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Irrational Exuberance with Chinese Characteristics: Origins of the 2007 A-Share Bubble

“Arise! Ye who have not opened an account! Pour your gold and silver in the hot market! The Chinese
nation faces its most crucial time. The passionate roar of our people will be heard!”

- Popular ringtone in Shanghai at the height of the bubble, a parody of China’s national anthem

“Money, again, has often been a cause of the delusion of the multitudes. Sober nations have all at once
become desperate gamblers, and risked almost their existence upon the turn of a piece of paper.”

- Charles Mackay, “Extraordinary Popular Delusions and the Madness of Crowds”

Introduction

In the fall of 2007, Chinese stock markets were roaring upward at what seemed to be an ever
accelerating pace. The exchanges, based in Shenzhen and Shanghai, had seen valuations grow by a
mind-numbing 140% in 2006 and a further 120% in 2007. All in all, over the course of about 22 months,
the value of Chinese stocks had grown almost five-fold. While it had been true that the profitability of
listed Chinese companies was indeed on the rise (growing by 70% over two years) 1, the valuations had
been virtually detached from economic fundamentals – at the height of the bull market, the average
Chinese company was trading at a ratio of fifty times earnings at a time when American companies were
trading at around sixteen times earnings. Due to the skyrocketing stock market, by late 2007 five of the
ten largest corporations (in terms of market capitalization) in the world were mainland Chinese
companies listed in Shanghai or Shenzhen.

The stock market euphoria at the time was palpable. There was word of millions of new brokerage
accounts being created at China’s securities companies as savers began seeking alternatives to low
yielding bank deposits. The rise in asset values was particularly prominent in China’s red-hot IPO
market, which in September of 2007 registered the two largest IPOs in the mainland’s history with the
listing of China Construction Bank and Shenhua Energy 2. The IPO market proved to be a quick and
profitable way for China’s state owned enterprises to use their large cash reserves, who invested heavily
in newly listed companies. In particular in Shanghai and Shenzhen, financial news became ubiquitous as
Xinhua created China’s first televised financial news network in 2006.

And yet the mania to invest in Chinese equities was not solely limited to those in mainland China –
international investors were similarly bullish. Baidu, regarded by many as “China’s Google”, was trading
on NASDAQ at a price of $409, or at an unbelievable 250 times earnings. Jim Rogers, a renowned hedge

1
PINR. "Economic Brief: China's Stock Market Bubble ." Power and Interest News Report 19 Februrary 2007.
2
Dyer, Geoff. "Worries Surface about a Potential Bubble." Financial Times 9 October 2007.
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fund manager and author of A Bull in China (a pop-investing book directing American retail investors
how to buy Chinese stocks) in 2007 advised 3:

I'm not selling my Chinese shares. As I said, I bought more of them last week. [I would sell only if] the
market tripled again in 2008. The Renminbi is going to be one of the strongest currencies in years to
come … if you invest in equities, think about China.

Of course, not all analysts were similarly bullish. RateFinancials, a private accounting firm which
analyzes and rates financial statements for publically listed companies, investigated the SEC filings for
the ten largest Chinese firms listed on the New York Stock Exchange. They found that the Chinese firms
all had “low quality earnings, aggressive accounting, low bad debt allowance, and insufficient cash
flow…” 4. The vice-chairman of the China Securities and Regulatory Commission (China’s primary
regulatory body overseeing securities markets, hereafter CSRC) warned Chinese investors of the “risks
investing in the stock market”, urging that “[Chinese Investors] should think carefully before entering” 5.

Almost predictably, in late 2007 the soaring equity markets came back down to earth - the Shanghai
Stock Exchange Composite Index lost almost two thirds of its value since the top in October. And while
speculative euphoria is certainly not unique to China, the rapid rise and subsequent crash exposed many
of the misperceptions that foreign investors have concerning China’s bourses. This paper will argue that
the Chinese stock market has entirely different fundamentals than much of the world’s equity markets.
In most countries (even those with similarly underdeveloped capital markets), investing in stocks gives
the investor adequate exposure to the locality’s economic growth. In China, however, the value of
equities can be and often are fundamentally detached from the underlying economic reality. To the
casual observer, it appears that many investors rushed to participate in China’s stock market boom
without a firm understanding of exactly what the assets they purchased actually represented.

To this end, the stock market in China has often been characterized as a “policy driven stock
market”. While it is difficult to make an authoritative definition of what exactly a policy-driven stock
market is, Professor Sebastian Heilmann characterizes such a market as “a market in which political
calculations, policy missions, and administrative interference are more important than the dynamics of
market competition for determining price fluctuations” 6. It is precisely this political dimension that was
the origin of China’s rapid and precipitous rise in stock prices as well as the basis for the subsequent fall.

3
Rogers, Jim. Jim Rogers Continues to View China as the World’s Best Long-Term Profit Play Keith Fitzgerald. 20
August 2007.
4
RateFinancials. Government Controlled Entities Masquerading as Independent Public Companies. Financial
Survey. New York: RateFinancials, 2007.
5
Dong, Zhixin. "Regulator Warns on Stock Market Risk." China Daily 29 April 2007.
6
Heilmann, Sebastian. "The Chinese Stock Market: Pitfalls of a Policy-driven Market." China Analysis (2002)
 Page |3

The dual facets of the Chinese economic system

In analyzing the Chinese economy, it becomes apparent that China is segmented into two sectors
with entirely disparate fundamentals, which I describe as the “institutional economy” and the “private
economy”. The institutional economy comprises of the enterprises in China that are either derivative of
China’s work units from the Mao era or those that have been incorporated and financed in Hong Kong.
Because of their relative size and political prominence, institutional economy is able to utilize the
mainland Chinese banking system and thus such enterprises have the ability to rapidly grow their asset
base. Without a doubt, the dominant actors in the institutional economy are China’s state-owned
enterprises (comprising of 98% of the sector) 7 and their interactions with the central government in
Beijing.

The “private economy” in China consists of mostly small to medium size enterprises (comprising a
similar 98% of the sector). These companies, due to their small size and lack of political connections, are
largely left out of the formal banking sector. In total, loans to the private sector make up only .66% of all
bank loans issued in China. Research from the CICC estimates that 26% of private sector capital comes
from paid-in capital, 30% from retained earnings, 37% from informal financial channels, and only 7%
from formal channels 8. This reliance on self-financing and the curb market means that the private
sector is largely immune from government-directed changes in the money supply or economic policy,
reducing the control that the Chinese government has over its private sector in comparison to their
OECD counterparts.

At first glance, it may appear as though the institutional sector should be the primary driver of
China’s growth, given the significant financial and political disadvantages piled on the actors in the
private economy. However, precisely the opposite is true: the private sector grew from a negligible
amount on the onset of reform to in excess of 60% of GDP in 2005 9. This means that a significant
portion of China growth has been by way of consumption and investment coming from private
enterprise; indeed, it is estimated that 65% of China’s economic growth comes from its SMEs. In
addition, the private sector has been the primary driver of China’s much lauded manufacturing industry,
creating 75% of China’s industrial output since 1990 and 69% of the nation’s exports 10. Perhaps most
importantly, the private sector is much more efficient than the institutional sector; the profitability

7
Liu, Chen Xiang. "SME Financing in China." Economics Working Papers, University of Paris (2007).
8
Tsai, Kellee S. "Congressional Testimony on China's Financial System." US-China Economic and Security Review
Commission. Washington D.C.: USCC, 2006.
9
Liu, Chen Xiang. "SME Financing in China." Economics Working Papers, University of Paris (2007).
10
Jia, Chen. "Development of Chinese Small to Medium-sized enterprises." Journal of Small Business and
Enterprise Development (2006).
 Page |4

(measured by return on assets) of private enterprises is on average double that of state controlled
companies 11.

Unfortunately for investors in China’s stock market, the bourses are overwhelmingly dominated by
corporations coming from China’s “institutional economy”. State-controlled enterprises make up 94% of
all stocks listed on Shanghai and Shenzhen – of the remaining 6%, many are actually Hong Kong listed
and domiciled (see: Exhibit 1). Indeed, in China equity listings have almost always been a vehicle for
SOEs, not than private companies, to raise financing. This dynamic may seem odd to Westerners, who
tend to perceive vibrant and active stock markets as epitomizing free market capitalism. However, as
China has privatized over the past three decades, the Shanghai and Shenzhen exchanges have served as
an intermediary of sorts for the gradual transformation of the country’s work units into enterprises
limited by shares. Therefore, to get an understanding of what China’s A-shares actually represent, it is
crucial to understand the nature of these work units and their transition into Western-style businesses.

The Restructuring and Listing of China’s State-Owned Enterprises

In Maoist China, work units used a Leninist style of accounting called “fund accounting”. In contrast
to Western style accounting whose focus is primarily to induce the economic value of an enterprise, the
purpose of fund accounting is ostensibly to prevent a work unit from embezzling capital from the state.
In fund accounting, the enterprise’s T-accounts comprise of “Fund Use” and “Fund Source” instead of
debits and credits. “Fund Use” refers to the use of designated funds to acquire property and supplies,
and “Fund Source” the specifically identified channel used to obtain the funds. At the end of every
period, the work unit had to prove to the government body that oversaw it that the total funds used
was equivalent to the total funds sourced.

To help with the accounting, funds were split into three separate types of funds: fixed funds (similar
to what Western accounting would refer to as investment in fixed assets), current funds (similar to
working capital), and special funds (derived from the enterprise’s cost of production, e.g. a product
development fund, an employee incentive fund, and a sinking fund for depreciation). Even into the mid-
to late- 1990s, many SOEs stuck with fund accounting rather than switch to total enterprise accounting
methods. The key difference of the accounting methods is this: if a company uses fund accounting, it
implies that the enterprise has no equity capital of their own.

The importance of this seemingly esoteric distinction was that as these SOEs restructured and were
spun off from government bodies, it made valuing these enterprises next to impossible. For example, if
the Bureau of Heavy Industry contributed a certain asset to a work unit, that specific asset would
technically belong to the Bureau of Heavy Industry, not the newly formed enterprise. As the stock
markets in China developed and enterprises found that shares were an attractive way to raise capital,
the assumptions of fund accounting proved difficult to apply to total enterprises. Because fund
accounting is a rules-based rather than a principal-based system, accountants had no choice but to
assign ownership of based upon the source of funds: because shareholders contributed cash to the

11
Chen Xiang Liu: p. 4.
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enterprise, the shareholders were assigned ownership of the enterprise’s cash accounts. This implied
that if someone owned a share of an SOE anytime during the first sixteen years of reform, their legal
ownership was not a share of the company itself but rather a share of the company’s cash balance. This
structure is, to put it bluntly, completely absurd. If an investor simply wants to own cash, putting it in a
bank is certainly a far superior option.

This legal peculiarity was finally addressed by China’s reformers in the 1994 Company Law, which
outlined a system to structure SOEs called the “promoter method”. Reform had been delayed
throughout the early 1990s because the government bodies that historically contributed assets were
unwilling to surrender ownership, due to their resounding reluctance to giving up control of ‘state
assets’. The 1994 Company law was a compromise that gave the governmental body equity ownership
in proportion to the percentage of the SOE’s assets that their contributed. Since 1994, most of China’s
SOEs have restructured themselves using the promoter method 12.

This method is a process whereby the work unit splits itself in two separate pieces – the Parent SOE
holdings group and the company to be limited by shares. As the work unit gets audited, those assets
deemed most profitable are carved into the shareholding company. The leftover assets (housing,
pensions, etc.) remain with the parent group, which maintains the Leninist fund accounting structure.
Because by legal definition the parent group ‘supplied’ the assets to the shareholding company, the
group maintains the vast majority of the equity.

In is important to remember that at the time, the former U.S.S.R. was also in the process of
restructuring their work units, albeit under the guidance of Western economists. The restructuring
undertaken in the U.S.S.R. was different than China’s in that the shares of the new company were given
to the employees of the work group rather than government ministries. While on the surface the
method used in the U.S.S.R. may seem more sensible, it proved disastrous in practice. Uneducated
about what ‘shares’ actually meant, many workers were willing to sell their holdings for a few rubles. A
handful of enterprising individuals ended up buying up many of Russia’s largest companies, exacerbating
wealth inequality in the former Soviet state.

Seeing this development, it is perhaps understandable that the government was worried about a
‘loss of state assets’. To this end, in the 1994 company law, those shares promoted by government
entities were deemed non-tradable. These non-tradable shares were deemed “legal person”, or LP
shares. While during the process of restructuring the SOEs these LP shares are largely a non-issue, as
SOEs began to list on the exchanges the presence of a significant number of non-tradable shares for
listed stocks became much more of a problem. Because LP shares are non-tradable, in theory their
economic value is only a function of dividends and voting rights (of course, a large majority of China’s
SOEs never distribute dividends to LP shareholders) 13. In practice, people found loopholes in the 1994
Company Law to trade LP shares anyway (LP shares could only be transferred to another “legal person”,

12
Howie, Fraser J.T. and Carl Walter. Privatizing China. Singapore: John Wiley & Sons, 2005, pp. 90-91
13
World Bank Beijing Office. SOE Dividends: How Much and to Whom? Policy Brief. Beijing: World Bank, 2005.
 Page |6

so dummy corporations would be set up to exchange shares). The presence of two separate markets for
the equities of Chinese SOEs – the exchange-based A-share market and the over-the-counter LP-share
market – added significant legal and regulatory uncertainty to the Chinese stock markets. This dynamic
contributes significantly to the policy-driven nature of the Chinese stock markets: if a large portion of
the uncertainty of holding a certain asset is due to legal risk rather than economic risk, is it any wonder
that the valuation of the asset will depend more on the political climate rather than the economic
climate?

Underscoring this uncertainty is the fact that even as Chinese SOEs list on exchanges and sell shares
to the public, most decide to do so while their promoters still hold the overwhelming majority of the
equity. Of the companies on the Shanghai Stock Exchange, 72% are still majority owned by government
entities. In sum, A-shares only make up 39% of the equity capital of the companies listed on the
Shanghai exchange 14.

China’s Listed SOEs

As reform progressed, the market for tradable shares was rapidly developing, culminating in 1990
with the creation of the Shenzhen and Shanghai stock exchanges. The vast majority of SOEs that listed
on China’s exchanges were work units spun off by city and provincial governments; these SOEs still
comprise a large majority of China’s bourses to this day (so-called “Red Chips”). Yet as more and more
of China’s most profitable SOEs were listed on the exchanges, by the 1996 deal flow in China slowed
down to a trickle. The problem appeared to be that China simply did not have enough profitable SOEs
to satiate market demand for equities. The primary obstacle in finding profitable SOEs for listing was
that during the restructuring process many SOEs came under significant political pressure from
provincial governments to leave enough cash generating assets in the holdings group to cover the
parent’s expenses (e.g. for pension funds, housing, etc.). Yet while the IPOs for standard SOEs
decelerated, the increasingly dormant primary market for A-shares was revitalized by a new, innovative
legal structure: the infrastructure company.

The frenzied investment in the nation’s infrastructure is perhaps the Chinese government’s most
oft-lauded policy during the reform era. It is true that developing useful and reliable physical
infrastructure can be a significant factor in increasing economic performance, but rarely is the question
asked how the government finances these massive infrastructure investments. Even odder still is that
this massive investment is undertaken by government entities, yet most of China’s governmental bodies
remain of sound financial state (see: exhibit 2). Indeed, the track record is undeniably impressive: in the
reform era China’s fiscal deficit has never exceeded 3% of GDP 15.

14
Howie, Fraser J.T. and Carl Walter: p. 124
15
Shen, Chunli and Hengfu Zou. Fiscal Decentralization in China - Potential Next Steps. Washington D.C.: The World
Bank, 2005.
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In China, just as it is in the United States, the vast majority of infrastructure projects come from local
governments (86% of projects in 2002) 16. Because local governments have hard budgetary constraints
(i.e. local governments cannot print money to make up for budgetary shortfalls), in the United States
local governments most often use “revenue bonds” to pay for infrastructure projects. In contrast to
general obligation bonds, interest and principal of the revenue bond are guaranteed by the project’s
cash flows rather than the locality’s tax receipts. This allows the local government to finance spending
without outwardly running at a fiscal deficit. Unfortunately, China cannot replicate this structure due to
the country’s nascent bond markets and the murky legality of project-based debt financing. However, in
conjunction with an increase in state-directed lending from the policy banks, the creation of
“infrastructure company” listings heavily mitigated the financial challenges faced by China’s provincial
governments.

The structure of a typical infrastructure company involves spinning off an SOE that will be
responsible for managing whatever infrastructure the local government builds. The SOE’s revenues are
made up of ‘tariffs’ (e.g. tolls for highways, bill payments for power plants, etc.) which are projected by
the underwriter of the issuing government. Once the IPO is completed, the cash generated from the
offering is transferred to the provincial government and the SOE receives the infrastructure assets. It
should be noted, however, that these ‘infrastructure companies’ were not really companies at all, but
rather a collection of assets backed by a “tariff structure”. Often the listed infrastructure companies
were not even independent accounting units from the provincial government and had no power to set
prices. Prices for all of the services the provincial governments provide are instead under the control of
the State Price Control Bureau. Of course, the fact that the ‘company’ is not an independent accounting
unit 17 and has no control over prices means that buying a share of an infrastructure company is,
economically, virtually identical to buying a revenue bond.

The boom in the listing of infrastructure companies from lasted until it became apparent that the
‘tariff’ projections by the underwriters proved wildly unrealistic. The State Price Control Bureau was
heavy handed in their approach to pricing the tariffs received by the infrastructure companies, often
denying petitions to simply increase prices along with inflation. The Price Control Bureau ostensibly did
not want to see consumers getting ‘gouged’ by the new market economy. Due to this political
wrangling, the profitability of the infrastructure companies languished. And while the popularity of
these listings has indeed diminished since the late 1990s, the infrastructure companies still make up a
large portion of the equity markets in China – in sum, they still comprise almost 15% of Shanghai’s SSE
180 Index.

As the IPO market for infrastructure companies cooled down, another structure for listing SOEs
began to take form. A big problem facing many of China’s newly restructured SOEs was that for the
most part, China’s SOEs are fragmented not by industry but rather geographically. Because of this, most

16
Asian Development Bank. PRC: Strengthening Public Infrastructure Investment Policy in China. Manila: Asian
Development Bank, 2002.
17
Howie, Fraser J.T. and Carl Walter: pp. 101-103
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companies take the form of conglomerates that hold only loosely related assets, albeit dominated in one
province or locality. Since the new millennium, a much more common structure for a newly listed
company is ‘Entire Industry Packaging’. Entire Industry Packaging consists of taking related assets from
SOEs throughout the country and putting them together into one company to be limited by shares
(called by many to be China’s “National Champions”). This creates the potential for synergy between
the assets and results in a more focused, well capitalized final company. The first IPOs in 2000 proved to
be successful in the market: the PetroChina, China Unicom, and Sinopec offerings netted $2.9, $5.1, and
$3.3 billion respectively. Ever since, entire industry packaging has proven to be extremely popular – in
the subsequent five years after these trial IPOs, ten more national champions listed on China’s bourses,
raising a total of $36.3 billion 18. Even more importantly however, the “National Champions” are perhaps
among China’s first true companies derived from SOEs since the 1994 Company Law.

Unfortunately, due to their comprehensive nature, the “National Champions” make up only a small
percentage of the listed companies in Shanghai and Shenzhen; the vast majority is made up of Red Chips
and Infrastructure Companies of questionable profitability. Because many of these firms struggle to
meet earnings targets, aggressive accounting methods are rampant in China – it is estimated that almost
7% of Chinese firms engage in earnings manipulation 19. Compounding these factors is still the fact that
tradable shares make up a minority of the equity capital of the listed companies on the exchanges. This
certainly begs the question: who exactly are the investors buying A-shares, and why do they choose to
invest in China’s stock markets?

The Buy Side: Investors in China’s Equity Markets

It is often reported that China’s stock markets are dominated by millions of small retail investors –
allegedly, there are 108 million retail accounts in China which hold upwards of 60% of the A-shares on
the Shanghai Stock Exchange. If true, this would be an astounding figure. In comparison, retail investors
hold roughly 20% of the capitalization of the NYSE and 30% of Hong Kong’s Hang Seng 20. With the SSE
soaring to new heights in 2007, the number of account openings accelerated at an astonishing rate –
measuring a year over year increase of about 55% from 2006 21. This elicited some observers to wonder
if social instability could result if a large number of retail investors lost their savings if the market turned
south.

Regrettably, in China data is not always all that it first appears. To begin with, the reported figure
counts separately accounts on the Shanghai and Shenzhen exchanges. Because Chinese brokerages
automatically set up accounts on both exchanges when an investor opens with the broker, the 108

18
Howie, Fraser J.T. and Carl Walter: pp. 105-106
19
Qiao, Yu, Du Bin and Sun Qian. "Earnings management at rights issues thresholds - Evidence from China." Journal
of Banking and Finance 10 January 2006: p. 3465.
20
Lin, Li. "Chinese investors start to shun stock market amid volatility ." Xinhua Finance 7 July 2007.
21
PINR. "Economic Brief: China's Stock Market Bubble."
 Page |9

million number implies double counting between the two exchanges. In addition, there is substantial
evidence that the vast majority of these accounts currently sit empty – once adjusting for these two
factors, one finds that the maximum possible number of active investors in China’s stock market is
13.345 million (see: Exhibit 3).

However, there exists a third factor that further whittles down the number of investors in China’s
stock market: many of China’s major market players hold “ghost accounts” (i.e. some investors hold
more than two accounts). These accounts are opened illegally in the name of a person, often from a
rural inland province, that has sold or given the investor their ID card. Evidence regarding the existence
of ghost accounts is widespread, although aggregate data is difficult to come by. For example, in
February of 2001, Gansu province (hardly a financial hotbed) recorded an opening of 4332 new
accounts. While this is paltry compared to aggregate numbers of account openings in east coast
provinces, what is odd is that 99.93% of the accounts were opened on two days – 2751 accounts on
February 15th and 1578 accounts on February 27th. Similar activity has been found throughout China’s
impoverished West, with much of the activity dominated in Qinghai and Gansu provinces (further
supported by the fact that 35 of Gansu province’s 52 brokerages were closed down for fraudulent
activity in the CSRC’s 2001 crackdown on China’s securities companies) 22. As explained by Hu Shili, the
chief editor of Caijing magazine 23:

The true number of active investors in China is at most 3% of the number commonly cited in the
media. Experts estimate that truly active accounts trading at least once a week number no more
than [7 million], and those ‘professional investors’ who operate every day no more than [2 million].
This figure doesn’t even include ‘ghost accounts’, that is, those opened by one speculator who
purchases thousands of ID cards to open those accounts.”

Ghost accounts can prove useful for many investors that, for whatever reason, need to hide their
investment on paper. Lu Liang, one of China’s infamous market manipulators, was noted for opening
thousands of accounts in rural areas in order to disguise the nature of his transactions. For the
manipulators, ghost accounts help enable them to acquire majority control of a listed company
opaquely, without the knowledge of the other market participants (once an investor has majority
control, it is possible to execute a wide array of trading shenanigans). And while China’s stock markets
have indeed struggled with market manipulation, the majority of ghost accounts appear to come from
investors that want to hide not the nature of their equity investment, but rather the fact that they have
invested at all.

22
Howie, Fraser J.T. and Carl Walter: pp. 138-140
23
The original statement Shili states that active accounts are estimated at 4 million and professional accounts
number 1 million. These figures are, however, from 2002. The figures were simply scaled up in proportion to the
number of total account to maintain congruency with the calculations presented in Exhibit 3: Hu, Shili.
"Disadvantages Groups Should Stay Far from the Stock Market." Caijing 20 October 2002: 6.
 P a g e | 10

In 2001 the PBoC issued a survey reporting that these investors, coined by many as the “grey
market”, control an estimated 56% of the capitalization of China’s stock markets (RMB 1900billion in
2007) 24. Under the legal title of “financial advisors”, these companies nonetheless actively invest and
have an average of RMB150 million under management. Yet perhaps most shocking is not the scale of
the investment but rather the source of their funds: 80.8% of grey market funds are provided by SOEs or
subsidiaries of SOEs (by some estimates, this could be as high as 96.2% of funds if one includes dummy
corporations set up by SOEs to invest in the grey market) 25. This implies that gross SOE investment is
somewhere between RMB1540 billion and RMB1820 billion. This figure simply astounding –it is double
that of the total investment of all of the pension funds, foreign investors, insurance companies, mutual
funds, and brokerages in China combined. And yet, even these numbers do not completely account for
SOE funds invested in the stock market – SOEs also dominate subscriptions in China’s IPO market.

Ever since the exchanges’ inception, IPOs in China have followed a “fixed pricing” rule – the price of
the offering was based on a formula that applied a P/E ratio of 15 times the average of the company’s
earnings over the previous three years (while other pricing mechanisms have been legalized by the
CSRC, the subscription price still hovers around the fixed rule). While the rule was put in place to
protect against overvaluation based on the often overly optimistic earnings projections provided by
securities underwriters, the fixed rule resulted in precisely the opposite: on average, IPOs in China are
massively undervalued. The chronic undervaluation of the offering is bad for issuers (which receives
fewer funds from the IPO), but good for whoever may be lucky enough to subscribe to the IPO, as the
share price rockets upwards in the first few days of trading.

Most IPOs in China allocate a large block of shares to ‘strategic’ investors – these investors comprise
of mostly other SOEs that are required by the CSRC to hold their shares for at least six months (although
these regulations are often skirted by going through a third party). It is estimated that these corporate
investors have on average consisted of 40-50% of the funds raised on China’s primary markets 26. This
number does not even include the possibility of grey market funds entering the IPO market, of which
there are assuredly some. For SOEs, participating in IPOs has been an almost fail-safe way to book a
profit – often; securities underwriters in China actually guarantee the SOE a minimum amount of
proceeds from their investment.

Therefore, in a final analysis, the entire stock market mechanism in China appears to above all be a
massive circular flow of funds from China’s SOEs to China’s SOEs. Because an SOE in China has very little
equity capital of their own (owned primarily by the enterprise’s promoter), managers see very little
downside to a public offering, perceiving an IPO to be a source of free capital rather than a sale of
ownership. Due to this dynamic, a manager often is less concerned about pricing and more concerned
about finding a means to participate in the primary market. The securities companies face similar

24
Business Week. "China's Illusionary Retail Investor Class." Business Week 7 June 2007.
25
Howie, Fraser J.T. and Carl Walter: pp. 142-144.
26
Howie, Fraser J.T. and Carl Walter: p. 145.
 P a g e | 11

incentives – while the underwriter receives less of a fee in an underpriced IPO, the power these
companies have in assigning out subscriptions can more than make up for the loss of potential profit.

And yet while the primary market is structured to provide a riskless profit for China’s SOEs, the
secondary market offers no such guarantee. The fact that so much SOE funds are invested via the grey
market into the exchanges certainly begs the question: what happens if there is a significant, enduring
decline in stock prices? China’s bear market of 2001-2005 and the government’s subsequent response
gives ample evidence and illustrates the policy-driven nature of China’s bourses.

The bear market and the fight over China’s securities companies

These dynamics imply that the prices on China’s stock exchange depend not on the fundamentals of
the listed companies but rather total funds flowing into the market. It should be understood that in
theory, a large amount of capital moving into or out of capital markets need not necessarily dramatically
affect the price level of the assets: the stock would still be worth what its purchaser would pay for it, in
accordance to the fundamentals of the security (although one would probably observe higher bid-ask
spreads due to a decrease in liquidity). Of course, while reality rarely so neatly conforms to the
assumptions of the Efficient Market Hypothesis, one can use such a model to make a qualitative
assessment of the relative efficiency of various capital markets. From this perspective, it is practically an
indisputable fact that the efficiency of China’s stock market lags significantly behind its OECD
counterparts. For literature concerning the inefficiency of China’s exchanges, refer to Balsara, Chen,
and Zeng (2007), Ma (2000), and Chung (2006) 27. Other evidence supports this view: it is estimated
that only 20% of China’s investors understand what a price-to-earnings ratio is (the most basic market
industry standard for determining valuation) 28. Furthermore, the stock prices of companies that list A-
shares as well as H-shares (that is, shares of SOEs listed in Hong Kong) can and frequently do diverge,
violating the law of one price.

Against this backdrop, Zhou Xiaochuan, protégé of the infamous reformer Zhao Ziyang, was named
head of the CSRC in 2000. Upon his arrival, Zhou Xiaochuan overhauled the CSRC’s personnel, hiring
foreign-educated economists and dismissing those who he deemed to have too close of an affiliation
with the securities companies (which he felt were corrupt). During the first year of his tenor, Zhou
earned the nickname “Zhou Bapi” (loosely translated as “Zhou the Flayer”) for his frequent probes into
corruption inside the securities companies and some of China’s listed SOEs. And yet, to Zhou Xiaochuan,
the fundamental problem with the Chinese stock markets was not corruption but the fact that the SOEs
which dominated the exchanges were still majority held by government entities. This led to the CSRC to
propose a reform in 2001 whereby at least 10% of all new shares issues consist of state shares, with the

27
All of these papers test the “weak-form efficiency” of China’s stock markets. If a market is weak-form efficient, it
means that all past prices are reflected in the price of a stock today. It implies that an investor still cannot earn
more than the market return using trading rules, but it is theoretically possible to do so using sound fundamental
analysis. All of the papers reference determined that China’s bourses are weak-form inefficient.
28
Mitchelson, Laura. "Profile of A-share investors." Australia China Business Connections June 2008.
 P a g e | 12

intention of eventually moving to a “100% float”. Even to this modest proposal, however, stock prices
plummeted: the Shanghai composite dropped 5.3% the day of the announcement and a further 13.3%
over the course of the next two weeks.

If China’s stock market was driven by company fundamentals, the extra shares going to market
would not have materially affected valuations. After all, if a stock price reflects the discounted value of
a company’s future dividends, it should not make altogether too much of a difference what the
ownership structure of the equity is. Yet it was the grey-market funds flowing into China’s bourses that
were the primary driver of the bull market of 1997-2001; consequently, the escalation in prices
represented the mismatch between massive SOE purchases of securities and the relatively smaller rise
of stocks supplied by China’s IPO market. As lending to SOEs slowed due to the restructuring of China’s
banks (which were pressured to decrease their level of NPLs) in preparation for WTO entry, a large
increase of the supply of stocks would have the potential to rapidly deflate stock prices 29. This dynamic
was not lost on the investors in the Shanghai and Shenzhen exchanges: the prospect of the State selling
its holdings, thereby flooding Shanghai and Shenzhen with A-shares, terrified China’s investors.

The CSRC was forced to stop the sale of state shares in late 2001 amidst concern over the stability
over China’s securities companies, most of which held large proprietary trading books and were
struggling with the CSRC-induced rapid decline of stock prices. As valuations deflated, the head of the
People’s Insurance Company of China ominously predicted 30:

“If the market falls to 1300, the securities companies, funds, the entire market will be completely
bankrupt. The financial links between the securities companies and the banks will be broken …
leading to systemic risk in China’s financial sector.”

Indeed, the securities industry over the next few years witnessed widespread bankruptcies. By the
end of 2004, total losses were counted to be in excess of RMB 19 billion. Starting with the bankruptcy of
Anshan securities in 2002, the securities industry saw a steady stream of closures. The true size of the
problem became apparent when Caijing reported that Shenzhen-based Southern Securities (one of
China’s “big three” securities companies) was collapsing under USD 4 billion in bank loans and other
liabilities. The securities companies, not lacking in political clout, forced the CSRC’s hand and Zhou
Xiaochuan was reassigned to the PBoC 31.

As the crisis in China’s securities companies worsened over 2003 and 2004, the CSRC found itself
completely depleted of funds. The Ministry of Finance, who could normally serve as the role of lender
of last resort in such a crisis, was under similar liquidity constraints due to their capitalization of China’s

29
Yao, Shujie and Dan Luo. Chinese Stock Market Bubble: Inevitable or Incidental? China Briefing. Nottingham:
University of Nottingham, 2008: p. 9.
30
Howie, Fraser J.T. and Carl Walter: p. 219.
31
Naughton, Barry. "The Politics of the Stock Market." China Leadership Monitor 26 May 2002.
 P a g e | 13

Asset Management Companies (the AMCs were created in the 1998 bank reorganization, and was
responsible for managing the banking sector huge portfolio of NPLs).

However, the securities industry ended up staving off disaster, albeit from an unlikely source. Zhou
Xiaochuan resurfaced with his ascension to governor of the PBoC – with his new leadership, the PBoC
refocused their attention on the securities companies, who still desperately needed recapitalization and
Zhou still desperately wanted to reform. The PBoC, unlike the MoF and the CSRC, was awash in cash
and could afford to extend loans to or inject equity into the securities companies. To finance the
bailout, the PBoC created two investment vehicles, Huijin Investments Ltd. and China Jianyin
Investments Ltd, bankrolled directly by funds sourced to SAFE’s foreign exchange holdings. These
investment vehicles proceeded to buy up large allotments of equity in China’s securities companies,
achieving a majority holding in nine of China’s largest brokerages. At last, even if only via ownership
rights, Zhou Xiaochuan was able to start his restructuring of China’s securities companies – a process
that had seen little progress while he was working at the CSRC.

Unfortunately, the recapitalization and restructuring of the securities companies proved to be a

political misstep for the PBoC. After all, the regulation of the securities companies was the jurisdiction
of the CSRC. Further complicating the situation, the PBoC decided to act unilaterally to pay for losses
that retail investors incurred from the activities of fraudulent securities companies – a plan which was
supposed to be financed multilaterally by not only the PBoC but also the MoF, the CSRC, and the CBRC
(China Banking Regulatory Commission). At the same time, the PBoC was pushing a policy proposal to
allow foreign firms to acquire majority ownership in securities companies – a controversial proposal.
The State council has historically only allowed majority foreign ownership in industries that it deemed
underdeveloped and in need of foreign expertise; conversely, it has heavily restricted foreign ownership
in industries it deemed strategic. Predictabily, the securities industry was considered by the PBoC as
underdeveloped and the CSRC as strategic.

The bureaucratic struggle that ensued widened the schism between the CSRC and the PBoC. And
while at first it appeared that the State council would side with the PBoC, their tone reversed as the
PBoC came under significant fire from other Ministries and, eventually, the media. The director of the
National Development and Reform Commission lambasted the PBoC for encroaching on the jurisdiction
of other Ministries. The political environment grew exponentially uglier as Zhou Xiaochuan came under
direct personal attack from the Hong Kong press. The issue was finally settled as the State council sided
with the CSRC: the PBoC was forced to transfer oversight of the securities companies to the CSRC. This
was the best possible result for the securities companies, as they had been recapitalized by the PBoC but
with minimal operational changes due to the lax supervision from the new regulators at the CSRC.

The origins of the bubble

When Zhou Xiaochuan was dismissed from the CSRC, he was replaced with Shang Fulin, a much less
controversial figure who have off the impression that he had no desire to continue with Zhou’s reforms.
His priorities could not have been more different: Fraser Howie, author of the book Privatizing China,
 P a g e | 14

characterized Shang as “a career politician with deep industry connections and a lack of understanding
of capital markets” 32.

Shang’s primary focus was not to restructure the industry, as had been Zhou Xiaochuan’s, but rather
to simply increase the prices of stocks (thereby staving off industry criticism). His efforts were lauded by
many in the financial sector, as the new policies were congruent with the concerns of many of the
entrenched interest groups. As the Shanghai composite approached 1000, the CSRC introduced a wide
array of reforms in an effort to incentivize investment in the bourses. In 2002, the CSRC announced a
program to allow institutional investors to purchase A-shares, dubbed QFII (Qualified Foreign
Institutional Investors), introducing a large new potential source of funds into the market. In the same
week, the State council announced that it would allow foreigners to make “strategic investments” in
SOEs by way of purchasing non-tradable LP shares, a reversal of a ten year ban. Furthermore, the CSRC
issued a regulation changing the nature of the voting rights of A-shares, allowing them to vote on certain
issues such as rights offerings and company restructurings.

Yet all of these actions had only a marginal affect on market prices – there simply was not enough
funds flowing into the stock market as SOEs shied away from investment in equities during the bear
market. In a desperate effort to stop the selloff, in 2005 the CSRC declared a two year moratorium on
IPOs and decided to come up with a final solution for the non-tradable share problem. While the reform
was less than comprehensive, it proved to be an adequate compromise for both the LP share holders
and the A share holders. In essence, the reform (dubbed “G-company reform”) allowed a medium for
direct negotiation between LP and A shareholders as to the adequate compensation for A-shareholders
in exchange for the state’s LP shares to become fully tradable. It is important to note that even as the
shares became tradable, they would only do so slowly, over the course of three years.

In sum, the program was received as well as it could be by the market. Above all, Shang Fulin’s fix
diminished the uncertainty A-shareholders had concerning the possible future float of state shares: the
A-shareholders finally knew that the SOE could not issue their promoter shares without the explicit
approval of those holding the tradable shares. And yet while the moratorium on IPOs stopped the
growth in the stocks supplied to the market and the G-company reform mitigated much of the
uncertainty with regards to the state’s LP shares, the market may not have rebounded without one final
impetus: massive purchases of securities by the state-run pension fund, the NSSF.

The NSSF was organized in 2001 as an aggregation of all SOE pension funds (most of which were still
held by parent SOE groups, much of whom faced significant funding gaps). The fund was given RMB190
billion under management and allowed a 25% allocation to invest in China’s equity markets. Of course,
an allotment of RMB45 billion pales in comparison to the gross amount invested in the Chinese stock
market, but the NSSF used their allotment to strategically prop up the markets. Whenever the index
would approach 1000, the NSSR would purchase a block of A-shares moving the index up past the 1000
threshold (e.g. when the market was spiraling downwards in late 2004, the NSSF increased their equity

32
Howie, Fraser J.T. and Carl Walter: pp. 222-223.
 P a g e | 15

investment by a factor of three) 33. More importantly however, the NSSF legitimized Shang Fulin’s G-
company scheme by making large investment in stocks that had undertaken the reform: the NSSF
(lauded as the “national team” by China’s press) boasted that it had actively intervened in the 3rd and 4th
quarters to buy newly created G-companies, increasing their investing in the Shanghai 50 and Shenzhen
100 indices by 50% and 30% respectively 34.

With all of these actions – governmental bodies stepping in to stabilize the market above the 1000
level, massive purchases by the NSSF, a moratorium on new issues, and an adequate reform in place for
LP-shares – the groundwork had been laid for China’s A-share bubble. The actions undertaken by the
CSRC and the State council sufficiently assuaged Shanghai and Shenzhen’s investors that the
government simply would not let the prices on the bourses fall. A quote from one of CITIC Security’s
equity analysts sums up this predisposition perfectly, telling Jingji Guanchabao: “We just calmly wait for
the government’s next step to see if there will be any more policy incentives to invest” 35.

In late 2005, the SOEs which once shied away from the market began to reinvest heavily, eliciting a
rapid rise in stock prices. In 2006 and 2007, at least RMB 585.37 billion of SOE funds poured into the
stock market as prices soared higher and higher 36. Further complicating the economic reality, in early
2007 the Chinese government quietly changed their accounting regulations to allow an increase in asset
values to count as net income. Because of this change in accounting standards, in 2007 SOEs reported
above average earnings growth, although on average 31% of SOE profits came from investments in
securities and not from operations 37. It is estimated that 66% of listed companies invested in China
bourses 38. All in all, the same dynamics that dominated the exchanges in the late 90s were similarly
present in 2006 and 2007.

Of course, stock valuations cannot stay at such high levels forever. Due to concerns about inflation,
the PBoC raised the reserved requirements for Chinese banks ten times over the course of 2007 39,
predictably elicited far fewer loans extended to SOEs. Because Chinese SOEs had on average very low
cash flows from operations, with the drying up of credit there was minimal cash left to invest in

33
Yao, Shujie and Dan Luo: p. 5.
34
Howie, Fraser J.T. and Carl Walter. Privatizing China. Singapore: John Wiley & Sons, 2005, p. 239.
35
Sebastian Heilmann: p. 7.
36
Caijing. "Beijing Clamps Down on SOE Expansion." Caijing Magazine 23 July 2008.
37
Business Week. "China's Illusionary Retail Investor Class." Business Week 7 June 2007.
38
This dynamic could be compared to the massive cross-holdings that listed Japanese companies held in
eachother’s equity, and the role this played in the rapid escalation of stock prices on the TSE in the late 1980s:
Yang, Qian and Don Durfee. "Losing Their Grip." CFO Magazine 1 February 2008.
39
Xinhua. "China to Raise Reserve Requirement for 10th Time This Year." Xinhua 9 December 2007.
 P a g e | 16

securities 40. In conjunction with the leveling off in demand, three factors rapidly pushed up the supply
of stocks available to Chinese investors: first, China’s primary markets once again began issuing a large
number of SOE IPOs, recording some of the mainland’s largest; second, the G-companies continued their
gradual conversion of LP shares into A shares; third, many Hong Kong domiciled mainland Chinese
companies decided switch their listing from Hong Kong to the mainland, tapping into the abundant
liquidity of the Shanghai and Shenzhen exchanges. It is the third factor that is speculated to be the final
impetus of the collapse – PetroChina, China Mobile, and China Life all issued jumbo IPOs in late 2007,
absorbing a significant amount of the market’s liquidity 41.

Conclusion

When analyzing China’s institutional sector, it is at times difficult to remain optimistic. China’s SOEs
are intricately intertwined, often susceptible to political motivations, and at times outright corrupt.
While the reform of China’s institutions is steadily progressing, periodic regression is common. For
example, in response to the current economic slowdown, the State council has enacted a ‘stimulus
program’ whereby it has directed the banks to aggressively expand their loan portfolio. With this
blessing from the central government, the banking industry in China extended RMB 1.6 trillion of loans
to SOEs in January alone 42. This figure is more than Chinese banks have ever lent in a monthly period
and one third of the aggregate amount of loans extended in 2008. Predictably, the stock market has
been one of the primary beneficiaries of this lending: the Shanghai composite has increased 33% since
the start of the year (or 213% annualized). Of course, unless the institutional sector rapidly increases its
productivity, the 2009 ‘stimulus package’ will most likely prove to be nothing except a large package of
NPLs by 2015. This certainly begs the question: who pays for the staggering misuse of capital employed
in China’s institutional sector?

The short answer is, of course, the private sector. In excess of 80% of China’s workers are employed
in the dynamic and rapidly growing private sector 43, and it is the savings of these workers that indirectly
capitalize the entire formal financial system, from the banking establishment to the securities
companies. The 2007 Chinese stock market bubble was not a onetime occurrence; it was not the result
of intangible factors such as investor euphoria or changes in social norms. The historic rise in stock
prices from 2006 to the end of 2007 happened simply because of the way China’s institutional economy
is structured. The nature of the bubble was not altogether different than the bull market of 1997-2001,

40
RateFinancials. Government Controlled Entities Masquerading as Independent Public Companies. Financial
Survey. New York: RateFinancials, 2007.
41
Shujie Yao and Dan Luo: pp. 9-10.
42
Pettis, Michael. "China Financial Markets." 9 February 2009. Will China have to choose between social stability
and long-term growth? <http://mpettis.com/2009/02/will-china-have-to-choose-between-social-stability-and-
long-term-growth/>.
43
Jia, Chen. "Development of Chinese Small to Medium-sized enterprises." Journal of Small Business and
Enterprise Development (2006).
 P a g e | 17

only the scale. When analyzing the price fluctuations in the Shanghai and Shenzhen exchanges, I am
reminded of the thoughts of one of the participants in Great Britain’s South Sea Bubble of 1720 (a
bubble whose structure was eerily similar to that of China’s equity markets) 44:

“The additional rise above the true capital will only be imaginary; one added to one, by any stretch of
vulgar arithmetic will never make three and a half, consequently all fictitious value may be a loss to
some person or other first or last. The only way to prevent it to oneself is to sell out betimes, and let
the devil take the hindmost.”

And so, as more debt capital from China’s recent stimulus package gets siphoned into equities, it
should be remembered that none of the increase in value will be ‘real’ in an economic sense. Once the
cycle comes full circle and all of the imaginary wealth has disappeared, the private sector will be forced
to once recapitalize the formal sector, yet again being obliged to take the hindmost at the behest of
China’s institutions 45.

44
The south sea bubble of 1720 was a speculative bubble in the price of shares in the South Sea Company, a
company who received monopoly rights from the crown to develop in South America. The South Sea Company
bought up large portions of government debt, debt that was indirectly siphoned back to the South Sea Company to
fund their expansions. To buy the debt, which at the time was not tradable, the South Sea Company issued large
equity offerings – portions of which were allocated to well-connected government officials. The similarity lies in
the debt-financed nature of the South Sea Company’s expansion, as well as the fact that the massive purchases of
debt increased the lending capacity of the Bank of England, which fueled debt-financed speculation in the South
Sea Company’s stock.
45
A note on China’s financial troubles in contrast to the OECD’s current situation: this paper was not meant to be a
thorough comparative analysis between the financial systems in the United States and China. Perhaps to a Chinese
citizen, it may seem rich to read an American criticizing the structure of China’s financial system when the United
States’ is currently in crisis. Yet it is my personal opinion that while the United States’ financial system has
certainly overextended itself, there does not exist in the United States the staggering circular misuse of capital that
is characteristic of China’s formal financial system. It has often been noted that 40% of the market capitalization of
the NYSE in 2006 consisted of financials (certainly a hefty percentage) – contrast with the fact that 96% of the SSE
consists of SOEs. Fortunately, China still has much room to grow simply by expanding their economic inputs; the
vastly more developed OECD must rely more heavily on increases in total factor productivity (i.e. economic
efficiency), which is largely derivative of the effectiveness of the financial system. As reform continues to progress,
it is imperative that China restructures its formal financial sector.
 P a g e | 18

Exhibit 1: The Financial History of China’s Most Profitable Companies

• Lenovo: Incorporated in Hong Kong in 1984 as a spinoff of part of the Chinese Academy of the
Sciences. Financed in Hong Kong; Corporate HQ in Hong Kong. Legend Holdings Limited, a
mainland investment vehicle, owns a large chunk of the equity.
• Huawei: Founded in 1988 by CCP member and former PLA officer Ren Zhengfei. Vast majority
of sales consisted of equipment to provincial governments or state-owned infrastructure
companies. Has been given over US $10.5 billion in subsidized credit from China’s Policy Banks
to fund overseas expansion – Huawei passes along the cheap loans to their customers, offering
vendor financed sales of in excess of 70% (a program very popular in developing countries in
Latin America and Africa). Still not publicly traded despite Asia’s buoyant equity markets over
the past decade – ownership structure murky and kept secret.
• Baidu: Founded by Robin Li, a Chinese-American working in Silicon Valley in the mid 90s. Raised
about US $11 million from four American venture capital firms and incorporated in the Caymen
Islands in 1999. Headquarted in Beijing, went public on NASDAQ in 2005 (yet to be listed on any
Asian Exchanges).
• Haier: Formed from a joint venture between Germany’s Liebherr Group and Qingdao
Refrigerator Co, a Shandong SOE run by the charismatic, Hong Kong-educated Zhang Ruimin.
First listed in Hong Kong via a backdoor listing in 2004, with a follow-on offering on the NYSE.
• Alibaba Group: Incorporated in Hong Kong in 1999 by Silicon Valley-based entrepreneur Jack
Ma. Received start-up capital from Goldman Sach’s VC arm; later received a direct equity
injection from Yahoo. Listed on Hong Kong’s exchange in 2007.
• Wahaha: Joint venture between Hangzhou-based red-chip, the Hangzhou Wahaha Group, and
French conglomerate Danone. Slight majority of company held by Danone. Not listed on any
exchanges (Danone is listed on Euronext).
• Gome: China’s largest electronics retailer, GOME was self financed with US $500 of seed capital
and relied on the informal financial sector to finance its growth. In 2004, the company was
incorporated in Bermuda and listed on the Hong Kong stock exchange.
 P a g e | 19

Exhibit 2: Expenses of the Chinese Government

Source: The World Bank, “Fiscal Decentralization in China—Potential Next Steps”

 P a g e | 20

Exhibit 3: The Calculation of the True Number of China’s Investors

Total Number of Accounts: 108,000,000

Inactive Accounts: 81,310,000

Total Active Accounts: 26,690,000

Double Counting of Accounts 13,345,000

Maximum Number of
Accounts 13,345,000
Ghost Account Factor 4.12

Total Active Investors 3,240,000

Based on calculations performed in “Privatizing China”, albeit with updated statistics to reflect the
2007 equity boom 46.

46
Howie, Fraser J.T. and Carl Walter. Privatizing China. Singapore: John Wiley & Sons, 2005, pp. 132-141.
 P a g e | 21

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