China’s Unwelcome Stock Market Watchdog

By | May 23, 2017

Courtesy of Zuofa Wang

2016 was a wild ride for Chinese equity markets, with many institutional and retail investors suffering significant losses. Ironically, the market’s primary watchdog – the China Securities Regulatory Commission (CSRC) –  was the chief culprit for the market’s gyrations. This wasn’t the first time the CSRC intervened in China’s stock market to unwelcome effect – nor will it be the last. At issue is a market regulator who lacks the relevant expertise and is beholden to the priorities of the Communist Party of China. Needless to say, free and fair financial markets are not one of those priorities.

The Chinese Stock Market: 2016 Year in Review

The figure below highlights the impact that CSRC policy decisions had on China’s main equity market index – the Shanghai Stock Exchange Composite Index (SHCOMP).

The beginning of 2016 saw an influx of new rules and regulations. On January 1st, a new IPO rule went into effect which eliminated the requirement for IPO subscriptions to be paid in advance. The hope was that by releasing investors from this requirement, demand for IPO shares would increase, especially among small investors with limited liquidity. This change in policy may help explain the slight increase in the index at the beginning of the year.

However, this increase was short lived, as the impact of another new regulation came to the fore. Also on January 1st, the CSRC implemented the new index circuit-breaker rule. Under this rule, when the Share Price Index Futures based on 300 stocks from the Shanghai and Shenzhen securities exchanges rise or fall by 5%, the market will suspend trading for 15 minutes; if the index rises or drops 7%, the market will terminate trading for the remainder of the day. The CSRC hoped that the circuit-breaker would maintain market stability, and avoid a repeat of the drastic fluctuations that occurred in the stock market in 2015, which was a source of embarrassment for the Party.

It didn’t take long for the circuit-breaker policy to be put to the test. On January 4th, both the Shanghai and Shenzhen securities markets opened lower, with the Shanghai market continuing to drop precipitously. By 1:13 p.m. the Share Price Index Futures had declined 5%, and the Shanghai Securities Exchange, Shenzhen Securities Exchange and China Financial Futures Exchange (CFFEX, which undertakes stock futures trading) suspended trading for 15 minutes under the circuit-breaker rule. When trading resumed, the Share Price Index Futures continued to drop until it triggered the 7% threshold value, at which time all three exchanges halted trading for the remainder of the day.

Any hoped-for relief was short lived, when on January 7th the circuit-breaker was tripped once again.  By 9:42am, the Share Price Index Futures dropped 5%, and when trading resumed 15 minutes later, it took just three minutes for the 7% threshold to be hit – halting trading for the rest of the day.

Fearing the circuit-breaker was doing more harm than good, the CSRC suspended the circuit-breaker system on Jan 8th. However, the market continued to decline, with the SHCOMP dropping 21% over the next 11 days, bottoming out at 2650 on January 28th. The circuit-breaker system has yet to return.

Market Recovery

The market’s long and slow recovery can be partially attributed to an increase in mergers and acquisitions (M&A), with insurance companies playing a leading role. Under China’s current securities laws, when an acquirer purchases up to 5% of the voting shares of a publicly traded company, it must disclose the acquisition – within three days – to the acquired company, the CSRC, the exchange where the shares are listed, and the public. The acquirer must file new reports whenever it acquires another 5% of outstanding shares. From these disclosures, we know that Chinese insurance companies invested in at least 5% of the outstanding shares of more than 120 listed companies last year.

Not all of the target companies were pleased with their new-found suitors. In the fight against hostile takeovers by insurance companies, the managers of several target companies took full advantage of the political situation in China. Against a backdrop of general anxiety about the economy, especially in the manufacturing sector, they tried to arouse sympathy by characterizing the acquirers as corporate raiders out to destroy entrepreneurs at the expense of the broader economy. For instance, the chairman of the board of Gree Electric Appliances Inc., Ms. Dong Mingzhu, used her political and business influence to make a well-publicized speech in the official central media to condemn a potential acquirer, the insurance company Qian Hai Life Insurance Co. Ltd, and appealed to the Party for help in cracking down on hostile acquisitions.

The Chairman of the CSRC Speaks

In December 2016, as the Chinese equity market was approaching pre-circuit-breaker levels, newly installed CSRC chairman Liu Shiyu dealt another blow to the market. Speaking at a conference, he condemned the insurance company acquirers as Yao Jing (evil spirits), Hai Ren Jing (pests), and Barbarians, all extremely harsh insults in Chinese culture. He warned that if those companies active in acquisition transactions did not behave themselves, they would face severe legal punishment.

Liu’s open condemnation had two effects. First, it scared insurance companies enough to halt their shopping spree. As a case in point, the previously mentioned insurance company, Qian Hai Life – which had recently acquired 4.13% of Gree Electric –  bowed to the pressure and announced that it did not intend to control the target company, it would stop acquiring additional shares, and it would sell the shares in proper time. Second, Liu’s comments led many retail investors to dump shares out of fears that the CSRC could force insurance companies to reduce their holdings. This selling pressure sent the SHCOMP from 3260 points on December 2nd to 3103 points on December 30th.  It wasn’t just retail investors who suffered, some institutional investors suffered losses too. In his annual letter to investors, Liu Yewei, the president of Time Capital, a stock investment company, complained that the company had been struggling for almost a year to climb out of the pit caused by the circuit-breaker rule and that Liu Shiyu’s remarks pushed the company back into the red.

The CSRC’s History of Market Interference

Last year was not an anomaly for the CSRC – they have a rich history of blunderous interference in Chinese financial markets ever since the Shenzhen and Shanghai stock exchanges opened in 1990. But why is this? I believe there are two root causes. First, a lack of financial markets expertise within the CSRC leadership ranks, and second, improper Party influence.

The CSRC, like other government agencies, falls under the control of the Chinese Communist Party. The chairman of the CSRC is appointed by the Party, and the Party traditionally values loyalty over technical expertise. The three previous CSRC chairmen came from banking backgrounds and had little knowledge or experience in securities regulation.

Even if the CSRC’s leadership had the requisite expertise, they would be unable to exercise independent judgment. Rather, decisions would be made – as they are now –  in accordance with the Party’s wishes and priorities.

The CSRC’s lack of independence and expertise is perfectly highlighted by their attempts to assist the Central Party in their efforts to modernize state-owned enterprises (SOEs) through the pursuit of ‘mixed ownership reform’ in 2015. The CSRC, thinking that the reform effort would be more likely to succeed in a bull market, put forward a rule to allow for more margin trading in securities markets. On cue, securities companies began relaxing client margin requirements while new private companies sprang up overnight to provide margin financing to willing investors. The impact of these changes was immediate.  Between July 15, 2014 and June 30, 2015, the SHCOMP rose from 2042 points to 5200 points, while the market capitalization of China’s equities market increased from 28,000 billion to 78,000 billion Renminbi (RMB), making it the second largest equity market in the world.

The sharp rise in equity prices led to concerns among Party leadership that the equity market had become overheated and unstable. The CSRC responded by reversing their previous policy on margin trading and cracking down on private companies providing margin financing. Startled traders scrambled to sell their positions and some investors were forced to close their margin positions. Index futures traders attempted to capitalize on the selling pressure by going short. The net result of these actions was a steep market pullback, with the SHCOMP losing nearly a third of its value in one week.

The above examples highlight the difficulty associated with applying a central planning model to something as fickle as the stock market – in attempting to solve one problem, you create even more. For instance, the circuit-breaker rule, which was intended to bring stability to the market, increased volatility by incentivizing traders to either buy or sell before the circuit was tripped and trading ceased for the day. Not knowing what the next day would hold, traders faced another incentive to exit their positions immediately upon the market’s open the following day, thereby increasing the likelihood the circuit-breaker would be tripped yet again.

The CSRC Going Forward

Unfortunately, it doesn’t look like the CSRC has learned any lessons from their previous mistakes. Even if they had, the organization is still subject to the whims of Party leadership, which can change at a moment’s notice. Take for instance the IPO process, which was suspended for four months in 2015 in order to preserve liquidity in the market. Upon reopening the IPO market, the CSRC vowed to move towards a “registration-based” system, which is similar to the U.S. IPO system, and away from an approval-based system where the CSRC, and by extension the Party, signed off on each new IPO. However, these reforms never got off the ground due to concerns around market stability, and this past February, CSRC chairman Liu Shiyu made it clear that a “registration-based” system was not forthcoming. Liu’s comments came right before the National People’s Congress, and it’s likely he didn’t want to rock the boat too much ahead of significant leadership changes.

More recent evidence of political interference in China’s securities market was provided in the Wall Street Journal two weeks ago. The paper reported that Chinese brokerages and investment funds received informal guidance from regulators telling them “not to process large orders to sell stock.” The assumed reason for the guidance was to prevent any kind of embarrassing market decline ahead of Chinese President Xi Jinping’s One Belt, One Road economic summit.

China’s Stock Market is Still Attractive

Despite the CSRC’s unwelcome interference, China’s financial markets remain a viable source of funding for Chinese companies and an attractive investment for global investors. Speaking at the World Economic Forum in Davos this past January, Fang Xinghai, the vice-chairman of the CSRC, indicated that there are still over 600 companies waiting to go public in China,  and that the total amount raised in Chinese equity markets last year  was 1,500 billion RMB.  As remarkable as these numbers are, one wonders what China’s securities markets would be like without the heavy-handed interventions of the CSRC and other government agencies. Unfortunately, it doesn’t look like we’ll find out anytime soon.

Zuofa Wang is a visiting scholar at Duke University School of Law and a researcher at China University of Political Science and Law, focusing on corporate bankruptcy and securities law.

 

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