China's Inefficient Securities Markets

Over the last few years, there has been a great deal of excitement and interest about China. Not surprisingly, this also extends to the world of finance and business. For good or for ill (more often than not, the later), people have dreamed about the economic prospects of investing in China.

Despite the hoopla and the enthusiasm, however, it's clear that China's financial markets have to develop further before they are can live up to lofty expectations. The Economist magazine recently had two articles that highlights the perils of expecting too much out of China's securities markets and financial system.

The first article, Imperfect markets: China's different share classes damage its own prospects, points out the fact that share prices for the same publicly traded Chinese companies are different depending on the market in which those shares (again, for the very same company) are traded. Larger or more recognizable companies tend to have higher prices outside of mainland China (in Hong Kong, etc.) than they do on domestic stock exchanges (in Shanghai and Shenzhen). Smaller companies reverse this trend: they tend to trade at a premium on domestic exchanges relative to their valuations outside of the mainland.

These distorted prices -- where what is theoretically the same thing are priced higher in one place and lower in another -- violates the Efficient Market Hypothesis (EMH). According to EMH, arbitrage should eliminate these price discrepencies in short order. The distorted pricing of Chinese stocks violate the central tenet of economic price theory: Prices should be the ideal mechanism for conveying economic information about the good, service, or asset in question. When prices don't conform to the 'one price' principle, it makes the information revelation and exchange process -- via prices -- less efficient and less useful.

So why haven't these prices been arbitraged back towards some equilibrium price? The answer, as the article suggests, is that it is difficult to arbitrage Chinese securities because of institutional limitations. (To be fair, even with the limitations, there has been a narrowing of the gap between prices for companies traded in both Hong Kong and on mainland exchanges in Shanghai or Shenzhen.)

Chinese companies tend to issue shares using separate share classes with differing rights and restrictions. That, along with the reluctance of the government to cede authority over corporate governance matters in certain key industries, create legal risks that contribute to the pricing disparities. Furthermore, until recently, very few derivatives products have been allowed; derivatives that take into account share class differences and cross-border issues would allow traders to arbitrage away many of the distortions that now exist.

Despite its title, the second Economist article that caught my interest, Profits and prophecies: Chinese companies earn higher returns than is commonly claimed, also deals with the still developing nature of investing in China. This article highlights the debate between those optimistic about China's business prospects -- a couple of World Bank economists and Ms. Hong Liang of Goldman Sachs -- versus those who are more skeptical -- Mr. Weijian Shan, an economist and private equity investor for Newbridge, and others.

The optimists point out that both returns on capital and returns on equity have risen at a more than respectable rate for Chinese companies. They also cite reasons for optimism regarding how Chinese companies are financing their business investments. One of the fears that people have for China's economy is that there exists a pile of bad or dodgy debts that may collapse one day -- bringing down with it much of China's recent economic advancements. The optimists suggest that Chinese firms are increasingly relying on internal financing (investing out of their own cashflows and retained earnings) rather than bank loans.

Skeptics, like Weijian Shan (who I have a great deal of respect for; you can read a profile of him by clicking here), point out that costs -- commodity prices, labor costs, etc. -- are rising and China doesn't have the pricing power (i.e., goods are manufactured and bought from Chinese companies because of low prices) to offset those rising costs, profit margins are falling and may continue to fall. Furthermore, the skeptics point out that the optimists are naive in thinking that whatever move away from bank financing that may exist would solve the debt/insolvency crisis that could happen at any time in the near future.

[I ignore the issue of the rather sketchy nature of economic statistics and accounting in China. The optimists are well aware of the issue and do the best they can to deal with that (e.g., they look at return on equity of companies whose shares are traded outside of China).]

Without taking sides on this debate (since both sides make meritorious arguments), I think it's safe to say that a big part of the problem is that China doesn't have fully developed securities markets. Besides lacking full-featured derivatives markets (which is not necessarily a bad thing considering the stage of economic, regulatory, and legal development China is currently in), China doesn't really even have a mature bond market -- something so basic that we in the 'West' often take it for granted: As the article points out, corporate bonds are only 4% of China's GDP while they are over a 100% of U.S. GDP.

Having fully developed securities markets (debt markets, stock markets without byzantine multiple class divisions, etc.) would make the debates about China's economy and financial system much more fruitful. Although I doubt that what I'm proposing would fully solve all the thorny problems that exist, at the very least we would able to better measure -- through more efficient pricing -- the true condition of China's economy and that would, hopefully, allow policymakers, investors, and managers to better tackle the problems that exist.


PS: A brief sidenote on some econometric issues related to the second Economist article. The article points out that the optimists believe that improvements in what economists call 'total factor productivity' (or TFP) will offset high commodity costs, rising wages, and (although the Economist article doesn't mention this) demographic risks, that affect the inputs into China's manufacturing sector. The otherwise excellent Economist article neglected to mention the skeptics' potential objections to the increasing productivity argument. Namely, productivity gains (and losses) are difficult to measure and their affects, even if they could be properly gauged, is highly uncertain. So it's not clear to me that, as the article seems to suggest, TFP gains (even if they are real) would fully offset the risks.