By Wei Gu
HONG KONG, Oct 21 (Reuters) - Investors should think twice before putting a big bet on China. The Chinese economy may have turned out to be more resilient than people thought, but returns on Chinese equities have been lacklustre when compared to its breakneck economic growth. This is because the stock market does not yet serve as a proxy for China's economy.
Despite a stellar performance this year -- the Shenzhen index <.SZSA1> is the world's top performer among large markets -- Chinese stocks have not been especially profitable over the long term.
The Shanghai Composite Index <.SSEC> is up about 3.5-4 times its level of 15 years ago, when it first "emerged", according to Charles Dumas of Lombard Research. This represents a compound annual gain of 8.5 percent to 9 percent, which is unimpressive in a country which enjoyed a 10 percent real annual growth rate over the same period and a nominal growth rate of 15 percent.
These figures raise questions about the current investment trend of increasing exposure to emerging markets. Moreover, returns on the Chinese market are even less impressive given the often violent fluctuations of stock prices when compared to, say, U.S. equities. This volatility makes share prices less useful guides for allocating resources and increases the cost of capital to corporations.
True, the 15-year timescale chosen by Dumas may seem a bit arbitrary, and returns can be a lot higher when you take the whole 19 years. Market indexes that track just blue-chip companies, rather than the broad Shanghai Composite, have also produced better returns. Nevertheless, it is worth asking why China has so far failed to translate fast economic growth into attractive investment returns.
This poor track record is not limited to China. Most emerging Asian stock markets -- with the exception of India -- have trailed the economic performance of the underlying economy. So did Japan over the past ten years. One explanation might be that most Asian markets are relatively young, with the century-old Indian market being a notable exception.
As recently as five years ago, China's stock market was mainly made up of uninspiring and second-rate state-owned enterprises. The most profitable SOEs, such as China Mobile <0941.HK>, went public in Hong Kong or New York, as the domestic market was deemed as too small for them. The result is that the Chinese market lacks blue-chip stocks.
The equity market is also too small to represent the economy. Although China's domestic market capitalization has recently edged above that of London, most shares are owned by the state and are therefore untradeable. China has 1,631 listed companies, small when compared to 6,013 in the United States, 4,946 in Mumbai, and 2,864 in London.
Foreign investors are probably better off getting exposure to China through Hong Kong, which hosts some of China's most profitable companies. Taking out the big swings at the start from 1994-1999, the Heng Seng Chinese Enterprise Index's <.HSCE> annualized return in the past ten years is almost 30 percent.
This suggests that the problem lies not with China's economy, but with the country's capital market. Boosting returns will require tackling fundamental problems such as fraudulent financial accounting, market price manipulation, rampant company cross-holding, a large amount of locked-up shares, and frequent government intervention.
Heavy-handed government policies have played a counter-effective role. China is one of the few countries where the regulator, not the market, decides when companies should raise money. This overly complex and often opaque application and approval process, which includes considerable administrative influence, increases transaction costs.
The quality of the market also suffers from the lack of an effective de-listing system. The market capitalization of companies delisted by the Shanghai Stock Exchange last year is less than 1 percent of the value lost by the New York Stock Exchange. Mumbai got rid of 20 times more than Shanghai did last year.
In addition, the delisting rules are often too simplistic -- they are related to whether or not a profit and loss statement shows a profit, which creates a great incentive to falsify accounts if a company is in danger of being de-listed, according to Zhou Qinye, executive vice president of the Shanghai Stock Exchange.
Rampant corporate fraud and market manipulation force investors to spend undue time and energy looking for legitimate trades, and avoiding opportunistic behaviour. This has scared serious investors away, and increased the risk premium and transaction costs.
China's stock market remains largely off-limits to foreign investors, which may not be such a bad thing given the unimpressive returns. But it will be hard for China to enjoy sustained development without a mature capital market powerful enough to match its growing economic needs. Continued stock market reforms could benefit both China's economy and investors seeking emerging market returns.
- At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund -
Zhou's paper on the history and prospects of the Shanghai Stock Exchange can be found in China's Merging Financial Markets (John Wiley & Sons), which offer varied perspectives from top Chinese decision makers and Western financial industry leaders.
