No Quick Fix Seen for China’s Class B Stocks

China’s casino-like foreign currency stock markets in Shanghai and Shenzhen in late spring were the world’s last to slump in the wake of the global slowdown. Despite the country’s strong economic growth, analysts are predicting no quick recovery.

“In the short term, I don’t see an upside,” said Yi-Ping Huang, who tracks China’s economy for Salomon Smith Barney in Hong Kong.

Huang and others believe the markets in both cities require fundamental reform before foreign currency stocks--called Class B shares--can return to growth. Stocks restricted to local investors--known as Class A shares--also have declined, but not so precipitously.

“Without improved transparency and controls, I don’t believe investors will come back,” Huang said.

Frederick Zhang, managing partner of Boston-based TangMei Funds, a funds management company that focused on investing in China’s publicly traded companies, cited the poor quality of available stocks and the speculative nature of the Class B share market as reasons to stay on the sidelines for now.

“It’s hard to say where it’s all headed,” Zhang said.

Driven by speculation, white-hot investor expectations and a rapidly expanding Chinese economy, the Class B markets in both cities grew at an accelerated pace last year. In Shanghai, the 136% rise in share value made it the world’s fastest-growing equity market in 2000. It was a bull run that continued through late spring this year, seemingly defying the pessimism that pulled down markets elsewhere.

Beijing’s decision early this year to allow locals access to Class B shares, a market previously restricted to foreign investors, added further fuel.

But when reality arrived, it came quickly. The index nose dived through much of June and July. By Friday, the Shanghai Class B share index was up from its low point this month, but was still down 30% from its late May peak. The Shenzhen index was off 31% from its May high. Trading volume also has plummeted as investors flee.

Analysts believe investors initially were spooked by a government announcement last spring that it would begin selling some of its own large holdings to finance the country’s new social security system. Then came a report by a senior Chinese central bank officer that as much as $108 billion may be invested in the stock market by private, unregulated funds operating in a murky gray market. If true, it would mean that these funds control about half of all tradable shares on China’s stock markets.

The sell-off gathered speed as rumors grew that banks might need to seize--and sell--many of these shares to recoup losses on bad loans taken out by speculators to buy the shares in the first place.

Unlike past downturns in the decade since China’s equity markets first began trading, Beijing made no attempt to reverse the selling sentiment. Though the stock market is an important source of capital for private companies in China, and the Class B markets a magnet for foreign currency, the potential dangers of an increasingly artificial bubble apparently led the government to sit quietly as prices dropped.

Tales of poor market regulation and hints of subpar results from Chinese companies trying to navigate in a more competitive environment also have done little to inspire investor confidence.

As a measure of just how high investor expectations have been and how overheated the Class B share market had become, analysts noted that some recent initial public offerings sold at 50 to 55 times earnings, an amount far above the norm for most world equity markets.

On the more stable, mature Hong Kong market, for example, stronger companies are trading at 10 times earnings, analysts say.

“Fifty times earnings, that’s not sustainable,” Huang said. “I thought the government would want the market to unwind gradually, but they were taken by surprise [by the drop] and ended up just letting it go.”

Analysts believe the market crash will have only a limited effect on China’s growth, expected to be well over 7% this year. Bank lending capacity remains strong, they say.

Analysts say new rules establishing better regulatory control and greater transparency are among the measures needed to bring back foreign investors to China’s markets.

Huang noted the case of Guangxia Industry, a Ningxia-based conglomerate with interests in bio-pharmaceutical products. The company’s stock soared more than 400% on the Shenzhen exchange last year, largely because of its dazzling export earnings. Trading in Guangxia’s shares was suspended this month after a Beijing financial magazine, Caijing, reported the company had simply invented its export performance.

“This all may change in the medium term,” Huang said. “But for now, the market is too speculative.”