Economy's Rapid Growth Gets Stimulus as Markets Bounce Back
By JAMES T. AREDDY
December 15, 2006

[Photo: sohu.com]

SHANGHAI, China -- With its benchmark index having reached a record, China's stock market is finally reflecting the broader strides of the world's fourth-largest economy -- and starting to contribute meaningfully to its rapid growth.

The Shanghai Composite Index Thursday added 1.2%, or 25.65 points, to finish at 2249.11, topping the previous high of 2242.42, reached in June 2001. In 18 months, Shanghai's benchmark stock index has more than regained the ground it lost during a four-year slump that erased half its value and soured China's individual investors on stocks. As recently as July 2005 the index dipped below 1000, a level it hadn't seen since 1997. But this year, China's Shanghai and Shenzhen exchanges are the best performing major markets in the world, pushing total capitalization of the two to just shy of $1 trillion.

Once seemingly irrelevant to China's economy, the market is becoming the important tool that it is in more-developed countries. Chinese companies will have raised a record 20% of their funding from stocks and bonds this year, whereas a few years ago they obtained nearly all financing from banks, according to Stephen Green, a Shanghai-based economist at Standard Chartered PLC.

Foreign investors' direct participation in this year's rally has been almost nonexistent. Individual foreign investors are barred from trading most Chinese stocks, limited instead to a tiny, specialized class of so-called B-shares not representative of market trends. No foreign entity has a brokerage license in China, and while foreign institutional investors have been allowed to buy Chinese stocks in recent years, the quota allotted them, currently about $10 billion, is about 1% of market capitalization. U.S. Treasury Secretary Henry Paulson, who is heading a cabinet delegation that Thursday began high-profile economic talks with Chinese officials, has said he wants Beijing to further open its capital markets to foreign participation.

Foreigners do have exposure to Chinese companies in other ways, however. Many of the biggest listed companies also list shares on markets in Hong Kong and New York. Those stocks include several of China's banks, which now represent a third of Shanghai's market capitalization and have helped drive this year's gains. And, while foreign companies don't operate brokerages here, they do run many of China's fund-management companies. Products that mirror the moves of Chinese stocks are traded elsewhere overseas.

Individual Chinese investors, meanwhile, have returned to the market this year with gusto, helping drive the Shanghai Composite Index up 94% so far in 2006. The Dow Jones China 88 Index finished Thursday at 167.49, a 52-week high, though below the 1997 record of 203.95.

Encouraging the remarkable turnaround have been government policy changes that began amid the market's doldrums early last year. Aiming to shore up investor confidence, Beijing ordered all 1,400 listed companies to restructure their share capital to enhance shareholder value. It adopted international accounting rules and tightened controls to avoid brokers from stealing client money. It even pumped cash into ailing brokerages with orders to buy stocks. This year, the government also began selecting banks and other big-name companies to list at home, adding blue-chip stocks to markets that had few of them.

The current sizzle reminds some analysts of the market's casino-like early days. "It would be absolutely foolish to think that all the problems in the market have been removed," says Fraser Howie, co-author of a book on the market.

But analysts say the improvements have made the market more stable than it once was. In the first three years after stock trading began in China in 1990, the Shanghai index jumped by a factor of six, a rally so intense that riots broke out among those hoping to get in on initial public offerings. Throughout that decade, stock manipulation and other scandals became commonplace, exacerbating huge swings in stock prices. Then, in 2001, investors became unnerved by high stock valuations and the market's foundations crumbled.

The collapse, which started months after the technology bubble popped in the U.S., triggered widespread anger in China. Distraught individual investors urged the market's regulator to stop waffling on overhauls they felt were needed to right the market. Protests outside the agency's offices became routine. In January 2005, a troubled investor lit himself on fire there as a protest.

Two months later, Premier Wen Jiabao told a nationally televised conference that fixing the stock market was a government priority. He referred to a survey that said Chinese people considered rescuing the market more important than stamping out corruption.

Then, in May last year, regulators announced a plan to tackle the market's thorniest issue. From the birth of China's stock markets, two-thirds of the equity in listed Chinese companies was held as special state shares that couldn't be traded. This limitation, a vestige of the Chinese economy's centrally planned past, allowed companies to ignore the interests of minority shareholder. The new policy was meant to force big shareholders, including government entities, to hand over a portion of their stock to smaller investors in exchange for the right to make all the equity tradable.

It was a gutsy move because the 2001 market fall was triggered by an effort to address the so-called state-share overhang. To head off another plunge, companies adopted lock-up periods that made it difficult to dump the newly tradable shares onto the market. To date, more than 90% of listed companies have made all their shares tradable.

The move worked, bringing average Chinese back to stocks in droves. "Euphoria can't even begin to describe what is taking place these days," Z-Ben Advisors Ltd., a Shanghai market-research firm, said in a report this week. China's mutual funds have raised more than $18 billion so far in the fourth quarter, according to Z-Ben. Individuals have opened 3.3 million trading accounts this year, and according to the central bank, they have even begun using once-sacred bank savings deposits to park money in stocks. Daily trading value in Shanghai has tripled this year to $2.63 billion.

Potholes remain. Stocks are getting expensive in Shanghai, according to the average price/earnings ratio. It is about 23 times in Shanghai, compared with 15 in Hong Kong. And despite the share overhauls, more than half of the stock market remains in the hands of government entities and big investors. Moreover, this year's rally is disproportionately driven by big stocks, with 70% of issues lagging behind the benchmark index.

Still, investors remain bullish, even if some aren't sure why the market is up. "It's been falling for years," says 65-year-old Shanghai investor Gu Min. "The stocks I have bought in the past two or three years have doubled. I won't sell -- I'm optimistic."

--Tang Hanting and Helena Yu contributed to this article.

Write to James T. Areddy at james.areddy@wsj.com