Stock Exchanges and Market Inefficiencies in China
Since the inception of China’s domestic stock exchanges, the SHSE and SZSE, in 1990, they have been growing very fast. At the end of 2005, HKSE was ranked 8th among the largest stock exchanges in the world, with the total capitalization reaching roughly half of GDP. Despite the fast growth of the markets, however, their efficiency still leaves much to be desired. The inefficiencies from the political decisions of protectionism, poor regulation and intermediation, result in problems of adverse selection among firms seeking an initial public offering (IPO), and a moral hazard problem among already listed firms.
Firstly, even though there has never been any explicit regulation or law against the listing of non-state owned firms, the going public process strongly favors former SOEs with connections with government officials. For example, each candidate firm must obtain listing quota/permission, disclose financial and accounting information, and is subject to a lengthy evaluation process; the whole process is inefficient due to bureaucracy, fraudulent disclosure, and lack of independent auditing. As a result, most of the listed firms are indeed former SOEs. Secondly, once listed, managers in firms with severe agency problems do not have an incentive to manage assets to grow, but rather to rely on the external capital market to raise funds (mainly through mergers and acquisitions, and seasoned offerings of securities) to pursue private benefits. These problems can nicely be seen in the following case study.
First, the IPO experience of Hongguang Industrial Co., Ltd., with its headquarters in Chengdu (capital city of Sichuan Province), illustrates the inefficiency of the listing process. With an IPO price of RMB 6.05 (on the SHSE), Hongguang raised RMB 410 million in June 1996. In its prospectus, the company claimed that it had made profits in each of the three years prior to the IPO year, its financial statements were audited by a Chinese CPA firm, and its forecasted 1997 net income (RMB 71 million) and EPS (31 fen; equivalent to 31 cents) were in line with the disclosed figures for pre-IPO years. Within one year of its public listing, the company announced that it incurred a net loss of RMB 198 million and EPS of negative 86 fen. A CSRC investigation revealed that in order to meet the criteria for an IPO, the company had not only forged its profit records for all three years prior to the IPO year, but also failed to disclose that its major production facility was so outdated that it could not maintain normal operations. The company used more than 80% of its IPO proceeds to pay off its debt, in contrast to the stated purposes in the prospectus, and it actually under reported the amount of losses in 1997 by 15%. How did such a company obtain the precious IPO quota in 1996? The municipal government of Chengdu championed the company’s IPO application by stating that “… this high-tech enterprise will become one of the 100 modern enterprises of China…” In reality, the listing of this financially distressed former SOE shifted the burden from the government to the investing public.
Second, following the scandal of Guangxia described above, Sanjiu Medical & Pharmaceutical Co., Ltd (hereafter the Company), another SZSE listed company, was the target of a CSRC investigation in 2001. The Company belongs to the Sanjiu Group (hereafter the Group), the largest domestic pharmaceutical group in China, founded by Mr. Xinxian Zhao in 1985. Since then, Mr. Zhao pursued an aggressive expansion policy through acquisitions financed by bank debt, but many acquired companies performed poorly and the Group’s high leverage ratio significantly constrained its ability to receive more loans and further expand. The solution was the IPO/listing of the Sanjiu Company in 1999 (a major subsidiary of the Group), which raised RMB 1.69 billion (around US$200 million). During the first year after its IPO, the Company paid RMB 360 million to its parent (the Group) to cover acquisitions of six companies, and this practice continued in the following two years. Essentially, the listed Company became the ‘cash cow’ for the struggling yet still expanding parent. By May 2001, the Group and associated companies had ‘tunneled’ more than RMB 2.5 billion from the Company, which accounted for 96% of the Company’s net assets, yet the Group was still in financial trouble with high debt ratios and low return on assets. The joint financial status of the Group and Company triggered lawsuits by banks, forcing repayment of loans immediately. How can such ostensible expropriation of the Company’s shareholders’ wealth take place? Because the Group, through direct and indirect ownership, owns 73% of the Company’s stock, while Mr. Zhao was the President of the Group and Chairman of the Board of Directors of the Company.
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