Sara Hsu
Sara Hsu

After lengthy negotiations Alibaba picked the New York Stock Exchange for its listing, not a Chinese stock market, or even not Hong Kong. Financial analyst Sara Hsu still sees hope for the Chinese stock markets, she writes in TripleCrisis. China has to reform its exchanges, as a part of its financial reforms.

Sara Hsu:

China’s stock market is the third largest in the world by market capitalization, weighing in at $3.7 trillion in 2013. However, despite recent reform proposals for a streamlined registration-based listing system that would allow companies that meet criteria for making a public offering (instead of the current system in which the China Securities Regulatory Commission approves IPOs), China’s stock market remains one of the poorest-performing in the world. This can be seen in the MSCI Index, calculated by Morgan Stanley, and even in the Shanghai Composite Index.

The Chinese stock market has often been criticized for channeling funds to state owned companies and their subsidiaries, via other state-owned companies that purchase shares. This does not reflect a market-based environment, but rather is reminiscent of earlier practices of earmarking bank loans for state enterprises that have been part of China’s state led development model. Insider trading and accounting fraud are also problems for investors. A recent crackdown on “rat trading” has sought to eradicate fund managers’ practice of purchasing shares using personal accounts and selling them for a profit once they gain in value. Accounting fraud presents investors with incorrect information, including incorrect revenue recognition and fraudulent asset information, among other abuses.

China’s stock market does have potential to improve. Despite being branded early on, by Chinese economist Wu Jinglian and others, as a “casino” in which speculation, accounting fraud, and stock price manipulation play a large role, Carpenter, Lu, and Whitelaw (2014) show that stock prices are now informed by real indicators of risks and returns. China’s stock market has been relatively limited in scope and therefore has weathered the Asian financial crisis and the recent global crisis despite casino-like speculation in earlier years. Meanwhile, the stock market does not contribute to financial deepening due to the same limitations. In addition, Ya, Ma and He (2014) find that herding behavior, in which investors mimic the behavior of others by making the same stock purchasing choices, is not a significant issue in Shanghai’s and Shenzhen’s A-share stock markets.

These findings show that while the companies that list on China’s stock market may be inefficient or distorted in their financial reporting, and the process that lists the companies may be slow and cumbersome, the market itself is “efficient” in its pricing of risks and returns. Poor performance can likely be chalked up to the underlying companies themselves. Although subject to further rigorous analysis, this conclusion has important implications.

This means that if stock market reform improved the quality of companies that list, performance might improve. This resonates with research that shows that listed non-state owned firms perform better on China’s stock markets than do state-owned firms. Enhancing accounting and auditing standards of listed companies and encouraging the listing of innovative companies over more static state-owned companies would increase the quality of China’s stock markets and prevent the financial “brain drain” that China has recently experienced—as the most innovative companies have listed outside of the country, drawing financial pools and returns from the nation.

As China restructures, it is critical that innovative companies have sufficient access to funding. Further reform of mainland stock exchanges will benefit both the listing companies themselves and China’s financial economy. If, indeed, the stock market is now becoming efficient in pricing risks and returns, then deepening capital markets through the stock market should not be an impossible task.

More in TripleCrisis.

Sara Hsu is a speaker at the China Speakers Bureau. Do you need her at your meeting or conference? Do get in touch or fill in our speakers´ request form.

Sara Hsu will be joining a discussion on China´s debt mess and the declining shadow banking industry at a China Hangout on Tuesday 7 October, 10am EST. 4pm CEST, 10pm Beijing time. Do you have questions or do you want to follow (or even participate) in the conversation: check us out here.

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