Stock Market News in China

Executive summary

China is gaining more attention of the world due to its high economy growth speed. However, China security market is telling a bad story to us, which conflicts with the good picture of China economy. In this report, we try to discuss why China security market did not work as well as American market did. We mainly illustrate this question from typical differences on corporate governance between China security market and North American market.

Discussion

Comparing China’s stock market with US’s

Overview of the Stock Market in China and America

In contrast to US, China’s stock market has a history of only 23 years. As a country, China has the second largest stock market by trading volume and the third largest by market capitalization, $3.7 trillion in 2013, after the US and Japan. The main boards of the Shanghai and Shenzhen Stock Exchanges list larger more mature stocks, like the NYSE in the US. The Shenzhen Stock Exchange also includes two other boards, the Small and Medium Enterprise Board and the ChiNext Board, also known as the Growth Enterprise Board, more comparable to the NASDAQ in US, which provide capital for smaller and high-technology stocks. In a whole, China stock market is very large and seems like US stock market. 2.1.2 Some differences between China’s stock market and America’s China’s stock market has some distinctive features.

First, it is a pure order- driven market, as opposed to a quote-driven market, whereas the US and several other countries have hybrid equity market systems. Second, it is a centralized market, whereas the US market is fragmented, with dark pools and other off-exchange trading. This may have important implications for market in formativeness. There are no dark pools with hidden orders in China, all orders are visible. Moreover, there is no extended trading period for institutional investors. Institutional and retail investors have equal access to information from a market microstructure point of view. In addition, China’s stock market has a price move limit of 10% to deter excess volatility and stock manipulation.

China’s dual-share system

Different with the US, China’s stock market has a dual-share system in which domestic investors can invest only in A shares, while foreign investors can invest only in B shares. In addition, many firms have H shares, traded on the Hong Kong Stock Exchange. A number of articles, such as Chan, Menkveld, and Yang (2008) and Mei, Scheinkman, and Wei (2009), study the discount of B share and H share value relative to A shares, which they attribute to information asymmetry between foreign and domestic investors and speculative motives. With the introduction of programs such as the Qualified Foreign Institutional Investors (QFII) program of 2002, which relaxed the cross-trading restrictions, B share issuance and trading have mostly vanished. In addition, China’s equity market used to have a large non-tradable component, held by corporate founders, often central or local governments. With the share structure reform starting in 2002, this phenomenon has mostly disappeared among mid and small-cap stocks, though not entirely among large stocks.

Settlement date

Settlement date is another difference between China and America. China’s share market adopted T+1 which means the settlement date of security transactions and denote that the settlement occurs on a transaction date plus one day. As many other countries, the settlement date of US’s share market is T+0 which means you can sell the shares on the same day when you buy it.

Three typical characteristics of China’s listed companies

In 2001, a famous Chinese economist, Wu Jinglian, characterized China’s stock market as a ‘Casino’ manipulated by speculators, misled by the central government’s visible hand to unfairly support state-owned enterprises (SOEs), and without a strong link to fundamentals (Allen et al, 2005). These listed companies have great concern due to three typical characteristics (1) Percentage of State ownership is relatively high: The majority of these listed companies in China evolved from State-owned enterprises. To make sure those companies are still state controlled, the percentage of shares available to the open market is relatively low. (2) Percentage of negotiable shares is relatively low: State-owned shares and legal entity shares are not traded in the open market. As such, much more than global average level of the shares are non-negotiable. (3) Number of individual shareholders is relatively high: China securities market is primarily made up of individual investors and lack institutional investors. However, the shareholding ratios are relatively low, and they cannot participate as effectively as American shareholders do. These three characteristics are also different characteristics from American market, which are also three most important reasons weakening shareholders’ abilities to participate in the corporate governance of public companies and keep the stock market’s soundness.

Corporate governance’s influence

As is mentioned, it is thought that China’s stock market misled by the central government’s visible hand to unfairly support state-owned enterprises (SOEs), and without a strong link to fundamentals. Due to this, the corporate governance can partially explain the reason why the performance of China’s share market cannot play the role of weatherglass of its economy.

The shareholders

1. Highly concentrated corporate ownership: In China, present corporate ownership system includes state share, legal person share, which is owned by companies, and social common share (Cheng, 2003). The state share and legal person share are non-tradable shares. According to a report, at the end of 2004, 47% of public companies’ shares are state share, and 16.55% of shares are legal person share. According to Cheng’s opinion, the result of majority non-tradable share is conflicts between interests of holders of social common shares and the state. Because majority shares are owned by the state and the companies themselves, common shareholders cannot effectively monitor management’s behavior and the state usually does not exercise its rights as a shareholder to influence management effectively. For example, the Ministry of Agriculture, which is the supervisory agency of Lantian Co. Ltd., was either unable or unwilling to find out the company's financial misconduct before it was reported by a university professor (Shi, 2002). In addition, since only minority shares can be freely traded in the market, the stock price can not reflect companies’ performance. It’s easy for the stock price to be distorted by the non-rational investors. For instance, in the Initial Public Offer (IPO) of Mingdong Power in 2000, the P/E ratio was 88. These phenomena seldom appear in US because of widely held ownership. Therefore, reducing the percentage of state shares is one way to resolve the problems of highly concentrated ownership structure.
2. The relative small size of Chinese stock market: China’s financial system is dominated by its large state-owned banking sector and expanding shadow banking sector. Total bank credit was 128% of GDP in 2012, according to Elliott and Yan (2013), and total credit in the shadow banking sector was reckoned to be anywhere from 40 to 90% of GDP, while China’s stock market capitalization is only 44% of GDP. By contrast, US bank credit and stock market capitalization were 48% and 118% of GDP in 2012.
3. Weak protection for shareholders, especially individual minority shareholders’ rights: Chinese laws relatively neglect civil liabilities and compensation, and have not provided a procedure and specific clauses for enforceable civil actions. In addition, there is no provision for a class action lawsuit under Chinese law and it is very difficult for an individual shareholder to sue a public company for fraud (Lin, 2004). To improve corporate governance, efforts are needed to strengthen the mechanism for shareholders to enforce their rights.
4. Common shareholders’ short-term behaviors: According to Cheng’s investigation, in China, 76.3% of investors’ investment cycles are no more than half year, and 27% of investment cycles are shorter than one month. According to Prisoner’s Dilemma theory, short-term investors have less incentive to take part in the corporate governance because of reason of cost-efficiency. Another problem is the low education level of common shareholders. The investigation of Shenzhen Stock Exchange in 2001 shows that 44% of common shareholders’ education level is lower than senior high school and more than 12% of shareholders’ education level is lower than junior high school. Because of limited professional investment knowledge, it’s hard to ask them to make rational investment decisions and get involved in corporate governance.

The board of directors (BOD)

1. Legitimacy of supervisory BOD: Different with US, in China, many supervisory BOD members are leaders of Party Committees of the company who are appointed for legitimacy by the government due to the state-owned nature, they actually lack of motivation to monitor the management BOD. The supervisory BOD meets far less often than management BOD, and lack of expertise impairs the function of supervisory BOD. According to the stakeholder theory, the company should be responsible to all who has a direct or indirect interest in the firm, rather than only to maximize shareholders’ interest (Hasnas, 2013). Due to high state ownership in China, it is suggested that the supervisory BOD should have representatives of common shareholders, and more expertise should be included.
2. Weak independency and poor duty and responsibility of management BOD: BOD should obey the fiduciary duty theory, which means acting in the interest of shareholder rather than maximize their own interests. However according to a survey (257 companies listed in Shanghai Stock Exchange), in China, only 3.1% of BOD has some degree of independency (Guo et al, 2013). Lack of law is one reason, only the regulations cannot enforce the implementation of BOD independency. Besides, most of the members in BOD who lack of knowledge and professional experience are directly appointed by the government; usually the chair of the company is the leader of Party Committee of the company. Moreover, the goal of BOD is not clear, most of the BOD acting as a consultant rather than monitoring management behavior and maximizing shareholders’ profit.

Weak external governance structure

1. Lack of professional management and its market, obstacles in regulations, and lack of information transparency (Lin, 2004): In America, professional managers will face pressure from the management profession. If they are caught of fraudulent behaviors or lost due to bad performance, their career in this industry will be dark. There is no such pressure in China because there is not such a profession.
2. Weak or absence of monitoring role by banks: In the US, banks, as the creditors, have great incentives to monitor companies’ behavior and can influence companies to perform well. In China, if the state controlled banks suffer from bed debt, they will not go bankrupt, because the government will take the loss. As a result, the banks will not take all effort to monitor the companies.
3.  Small and insignificant number of institutional investors that do not play a major role to improve corporate governance: In America, many institutional investors trace companies’ information, and information asymmetry is reduced to lower level, which is beneficial to efficient market. However, in China, the absolute number and the expertise of those institutional investors are not comparable to those in America, and their influences on companies are relatively weak.

Conclusion

China’s stock market is obviously different with America’s. Many factors make them different but the role of the government is the most important one. High state ownership lowers down market functions, and government interference does it further. In America, this is very rare. Even though Chinese government failed to sway the markets by many ways, it is reforming its SOEs recently to deal with problems exist in its listed companies which may help its stock market escape from the trend of decline (Lim, 2014). Due to influence of SOEs is a major reason for bad performance of China stock market, this reform is highly possible hopeful to make succeed. Actually, in the past several months, China stock market appeared a tendency of rising as figure 2 shows. Figure 2 Shanghai Stock Exchange Composite Index last three months.

 

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