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Avoid the Chinese Stock Market At All Costs

In China, the repurchase of shares to artificially value the price of companies is a common practice

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China has been seen as the economic miracle of the last 30 years, going from being a third world country with an impoverished population to becoming the second economic power in the world in little more than a generation.

It is increasingly common to hear about the rise of Chinese companies in the international market, such as Alibaba in the retail sector or Huawei in technology, making headlines in economic and business newspapers.

Given China’s growth expectations, one would think that the stock market is dynamic and a reflection of the real growth of the country’s economy. Nothing could be further from the truth.

Compared to other stock exchanges, those in Shanghai and Shenzhen have performed poorly for two different reasons: in some respects the Chinese stock market is over-regulated and in others it is under-regulated.

The problems with China’s over-regulated stock market

The Shanghai and Shenzhen stock exchanges, unlike their counterparts around the world, are not a private initiative, they are owned by the government. This condition allows political control over the stock market and its rules to be shaped in the interests of the Communist Party of China.

Unlike other stock exchanges around the world, where anyone is allowed to invest in stocks, those in Shanghai and Shenzhen require at least one of the following conditions to be met in order to invest as a foreign citizen:

  • a permanent residence in China;
  • being an employee of an A-rated company with shares listed on a Chinese stock exchange and with an ownership interest in the company;
  • living in China;
  • being a majority shareholder of a company with international operations in China

Even if a foreigner meets any of these criteria, he or she won’t be allowed to buy current shares in order to prevent him or her from having a vote within the company and from participating in the company’s decisions, such as the appointment of the board of directors. China imposes these restrictions to ensure that its major companies are free from foreign influence that goes against their geopolitical interests.

China’s political stock market regulations have discouraged thousands of investors from investing in companies listed on the Shanghai and Shenzhen stock exchanges. (EFE)

These political, rather than technical, regulations have worked against Chinese companies themselves, as the rules discourage or prevent thousands of foreign investors from investing in the stock market, limiting the ability of these exchanges to raise capital for their companies. It is no coincidence then that the largest Chinese companies listed on the stock exchange are mainly state-owned enterprises with a smaller share of the general public, causing the stock’s performance to be mediocre in relation to China’s economic growth.

How the lack of regulation harms China’s stock market

Excessive regulations on non-fundamental matters in the Chinese stock market have caused the market to be unsupervised and even encouraged to avoid things that do require stricter regulation.

In China the repurchase of shares to artificially value the price of companies is a common practice, often encouraged by the very authorities in charge of “regulating” this type of practice so criticized in the United States.

On the other hand, the direct manipulation of interest rates by the government has made it impossible to make an assertive assessment of the level of company debt, making the Chinese stock market more reactive to government impulses than to the real sector behavior of listed companies.

The authorities are often complicit in the bad practices that occur within the Chinese financial world. (EFE)

But perhaps the worst known practice in the Chinese financial sector, and one that has affected other stock exchanges, is the reverse merger of companies listed on foreign indices with Chinese paper companies.

Usually the process of majority acquisition of a public company by a non-listed company is a highly audited process to prevent possible fraud and devaluation or affect the operation of a functional company.

Unfortunately, the Chinese government has intentionally made it difficult for U.S. regulators and other stock exchanges to scrutinize companies in China, allowing many companies listed on the New York or Hong Kong stock exchanges to end up being acquired by shell companies.

Corruption is so widespread that a shady investor can easily set up a paper company in China with only a tax address, a website, an inoperable warehouse, and fabricated accounting books, in order to buy the majority stake of companies listed on foreign stock exchanges, announce a reverse merger of the two companies, and then sell all the shares at the temporary price of the merger.

This has become so common that the United States has begun to delist several Chinese companies or companies acquired by them to avoid such cases in the future.

There is no one holding them to account

The most worrying thing is that these aren’t isolated practices, since they occur with the complacency or complicity of the Chinese authorities, and the worst thing is that very few people dare to denounce them, and those who do can face the wrath of the Chinese Communist Party, as has happened with investors like businessmen Ren Zhiqiang and Xiao Jianhua, who are deprived of their freedom for speaking out against the horrible practices that occur not only in the stock market, but also in real estate.

At this time, Alibaba’s founder, Jack Ma, who was an integral part of these practices and is facing an antitrust suit by Chinese authorities, has been out of the public eye for two months, and there are fears for his safety.

In a certain way, the Chinese Communist Party has perpetuated a nationalized capitalism without freedoms that silence those who denounce it and corrupts those who choose to ignore its aberrant practices. The stock market in China is just another example of malpractice from one of the world’s most malevolent dictatorships.

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