Its Problems Become the World's
By Ariana Eunjung Cha
Washington Post Foreign Service
Sunday, March 4, 2007
SHANGHAI -- Looking at the facts, the past year seems to have been disastrous for Worldbest Pharmaceutical. First, there were reports of accounting irregularities and exaggerated profit. Half the managers were fired. Then, in the summer, six people died and at least 80 fell ill after receiving an antibiotic injection manufactured by a subsidiary. Most recently, the company warned investors that it was likely to report its third consecutive year of losses.
None of that cooled the enthusiasm of investors on China's Shanghai Stock Exchange, who since the end of March 2006 have driven the value of Worldbest's shares up 44 percent.
The Shanghai exchange and its smaller counterpart in Shenzhen, near the country's extreme southern border, have long been viewed skeptically by global capitalists, even those enthusiastic about the broader Chinese economy. The markets were considered too new, too small, too closed and too quirky to matter.
That attitude was put to a test last week when, for the first time, a big drop in the Chinese markets helped spark a global stock sell-off. Suddenly, it seemed, the views of Chinese investors mattered to the rest of the world.
And as the Chinese government takes steps to clean up market practices and allow more foreign investments, the rest of the world's markets are likely to continue to feel its growing pains.
Though China's is one of the fastest-growing economies in the world, it remains heavily influenced by the Communist state. The stock markets are not the main source of capital in China -- that role is played by banks, all of them controlled or heavily influenced by the Chinese government. Many analysts also see the stock markets as subject to more government manipulation than is the norm in capitalist countries.
It remains murky exactly what role the Chinese government played last week, when the Shanghai composite index fell 9 percent, either in setting off the panic by talking about new regulations or in countering it after it started by buying securities.
"There were some reports of state buying -- I don't know how reliable those are. But it's also possible people may have decided 9 percent in one day was too much and they are still bullish on stocks," said Stephen Green, senior economist at Standard Chartered Bank in Shanghai. "I don't think anyone really knows where we go from here."
The Chinese markets made up half of Tuesday's losses in Wednesday's rebound. The Shanghai composite index ended the week down about 4 percent, at 2831.53. Global markets also stabilized after Tuesday's drop and then rose modestly. But the fall left investors wondering whether China's new influence over stock markets adds fresh risks to a global financial picture already plagued by huge trade imbalances and bubbles in the prices of many assets.
China's strict capital controls -- the fact that it is hard to convert the yuan into other currencies and vice versa -- for years insulated its stock markets from outside tremors. Concerns about transparency and corruption have also kept some investors away. Although foreign institutional investors have increased the number of shares of Chinese-listed companies they own in recent years, they still hold less than 4 percent in the Shanghai and Shenzhen markets.
"When you think of the Shanghai market, it's best to think of it as another continent or even another planet," said Jonathan Anderson, UBS chief economist for Asia.
Concerned that isolation would stall its economic transformation, China has introduced a number of reforms in recent years. As a result, China's equity market is becoming increasingly integrated into the rest of the world's. Dual listings of Chinese companies have meant that rumors that start on the mainland can jump to Hong Kong. London companies with large shares in public Chinese companies mean that their bottom line could fluctuate based on what happens in the Shanghai market. Hedge funds, lightly regulated investment pools that specialize in risky investments, hold stocks in China as well as New York. That has meant that an automatic sell-off of one fund could affect more than one market.
Economic success in China and other Asian countries has given the region large foreign reserves, producing a global money glut that has driven down interest rates and driven up the price of assets from San Francisco to Sydney to Shanghai, creating worries of an asset bubble in China and elsewhere. The Chinese government has been trying to address those imbalances, but it is unclear whether that can happen in an orderly way in an economy so heavily controlled by a Communist government.
An announcement by the Chinese government that it was cracking down on illegal trading contributed to the Shanghai stock exchange's dramatic slide on Tuesday.
Established in 1990, the Shanghai market has for most of its existence has been considered one of the world's worst stock exchanges.
From 2002 until the beginning of 2006, even as the Chinese economy grew 10 percent a year, the stock market fell. And as late as mid-2006, large Chinese companies would not list their stocks on the mainland markets as a matter of course. But Chinese policymakers pushed changes to improve the credibility of the market. Instead of requiring only annual or semiannual reports, for example, companies now have to release quarterly reports.
Three years ago, Chinese officials took control of five brokerages that had engaged in illegal trading. Last year, securities regulators freed the more than 1,300 listed companies to sell their state-owned shares over time, in effect putting $270 billion in government-controlled assets into the public sphere.
Analysts think that was at least partially responsible for setting off the recent stock market boom. Another factor was the increasing number of Chinese consumers borrowing against real estate and investing in stocks. State-owned enterprises and large Chinese investment firms control 40 to 50 percent of shares, with the rest owned by individual Chinese shareholders. This differs from the United States and other more mature markets, where institutions control 80 or more percent of shares.
As of the end of 2006, 842 companies were listed on the Shanghai Stock Exchange. Its composite index was up 130 percent from the previous year, far outperforming the Dow Jones industrial average, which was up 16 percent.
In recent months, the Shanghai and Shenzhen exchanges have had a combined market capitalization of roughly $1.4 trillion, compared with the New York Stock Exchange's $20 trillion.
There are other indicators that the government influence on the markets is starting to recede.
Ninety to 95 percent of the companies listed, such as China Telecom, Baoshan Iron & Steel and the Industrial and Commercial Bank of China, remain state-owned. But in recent months, "we're finally seeing for the first time, good, big companies listing rather than heading straight for Hong Kong," said Peter Alexander, founder and principal of Z-Ben Advisors, an investment consultancy in Shanghai.
Many challenges to achieving a fully transparent and fair stock exchange remain, however.
Part of the difficulty is that the typical structure of Chinese companies listed on the exchanges differs from those of the United States in that most have state-owned parent companies that are not listed.
"There is a degree of interconnectedness among companies and parent companies and stockbrokers and securities companies that really is pretty much without parallel. There is a possibility for insider transactions is much greater in China than most places," said Barry J. Naughton, a professor of Chinese economy at the University of California at San Diego and a contributor to the Hoover Institution's China Leadership Monitor publication.
Still, UBS's Anderson said many investors stay in the stock market knowing full well that the system and companies may have some problems.
Take the case of Worldbest Pharmaceutical. Or that of Pudong Development Bank. In June, the bank announced that it was duped by a customer who used fake identity papers to apply for 126 million yuan in loans that he used to buy 91 luxury properties that had since fallen in value. Then, in September, it discovered that 12 bank employees from its wealth-management operations had misused 73 million yuan.
Share prices fell briefly after the two announcements but quickly rebounded. Today, the stock is up more than 140 percent from when first announcement was made, closing at 21.95 yuan a share on Friday.
Shanghai-listed Sichuan Mingxing Electric Power has been informing shareholders that its biggest shareholder, Zhou Yiming, had been effectively embezzling hundreds of millions of yuan in company assets by pledging them against loans. But the company's stock has soared 81 percent from 3.66 yuan a share since January 2006, when the company warned the scandal would affect its bottom line, forcing it into the red.
On Internet bulletin boards for the three stocks, investors dissect the companies' troubles but then say they will hold or buy anyway. One reason is optimism that China is growing so fast that any stock whose value depends on Chinese consumers -- medicine, banking services, or energy -- can only go up. Then there's a sense among some investors that if things go wrong the state will bail them out.
For example, Worldbest was flagged for "special treatment" by the stock exchange in April 2006. That is usually bad news, that trading may be suspended or that the stock may be delisted. But Worldbest investors figured that it meant the state had become aware of the company's problems and was preparing to step in. They took it as a buy signal.
"It's a recognition of reality that the Chinese government has the ability to move these markets. Nobody doubts that," Naughton said. But faith that the Chinese government, despite its deep pockets, will always be around to help is misplaced, he said. "They may have the ability to make the markets go up. But they don't have the ability to make them go up forever."
Researchers Catherine Matacic in Beijing and Richard Drezen in New York contributed to this report.
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