By Maria Trombly | Securities Industry News | May 9, 2005

The Chinese government has formally announced a plan to begin selling off state-owned shares, which today make up two-thirds of all outstanding equities.

The announcement was made last week by the China Securities Regulatory Commission (CSRC), just ahead of the week-long May holidays, making it difficult to gauge the market's reaction by press time.

The split-share system, which divides shares into government-held and privately held shares, is widely regarded to be a major stumbling block to corporate reforms, since company managers have an incentive to satisfy the politicians who appointed them instead of acting independently in the best interests of shareholders. Today, only five public companies have no non-tradable shares.

Some observers worry, however, that this latest announcement is lacking in detail, which may signal that the plan will be abandoned, as were the two previous attempts at divestment.

Looking to the Future

An unidentified CSRC deputy chairman was quoted by Xinhua, the official government news agency, as saying that the current split-share system hurts the stock market.

"It is the biggest headache holding back the development of the Chinese market," he told the agency. "We should spare no efforts to solve it."

The Chinese stock market is currently at a six-year low.

"The key reason for the long-standing sluggish market lies in that there aren't decent companies to invest in," says Ming Huang, a finance professor at Stanford Business School who is currently a visiting professor at Beijing's Cheung Kong Graduate School of Management. This includes both domestic and international investors, he says.

"Foreign investors won't invest in a market consisting of companies with serious corporate governance problems," says Huang. The only thing that can help, he says, is a radical change in the corporate governance structure, which will create more good companies for investors to put their money in. "The announcement is just a first step," he says. "It begins the process of revolution in the securities market."

The CSRC announcement lays out a set of guidelines for government entities that want to sell off their heretofore non-tradable shares. According to the announcement, the conversion process can begin a year from now.

Repressed Urge to Merge

The split-share structure has also hindered M&A activity. Although some firms--including foreign investors like George Soros--have been able to acquire non-tradable shares through private deals with government ministries, it can be very difficult to buy a controlling stake in a company. And even if non-tradable shares can be bought, it is almost impossible for the buyer to sell them again later.

Fraser Howie, co-author of Privatizing China: The Stock Markets and Their Role in Corporate Reform, told Securities Industry News that foreign investors who buy non-tradable shares often have to pay a significant premium over the market price.

"Although there's M&A activity at present, it isn't market-driven and usually involves a series of behind-the-scenes deals," he says. "After the sell-off of non-tradable shares, M&A will become much easier."

John Fan, a manager at the Perfect Futures & Securities Brokerage in Shanghai, agrees, and thinks the conversion of non-tradable shares to publicly tradable shares will enable the market to start rising right away.

Over the past three years, the market has fallen, despite average annual economic growth rates approaching 10 percent. The average Chinese retail investor has lost 10,000 yuan ($1,200) over this time period, says Fan--a very large sum by local standards.

"After the implementation of the sell-off," says Fan, "the stock price will probably slump due to the dilution effect." As the governance of listed companies gradually improves, however, he expects that they will rebound and increase steadily in the long run.

A Thousand Li To Go

After the implementation of the sell-off, the stock price will probably slump due to the dilution effect. As the governance of listed companies gradually improves, they should rebound.

The conversion process won't begin immediately and, once it does, there are plenty of obstacles along the way. For one thing, the CSRC has said that trading in stocks undergoing conversion will be temporary halted during the conversion process. And even after state-owned shares become tradable, there will be strict limits on when and how many can be sold onto the open market. For instance, once conversion is complete, holders will be prohibited from selling for 12 months.

The up side of this is that it gives investors an opportunity to adjust to the sell-off and lets companies--and the government--organize an orderly transition.

There are additional restrictions on major shareholders, defined as those who hold more than 5 percent of a company's shares. Once the one-year waiting period is over, they can only sell 5 percent of outstanding shares the first year, and another 5 percent the second year

But the most significant threat to the progress of the conversion process is a requirement for two-thirds shareholder approval, says Thomas Liu, professor of finance at Shanghai's Jiao Tong University.

Many retail investors in China are very passive and inexperienced, says Liu. If the government demands that a certain percentage of shareholders participate in the vote, decision-making power could shift back into the hands of a select few.

"Some people are uneducated and lack investment knowledge," Liu says. "And some people are just fed up and prefer to close their eyes to the bear market. Others prefer free-riding because they think the stock isn't valuable enough to be worth doing research on."

Liu believes institutional shareholders and large shareholders of the company could take advantage of this passivity and manipulate prices with ease. The social unrest that might follow revelations of manipulation could derail the entire process, Liu says.

This is the third time the government has announced a plan to sell off government-owned shares, Howie notes, adding that both of the previous attempts were scrapped within six months. This new effort may fare no better. Howie is one of those who see the CSRC announcement as suspiciously brief and vague. For example, it contains no information about how, or even whether, shareholders will be compensated for share dilution.

"This is lacking a lot of detail," Howie says. "It's all extremely unclear." As a result, he says, foreign investors are taking a "wait and see" approach to the latest announcement.

Fan, for one, is more optimistic. China's entry into the World Trade Organization requires that markets be opened by 2008, by which time a whole portfolio of market reforms must be in place. Foreign companies--including financial firms--will be able to enter China and compete on an equal basis. Firms that aren't responsive to the markets will be at a significant competitive disadvantage.

"[For China] to be a real market economy, those state-owned shares must be turned into market assets," Fan said. For that reason, he believes it's unlikely that the government will completely reverse course again.

Fan expects the market to rebound positively in the short term as investors start thinking about the potential upside to reform. A slowdown will mark the years of conversion, then the market will rebound, and investors will finally be able to benefit from China's economic growth.

Wendy Yu contributed to this report.