The Unique Primitive China Stock Market

China has two stock exchanges, namely the Shanghai Stock Exchange and the Shenzhen Stock Exchange. The market of securities trading in Shanghai begins in the late 1860s. The Shanghai Share broker’s Association is formed in 1891. In 1949 at the start of communist era it is suspended until 1990. The Shanghai Stock Exchange is now the fifth largest capital market in the world. Mainland China has a second, smaller, stock exchange: the Shenzhen Stock Exchange.

There are two types of stocks being issued in the Shanghai Stock Exchange and the Shenzhen Stock Exchange: A shares and B shares. A shares are priced in the local Renminbi currency, while B shares are quoted in U.S. dollars. Initially, trading in A shares are restricted to domestic investors only while B shares are available to both domestic (since 2001) and foreign investors. However, after reforms were implemented in December 2002, foreign investors are now allowed (with limitations) to trade in A shares under the Qualified Foreign Institutional Investor (QFII) system. There is a plan to eventually merge the two types of shares.

Although equity derivatives, futures and options are very common in the rest of the world the China Financial Futures Exchange is still waiting to introduce it’s stock index futures. Once the stock equity derivatives begin trading they are expected to absorb much of the excess liquidity in the market. China has too much money and too little financial instrument to invest. This is pushing the stock market unrealistically high and causing alarming inflation. If one follows China’s stock market closely and have read my article on the THE LONG BULL MARKET you notice the market keeps rising and rising as though people have no fear. One theory is because of the excess liquidity and lack of derivative instrument and short selling. Since investor cannot put their money on the downside, they are force to bet on the upside hence pushing stock price higher and higher. But then of course they can always stop buying like they are doing now during this global subprime crisis.

There is no small cap market in China. In the U.K the small cap market is the AIM and in Hong Kong it is the GEM. The listing rules are less stricts for the small cap listings. It does not mean that there are no small companies in the Shanghai Stock Exchange and the Shenzhen Stock Exchange. On the contrary there are a lot of rubbish stocks on the mainboard. This is very important from a risk management point of view to separate them because you do not want the mainboard to be full of rubbish companies. It can make the mainboard more risky, lowering its price earning ratio lower.

As you can see China although is catching up fast is still very primitive. I remember a couple years ago there were two very young good looking people from a Chinese brokerage firm on the trading floor. We are an international investment bank in Hong Kong. I remember our head dealer was showing these two guys trading some basic trading conventions e.g. VWAP orders, Market On Close orders. Our head dealer told me that they are unfamiliar with some very basic concepts.

In summary, the Chinese Stock Market is like a lot of other Chinese stuff, nice but not quite there yet. In fact if you look close enough it is like a Geely Vision, trying to look sophisticated but does not have the quality. But I am sure foreign banks is helping enormously in raising the standard.