By Ichiro Suzuki The Financial Times reports that total market capitalization of Chinese equity markets, Shanghai and Shenzhen, has reached $10 trillion, eclipsing the high in 2015. China is performing very well this year, as the only major country that has succeeded in containing the novel coronavirus according to its state-run media. Well done, and this number is without tech powerhouses such as Alibaba, Tencent, Baidu etc. that are traded in Hong Kong and/ or the U.S. While the media tends to focus on the positive side of China’s financial markets, $10 trillion in fact looks rather small as Chinese equity markets’ value, even without the tech giants mentioned above. Since the size of the Chinese economy is approximately $14 trillion, equities’ value at $10 trillion is only about 70% of the economy. In contrast, U.S. equity markets boast of staggering $35 billion that far exceeds the economy’s $21.5 billion. That’s 165% of the economy. Whether U.S. equity markets are more than fairly valued or not is debatable. While it is often said they are expensive, the Fed’s super aggressive monetary policy is allowing unprecedented amount of liquidity to chase financial assets, be they equities or bonds. Given the current macro environment, there is little prospect of reversal of the Fed’s policy, which usually brings an end to a party. The People’s Bank of China (PBOC) is not printing money the way the Fed is doing. In the globalized financial markets, however, abundant liquidity always spills over to the rest of the world, making China a beneficiary of Chairman Powell’s monetary policy. So are the Chinese equity markets undervalued, with the size at only 70% of GDP? Probably not. Over or undervaluation can be corrected by market forces, within a reasonable time frame, often within one economic cycle of the U.S. economy and the rest of the developed world. Within an economic cycle, the Fed and other central banks tighten and loosen their monetary policies, and these actions straighten out deviations of the markets from fair value. Due to its strong organic growth potential, China has not had as distinct economic cycles as the developed counties. Nonetheless, China is still greatly affected by what is going on in the developed world. Since the size of the Chinese equity markets have always been well below that of the economy, it is fair to conclude that this is normal for China and its markets are not undervalued. What makes the Chinese equity markets small in relation to the size of the economy is primarily the presence of state-owned enterprises (SOEs) that represent over half of market capitalization. Unlike the majority of public corporations around the world, especially in the developed world, SOEs are not run by a strong drive for profits, always taking political perspectives into consideration. This lack of straight forward desire to maximize profits can be translated into lower valuation than management may wishes to see. Half a century ago, Milton Friedman famously said “The social responsibility of businesses is to increase profits”. This Friedman’s maxim is under scrutiny in the U.S. in recent years. Shareholder capitalism has probably gone too far in the U.S. in the last 50 years and the importance of stakeholders are now receiving some renewed attentions. Outside of the U.S., in Europe, Japan or developing countries, shareholder capitalism has not become that naked and stakeholders always had a stronger voice than in the U.S. for opaque reasons that may or may not be justified legally. That corporations in Europe, Japan and developing countries did not succeed in taking their businesses far enough Into shareholder capitalism does not mean they are ahead. In fact, management outside the U.S. has been struggling to raise shareholder value, despite it has been their stated goal for decades. SOEs’ presence in the market has been growing since Xi Jinping’s rise to power. President Xi has been tightening his grip on SOEs. Having not been run solely for profits before Xi already, SOEs are moving further away from the business of generating grater amount of profits for shareholders. Perhaps they are managed to deliver what the largest shareholder, which is the Chinese state, wants. For the Communist Party, SOEs are the tools to exert its influence over the economy, and profits might not matter to them as much as they do to shareholders as investors. The Communist Party would rather keep employment with SOEs than shutting down unprofitable divisions and laying off workers, thus making workers thank the party for pay checks they receive. It’s unwise for private sector investors, Chinese or else, to invest together with the Communist Party that has a different motivation. Another problem is its Chinese markets’ probably inflated size due to large stakes held by the state, making a large portion of the market unavailable for investors. Value of a company would not have been the same if the stakes held by the state are traded in the market, on altered supply-demand equilibriums. This is a common issue outside of the U.S., especially among emerging markets. Saudi Aramco has reached $2 trillion in market capitalization shortly after its IPO in December 2019. It would never have been a $2 trillion company, if the Saudi Arabia government has sold more than a tiny 1.5% of the company. Potentially vast supply of shares in the future could weigh on share prices. What if the Saudi government has a plan to sell all the shares they have, the remaining 98.5%? It’s implication could be devastating though this is a highly unlikely scenario. Even in a bit more probable event of the government’s plan to hold a more realistic 90% of the company, the markets would be flooded with shares several times over what are currently traded. In contrast, Apple that has also hit $2 trillion market capitalization is one of the most liquid large cap stocks, with non free-floating shares limited to some insiders’ stock option holdings. A part of the reasons that Apple has high free-floating rate is that Steve Jobs had dumped all the shares he had but one, when he was fired in 1985 by the company he cofounded. Apple’s value should be closer to $2 trillion even if shares held by insiders are sold in the market while that of Saudi Aramco definitely isn’t. China probably stands somewhere between Apple and Saudi Aramco on a free-floating issue. Very significant non free-floating shares in the hands of the governments cause a problem on the measurement of the market’s size. The market probably is not as large as what the numbers on the surface suggest, since non free-floating shares make the market size bloated. A true size of the Chinese market is very likely be lower than $10 trillion, even including those tech companies that are traded outside of China. Benchmark index provider Morgan Stanley Capital International takes into consideration non free-floatIng shares, not only state stakes but also shares held by insiders such as founders and venture capitalists and Japan’s mutual shareholding’s, in calculating market weights. As a result, China’s weight is low in international indices, as opposed to developed world countries.
About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan