THE recent moves by the China Securities Regulatory Commission to reform the A share initial public offering mechanism to enhance the integrity of the market and regain investor confidence could not have come at a more opportune moment, as all signs point to the US knocking China off its perch as the world's top IPO market for the first time since 2008.

According to CapitalVue data, 63 companies went public on the domestic bourses during the first four months, raising a total of 46.36 billion yuan (US$7.36 billion), a 64.3 percent year-on-year decline. This is less than the US$11.9 billion raised by new listings in the US during the same period, according to Dealogic. The gap widened further with the Facebook's US$16 billion IPO last week.

Although China was the top dog in the initial public offering market last year, with a total of 289.43 billion yuan raised from the share sales of 281 companies on the domestic exchanges, the amount raised was a significant decline from the 488.26 billion yuan raised in 2010, according to CapitalVue data.

Overcoming malaise

The market is hoping the reform measures will provide the spur needed to overcome the malaise surrounding the Chinese initial public offering market, which is currently beset by a number of problems. Investors have long complained of the high price-earnings ratios of new share offerings, significant drops in earnings growth soon after listing and continued weaknesses in the shares of many newly listed companies. For instance, high-end automobile distributor Pangda Automobile Trade, which went public last April at 45 yuan per share, closed trading yesterday at 7.35 yuan per share.

In addition, there have recently been more cases of companies terminating their share offerings due to their inability to meet the regulatory requirement of having more than 20 institutions participate in their bookbuilding. JiangyinHaida Rubber & Plastic, a maker of rubber components used in the subway, construction, automobile and shipping industries, was the third company which failed to meet this criteria.

In the past, Chinese companies that failed to obtain approval to list on the domestic bourses had tended to attempt listings in the US, Hong Kong and other overseas exchanges. However, accusations of accounting fraud by listed Chinese companies in the US and the poor stock performance of Chinese companies in Hong Kong have made this option harder as investors view them as being tarred with the same brush.

Another factor that would make a Hong Kong listing harder is the reform currently being pursued by the territory's Securities and Futures Commission, which seeks to impose criminal penalties on bank officials or sponsoring firms that fail to conduct proper due diligence. With sponsors certain to face higher costs and risks from arranging initial public offerings in Hong Kong, smaller Chinese companies may find it tougher to list in the special administrative region as the risk-reward ratio for the sponsors become less compelling.

Raising the bar

Where does this leave Chinese companies that need to tap the capital markets for funding?

All indications point to a raising of the bar both for companies and the sponsors underwriting the share sales. Whether they intend to list in China, Hong Kong or in the US, Chinese companies will have no choice but to lift their game if they intend to go public as underwriters step up scrutiny to better detect fraud and comply with a tougher regulatory regime.

The regulator hopes to curb overly high issue prices with a more market driven pricing mechanism. There are certainly no quick fixes, for if the prices are set too low, the fundraising targets will not be met and low prices may invite speculative trading on the secondary market, which may send stock prices soaring on their debuts. For instance, the stock of JPMG Guangdong, a maker of hard and soft ferrite magnets, surged 149 percent on its debut last July.

Strict punishment

Under the final guidelines released at the end of April, underwriters will be allowed to invite five to 10 individual investors to participate in the pricing procedures. Separate responsibilities for issuers, intermediary institutions, legal firms, accounting firms and rating agencies were detailed, and strict punishment for irregularities and illegal practices was established, according to a Xinhua news agency report.

In cases where the price-earnings ratios exceed that of industry peers by more than 25 percent, issuers are required to further analyze possible risks to disclose more information to investors.

The three-month lock-up period for institutional investors was removed in a bid to boost the circulation of new shares, while reforms are set to be made to the sponsor selection process.

These measures come after the CSRC injected greater transparency into the IPO approval process on February 1, when it published details of the process and released the names of 515 companies whose listing applications were under review.

According to a 21st Century Business Herald report, effective February 1, companies wishing to list will have to go through 10 procedures by various departments before obtaining the green light to list. The CSRC will update the status of each company's application on a weekly basis.

Alternative channels

It remains to be seen how the draft measures proposed by the CSRC to improve the IPO pricing mechanism, to increase the accuracy of information disclosure and to reform the sponsor system will alter the IPO landscape.

The proportion of funds raised through IPOs has been rising as the authorities look to the capital markets as alternative channels for fundraising after the breakneck pace of loan and money supply growth in recent years. In order for IPOs to continue to be the golden pot of manna for Chinese companies, higher listing standards are an inevitable and positive development.

Seen in this light, the drivers for the continued growth of the initial public offering market remain. China will continue with its urbanization drive and the restructuring of its economy toward one that is more consumption-driven. Not withstanding the latest 0.5 percentage point cut in the required reserve ratio, the quest for funds will take place in an environment of relatively tight monetary policies. This augurs well for the future of the initial public offering market in China.

CapitalVue provides China capital market, fundamental, and time-series statistical databases for institutional investors, government organizations and academic institutions. Read more on www.capitalvue.com.