For the last five years, one of the things in China that has constantly generated despair is its capital market.

 

Finally, analysts say, there is hope that 2006 may see a change.

 

Some of them have even gone so far as to suggest that there will be a sustained recovery.

 

This upbeat sentiment is based on the efforts that authorities have been carrying out since last May. They include the reforming of non-tradable shares, enhancing regulatory regime of the listed companies and unveiling of new investment instruments.

 

"The share reform has achieved the effect of removing an uncertainty that has been plaguing the mainland stock market for years," said Hu Ruyin, a professor with the Shanghai Stock Exchange's research bureau.

 

China's stock market has been in the doldrums for almost five years despite occasional spurts of speculative activity. The benchmark Shanghai Composite Index, which tracks both yuan-dominated A shares and foreign currency B shares, closed at 1,161 points at the end of 2005, down from 2,242 points in mid-2001. Daily turnover of A and B shares on the Shanghai bourse declined to an average of 8 billion yuan (US$1 billion) at the end of 2005, down more than a quarter from the previous year.

 

The overhang of massive blocks of government-owned shares in the listed State-owned enterprises was responsible for much of the decline, as major shareholders remained indifferent to price fluctuations of stocks and, consequently, stock transactions and capital allocation were hindered. The combined value of these so-called "non-tradable" shares at current market prices amounted to an estimated US$280 billion, or more than two-thirds of the total market capitalization.

 

Talks of reform in the past had many investors worried. Many chose to stay away from the market for fear that a sell-off of these "non-tradable" shares would almost certainly send the market into a tailspin.

 

A meticulously planned and cautiously executed operation by the government to release State-owned shares in orderly batches in recent months has helped strengthen investors' confidence. As of the end of 2005, more than 400 State-owned enterprises, together accounting for about 25 percent of the total market capitalization, had implemented the reform program approved at their shareholders' meetings.

 

The year ahead is critical for the share reform because 39 key government-owned enterprises that have yet to launch the program are scheduled to do so. The reform has been progressing so smoothly that analysts are now predicting that the government will lift the freeze on IPOs (initial public offerings), originally introduced to allow for the flotation of "non-tradable" shares.

 

"The share reform is a milestone in the history of China's stock market as it is creating one class of shares," said Lian Jie, executive director of capital markets at Goldman Sachs, one of the largest US investment banks. "I am emboldened to forecast a rush by H-share companies for domestic listing."

 

The positive perception of Goldman Sachs and other Qualified Foreign Institutional Investors (QFIIs) is well reflected in the fact that half of their quotas have been invested in G shares, the designation of those enterprises that have gone through the share reform, according to the latest quarterly performance report of the 1,356 domestically listed companies.

 

The revised and newly promulgated corporate and securities laws to better protect investors' interests are expected to provide a firmer legal framework to spur the market's growth. The two exchanges on the Chinese mainland are contemplating new listing and trading rules to fit in with the revised laws.

 

Most notable among the changes are that corporate executives will be held more accountable and that the rights of minority shareholders will be better protected. The laws' revision is seen by stock analysts as a fundamental structural improvement essential to restoring investors' confidence, which is a key to reviving the market at a time when 80 percent of retail investors lost money in 2005.

 

"The vitality of equity markets depends fundamentally on the quality of the companies listed on the exchanges. That, in turn, depends on rigorous enforcement of property rights, and on high quality corporate governance," said Howard Davies, president of the London School of Economics, during a recent China visit.

 

Another push factor is a series of initiatives taken last year directed at product delivery. China's first exchange-traded fund (ETF), the SSE 50 ETF, proved successful. An ETF is a basket of securities designed to generally track an index, yet trades like a single stock. The SSE 50 ETF tracks the Shanghai 50 index of the largest stocks on the Shanghai Stock Exchange.

 

The product currently has a daily turnover rate of 3.66 percent and a trading value of 253 million yuan (US$31 million), making it far more active than similar products offered in Asia such as the Tracker Fund of Hong Kong and the Polaris Taiwan Top 50 Tracker Fund. That was the finding of figures released by the China Asset Management Co Ltd, also known as Huaxia Securities, which offered the product in conjunction with its Boston-based partner, State Street Global Advisors, in February 2005.

 

Another well-received innovation is the introduction of stock options, allowing investors to buy or sell a stock at a given price within a set period. Since the issuance of the first option in late August 2005, seven options are now being traded on the Shanghai and Shenzhen bourses, and the total turnovers are surpassing that on the Hong Kong Stock Exchange according to Guotai Jun'an Securities analysts.

 

"It is set to add impetus to the stock transactions and, like other derivatives, it enables investors to hedge against trading risks arising from share positions," said Wu Jianxiong, a Guotai Jun'an analyst.

 

On the macroeconomic level, two other catalysts are expected to help the market broaden its performance. The first is oil product price reform and liberalization, which will redistribute profits between the upstream and the downstream. The recent rise in manufacturers' price of natural gas will benefit the oil extraction industry.

 

Next comes possible continued renminbi appreciation, which should keep domestic interest rate policy steady. "This is the most important factor that makes China different from many other markets where higher interest rates and a weaker currency are the common theme," said Frank Gong, a JP Morgan analyst.

 

However, because of the general slowdown in the economy, predictions are that the market will not end its bearish mode too soon. The benchmark Shanghai Composite Index is expected to rove between 1,000 and 1,400 points.

 

"As 40 percent of the domestically listed companies are from economically sensitive sectors such as energy, materials and industrials, the overall market is likely to be dragged down by the economic slowdown," Wu Jianxiong said.

 

According to the latest quarterly report, net profits of listed companies dropped for the first time in four years, which many analysts believe signals the contraction phase of the current economic cycle. The report shows the net profits of 1,293 listed companies in the first three quarters of 2005 totalled 130 billion yuan (US$16 billion), a drop of 2.3 percent compared with the same period in 2004, while earnings per share stood at 0.19 yuan (US 2 cents), down by almost 10 percent.

 

The current economic cycle started in 2002 with property and automobile consumption leading the expansion. Subsequent overinvestment in fixed assets has led to surplus production capacity: Statistics show current steel production exceeding market demand by 120 million tons and aluminium production exceeding demand by 2.6 million tons.

 

It is forecasted that in the year ahead, the Chinese economy will grow at about 9 percent, a modest deceleration from 9.4 percent in 2005, and will likely pursue quality and balanced growth with a focus on greener gross domestic product (GDP), development of rural and inland economies and a preference for domestic demand over trade.

 

The share of capital investment in China's GDP in 2006 is expected to be 16 percent, down from 2005's 25 percent, the share of export and import likely to be 20 percent, down from 30 percent, while the share of retail consumption is set to go up to 13.5 percent from 13 percent, according to Deutsche Bank's newly released China Market Strategy for 2006.

 

"The deceleration of foreign asset investment and export growth in the macroeconomic conditions would affect the performance of commodity and low-end manufacturing sectors in 2006," said Ma Jun, Deutsche Bank's chief economist for Greater China.

 

Consumers, infrastructure, telecoms/media, property and a few other defensive sectors are favored for investment, while the cyclically sensitive sectors - including commodities, industrial and airlines - are expected to have little return.

 

(China Daily January 24, 2006)