Fluctuations cause concern
By Yi Xianrong (China Business Weekly)
Updated: 2004-07-08 14:28

China's stock market has been falling over the past three months, amid concerns that the recently opened start-up board might divert new investments and result in funding constraints for shares traded on the main board.

The benchmark Shanghai Composite index has plummeted to about 1,410 points since rumours started to spread out in early April that policy-makers had approved the establishment of the second trading board. Prior to the recent market fall, the index in April peaked at 1,783 points.

On June 25, the market edged down by over 380 points to its recent low of 1,399 points as the start-up board started trading in Guangdong Province's Shenzhen Stock Exchange.

Many analysts link the recent market tumble to the establishment of the board for small- and medium-sized enterprises (SMEs), while others see it as a golden opportunity to buy into shares whose prices rose too high in the last market rally.

My view is, the fundamental reason for the violent fluctuations on the Chinese stock market are the existing regulatory framework's loopholes. In other words, regulators have been unable to create a regulatory environment suitable for domestic investors to reallocate their capital.

The size of the Chinese stock market remains small compared to its counterparts in New York and London. The market has a huge potential for future development, given the country's soaring economic growth.

The Chinese stock market will see few funding problems as deposits in the banking system continue to grow rapidly and funds outside the market are earnestly waiting for investment opportunities.

Indeed, Chinese residents hoard about 12 trillion yuan (US$1.45 trillion) in the country's banking system just because they find no better way to invest their funds.

In this sense, China's stock market has more than adequate funds from outside to support its growth, but has failed to attract them.

The Chinese market has long suffered from unclear regulatory rules and price manipulation by big investors. Many investors have withdrawn their funds during the recent market downturn and left altogether after suffering considerable losses.

The recent opening of the Shenzhen-based SME board is being used as a scapegoat for the market's negative performance.

Contrary to the prevailing view that the newly established board has been competing with the main board in attracting new funds, my understanding is the second board will instead be complementary, not posing a threat to the main board.

The NASDAQ-style board will only trade shares of small enterprises and high-technology firms, while the main board will stick to the listing of large-cap companies.

The start-up board will become the main funding channel for start-up companies, most of which are unable to borrow from commercial banks and are repeatedly rejected by the main board.

If properly managed and well regulated, the start-up board will provide financial support for the growth of China's small companies and high-technology companies, therefore benefiting the country's overall economic development.

But the board will face the same risk of price manipulation as the main board did a few years ago if regulation is unable to keep pace with the start-up board's development.

And this situation could be even worse. This is because shares traded on the board are normally from small-cap companies, with the share prices being much easier to manipulate.

Although the companies that are now listed on the SME board have huge growth potential, this simple fact should not have supported their soaring prices to date.

The first batch of eight stocks listed on the SME board for small-cap companies posted unexpected strong performances in the first trading day on June 25.

Hans Laser Technology Co, a private high-tech company specializing in laser products manufacturing and based in the technology-driven southern city, was the top gainer from the beginning to the end. It opened at 40 yuan (US$4.80) with a 334.8 per cent surge over its initial public offering (IPO) price, closing at 39.09 yuan (US$4.79).

However, the recent collapse of some privately-owned, public-traded companies, including the D'long Group, the Euro-Asia Group and the Shanghai Land Holdings, has reminded investors to consider the risks that large shareholders might easily infringe the rights of small investors under the current situation.

The share prices of small-cap companies are easily manipulated on China's stock market.

There have been rumours that privately-managed speculative funds from Zhejiang Province were behind the rapid rise in share prices on the first day of trading.

But the SME board is still too small compared to the main board, and therefore, trading on the start-up board is unlikely influence that on the main board.

The current bearish mood on the main board is simply a reflection of domestic investors' lack of confidence in the market's regulation.

Many of the institutional investors -- including securities houses, fund management companies and private funds -- which have participated earnestly in the market, are seeing trading of shares as an easy and fast way to generate exceptionally high returns.

Indeed, almost all large investors have profited greatly from the market, while a large portion of individual investors have lost their shirts.

Early this year, the State Council made a nine-item policy statement, in which the development of capital market is strongly encouraged.

The signal that the government is caring about individual investors has increased market confidence and created the year's first market rally.

But the process of creating a transparent and well regulated stock market is not an easy task and will cost time and effort.

The speculation that regulators will soon allow domestic investors to access overseas stock markets under the so-called qualified domestic institutional investor (QDII) is another factor contributing to the recent market fall.

Industry regulators will not allow more than US$10 billion to be invested in the early stage of the QDII scheme. And the QDII scheme will initially involve funds already denominated in foreign currencies, not renminbi.

The author Yi Xianrong is an economist at the Chinese Academy of Social Sciences' Institute of Financial Research.

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