[SCMP Column] China Needs Bold Reforms to Restore Investor Confidence

Stock Market Loses 8000 Trillion Won Over 3 Years
Big Tech Crackdown Weakens Momentum
Investors Demand Transparency... Emphasize Trust

James David Spellman, CEO of Strategic Communication
Photo by SCMP

The Chinese stock market has suffered a staggering loss of $6 trillion (approximately 8,000 trillion won) over three years as foreign investors withdrew. To reform this and attract investors back, unprecedented changes are necessary. There are various areas to address, from enhancing the transparency of corporate financial statements and strengthening supervision to reducing control over local ownership.

However, if China's 'common prosperity' policy sweeps away the free-market principles that have driven unprecedented growth for over 40 years and suppresses financial innovation, such reforms will fail.

Wu Qing, the new chairman of the China Securities Regulatory Commission, known as the 'broker slaughterer,' acknowledged the difficulties and emphasized to investors that the Chinese government has new plans and wants to bring about change. This is one of several statements from senior officials aimed at reversing the economy, which is in crisis due to the record slump in Chinese real estate. Real estate, the largest asset of Chinese households, accounts for one-fifth of the national economy.

Over the past decade, domestic and foreign investors have willingly overlooked regulatory flaws, opaque corporate structures, market deception, and the risks of party-centered control to reap large profits in China. The Chinese stock market tripled between 2014 and 2020. Growth accelerated especially after Chinese stocks were added to the MSCI index in 2018.

However, as economic recovery became difficult after COVID-19, the joyful cheers turned into gloomy sighs. According to Bloomberg, by December, the debt ratio reached 286.1% of gross domestic product (GDP). Structural problems inherent as the national economy entered maturity became apparent.

In particular, the Chinese government's crackdown on global big tech companies over nearly three years weakened corporate momentum and even thwarted the world's largest initial public offering (IPO). All of this dampened expectations that a new China would emerge under President Xi Jinping's administration.

MSCI has excluded Chinese companies from the ACWI (All Country World Index), encouraging global asset managers to divest from Chinese stocks. Last year, new foreign direct investment in China fell to its lowest level in three years. Jamie Dimon, CEO of JPMorgan Chase, recently said, "The risk-reward profile has changed dramatically."

Following Dimon's remarks, the CSI 300 index rebounded from a five-year low recorded last month, marking the longest rally since 2018. However, despite this rally, China's major stock indices remain 40-50% below their 2021 peaks.

Investors are raising their voices demanding transparency. China has agreed to comply with International Accounting Standards Board (IASB) standards and to allow U.S. auditors better access to corporate audits. Nevertheless, investors remain skeptical of corporate financial statements.

There are several significant differences between Chinese standards and IASB standards, particularly in asset valuation and revenue recognition methods. A report prepared by a U.S. institution last year revealed widespread audit deficiencies. Research shows that better alignment between Chinese standards and IASB standards could reduce fraud.

Part of the disclosure problem lies in the corporate governance commonly practiced in China. Stress in the real estate sector has worsened the situation and exposed weaknesses. Ownership structures are extremely concentrated, and board oversight is weak.

Additionally, issues commonly seen in U.S. and European corporate governance, such as the side effects of compensatory stock options, encourage short-sighted decision-making. Investors are less tolerant of these problems than during China's previous boom period.

Regulatory supervision must be strengthened to prevent market manipulation, fraud, and insider trading. The think tank Bruegel stated, "The network of interests, including banks, non-banks, shadow banking, and competition among local and central governments and party officials, complicates the situation."

To prevent excessive risk-taking, risk management mechanisms must be stronger to monitor margin financing and leverage levels, identify systemic risks, and mitigate them. Coordination and communication blind spots and failures among Chinese regulatory agencies are part of the problem. The Chinese government recognized this issue when it approved the establishment of a new supervisory body a year ago. At a recent press conference, Chairman Wu promised strong penalties.

Market infrastructure, including trading systems and settlement processes, must be upgraded to improve efficiency and reduce operational risks. This means introducing more technologies like blockchain to enhance trading transparency and security. Derivatives trading venues need modernization. China recognizes this as part of plans to integrate regional markets but hesitates to fully push forward.

The Chinese government's measures are often off-target. New regulations were imposed on 'quant funds' that use algorithms to execute trades, causing investors to flee and triggering a 'quant quake.' The crackdown on short selling also shows how reforms can be a double-edged sword. The Chinese government blames short selling for stock declines, but short selling is an important source of market liquidity and regulation that exposes corporate wrongdoing.

Ultimately, China's fundamentals are expected to attract investors again. However, it is important not to overlook that a new stage is taking root as society evolves. An aging population and slowing rapid growth lead to reduced demand and increased social costs, an inevitable trend for a mature economy. Past policies, from large-scale government capital injections to ownership policies, are obstacles to the future.

Recently, China has emphasized how crucial trust?the foundation of the market?is. Many Chinese who lost their lifelong savings say they will never buy stocks again. Even if efforts are made to attract foreign investors back, these fears must be addressed. The Chinese government recognizes the urgency but rushing could lead to mistakes. Balancing attention and caution will be the stepping stone going forward.

James David Spellman, CEO of Strategic Communication

This article is a translation by Asia Economy of the South China Morning Post (SCMP) column titled "China needs drastic reforms to win back investor trust and confidence."