INVESTING IN CHINA, by Winston Ma, Risk Books, London, 2006
Norwood P. Beveridge
Posted Monday, May 1, 2006
6 U.C. Davis Bus. L.J. 27 (2006)

Information on Winston Ma can be found at

Additional information on Investing in China: New Opportunities in a Transforming Stock Market (2006), can be found at

Every lawyer, market professional, and serious investor interested in gaining insight into the securities markets in China should read, Investing in China. This book is particularly relevant at a time when Chinese markets are in the process of intense structural reform and are being opened up in unprecedented ways to foreign investors. The author, Winston Ma, explains in a clear and concise manner the many fascinating details of Chinese financial markets. Ma describes how Chinese financial markets operate with distinctive Chinese characteristics despite their outward similarities to other international markets.

Ma is uniquely qualified for the subject matter of this book. A native Chinese, he has practiced as a capital markets attorney in both the United States and China. He is also presently a Vice President at a major international investment bank based in New York City. His hands-on experience and practical insight are evident on every page as he details the process of the formation and transformation of the Chinese markets, a process the Chinese government has described as "crossing a river by feeling the stones underneath."

The story begins with the opening of the Shanghai and Shenzhen stock markets in China in 1990 and 1991. Prior to their opening, the Chinese government closed the Shanghai Stock Market for forty years following the communist takeover in 1949. In an historic speech during his Southern China Tour in the Spring of 1992, China's leader, Deng Xiaoping, officially endorsed the reopening of the market. Explaining the opening of the securities markets in the context of China's evolving socialist economy, Xiaoping said, "[a]re securities and the stock market good or bad?... Can socialism make use of them?...[W]e must try these things out."

The Shanghai and Shenzen stock markets are the subject of the book, since the stock market in Hong Kong is separately administered by the Hong Kong Securities and Futures Commission. Currently, 1,400 companies are listed on the Shanghai and Shenzhen exchanges. Despite the enormous economic growth in China over the past twenty years, the performance of the securities of these listed companies has been dismal. The bear market in China has continued over the past five years, and the markets have lost about half of their value since an historic high in 2001.

The single most important fact to bear in mind is the unusual share structure of these listed companies, which is referred to as "segregated equity ownership." When these formerly state-owned enterprises were restructured to issue shares to the public, public investors became owners of only one-third of the outstanding shares on average. The other two-thirds were divided equally between state-asset management entities ("state shares") and local governmental bodies ("legal person shares"). The result was that fully two-thirds of the outstanding shares were held by multiple party and governmental entities and did not trade.

Segregated equity ownership had a profound effect on the trading of the publicly held shares. In fact, it virtually ensured that the price at which public shares traded was not related either to firm value or to the value of the nontradable shares. The public shareholders, who had no hope of participating in firm management, regarded the exchanges primarily as a vehicle for speculation, and over the period 1994-2001, a share of listed company stock traded on average five times a year. That is a holding period, on average, of less than three months, compared with a holding period of two years in developed markets. Conversely, the controlling shareholders and corporate management did not have a compelling interest in the market price of the tradable shares since the value of their own shares was different.

Moreover, segregated equity ownership frequently resulted in self-dealing by management for two reasons. First, Chinese law did not recognize the stockholders' derivative suit or class action as a constraint on managerial misconduct. Second, the unavailability of the public tender offer eliminated the risk and corresponding discipline imposed by the threat of a hostile takeover.

In addition to the segregated equity ownership phenomenon, the publicly-traded shares are themselves divided into different categories of shares. "A shares" are the
predominant class of publicly owned shares and comprise approximately 27% of
the outstanding shares. Originally, only Chinese nationals were allowed to acquire "A shares" and these shares were denominated in Chinese local currency, the yuan or Ren Min Bi (RMB).

The second class of publicly held shares are the "B shares." At first, only foreigners were allowed to acquire "B shares," which account for about 3% of the outstanding shares. The "B shares," although denominated in local currency, are traded in foreign currency. U.S. dollars purchase "Shanghai-traded B shares" while Hong Kong dollars buy "Shenzhen-traded B shares."

Finally, there are shares traded on foreign stock exchanges: "H shares" on the Hong Kong Stock Exchange; "N shares" on the New York Stock Exchange, the Nasdaq Stock Market as well as U.S. American Depositary Receipts ("ADRs"); and shares traded in London or Tokyo. These foreign shares account for around another 6% of the outstanding shares. The yuan is not freely convertible into foreign currency, and the trading prices of foreign exchange traded shares diverge from the prices on the domestic exchanges of the "A shares" and "B shares."

Over the past five years since its December 2001 accession to the World Trade Organization (or reentry since China was one of the founding parties to the predecessor General Agreement on Tariffs and Trade in 1948), the Chinese government has taken a series of steps to try to open up and normalize the operations of the two domestic exchanges, which have been and are at present far from being efficient securities markets.

As far as Chinese investors are concerned, the government has permitted Chinese nationals with foreign currency accounts to invest in the B-share market since February of 2001. Although the results seem to indicate that the B-share market is very limited and is not expected to grow in the future, China continues to permit this type of investment.

Furthermore, the Chinese government has provided foreign investors with new opportunities to purchase securities in its capital markets. For example, beginning in November of 2002, China introduced the Qualified Foreign Institutional Investor (QFII) program. Under the program, foreign institutional investors meeting the substantial minimum capital, operating history, and assets under management criteria are allowed to participate in China's capital markets directly. Acting through Chinese domestic brokers and custodian banks, QFII investors may buy not only "A shares" but also Chinese Treasury Bonds, convertible bonds and listed corporate bonds. A number of foreign banks, insurance companies, and fund management companies quickly subscribed to a majority of the U.S. $10 billion account total offered. The program does not allow for free repatriation of funds and limits were put on the amount of outstanding "A shares" that might be acquired in any one domestic listed company (10% for any one QFII investor and 20% for all combined). At the same time, the Chinese government permitted foreign investors to acquire the nontradable state-owned shares. These purchases were accomplished by private negotiations, and the state-owned shares traded at a substantial discount to the publicly held share price.

However, the big news is that after a few false starts beginning in 2001, China is at last seriously addressing the problem of the overhang of the nontradable state and legal person shares by seeking to make all shares fully tradable. This "full-flotation reform" or "state-share overhaul reform" began in May 2005 with a few pilot programs. By the end of that year, 300 public companies had completed the share reform project. Another 400 to 500 companies are expected to complete the reform by mid-2006. Completing the program requires the approval of the China Securities Regulatory Commission and a two-thirds majority of the outstanding tradable share holders.

The key to the program is the compensation in the form of cash, warrants, or free shares of stock to be given to the holders of outstanding tradable "A shares" to make up for the expected diminution in value of their shares by such a large increase in the tradable shares outstanding. At the same time, the state and legal person shares do not become immediately tradable. Holding periods, limitations on the amount of such shares which may be sold in any one year, and requirements of public disclosure of sale will in practice limit the sale of these shares, with an eye to avoid flooding the market beyond its ability to bear.

There is much more in this book. The author offers an account of the steps the Chinese government is taking to bring more of its institutional investors such as domestic banks and insurance companies into its markets. He recounts the new developments in the China Merger & Acquisition field as well as the China Management Buy-Out market, in both of which foreign investors may participate. There are detailed descriptions of the various investment products and trading options available, such as convertible bonds (with Chinese characteristics), warrants and options, exchange-traded funds, principal-protected investments, stock index and index products, short sales, repos, and futures. In sum, Ma provides a comprehensive, informed, and compelling story. The reader will appreciate Ma's practical experience in these markets as he relates in real time a very fast moving story.