There’s been a growing chorus of China watchers who have been saying–for years now–that one day, it won’t be annoying Americans overflowing the world’s greatest cities, but equally annoying Chinese tourists. But there’ll be even more of them, as China’s middle class is predicted to explode from something like 6 percent of their 1.3 billion population right now to 45 percent in 2020.
I don’t doubt that this will be true one day. The question is, though, will that day be any time soon? Given the recent global meltdown, many have seen a monumental shift in economic power, from America and the west to China and the east (as well as other regions with emerging markets, such as Russia and South America). But the market crashes in a wide swatch of developing countries have really brought this “decoupling” theory–in which emerging markets are no longer linked to the fate of the US economy–into question.
I think to examine this shift in economic power and to answer the bigger question of should we be worried, it may be effective to look at one small part of the puzzle: initial public offerings (IPOs). You remember those from the heady tech-bubble days, right?
By most measures, the US IPO market had a tremendous year in 2007, with the most capital raised ($53 billion) since 2000. But compared to China’s $90 billion haul, the US seems to be losing its financial dominance. In 2007, for the first time, Chinese IPOs raised more capital than their American counterparts.
Yet this does not suggest an immediate collapse of US financial dominance, for China’s IPO market has been disproportionately inflated by a slew of mega SOEs. As the three domestic Chinese markets mature, however, they face a daunting array of challenges to maintain recent paces of IPO fundraising. In the long-term, with China’s increasingly deep capital pool and continued high economic growth, the US must significantly reform its legal and regulatory structures to remain competitive.
The dramatic year-to-date declines in the Shenzhen (65%), Shanghai (60%), and Hong Kong (45%) indexes suggest that China has not decoupled from the US economy. Last month, China’s Securities Regulatory Commission (SRC) announced they would stop processing IPO applications in an effort to bolster lagging capital markets, a call back to 2005 when the commission froze offerings for an entire year.
At a fundamental level, investors expect higher returns on the Hong Kong, Shenzhen, and Shanghai exchanges because of the country’s record economic growth and low capital market penetration relative to the EU and US. Perhaps more important, China has only recently opened its monolithic state-owned enterprises (SOEs) to partial privatization, most often through IPOs; for instance, five companies raised 39% of Chinese equity capital in 2007, with each IPO greater than the largest US IPO, Blackstone ($4.1 billion).
Before the freeze, Chinese IPOs only raised $7.3 billion this year-to-date, in part because three-quarters of its largest state enterprises have already publicly listed. Now with the devastating global credit crunch, the IPO market in China should significantly contract in the short-term. There are also several systemic cracks that pose barriers to maintaining China’s recent pace in growth.
- Pervasive insider trading. Chinese courts do not have the ability to handle complex insider trading cases, and in fact, almost never pursue punitive actions. This vulnerability to manipulation will deter foreign investors from the market.
- Poor corporate governance. Because state-run enterprises are notoriously opaque, preparations to bring their accounting processes to international standards for an IPO may take up to three years. Even publicly listed companies do not exhibit the same level of transparency as their US counterparts, which again deters investors.
- Decline in secondary market interest. According to an analysis by JPMorgan, the secondary IPO market is not attracting sufficient interest, in large part due to the influx of “stock flippers,” with firms unable to assemble adequate order books.
- Collapse of confidence. Declining corporate profits, fear of oversupply, and significant volatility of the Shenzhen, Shanghai, and Hong Kong exchanges have already led to a crash in the 2008 IPO market, with the short-term outlook equally dim.
In the short-term, China’s IPO market does not pose immediate danger to US financial dominance since their recent transactions have been inflated by a slew of mega SOEs being brought “online” to the three domestic exchanges; three-quarters of the major SOEs are now listed, so supply should dramatically decrease. The country’s capital markets also suffer from several fundamental flaws, discussed above. On the US side, a 2007 study indicates that there still exists a significant listing premium for the New York exchange, as firms receive a “governance benefit” from being more closely regulated than in Shenzhen, Shanghai, and to a lesser extent, Hong Kong.
“[Chinese companies] ask, ‘Do we list on London’s AIM now, or do we bite the bullet and spend the next six months making our company better and stronger, and try to meet US stock requirements and list in the US?'” explains Jocelyn Choi, a senior vice president at Lehman Brothers in Asia explains. Ultimately, there remains and will remain for the near future a tangible prestige cachet for any small and mid-cap firm to list on an US exchange.
However, in the long-term, China’s burgeoning middle class and ever-increasing pool of capital and foreign reserves present tremendous risk to the US’s ability to raise equity, particular from multinational firms. Furthermore, while Chinese firms continue to favor American capital markets (half of the 25 top-performing US IPOs in 2007 were companies based in China), increased capital liquidity back in the home market would make such a move unnecessary. I recommend two policy changes to be implemented for the US to remain competitive:
- Revisit Sarbanes-Oxley. While proper disclosure provisions have attracted investors, and hence multinational firms, to the US IPO market, the excessively burdensome regulatory practices within Sarbanes-Oxley is at the same time driving private firms to raise equity in London or Hong Kong. The $4.36 million cost for the average firm to stay SOX-compliant can often be a deal-breaker in itself.
- Address frivolous litigations. Multinational firms see the high risk of class lawsuits and legal liabilities of a US listing as an important reason to list in London or Hong Kong. We need to reform the legal system to prevent frivolous and excessive litigation.