China’s stock market began a historic rise to prominance when the Shanghai Stock Exchange opened in 1990, followed by Shenzhen a year later. These initiatives opened a brand new channel for Chinese companies and people to create and manage their wealth.

In 1990, the Shanghai stock exchange started formal operations with 45,000 registered investors and 30 listed stocks. On the first day of trading, the Shanghai Composite Index opened at 96 points. After being in operation for 18 years, China's stock market has grown significantly. In December 2007, the Shanghai Stock Exchange ended with over 71.30 million investors and 860 listed companies. China's stock market has witnessed extreme volitility in past years. In 1991, China welcomed its first bull market, seeing the Shanghai Composite Index up 100 points within 10 months. May 19th, 1999 was a spectacular day. It began a new round of bull run. The Shanghai Composite Index climbed to a historic high of 2245 points in 2001. From 2001 to 2005, the stock market slumped and Shanghai's market value halved after the Index had reached its peak in 2001. In October, 2007, the Shanghai Composite Index climbed to a record high of 6,124 points but within a year fell sharply to around 1,700. What is the reason behind such huge volitility? How should we encourage innovation in the securities market?

To discuss these issues, we caught up with Fang Xinghai, Director of the Shanghai Financial Services Office.

Fang Xinghai has served as former Deputy CEO of the Shanghai Stock Exchange from 2001 to 2005. After graduating from Stanford University in 1993 with a PhD in Economics, Fang Xinghai was recruited by the World Bank's Young Professionals Programme to work at its Washington headquarters. He returned to China in 1998 and took a job with China’s Construction Bank. He is now the Director of the Shanghai Financial Services Office.

Q: Dr. Fang, welcome to the main talk.

F: Good to be here.

Q: We know the Shanghai and Shenzhen stock exchanges were both be set up in 1990. Why is that? What’s so special about that time?

F: It was right after the incidents in the Tiananmen Square and there was, I believe, a need to speed up the reform process, and setting up these exchanges is a very good measure, in terms of speeding up the reform process.

Q: And that’s why they decided to open these two exchanges (F: I believe so.) Over the past years, we’ve seen turbulence in both markets. So, what day or what time period was most impressive to you, in terms of the market turbulence?

F: End of last year was very impressive; the market shot up to more than 6000 point, and it began to decline. Boom and bust is a enduring feature in the Chinese stock market. And the reason for that was that we have so many investors, and they did not have alternative investment opportunities in the Chinese market. So, when the market went up, millions of people piled in, and then, the market went to an unsustainably high position. Any bubble has to deflate. So, after it deflated, everybody run away, and then we have a big bust. And so now we are in a big bust.

Q: Boom and bust, this is an enduring nature at the Chinese market. Are you saying this is something unique for China, or are you saying that any other mature market has not experienced such turbulance?

F: Usually a unique feature of all these emerging markets, most of these emerging markets are like that. But, the Chinese market has been more like that than some other emerging markets.

Q: What is the fundamental reason?

F: The reason is that we have so many individual investors; no other emerge markets have so many individual investors, and they are not very well-trained investors. So, they rush in to catch up the rising trend. In the beginning, everybody makes money, and money draws more money in, and then the market goes to a  too high a level, and then, when it is begins to deflate, then everybody run away, and then it goes to usually a  too low level. That’s the fundamental reason behind this votalitity in the Chinese market.

Q: As a insider of the market and form a regulator point of view, how would you define the development stages of the Chinese stock market from the very beginning to now?

F: Before 2001, I would consider that period as a period of initial stage; the market certainly became bigger along with the Chinese economy.  But, it was very immature, and there is a lot of Chinese characteristics in this market. For example, more than 80 % of the stocks were classified as nontradable stocks.

Q: What was the orignial reason for such a policy that 80% is nontradable?

F: It was because most of these listed companies were state-owned, and there was a concern that if every stock is tradable, then over the time, the state owned share would be diluted. So, they classified most of these state-owned shares as nontradable. But that caused other problems which was not anticipated at the beginning. And after these other problems manifested, people realized that that was not a very good design, so after 2001, we began to solve this problem. And it took around 5 years to solve that problem. Actually I predict that after current the stock bearish the market continues for sometimes we will be entering to the second faze of resolving some of these fundamental problems of the stock market and that is will be introduce more instruments for the institutional investors to use, such as stock index futures and short selling and so forth, and that will give a big boost to the institutional investors, and they will influence in the price of the stock market.

In 2002, China officially launched the Qualified Foreign Institutional Investor (QFII) program that allowed foreign investors to buy yuan-denominated shares and bonds. This year, China has expanded its QFII quota to $30 billion from $10 billion back in December 2007.

Q: Do you think the QFII program is just a token of good will?

F: QFII, so, it was not just a token, gesture of good will. It was important to the Chinese stock market's development. But, QFII was too little; it was simple overwhelmed by the millions, the hundreads of millions of Chinese individual investors. But, once stock index and other products are introduced, and once institutional investors have more tools to play, thenQFII will become, again, more important.

Q: You also mentioned, you know, you actually defined the first stage is first ten years after the establishment of the stock market, and the second stage is from 2001 to 2006. What happened in 2007 and now 2008?

F: The market was very healthy until the end of 2006, but 2007 was such an interesting watershed year for the Chinese stock market because nobody anticipated so many individual investors would rush into the market.  Everybody knew it was a huge bubble, but nobody could stop it.

Q: They jumped in…

F: The government tried, and remember in May last year, the government introduced a tripling of the stamp duty tax on stock trading, but even that tripling did not prevent the bubble from becoming bigger. But bubbles, of couse, finally deflate, just by themselves. It began to deflate in the middle of October, and unfortunately, the economy also began to slow down after that time, and so, earnings become more sort of vague, murkey.

Q: Had a lot of external factors....

F: So everything kind of ….. Disaster always happen like that way. A lot of bad things come together. And once the market began to decline, then all the investors began to flee. But still remember today’s market is much heather than 5 years ago. When a lot of nontradable share were still around. How do I define healthier?  For example, last time when it declined from 2245 to the lowest point of around 1000, in early 2005, it took almost 4 years to do so. And this time, it only took us like 6 months or 7 months, which means the market is more efficient. It takes much less time to adjust, and its efficiency is caused by a lot of institutional investors that are now setting the price, generally, for small investors. So, they began to lead the market, and now they are setting the tone for the market. So that’s very healthy.

Q: Talking about institutional investors, I want come back to the QFII program. You said the number of institutional investors or the scale of their investment is still relatively small compared to the vast majority of the individual investors that exist in the China’s market. But, with the government expanding its QFII quota, is it likely to whether the fluctuations in the market, with the approval of additional QFII quotas?

F: The quota right now...the total quota is $30 billion USD. But that's still very, very small compared to the market capitalization of the A share market. So, QFII investors, they will continues to play some sort of a trend leading, role but they are not going to be the most important investors in the Asian market. Because they are...their size is still too small.

New elements

In 2007, the aggregated market capitalization of 1,530 companies listed on two bourses amounted to 32.71 trillion yuan. Some predict that there will be a green light from the central government to allow red chips in Hong Kong to return to the mainland for the first time. In addition, the China Securities Regulatory Commission has been actively preparing to launch trade in stock index futures, but has no concrete timetable for doing so.

Q: From the perspective of  regulator, and an insider, how would you prioritize the following things to be done: first, the launch of stock index features, second, the return of red chip companies, third, the establishment of domestic growth enterprise board, and forth, the merge of the A share and B share markets?

F: Given the market condition, I would think the return of red chips would be the first thing we can accomplish. Stock index features would be the second think to take... to launch. The small enterprise board, perhaps, is the third thing we can do. The merging of A and B shares is, perhaps, the last thing we can do, which, incidentally, is also the least important thing.

Q: Why would you say the return of red chip is most likely to achieve in the first place?

F: That's what the investors want. They need to invest their money to good companies and most of these red chip companies are quite good.

Q: What do you think has been the impediment before these red-chips on their way back to the mainland markets?

F: Well it's a...there's a timing issue and a regulatory issue, because it's red-chip companies registered in Hong Kong. So, they come back to mainland, you have to coordinate between the Hong Kong regulators and the mainland regulators, and that takes some time. And then was this issue of when is the best time for the red chips to come in, which I think it was a phony question, becasuse it can come in at any time, and it's always good for the domestic market. But, some people still have this notion that when the market is declining, then you should not let IPOs come out. This is just not healthy thinking.

Q: That's just another false argument in your mind.

F: I think it's totally false, you know.

Q: What about the stocks index and futures? Keep talking about this…

F: This is certainly hugely important product and…

Q: You've been talking about this for many times.

F: I think we missed some opportunity for this product to be launched.

Q: For example?

F: I think, early last year, when the market is rising from 2500, the early part last year, that was a perfect opportunity for stock index product to be launched, but there was some fear, at that time, that if you launch such a big product, it could stunt a rising market, which would cause the red among small investors. So, that was delayed. And then later, when the market reached such a very high level, again, there was a fear that if you launch this product, it could prick this bubble.  In retrospect, even if you have launched that product in the early part of last year, the market would still have reached a very high level, although not as high as it reached

Q: 6000

F: But would still reach a very high level because all these small investors would continue to come in.

China hopes to open its long-awaited growth enterprise board for domestic stocks, which will support the development of small- and medium-sized enterprises. Lack of finance has been a problem for those enterprises. Less than 2 percent of  SMEs access funds directly from the financial market.

F: My personal view is that that small enterprise board should have been launched a long time ago, we're already late. And again, the fear is that if we launch this board, it could further depress, you know, the main board, because some people believe the money would be siphoned off to that market. That's ok, I mean money has to flow where they can make money.

Q: We've seen a lot of Chinese companies getting listed overseas in New York or London or Hong Kong in recent years, and they, well, some of them have performed well, but they all promise rapid growth. So, once we have this growth enterprise board established, here, in the Chinese mainland, do you think these companies are likely to come back?

F: After we launch our small enterprise board, then certainly they are qualified for listing, but they may still go abroad for valuation reasons, that investors in overseas market can recognize their values better. But, that is a gap that, I believe, can be overcome quite soon, because investors here can learn how to value a company that has not made a profit yet, you know, quite quickly. So, I am not worry about that point.

Investment Risk Control

Fang Xinghai has been working in financial services for 18 years. In the face of the global economic crisis, he said recently that although many foreign financial institutions have been seriously hurt by the crisis, Chinese financial institutions can still learn from best practices, such as superior operation management, financial innovation, and risk-control experience.

Q: You have a solid academic background and also professional experience in finance and economics; so, how would you describe yourself as an investor? I mean are you a risk-taker or are you risk-averse?

F:  I guess I am someone that will take some risk. I think the Chinese economy will continue to grow, and in a growing, emerging market, the best class of asset is equity or real estate, equity and real estate, but you have to hold it for some time. And if you look back in the history of the Chinese investment market, I think anyone who has purchased an apartment 10 years ago in Shanghai or Beijing would have made some money; anyone who has purchased A share, let's say 10 years ago, which is 1998, and has held until today, even given the big decline of the past one year, these investment would still have been valued very good. So, in any rapidly growing economy, real estate and stock and other investments to go.

Q: You are now investing in A shares, but are you investing in any sort of stock or equity?

F: When I was in the US, you know, before I came back to China, yes I invested into these hi-tech companies, I made some money and then they all went away.

Q: How did you manage your portfolio back then? Was that all hi-tech companies, dot-coms?

F: Mostly

Q: Over 90%?

F: Some are very high risky hi-tech some are not so risky hi-tech. I remember I invested into CISCO, which did me very well in the beginning, but then of course it began to decline, but CISCO's decline is not as, say, steep as some other dot com companies.

Q: Because it was pretty much the mature company. Can you share with us some of your inspiring experience in terms of investment, or instructive?

F: I think I made some money in real estate market, actually. For example, I purchased an apartment in Beijing back in 2000.

Q: How much was it then, per square meter?

F: It was already very expensive actually, it was about 10,000 Chinese Yuan per square meter, and now it's about 20,000. So, it has doubled over a period of eight years, which is not exceedingly good but it's ok.

Q: So how would advise me to make investment now, given the current market condition and housing prices, and everything?

F: I think the stock is the place to go right now. You know, you pick up some good companies, some good banks, for example. Their stocks have been devastated quite much, and then, you just have to hold it.

Q: In terms of the next round of China’s development of its stock market, capital market, popular arguments are that it should be less intervened by the government, and also, we should exoabd or add more type of asset chasses that could be invested in, for example, a much bigger corporate bond market. What is your take on that?

F: Yes, it is important if you can cultivate a healthy corporate bond market then it is very important. But, it takes a lot to have a healthy corporate bond market, and China is not at that stage yet.

Q: What are we lacking now?

F: Well, for example, we do not have a lot of very qualified issuers to begin with, and secondly, China doesn’t have a functioning bankruptcy law. So, it’s very difficult to value the value of a corporate bond, if you do not know what you will get in the case of bankruptcy. And thirdly,  institutional investors are usually the investors for corporate bond market, the corporate bond market can not rely on small individual investors.. And they are now  under the various different regulators, and these regulators sometimes have odds.

Q: What about less government intervention?

F: Rely on the market, if the market can do it itself. But, sometimes when the market failed, or the market can not do it itself then government has to come in. The regulators and the various, you know,  different agencies of the government still have a lot of influence on the market, because they have these approval powers. And there are too many of these approval powers at this point. S,o in that sense, the various agencies are influencing in the market because they can always deny something to happen. Now, if you believe that is too much intervention from the government, that is true, but it is kind of negative intervention, it is not positive intervention.

As we speak, there’s been a growing demand for more creativity in China’s securities market. But we know innovation could be a double edged sword. Therefore, policy makers should already remember to strengthen monitoring and control to prevent innovation from going too far.

                                                                                                       Nov.2008     ICS