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Securities reform likely to continue despite risk, global financial crisis

CHINA'S securities regulator has pledged to press ahead this year with reforms that may include the establishment of a new Nasdaq-style board for smaller start-up companies and the introduction of margin selling and other tools investors may use.

The commitment comes against a backdrop of sharply slowing economic growth that may erode corporate earnings and amplify stock-price volatility, making market overhaul a more difficult task, analysts said. China was the world's worst-performing major stock market last year.

"The big fluctuation of the A-share market in the past two years was partly due to slow progress in the build-up of regulatory systems," said Chen Wenzhao, an analyst with China Merchants Securities Co. "The signal from the securities watchdog this time is that the country will do more to improve market fundamentals in 2009."

The China Securities Regulatory Commission said in a statement after its annual work conference last month that it will proceed steadily with market innovations and continue to open equity investment to overseas participants on a measured basis.

The commission said the domestic stock market remains healthy even after its 66-percent drop last year. It said its priorities are the protection of investors' interests and a continuing crackdown on market manipulation.

The long-awaited growth enterprise market in Shenzhen is likely to be unveiled late in the year as the government steps up efforts to help small companies raise capital during the financial crisis, analysts said. The so-called GEM is to be patterned after the Nasdaq market in New York, with emphasis on smaller, cash-strapped technology companies that show solid growth potential.

The Chinese central government has been preparing for the GEM's launch in the past three years. Earlier fears that GEM might siphon capital from existing main markets have eased, with industry analysts now saying the new bourse will be focused on smaller capital raisings and then only on a trial basis.

"The spreading financial crisis has threatened the survival of smaller companies in China, and the second board will give them a shot in the arm," said Xu Lili, an analyst with Bohai Securities Co. "The launch of GEM carries a low risk."

The Nasdaq-like board will have lower listing thresholds than the main boards in Shanghai and Shenzhen. Listing candidates must show two consecutive years of profit, with combined earnings of at least 10 million yuan (US$1.5 million). If a firm fails to meet the cumulative profit requirement, it must have revenue of at least 50 million yuan and a profit of at least 5 million yuan for the latest fiscal year.

By comparison, firms that list on the main boards must post profit for three years in a row, during which collective earnings must be at least 30 million yuan.

GEM is only part of the ambitious market overhaul announced by the regulator. The commission also said it would work on establishing China's first equity index futures, margin trading and short selling.

Market observers are divided on whether innovations that feature bigger risks and may stoke speculative activity are appropriate in a year when the economy faces a drastic downturn.

China, the world's third-largest economy, posted growth of 6.8 percent in the fourth quarter of last year, dragging growth for the full year to a seven-year low of 9 percent.

The decline, hit by a downturn in global demand for Chinese goods, has forced the government to start a massive 4-trillion-yuan stimulus package aimed at boosting investment and spurring domestic consumption to offset weaker exports.

Educate investors

Nicole Yuen, head of China equities at UBS, said a volatile market and declining investor confidence form a poor backdrop for the introduction of index futures, short selling and margin trading.

"Under the current depressed market sentiment, it's not wise to go ahead with these reforms," said Yuen. "But preparation for these innovations should not be stopped."

Margin trading is the practice of borrowing money from a broker to purchase stock. It allows an investor to control more shares than he would normally be able to finance. Short selling permits people who believe share prices will drop to sell borrowed securities and buy them back at a lower price to repay the lender. Both mechanisms carry high risks and can be ruinous to unwary investors.

The risk and the need to educate investors how the systems work has caused at least two postponements in the last three years.

Industry analysts predict only select brokers will be allowed to participate if the systems are introduced on a trial basis later this year.

China set up its financial futures exchange in September 2006 in preparation for the debut of index futures contracts, which will be based on the CSI 300 index that tracks the top 300 Chinese mainland-listed firms.

Index futures, often used as hedging tools, allow an investor to make bets on the direction of an entire index rather than individual stocks. Like margin trading and short selling, they are speculative trading mechanisms and require sophistication on the part of investors.

"The global financial-market meltdown will make regulators take an even more cautious attitude in the introduction of index futures," said Xu at Bohai Securities. "Unless the stock market shows signs of overheating, it's not likely the futures products will be unveiled this year."

Analysts interviewed by Shanghai Daily said they doubt the securities regulator will set up a government-led buffer fund to stabilize the stock market this year or introduce more measures to curb a glut in stock supply caused by the expiry of lock-up periods. Neither was mentioned in the summary of the meeting last month, they said.

The stock market's tumble last year was partly blamed on the volume of shares hitting the market after lock-up periods on offerings of state-owned shares expired, making non-tradable stocks tradable.

China's stock regulator has already asked big stakeholders who hope to dispose of more than 1 percent of a listed firm's total shares to sell them in off-market block trading. But some market analysts are urging more government action to counter the possible negative effects of non-tradable shares hitting the market.

"The regulator is expected to improve the block trading system instead of unveiling new measures to prevent an equity glut," said Jiang Jianrong, an analyst with Shenyin and Wanguo Securities Co. "It's almost impossible for the government to launch a stabilization fund."

UBS's Yuen suggested Chinese market authorities should look to Hong Kong for workable solutions.

In 1998, Hong Kong acquired a substantial portfolio of shares to stave off collapse during the Asian financial crisis. A year later, as the first step in a program to dispose of the shares, it launched the initial public offering of the Tracker Fund, which allowed the government to extract value from the shares without dumping them on the market.

Among other plans unveiled last month, the stock regulator said it hopes to boost the value of mainland-listed stocks by encouraging public companies to increase dividend payments and buy back more equity.

But what's more important for the regulator, analysts said, is to weed out corruption and illegal trading to bolster investor confidence.

"One of the regulator's priorities is to ensure all market participants operate in line with rules and regulations," said Shenyin and Wanguo's Jiang. "Compliance seems important against the backdrop of the ongoing financial crisis and tough economic times."


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