Equity Series Part 1: Primer on China’s Stock Markets



China’s stock market has been on a wild ride lately.  The Shanghai Composite Index, which closed at 5023 on June 5, a 146 percent rise from a year ago, has dropped over 30 percent in the past month.  Why? China’s government had been actively encouraging investors to pile into the domestic stock market for a couple reasons.  One, the government wants to raise the stock price of state-owned enterprises so they can sell equity at high prices to help pay down debts.  Developed capital markets characterize any advanced economy, which China would like to be one day, so encouraging growth in the stock market seemed natural.  Then as stocks rose, authorities did little to prevent the skyrocketing margin debt, which reached nearly $350 billion (see figure 1).  Margin is money brokerages lend to investors to invest in the market.  By June, China’s market capitalization was approaching $10 trillion, and then the market started falling.  Although authorities claimed in the Third Plenum that they would allow more “market forces” in the economy, they had a big hand in pumping up the stock market, and now they have unleashed an unprecedented number of measures to stop the outflow.  This post goes over the basics of China’s stock market.

Figure 1. Market capitalization ($ Billions) and margin lending ($ Billions)

Market cap Margin lend

Source: Wind.

Overview of China's Equity Markets

China has two main equity markets where domestic companies can issue shares through initial public offerings (IPOs) and their shares can be traded, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE).  The SSE has around 1,000 listed firms, and the SZSE has around 1,500.  The stocks on these exchanges are divided into A-shares and B-shares, with A-shares being traded in renminbi (RMB) and B-shares in dollars (US$ for the SSE and HK$ for the SZSE).  A-shares are open to domestic investors only, except through restricted programs to foreign institutional investors, called QFII, RQFII, and the Hong Kong–Shanghai Stock Connect (more on these in an upcoming post), although shares purchased through these programs represent less than 1 percent of total shares.  B-shares are open to foreign investors, but only about one-twentieth the firms are listed versus A-shares; most of the action is in A-shares.  The A-share market comprises around two-thirds of state-owned enterprises by market capitalization.  Chinese firms can have A-shares, B-shares, H-shares (Hong Kong Stock Exchange), and N-shares (listed on the NYSE or NASDAQ).  There are also red chips, which are state-owned enterprises listed mainly in Hong Kong.

China’s two other large equity markets are the Small and Medium Enterprise Board (SME Board) and ChiNext (GEM), and both operate under the auspices of the SZSE.  The SME Board has over 750 listed companies. ChiNext has nearly 500 and focuses on smaller high-technology and innovation based firms.   Total market capitalization of ChiNext rose from $118 billion at the beginning of 2012 to around $320 billion at the end of June, while doubling the number of listed firms.  China has also created the New Third Board to facilitate the exchange of equities for firms that may not meet the requirements of listing on the bigger boards. This board is China’s leading over-the-counter (OTC) equity exchange.  It helps smaller and less experienced firms gain access to capital without having to secure a loan.  The New Third Board hosts more than 2,000 firms, the vast majority of which signed up since the beginning of 2014.  China’s state council is considering opening a new board under the SSE that will focus on emerging industries.  Beijing is also planning to let pension funds invest up to 30 percent of their net assets in the stock market.

China’s main stock exchanges, SSE and SZSE, consist of largely state-owned enterprises, including banks, insurers, oil and gas, manufactures, and information technology firms.  The smaller exchanges consist largely of smaller technology, media, healthcare, and consumer goods companies. The SSE has fairly strict listing conditions, including having capital stock of RMB 50 million, publicly listing 25 percent of a firm’s total shares (10 percent for larger firms), and no legal violations in the past 3 years.  The SSE also allows trades for bonds, including T-bonds and corporate bonds, and trading for funds.  Table 1 presents basic data on China’s three top boards. The most striking figure is the median price-to-earnings (P/E) ratio of the SZSE at 61, indicating over half of the firms has P/E ratios above that figure, normally a sign the market has gone too far.

Table 1. China’s Equities Markets (as of July 8 2015) Stock Market Table Source: Bloomberg, author’s calculations. *SZSE information includes SZSE main board, SME board, and ChiNext.

The China Securities Regulatory Commission (CSRC) regulates the equities market.  The Chinese exchanges have certain regulations that are not common to similar exchanges abroad.  One example is that stocks can increase or decrease only by 10 percent per day (except on its IPO day).  The CSRC has power over IPOs, illegal trading, legal enforcement, etc.  It’s also in charge of preventing and solving financial risks, which sometimes causes it to clamp down on the more aggressive brokerage firms.  China’s securities law is under examination by the National People’s Congress and could be amended soon, which could make IPO listings easier, reduce administrative barriers, and strengthen the securities market.

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