The Economist: China distorting its stockmarket by trying to prop it up

The Economist has published an article arguing that state purchases of shares are bad enough, but other measures are far more destructive. Caliber.Az reprints the article.

Investors in China’s stockmarket have been doing handsomely this year. The Shanghai composite index has risen by 13% from a multi-year low in February, notwithstanding a recent drop. Equity analysts and state media alike are cheering. For Xi Jinping, China’s leader, the rally was a relief, since retail investors own at least 80% of the market. A previous rout hurt them badly, adding to anxieties about the country’s future. To many, the recovery reflected good governance and fortune.

Part of the rally came from the purchase of tens of billions of dollars-worth of shares by the “national team”, a group of state-owned institutions that ride to the rescue when China’s markets wobble. For Mr Xi, the bill may appear worth it. But the state has also tinkered with the market in other, more destructive ways. In an effort to boost share prices, it has put an end to a bonanza in initial public offerings (IPOs). With fewer exit opportunities for private investors, state capital has become more dominant. The danger is that these distortions will crimp the growth of China’s most innovative firms.

Over the past decade, Mr Xi has ensured that financial markets are guided as much by government policy as by price signals and animal spirits. He has redirected capital from once-frothy sectors such as consumer-internet services and fintech, and into favoured industries such as chipmaking, AI and high-end manufacturing. Thousands of state funds have invested in these areas, becoming a major force in Chinese venture capital (VC) and private equity.

For a time, public markets thrived under Mr Xi. In 2019 he established a specific market for tech shares, called Star. Two years later he launched a new stock exchange in Beijing for small firms. To keep the capital flowing, regulators made it easier for companies to list. By 2022 China was host to the world’s hottest IPO market, with companies raising 587bn yuan ($81bn) over the course of the year.

But all this has now come to a halt. China’s stockmarkets began falling in the second half of 2023, then plunged in early 2024 (see chart). That led regulators to start stressing the importance of an “investor-friendly” market. In practice, this has meant allowing far fewer IPOs, in the hope that liquidity supports the prices of existing shares rather than new ones. Just five Chinese companies listed on domestic bourses in April, down from 35 in April 2023. The IPO market raised 80% less capital in the first four months of 2024 than in the same period the previous year.

Those firms that do list face fierce scrutiny. On top of on-site inspections, regulators now review companies’ past business deals and trawl through executives’ bank accounts, according to Reuters, a news agency. Faced with this, at least 80 companies withdrew their IPO applications in the first quarter of 2024.

The knock-on effects move down the entire chain of capital allocation. Now that IPOs are harder, investors in unlisted firms have fewer exit options. Accordingly, the value of sales by Chinese private-equity investors plunged from $89bn in 2022 to just $46bn in 2023. The resulting fall in valuations has made fundraising harder and investors warier of deploying their capital.

Meanwhile, state-backed funds, once intended to bring together the invisible hand and government policy, now dominate markets. One state investment manager says private capital has retreated as exit options have vanished, while state capital continues to flow. Such investors are still sensitive to losses but, without private backers demanding quick returns, can wait longer to get their money back.

“If venture-capital funds want to survive, they have to find a way to get money from local governments,” concluded Robert Wu, a Chinese investor, in a recent blog post. But the objectives of private and state capital are not aligned. Officials may be seeking not just returns, but employment or tax revenues for their region. Moreover, state funds have onerous requirements and endless paperwork for any recipients of their cash. Mr Wu writes that VC funds ought to treat startups as clients, since they are their source of growth. Once state money is involved, though, the startups must serve their investors. “The industry’s logic has been completely subverted.”

Another problem—though Mr Xi may call it a success—is an increased focus on state-picked industries. Restrictions on IPOs have led many to believe that only firms advancing government policy will be allowed to list. And so investors are homing in on favoured areas such as flying taxis, near-space industries and machine-brain interfaces, dubbed “new productive forces” by Mr Xi, who hopes these industries will drive economic growth.

The effect on China’s innovation hotspots has been profound. A recent ranking by PitchBook, a financial database, found that Hefei, a city in China’s dusty hinterland, has hosted the fastest-growing startup ecosystem in the world for the past six years. Industries ranging from biotech to semiconductors and artificial intelligence have sprung up in this unlikely place, hundreds of kilometres from established hubs such as Shanghai and Hangzhou. But on one front Hefei scores dead last: the number of times investors have successfully sold their stakes. VC firms made 735 investments in companies there between 2017 and 2023, but just 23 exits.

It is not just Hefei. Of the ten cities at the bottom of PitchBook’s exit ranking, eight were Chinese. As China’s economic growth decelerates and IPOs become ever harder, the valuations of companies in these places look particularly vulnerable—as do their funding prospects. Mr Xi is trying to inspire the world’s most innovative companies, while also keeping private investors and average punters happy. But in the end someone must lose.