutional evolution usually endogenous goes hand-in-hand to the level of a country's economic development.

For example, the 2012 Corruption Perception Index published by the Transparency International ranks China at 80 among the 176 countries and economic entities surveyed. This implies that the new CSRC measures will only have a limited impact in helping improve the protection of investor rights as long as the overall quality of China's institutional and legal framework remains poor relative to advanced economies.

To defy the slowly evolving institutional environment, what the CSRC could do is further open the Chinese stock market by not only allowing international investors to bring capital to China's stock exchange via the QFII stimulus scheme, but also allow multinational firms already operating in China to become listed on the Shanghai Stock Exchange. An international board in the Shanghai Stock Exchange has indeed been discussed over the last couple years and it appears that the Shanghai Stock Exchange has been technically prepared for such a launch for some time.

There are important benefits to allow those leading multinational firms to become listed in China.

First, those firms will offer investment opportunities for Chinese investors because some are the cream of the crop among global firms.

Second, they can help set high standards for disclosing information because they have already been listed in key stock markets around the world where information disclosure is much more stringent than in the Chinese market.

Third, their listing in the Shanghai Stock Exchange will also reduce capital inflow to China as they no longer have to bring in capital from abroad for their Chinese business expansion.

Finally, their appearance in China's stock market will also make the Shanghai Stock Exchange a truly international exchange. This will also help boost Shanghai's status to become an international financial center.

Some fear that allowing multinational companies to garner listings in China could divert market liquidity, leading to an even lower Shanghai Composite Stock Index.

But one must understand where Chinese residents allocate their assets across different asset classes such as bank deposits, the stock market and the property market.

At this stage, Chinese residents still put much of their wealth in bank deposits and in the property market with considerably less in the stock market.

If the stock market offers a good return on investments, there could be more funds flowing from the bank deposits to the stock market. Therefore, the fear of liquidity diversion is exaggerated.

So what will be in store for China's stock market in 2013? There are some favorable initial conditions indicating that China's stock market could improve.

There is more confidence in China's economy after a successful political transition. With the economic rebound in the fourth quarter of 2012, the fear of a hard landing is diminishing. Meanwhile, the economy has gone through a rapid de-stocking process and enterprise profitability has returned.

Second, the stock market valuation in terms of the price and earnings ratio may have reached the bottom. Optimism in China's rebounding growth suggests the future earnings capacity of listed firms will only increase. This will then boost share prices.

Third, more capital flows will return to China as the major central banks in the world are still engaging in various forms of qualitative easing. Ample global liquidity conditions will certainly favor growing emerging economies. These positive domestic and external conditions, if supported by greater access to China's stock market for multinational firms, could create a strong stock market in 2013.

The author is the chief economist for Greater China with Australia and New Zealand Banking Group.

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