Will foreign investors improve China’s markets? In November of 2002, Beijing authorities announced the creation of a Qualified Foreign Institutional Investor (QFII) scheme that would give foreign investors access to mainland China’s domestic markets, including the $500 billion A-share market. Since last May, when the first approvals were given, Citigroup, Deutsche Bank, Goldman Sachs, HSBC, ING, Morgan Stanley, Nomura and UBS have received QFII licenses. The government hopes that these foreign investors will increase market stability and improve the market’s capital allocation mechanism by bringing sophisticated risk management techniques and a long-term investment orientation to what has been so far a speculative and inefficient domestic market. But even with further liberalization of foreign investment rules, the steps taken by the government are unlikely to help improve the financial markets in China. A sophisticated investor base in China does not require foreign investors; it requires a change in the way investors can process information. If this change occurs, foreign guidance will be unnecessary because sophisticated local Chinese investors will emerge spontaneously. If it does not, neither Chinese nor foreign investors will change the behavior of the market. To see why, it is important to understand how investors make trading decisions. An efficient and well-balanced market is comprised largely of three types of investors. Speculators take advantage of information about changes in supply or demand factors that will have an immediate impact on prices. By trading often they disseminate information quickly and provide other investors with liquidity. Value investors buy assets in order to earn the economic value generated over the life of the investment. Their role is to channel capital to its most productive use. Arbitrage traders exploit pricing inefficiencies to make low-risk profits. They ensure that markets provide clear pricing signals. Each of the three types of investor has a different trading strategy and focuses on different types of information. Speculators are usually “trend” traders, looking for many opportunities to make small profits. They tend to buy in rising markets and sell in falling ones and this behavior, by reinforcing price movements, can increase market volatility. Value investors typically do the opposite. They tend to have fairly stable target price ranges, and when an asset trades below or above the target price range, they buy or sell, thereby countering market volatility. Arbitrage traders look for assets that are mis-priced relative to equivalent assets, and they buy and sell simultaneously to lock in small, low-risk profits. A well functioning market requires all three types of investors. Without all three, markets lose their social value of ensuring that economically beneficial projects have access to cheap capital. A market dominated by speculators, for example, tends to be volatile and inefficient at allocating capital. This is because speculators focus largely on variables that may affect short-term demand or supply for the asset, such as changes in interest rates, margin levels, political and regulatory announcements, or insider behavior. They downplay the importance of long-term economic information. Moreover since their investment horizons are short, they can ignore the impact of high discount rates. In a market dominated by speculators, prices can rise very high or drop very low on information that may have little to do with economic value and a lot to do with short-term non-economic behavior. Value investors, however, keep markets stable and focused on growth. For value investors, short-term non-economic variables are not an important or useful type of information. They are more confident of their ability to discount economic variables that affect cashflows over the long-term. Furthermore, because the present value of future cashflows is highly sensitive to the discount rate used, these investors spend a lot of effort on developing appropriate discount rates. Who are the investors? China does not have a well-balanced investor base. There are almost no arbitrage traders because they require low transaction costs and the legal ability to short securities, neither of which is available in the mainland. There are also very few value investors. The vast majority of investors in China tend to be speculators. This makes the Chinese capital markets fairly volatile and very poor at rewarding companies for decisions that add economic value over the medium or long term. Why are there so few value investors in China and so many speculators? Some experts argue that this is because China lacks investors with long-term investment horizons, or that very few Chinese investors have the credit skills or the sophisticated analytical and risk-management techniques necessary to make long-term investment decisions. If these arguments are true, increasing the number of experienced foreign investment funds is certainly a good way to make Chinese markets more efficient. But the issue is more complex than that. China, after all, already has natural long-term investors. These include mutual funds, insurance companies, pension funds and, most importantly, a very large and remarkably patient potential investor base in its tens of millions of savers, most of whom save for the long term. China also has many bankers and academics who have trained at major financial institutions and the leading foreign universities, and they are more than qualified enough to understand credit risk and portfolio techniques. So why aren’t Chinese investors stepping in to fill the role provided by their counterparts in the other developed markets? The answer lies in what kind of information can be gathered in the Chinese markets and how the discount rates investors use to value this information are determined. If we broadly divide information into fundamental information, used for making economic decisions about long-term cashflows, and technical information, which covers short- term supply and demand factors, it is obvious that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make value decisions requires a great deal of confidence in fundamental information, like the quality of economic data and the predictability of corporate behavior, but in China today there is little such confidence. When it comes to technical information useful to speculators, however, China is very well endowed. Insider trading is common in China. Opaque corporate governance and ownership structures can cause sharp fluctuations in corporate behavior. Illiquid and fragmented markets allow determined traders to cause large price movements – in fact the newest fashion in the market is for speculators to trade on guesses about the purchasing and selling plans of QFII investors. In addition, the single most important player in the market, the government, often behaves in ways that are not subject to economic analysis. This has a very important effect on undermining value investment and strengthening speculation. In the first place, unpredictable government intervention causes discount rates to rise, since these must incorporate additional uncertainty. Secondly, it puts a high value on research directed at predicting and exploiting short-term government behavior, and so increases the profitability of speculators at the expense of other types of investors. Even credit decisions must become speculative since, when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but rather by political calculations. Value investors and China Telecom A dramatic example of the impact of government behavior on value investing was China Telecom’s initial public stock offering in November, 2002. The offering was scheduled to come out at a time of weak international demand, and there was some concern that it might not be as successful as hoped. Because the meeting of the 16th Party Congress was taking place in Beijing during that time, a successful transaction would have helped validate government policies and a failure would have been seen as a loss of face. In an attempt to bolster demand the Chinese government pushed through a large and unexpected increase in international interconnection fees, which would result in higher profits for the company. Instead of boosting demand for the stock, however, this actually had the effect of reducing demand. The deal, originally expected to raise over $3 billion, ended up raising only $1.4 billion, even after being priced at the bottom of the expected price range. Why was the deal a failure? Much of it had to do, of course, with weak global markets, but the final sudden drop in demand came about largely because by its actions the government made it clear that they would allow non-economic factors to affect the company’s profitability. Value investors, who dominate the large international markets and who would have been the main buyers of China Telecom, felt that their ability to judge the company’s future cashflows had suddenly been damaged. They saw that the company’s profitability depended not just on economic factors, which they are able to judge, but also importantly on political factors, which they cannot. As a consequence they raised their discount rate – that is, they lowered the price at which they were willing to buy shares. This illustrates one of the main problems facing the development of local capital markets on the mainland. China is attempting to improve the quality of financial information and is trying to make markets less fragmented and more liquid, but although these are important steps, they are not enough. Value investors need not just good economic and financial information, but also a predictable framework in which to derive reasonable discount rates. Here China has a problem. It is difficult enough to estimate discount rates in an environment of regulated interest rates and pricing inefficiencies in the market, but in addition, Chinese discount rates must account for excessively high levels of uncertainty. Some of this uncertainty represents normal business uncertainty. This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome. But Chinese investors must incorporate two other – economically inefficient – sources of uncertainty. The first is the uncertainty surrounding the quality of economic information. The second is the large variety of non-economic factors – market manipulation, insider behavior, opaque ownership and control structures, the lack of a clear regulatory framework that limits the government’s ability to affect economic decisions – that can influence prices. These factors force investors to incorporate too much additional uncertainty into their discount rates. Better information, not more foreigners This is the important point. It is not just that it is hard to get good economic and financial information in China. Even when good information is available, because of the variety of non-economic factors that affect value the appropriate discount rate is so high that it rarely will lead to a buying decision from a value investor except at a very low price. In China, value investors are essentially priced out of the market. Speculators however can be much more confident about the information they use and so it is their behavior that drives the market. The consequences are not surprising. Markets in China respond to a very large variety of non-economic information and rarely respond to estimates of economic value. China is betting that increased participation by foreign investors will improve the functioning of the capital markets by reducing the bad “Chinese” habit of speculation and increasing the good “foreign” habits of value investing and arbitrage. But this faith in foreigners is misplaced. There is nothing particularly unsophisticated or shortsighted about Chinese investors or Chinese investment practices. However the combination of weak fundamental information and structural tendencies in the market – heavy-handed government interventions, weak governance, and market manipulation – reward speculative trading and undermine value investing. This forces all investors to focus on short-term technical information rather than fundamental information and to behave speculatively. All rational investors in Chinese markets must be speculators if they expect to be profitable. As long as this is the case, investors will not behave in a way that promotes a productive capital allocation mechanism, and bringing in foreigners will have no meaningful impact. What China must do is something quite different. It must reduce the importance of speculative trading by reducing the impact of non-economic behavior from government agencies, manipulators, and insiders. It must improve corporate transparency and governance. It must continue efforts to improve the quality of both corporate reporting and national economic data. Finally it must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates. If done correctly these changes will be enough to transform the way Chinese investors behave by permitting them to make long-term investment decisions. They will reduce the profitability of speculative trading and increase the profitability of arbitrage and value investing, and so encourage a better mix of investors. If China follows this path, it will spontaneously develop the domestic investors that channel capital to the most productive enterprise. Until then, China’s capital markets, like those of many other undeveloped countries in Latin America and Asia, will be poor at allocating capital no matter how many famous foreign fund managers open subsidiaries in Shanghai, Beijing or Shenzhen. Michael Pettis (email@example.com) is a professor of finance at Tsinghua University and Columbia University and a former New-York-based investment banker and bond trader. He is the author of The Volatility Machine: Emerging markets and the Threat of Financial Collapse (Oxford University Press, 2001).
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