Weak Links Mar Investing in China; Stocks Trail the Rest of the Economy as State-Owned Companies Get Preferential Treatment for IPOs

June 25, 2013, 8:13 p.m. ET

Weak Links Mar Investing in China

Stocks Trail the Rest of the Economy as State-Owned Companies Get Preferential Treatment for IPOs

SHEN HONG

The selloff in China’s stock market abated on Tuesday, but a key issue for investors remains: The country’s financial system puts state-owned companies ahead of private businesses.

The Shanghai Composite Index fell 0.2% on Tuesday after tumbling 5.3% on Monday, its biggest one-day percentage decline since August 2009, on worries about a credit crunch. Chinese shares initially began trading on Tuesday with another sharp drop, but recovered after Chinese central-bank officials sought to soothe investors.Analysts and investors say that for the rebound to gain any traction, China needs to revamp a system that gives state-owned enterprises preference when granting approval for initial public offerings. More-profitable companies often must wait years to tap the stock market, which is composed mostly of domestic investors, because of strict quotas on foreign ownership of stocks.

“The IPO system is one of the key problems,” said Eddie Chow, portfolio manager at Templeton Emerging Markets Group. Mr. Chow’s team manages around $50 billion.

Many investors cite the government’s policies as the main reason Chinese shares rank among the world’s worst performers since the financial crisis, even as China has posted some of the fastest growth rates.

The Shanghai index is down 14% this year, while the Dow Jones Industrial Average is up 13%, even after recent turbulence caused by investors fretting about the withdrawal of Federal Reserve stimulus measures.

More than half of the companies listed on the Shanghai Stock Exchange are state-owned, the direct result of the government’s preference for them as IPO candidates. The State-owned Enterprises 100 Index on the Shanghai Stock Exchange has fallen 40% since it was launched in July 2009. The bourse’s Private-owned Enterprises 50 Index has declined just 1.2% since its debut on the same day.

In that period, the overall market has fallen 34%.

“The stock market has failed to reflect China’s good economic prospects because these [state-owned enterprises] aren’t very profitable,” said Shawlin Chaw, Asia strategist at Discern Investment Analytics, a brokerage in the U.S. “A lot of employment is being provided but it doesn’t necessarily mean they are making profit.”

Many investors expected stock-market changes to kick in last year. But now they say they are resigned to delays after China’s chief markets regulator was replaced in March during a political reshuffling.

Even foreign investors, who have clamored to get a piece of the tightly controlled quotas that allow them to invest inside China, are backing off.

According to data from EPFR Global, which tracks money flows, $3.13 billion left the Chinese stock markets between June 1 and June 21, compared with peak inflows of $4.4 billion in December.

Analysts say the favoring of state-owned companies over private businesses effectively undercuts the stock market’s role as an efficient allocator of capital.

Shandong Jinchuang Co., one of China’s largest privately-run gold producers, has been applying to list its shares since 2007 and has been rejected several times despite years of consistent profits, a key regulatory requirement.

The opaque listing process is one reason some of China’s most profitable and innovative private companies bypass the domestic stock exchange in favor of overseas listings. A unit of e-commerce giant Alibaba Group Holding Ltd. and Chinese Internet company Tencent Holdings Ltd. 0700.HK -0.21% both turned to Hong Kong, while microblogging provider Sina Corp. SINA +2.87% chose New York’s exchange.

Many investors in China have given up.

They are pouring their savings into property and risky trust products that promise high yields, prompting the government to try to rein in those markets. Trading volume in stocks has dropped 42% from a peak in 2010, while dormant trading accounts have risen by more than half since 2008.

“I am told the stock market is a barometer of the economy. What kind of barometer is that here in China?” said Li Zhiliang, a 57-year-old retired taxi driver who holds shares in auto makers, military-equipment firms and pharmaceutical producers. “The rallies in our stock market never seem to last. Whenever it goes up, it will fall the next day.”