The China story much of western media missed out on

- By Kunal Jaggi (References: A Quiet Revolution in China's Capital Markets - The McKinsey Quarterly, IPO Indicator - PRnewswire.com)

Everyone's been ranting about the 11% Chinese GDP growth rate, there's one angle much of Western media missed out on.

In the 1990's China first began privatizing its state-owned enterprises, in an attempt to use capital market economics to force them to become more commercially focussed. However, China being China, the government wanted to retain substantial shareholdings and influence, which led to a two-tier ownership structure. The original equity remained legally distinct from the new equity to form a separate class of shares held by existing state-linked owners. This class had the same theoretical rights to profits and votes, but could not be sold on public markets.

Two years ago, the government instituted new policies requiring companies to merge the two classes of shareholding to make the nontradable shares liquid. As of this spring, more than 90 percent of state-owned enterprises had already completed plans to that effect; shareholders at the last few companies are expected to finalize their reform plans this year. According to the James Ahn (partner in McKinsey's HKG office) and David Cogman (associate principal in the Shanghai office) , 20 percent of the non-tradable equity is in sectors viewed by the government as strategic. Around 55 percent is held by strategic investors with long -term interest in the companies. The remaining 25 percent represents shareholdings by state-owned financial investors. Out of that, more than 75 percent of the equity (by value) is in sectors open to foreign investment. The following figures give a deeper perspective on the kind of numbers we are talking about here

Non tradable shares as % of total sector capitalization (At present)
Coal mining - 67%
Food Mfg - 61%
Clothing, textile maufacturing - 52%
Real estate - 47%
IT - 37%
Pharma - 255

The two-tier structure dismantling road map estimates that by 2007 end tradable equities will account for 30% of net market cap, 55% by 2009 end, 90% by 2010 end and eventually 100%. Click here for the entire graph.

Now, the most immediate thought that comes to mind is that this entire process of converting huge amount of previously un-tradable equity to tradable, flooding the market with more supply than it could absorb, depressing price and diluting shareholder value. In 2005, China's State Council, the country's chief administrative authority, asked SASAC (State-Owned Assets Supervision and Administration Commission of the State Council - government department created to oversee and supervise listed and unlisted state-owned enterprises) and China Securities Regulatory Commission (CSRC - the Chinese equivalent of SEC) to come up with a definitive plan to end the two-tier equity structure. Although the companies themselves could determine the specific implementation of the merging of their equity, every plan had to include two key elements.

1. No more than 5 percent of the previously non-tradable shares could be sold in the first year following the integration and no more than 10 percent in the next year. Thereafter, companies had the power to specify longer voluntary lockup periods but there were no more regulatory restrictions. The first wave of companies to pass a reform plan will see their shares become tradable only in late 2007 and early 2008.

2. Plans had to involve some compensation paid by the holders of non-tradable shares to the owners of tradable ones. Many companies approved a proposal of bonus worth 20 percent of the equity stake, possibly combined with cash and options.

3. Each plan had to gain the support of a two thirds majority of the non-tradable shares and in a separate vote, a two-thirds majority of the tradable shares.

These clauses were put in place to ensure that the initiative would attract enough liquidity to make the price worthwhile.

Now, lets examine some of the potential benefits.

• The dismantling of the two-tier equity structure could trigger off a wave of domestic M&A activity (giving Chinese firms an opportunity to consolidate across the same industry) and increased opportunities for foreign investors.

• It would create a huge pool of equity potentially seeking liquidity - nearly twice the capitilization of the market today. By the time the last of the non-tradable shares become fully tradable, in 2012, current plans to reform the pension system and social security, if implemented, will have generated new funds for investment into the equity market. This increase will greatly enlarge the base of domestic institutional investors, which today account for only 10 percent of all investors. McKinsey research suggests that from 2005 to 2015 the funds under management of China’s asset-management industry could grow by as much as 24 percent a year. A professional, organized investor base would also be a powerful force in advancing best-practice governance. Can you imagine the rise of Chinese hedge funds ?

• A more organized equity market would boost Chinese middle-class investor to gain greater confidence and provide impetus to shift their assets to shares from present low-yielding bank deposit, which now account for almost three-quarters of China's financial assets, compared with around 20 percent in the United States. (according to Diana Farrell and Susan Lund, Putting China’s Capital to Work: The Value of Financial System Reform, McKinsey Global Institute, May 2006). This has already been demonstrated by the notable recent increase of chinese middle class investors.

• It is no secret that China is producing IPO's faster than Paris Hilton gets her pictures taken. The IPO indicator, reached a new high of 287.8 at the end of July (2007), a 13.2 percent increase from June.

• Due to exchange controls on China's currency, the capital in concentrated within the country. There is a great demand for investment opportunities of all sort, and domestic stock exchanges would become more attractive for listing. Already, some high-profile Chinese companies that had scheduled IPOs in Hong Kong have changed their plans, deciding instead to pursue a Shanghai listing. Aside from currently favorable pricing, this move has considerable public-relations value - attracting further foreign investors.

• It can be argued that over time, a healthy, liquid equity market will also take pressure off the banking system. As companies increasingly look to equity markets instead of bank debt for their capital allocation, an immediate result is usually greater emphasis on profit and corporate efficiency since they are no longer operating in the stodgy state owned banking environment - reducing the risks for both of them in the event of an economic downturn and allow private enterprise to play a greater role in accelerating the consolidation of many industries.

Of course, there are some caveats.

China is still way behind Western standards of accounting, legal and regulatory framework needed to profitable and sustainable equity markets. There are not enough Chinese-speaking accountants to meet the needs of every listed state-oned enterprise; accounting firms cannot hire and train people fast enough. Similarly, there are not enough courts, arbitration procedures, experienced lawyers of high quality. Lastly, effective market regulation requires independence and objectivity, but in today's China no government department truely enjoys them.