TROUBLED MAINLAND FINANCIAL SYSTEM HELPS FUEL

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 000335 SIPDIS SIPDIS STATE FOR EAP/CM AND EB MANILA PASS AMBASSADOR PAUL SPELTZ TREASURY FOR U/S TADAMS, DAS DLOEVINGER, OASIA-GKOPEKE USDOC FOR 4420 E.O. 12958: DECL: 01/26/2031 TAGS: ECON EINV EFIN PREL HK CH SUBJECT: TROUBLED MAINLAND FINANCIAL SYSTEM HELPS FUEL RECORD GROWTH FOR HONG KONG'S STOCK EXCHANGE Classified By: Acting DPO Simon Schuchat; Reasons: 1.4 (b/d) SUMMARY -------------- ¶1. (C) China-related listings boomed again last year in Hong Kong, led by China Construction Bank's USD 9 billion IPO, the world's largest for 2005. Hong Kong now ranks fourth in the world for raising equity capital. This impressive performance, however, derives in part from dysfunction within China's own domestic financial system. A prominent financial contact believes China has mismanaged the reform of its equity markets, creating a vicious cycle that will leave quality mainland companies permanently inclined to list in Hong Kong. He described China as "flying on one engine" by failing to lay the proper groundwork for a reliable equity raising capacity, thus placing further strain on an already troubled banking system. Other observers are less critical of China's reform efforts and believe the Shanghai exchange may see new initial public offerings (IPOs) as soon as the second quarter of this year. They display more acceptance of what they term as the mainland's necessity to rely on financial intermediation outside of the mainland's domestic economy until issues involving state shares, capital controls, currency convertibility, and corporate governance can be overcome. END SUMMARY OH, WHAT A YEAR IT WAS -------------- ¶2. (U) 2005 was a hugely successful year for Hong Kong's stock market, primarily because of the activities of mainland firms that have listed here. Highlights of note: o Hong Kong hosted the world's largest initial public offering (IPO) in 2005, China Construction Bank. The firm -- the first of China's "big four" banks to go public -- raised USD 9.2 billion in October. More generally, 82 percent of IPO funds raised in Hong Kong last year were associated with mainland firms. o USD 38 billion of equity capital was raised in Hong Kong in 2005, making it fourth in the world after New York, London, and Toronto. Of that capital, USD 21 billion came from IPOs, likely placing Hong Kong second only to New York for new offerings, once final tabulations are in. o Hong Kong market capitalization rose 23 percent to USD 1.05 trillion placing it eighth in the world. Mainland firms account for 39 percent or USD 409 billion of this figure. o 1,135 companies are listed in Hong Kong of which 335 are mainland-related entities. Specifically: -- 120 firms are "H shares," enterprises incorporated on the mainland that usually, but not always, have significant affiliation with the PRC government; this is the vehicle by which state-owned enterprises in China normally sell pieces of themselves off on a foreign exchange (Market Cap = USD 165 billion). -- 89 firms are "red chips," enterprises incorporated outside of the mainland but that have significant affiliation with PRC government (Market Cap = 219 billion). -- 126 firms are private enterprises, incorporated outside of the mainland but controlled by mainland individuals (Market Cap = 25 billion). o Although the Hang Seng Index rose only 4.54 percent in 2005, turnover on Hong Kong's exchange increased by nearly 14 percent, reaching a record USD 579 billion. A major attraction of Hong Kong for portfolio investors has been the use of mainland-affiliated stocks as a way to buy into China's growth story. Investors also buy China-related stocks here to speculate on the Chinese renminbi (RMB) because H-share values are calculated in RMB and then converted to Hong Kong dollars (HKD). HELPED BY AILING CHINA EXCHANGES -------------- ¶2. (SBU) Newbridge Capital Managing Partner Weijian Shan described the success of Hong Kong's stock exchange as both a symptom and future cause of structural economic problems in HONG KONG 00000335 002 OF 003 China. Speaking at an off-the-record event, Shan offered a scathing review of China's efforts to reform the country's domestic (A-share) market. Until recently, approximately two-thirds of A-shares were held as non-tradable shares, primarily by government-related entities. In 2005, China began converting these shares to make them tradable. Anticipation of these shares flooding the market has created an environment where it is difficult to list new companies, and IPO's have been at a trickle for two years. The "overhang problem" has also depressed share prices, with eight-year lows reached on the Shanghai and Shenzhen exchanges last July. ¶3. (SBU) Shan said that converting the shares is necessary. However, China is forcing holders of non-tradable shares to compensate holders of existing tradable shares for the losses associated with more shares hitting the market. In his view, this amounts to stock manipulation and disrespect for property rights. The state injecting itself into the value-setting process is corrosive to the markets themselves establishing a reputation for finding fair prices. This in turn will create a vicious cycle whereby China's best companies continue to seek listings outside of the mainland. ¶4. (SBU) According to Shan, the lack of a reliable means to raise equity capital is like forcing the domestic financial system to fly on one engine. Financial intermediation is reduced to the government taking savings from the public and channeling them through banks to build excess production capacity. This squelches profitability and keeps the rate of return for existing stocks below the rate of economic growth. Hong Kong, by contrast, has a strong reputation for rule of law. Nobody in Hong Kong worries about government shareholders selling their H-shares here because all players know that stock values in this well-functioning market are determined by fundamentals. ¶5. (C) Shan's negative outlook is illuminating, but it stands out against the conventional wisdom found in media coverage of China's stock market reforms. Numerous analysts have pointed to the impressive pace of non-tradable conversions -- 70 percent of market capitalization is likely to be converted by late this year, according to estimates. There has also been a recent positive trend in mainland domestic share prices, attributed in part to confidence about the reforms. Consulate Shanghai notes that foreign security advisors there see the conversion process as positive, though confusing, and some expect new IPOs as early as the second quarter of this year. That said, Shanghai Stock Exchange Executive Vice President James Liu recently told Consulate Shanghai that the Hong Kong Exchange's focus on the mainland is "eating our lunch." Liu's comment about the stock exchange's focus is consistent with what we have heard here: Hong Kong Exchanges and Clearing Chairman Paul Chow recently told us that the exchange's current strategic plan focuses exclusively on attracting new business based in Greater China. ¶6. (C) HSBC Senior Economist Hongbin Qu told us that he disagrees with Newbridge's Shan, asserting that ongoing share reform efforts are the only way to go forward. In the mean time, China must "outsource" financial intermediation until it can get its own house in order, and so will rely heavily on the Hong Kong stock exchange for years to come. Qu observed that beyond the question of working off non-tradable shares, China must also address capital controls, the convertibility of its currency, and corporate governance before its domestic stock markets will begin to function as Hong Kong's does. It will thus be a long time before Shanghai is ready to compete with Hong Kong for prized listings. After non-tradable share reform is complete, however, the Chinese government may start directing some companies to Shanghai, and this could take business from Hong Kong. ¶7. (SBU) Bank of China Hong Kong Senior Economist Michael Dai authored a research paper that he shared with us, taking a line similar to that of HSBC's Qu. Dai noted that "China simply cannot afford... (to halt) its own growth to buy time for its stock market reform. It is at this juncture that Hong Kong steps in and takes on the important financial intermediation role.... China's financial security also has to be considered. The mainland stock and bond markets have yet to be well established, resulting in banks shouldering most of the financing burden for economic as well as corporate developments... the concentration of risks in the HONG KONG 00000335 003 OF 003 banking sector carries huge destabilizing potentials itself. Hong Kong in this case does its part to help diversify some of the risks by helping Chinese companies to raise funds." ¶8. (U) This message was coordinated with Consulate Shanghai. Cunningham