ALLOWING overseas firms to sell shares in Shanghai is a key part of the city's strategy to become a global financial hub. But without a sound regulatory framework, speculators could spoil the party.

China has been gearing up to create an international board for overseas firms to list shares on the Chinese mainland for years. Hu Ruyin, general manager of the research unit at the Shanghai Stock Exchange, said earlier this month that the new board could be launched as early as next year.

More than rules

His comments reignited market enthusiasm about the long-anticipated initiative. Regulators were reportedly busy drafting rules for the board this year, though no details have been released to the public yet.

Rules only get you so far. The international board is designed to promote the clout and influence of China's capital markets; volatility could cripple it. A successful launch must, therefore, ward off problems before they arise. That requires careful organization of trading mechanisms and sufficient investor education.

China first seriously talked about an international board about four years ago, but the idea was placed on the back burner as regulators turned their attention at that time toward reviving a domestic equity market beset with worries about a glut of shares.

The issue returned to the spotlight last year when the State Council, China's Cabinet, issued guidelines to allow overseas firms to sell stocks and bonds in Shanghai. The initiative supports the city's ambition to become a global financial hub on par with London or New York by 2020.

Chinese securities officials have signaled that foreign firms that are well-known in China and have local operations will be among the first allowed to list. They have already been approached by interested overseas conglomerates from the financial, consumer, telecom and manufacturing sectors.

Companies, including HSBC, Standard Chartered, NYSE Euronext, Bank of East Asia and Unilever, have shown interest in selling shares on the mainland. Coca-Cola, General Electric and Wal-Mart are also reportedly keen.

Essential to goal

Permitting overseas companies to sell shares in China is essential if the country is to bring its capital markets in line with international standards. But the program will, by necessity, retain a strong local context. As long as China's currency remains non-convertible, foreign firms will likely be restricted to listing assets held by their mainland-incorporated units and then using the yuan-denominated proceeds for local expansion.

However, that's not an unattractive prospect. At present, the valuation of the mainland bourse is more appealing than valuations of mature markets overseas because domestic shares rebounded more quickly and more robustly from the global crash of 2008.

A Chinese listing would also allow foreign firms to diversify their shareholder bases and further boost public awareness of their brands and operations. Besides, individual investors may be willing to pay a premium for global brands.

Once listed, it would be easier for these overseas firms to seek more stock sales to finance future growth. They might even be able to sell stakes to mainland strategic investors.

With China expected to maintain its gradual appreciation of the yuan against the US dollar, it would be in the interest of foreign firms to issue more local-currency stock.

But speculation - and the market volatility it threatens to create - remains the biggest concern.

When ChiNext, the Nasdaq-style growth enterprise board, opened in Shenzhen last year, frenetic turnover resulted in some stock prices doubling, trebling or soaring even more on trading debuts. The massive highs were followed by equally deep lows in subsequent sessions.

In addition, irregularities such insider trading and market manipulation were rife.

After a year of operation, investors on ChiNext learned a valuable lesson: A market bent on fancy technology and innovative ideas doesn't necessarily lead to high returns.

It is unclear whether Chinese regulators will set a capital threshold or other restrictions on investors trading on the international board. But one thing is certain: there will be a supply shortage of equities when the market kicks off. In other words, if authorities don't allow a large number of companies to go public at one time, shares of overseas firms are likely to be massively oversubscribed. As a result, they will trade at a premium to their counterparts listed in foreign markets.

In the long term, Chinese investors will benefit if they gain access to the world's best organized and most profitable companies. The problem, as is always the case in China, is that institutional investors will get access first - either as cornerstone investors or first-movers who cash out when the speculators flood in.

Education vital

It is a recipe for volatility and not the image Shanghai wants to project as it bids to be an established, respected and orderly financial hub.

One of the priorities for the securities regulator is education. Protecting the interests of minority investors is as important to the development of China's capital markets as bringing in foreign companies.

Investors must be told about the risks of the international board. They must be given complete and timely access to information about the participating companies. They must be given a wider array of investment options - stock index futures, short-selling and margin trading, which are now being tried out in China - to help manage liquidity.

These measures should be included in a comprehensive plan for the international board that maps out how it will evolve - in size and sophistication - over the next two years. Investors also need to be aware that a new market is no guarantee of making money, even if it boasts members of the Fortune 500.

What also we need is a solid, share-pricing mechanism and a market that's effectively regulated. The watchdog needs to arm itself with stiff penalties against those who abuse the IPO pricing system.

Any collaboration between underwriters and institutions to artificially inflate prices must be disclosed and the culprits severely punished. Underwriters should be held accountable for their misbehavior even if it comes to light months after a listing.

It is time to get tough and ensure IPO pricing on the international board is transparent, reasonable and rule-abiding.

That would go a long way toward buoying investor confidence and reducing volatility in the market.