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Capital markets
Risky returns
China is struggling to unleash the power of stocks and bonds
May 7th 2016 | From the print edition
JUST BEYOND CHARLIE CHEN’S perch, Shanghai looks every inch the global financial centre it aspires to be. Skyscrapers shimmer in the spring light, capped by the names of some of the world’s biggest banks and insurers. On the pavement below, smartly dressed workers scurry from the crowded rush-hour subway to their offices in Lujiazui, the city’s financial district. The small team at MegaTrust Investments, Mr Chen’s firm, quietly taps away at computer terminals, reviewing overnight price movements and building trading models.
But anyone with a passing interest in business news will know that for all of Shanghai’s glistening modernity, its markets are still in their infancy. They are beset by corruption, price manipulation, insider information, government intervention and a mob-mentality trading style, all of which makes their counterparts in New York, London and Hong Kong, volatile as they are, look like paragons of orderly behaviour. “We like that the market can be so irrational. Otherwise it would be more efficient and we wouldn’t be able to beat it,” says Mr Chen. His flagship fund has averaged a tidy 45.5% net annual return over the past three years.
From a narrow perspective, it is easy to shrug off the dysfunctions of China’s markets. They are largely sideshows to the real economy. Investors have limited exposure to them and companies obtain relatively little funding from that source. Banks are the beating heart of the financial system.
But for China to develop properly, it must get its capital markets right. With a thriving stockmarket, companies could fund themselves with more equity, not just debt. A healthy bond market would take pressure off overburdened banks. Just as significant, transparent markets are needed to help investors price capital properly and press companies to improve their governance.
China’s stockmarket is often likened to a casino. Wu Jinglian, a respected local economist, once quipped that this comparison was unfair to casinos: at least they have rules. The propensity for wild swings and lawlessness has been on full display over the past year. Blue-chip stocks more than doubled in an orgy of debt-fuelled buying before crashing, landing not far from where they started. Officials panicked, ordering big shareholders to refrain from selling, pumping money into the market and drafting state-owned brokerages and banks into a “national team” to buy shares. They also detained dozens of investors, bankers and regulators in investigations of the market mayhem; at least two others committed suicide before the authorities could get to them.
Less in the global eye but potentially more dangerous, the Chinese bond market is growing explosively. Bond issuance last year reached 12.5 trillion yuan, up from 7.7 trillion in 2014. Despite the huge volume of offerings, spreads between yields on AAA-rated corporate bonds and government bonds fell to historic lows of less than 0.4 percentage points this January. A narrowing of spreads implies that investors see less risk of default in bonds, a prognosis which is hard to square with the slowing economy. Spreads have at least widened a bit lately, but yields for any company believed to have government backing, whether public or private, are still uncannily low.
Part of the reason for the bond rally is familiar from the stock bubble: leverage. In the case of bonds, investors have used repurchase agreements to multiply their investments (buying a bond with their own funds, then borrowing against that bond to buy yet more). Credit-rating agencies, which did not exactly cover themselves in glory in the lead-up to the 2008 financial crisis, are far weaker in China. Regulators have yet to accredit the big global agencies (Moody’s, S&P and Fitch) to provide ratings for onshore bonds. Instead, these are rated by domestic agencies, whose judgment has been highly dubious. In spite of falling profits and soaring debt loads, they upgraded ratings on 656 bonds last year and downgraded only 126.
Analysts typically point to the heavy presence of retail investors as an explanation for the madness of China’s markets, suggesting that more professional investors would bring greater stability and sanity. It is true that small-time investors are the dominant force in the stockmarket, accounting for roughly 80% of trading volume. Yet a larger share of professionals by itself is unlikely to be the solution. Institutional investors in China are not seasoned veterans. “I don’t know a single bond trader with more than five years of experience,” jokes one in his late 20s, exaggerating only slightly.
Moreover, many of the biggest investors play by the same rules as the smaller punters. The arrest last November of Xu Xiang, head of Zexi Investment, provided a rare glimpse of one of the masters of the game. Mr Xu was a leading member of the zhangting gansidui (go-for-max kamikaze squad): investors who pump up stocks, lure in unsuspecting money and then sell out after a few of days of gains. He had managed an eye-watering 3,200% return since 2009. But his outsized gains last summer even when the market crashed proved too much for the authorities: police charged him with insider trading and price manipulation. Even so, many would-be Zexis are waiting in the wings. When the regulators last year made it easier for fund managers to set up, some 20,000 of them registered for business, a fourfold rise in a year.
Voices of reason
Amid all the neophytes and kamikazes, there is an emerging class of investors with ample experience in global markets that is now plying its trade in China. Charlie Chen, like many in the industry, spent years working for foreign fund houses before founding MegaTrust, which now manages about $400m in assets. His seven analysts each meet about 200 companies a year. They sift through shareholding structures to work out who really controls them, a bottom-up approach to research that is rare in China. Shen Yi, a former trader with Goldman Sachs, is part of a cohort that has started to apply quantitative trading strategies to the domestic market, which is rife with the kinds of inefficiencies that are fertile ground for quants.
The bond market is also attracting serious players. Edmund Ng, formerly the Hong Kong Monetary Authority’s head of direct investment, last year launched a firm, Eastfort Asset Management, to trade Chinese bonds. The recent opening of the interbank bond market (the main bond market) to foreign institutional investors will bring in even more serious money over time.
The government is also looking to insurance firms to play a bigger role. By their nature, these are long-term, patient investors, just the kind that China lacks. Regulators have steadily loosened constraints on insurers, letting them lift their exposure to equities to 30% (the current industry average is 15%). With more aggressive marketing they have more than doubled their assets under management over the past five years, to nearly 13 trillion yuan.
The infrastructure around these firms is improving. Wind Information, a data provider, is trying to turn itself into the Bloomberg of China. Both Bloomberg and Reuters themselves have dramatically increased their Chinese-language offerings. Suntime tracks the returns of thousands of private fund managers. Sycamore Investment Services provides valuations of hard-to-price securities traded off exchanges. Small advances have been made even in the legal arena. Courts in big cities are getting better at handling disputes over investments that go wrong. “Previously, court personnel might not have even understood what arbitration was for,” says Violet Ho of Kroll, a consultancy.
Still, it would be naive to expect Chinese markets to mature of their own accord without major reforms. After all, foreign investment banks from UBS to Goldman Sachs have been underwriting stocks and bonds in China for the better part of a decade, but have had limited influence on the behaviour of their onshore peers. Investment quotas for large global institutions have also had little effect. And some of China’s insurers, the big domestic institutional hope, more resemble risk-taking shadow banks than prudent investors. They have been selling short-term investment products, offering returns in excess of 6%, and piling heavily into stocks. In one prominent case last year, Baoneng, until then almost unknown, used heavy leverage to fund a 30 billion yuan purchase of shares in Vanke, a property developer.
The rules of engagement in China’s markets need to change. These are some of the commonly heard suggestions: the government should stop micromanaging the timing and pricing of initial public offerings; clear the way for investors to short individual shares; make it easier for private companies to issue bonds; develop credible rating agencies; draft an effective bankruptcy law; and attract more experienced professionals into regulatory agencies. But at the root of all of these, and indeed underpinning a great many of the dysfunctions in China’s financial system, is something that is not easily changed: a belief that, when all else fails, the state will always be there to rescue investors from their mistakes.
From the print edition: Special report
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