Although Chinese authorities have moved to insulate the broader financial system from the ongoing stock market crash, the severity of the collapse and the evident desperation in Beijing’s response has led to questions about the government’s stomach for further pro-market reforms.
Right now, emergency measures such as declaring it illegal for major stakeholders to sell shares, or funnelling central bank reserves into the market, are counterproductive.
It would be a tragedy were the excesses of the stock market allowed to derail the goals of the Communist Party Third Plenum of 2013, when President Xi Jinping and Premier Li Keqiang called for market forces having a “decisive role” in the economy. It may take a long time for the market to find its floor, given the huge amount of leverage remaining, so authorities should think about structural improvements now.
If anything, China's leaders should double down on financial liberalisation. Here are five steps Beijing should take over the medium term to turn this month’s destruction of shareholder value into an opportunity to reform and strengthen the financial system.
1. Do whatever it takes to get A shares included in MSCI’s emerging market indices.
MSCI declined to include China A shares on June 9, citing remaining obstacles around onerous quotas for foreign investors and ease of repatriation of capital.
Given the subsequent meltdown, many global institutional investors probably felt relief that MSCI had not included A shares.
But the retail-dominated nature of China’s domestic stock market makes it all the more obvious how much China misses foreign portfolio investment. Laying down the welcome mat for global investors who are more likely to view stocks through the lens of fundamental research, and who generally take a longer perspective on holding stocks, is vital if China is to ever transform its stock market into anything other than a casino.
To that end, Beijing should consider broadening quotas. Abolish the Qualified Foreign Institutional Investor programmes and merge everything into a Stock Connect funnel that provides access to all listed opportunities. Replace quotas with a registration system, as is found in India and other emerging markets. Most of all, ensure foreign investors that they can repatriate capital at will.
All of these steps combined should enable China to enter MSCI indices, which will attract lots of global capital. When MSCI ruled to postpone inclusion in June, the markets assumed it would work with Beijing toward a positive outcome within six months or so. This past week has seen media reports suggest joining MSCI indices has now been postponed indefinitely. Beijing should do the opposite: get A shares into MSCI as soon as possible.
2. Liberalise stock lending while reforming margin lending.
China experimented with margin lending and stock lending at the same time. Margin lending by brokers took off, but opening up stock lending has not, and remains crimped by too many restrictions.
It may seem crazy now to call for more ways for hedge funds to short stocks, but that’s exactly what China should do. Allowing companies or institutional investors lend their stock to borrowers, including hedge funds, creates hedging tools. This is good for liquidity, by creating diverse sets of traders, and important to long-term market development.
At the same time, however, retail margin lending needs to be curbed – but in a responsible way. Margin should be restricted to qualified investors with a certain minimum net worth or market experience. About 83% of the Rmb1.98 trillion margin finance extended for stock market speculation was, as of the end of May, from retail investors, according to Goldman Sachs.
3. Shift returns on equity from issuers to investors.
One reason why the market is so heavily skewed to retail investors is the lack of incentives for potential institutional investors to participate. This week has seen more than 1,400 companies out of the approximately 2,800 listed companies (particularly small, private companies on the Shenzhen bourse) suspend trading.
This is an example of how the rules in China are skewed so that issuers, rather than investors, benefit the most out of stocks. In developed markets, companies remove themselves from trading only in cases in which to allow it to continue would constitute a conflict of interest, as in M&A situations.
Another anti-investor characteristic of the Chinese stock market is the paucity of dividends.
4. Encourage the emergence of domestic institutional investors.
If the government wants to see domestic institutions become long-term anchor investors, it has to give them a reason. Companies in turn are too incentivised by chasing market share rather than seeking profitability. Corporate taxes could be changed to slashed to boost earnings and cashflow, which could then translate into the ability to pay a dividend. Other measures could support share buybacks.
More simply, there needs to be more actual institutional investors in China. This suggests China should inject some urgency into the fostering of enterprise annuities and professionally managed provincial and municipal pension funds, instead of just relying on the National Council for Social Security Fund to manage pension assets.
5. Reinvigorate SOE reform.
Perhaps most importantly, the quality of listed companies should be improved. A healthy stock market is necessary if China is to reform its state-owned enterprises. The government needs to make a real push for getting SOEs to privatise high-quality assets. There has been speculation that it has preferred to rely on measures such as liberalising interest rates to nudge SOEs in the right direction, but Xi Jinping needs to use some of his amassed political power to now force change among entrenched interests among SOEs.