From the August 2010 issue of Research Magazine • Subscribe!

August 1, 2010

Reawakening the Dragon

China's stock market volatility has deep roots in a turbulent history.

China's stock market was born in the 19th century, abolished and reborn in the 20th century and in the first decade of the 21st has expanded to an unprecedented scale and importance. The market has been of intense interest to international investors, both long ago and recently, while remaining notable for its volatility, both in its stock price movements and in the turbulent shifts of China's political and regulatory environment.

The prospects and concerns facing investors in the Chinese stock market today have parallels in issues that confronted market players in the late 19th and early 20th centuries. Such recurrent themes include the vast growth potential of the huge country and the focus of Chinese reformers on developing the stock market. But other persistent features are daunting: the difficulties of obtaining accurate information about China's companies and economy; and the market's exposure to opaque and unpredictable politics.

In the past several years, China's stock market has taken investors on a wild ride. The Shanghai Stock Exchange's SSE Composite Index, which opened 2006 at 1,161, soared to a peak of 6,124 in October 2007 before plunging to 1,706 in November 2008. In early 2010 the index was back above 3,000, but hovered below 2,500 in early July following Chinese officials' June announcement of a more flexible exchange-rate policy.

In historical context, these sharp swings were not an anomaly. Indeed, volatility has been a salient feature of China's stock market from its 19th-century beginnings.

Opening Shanghai

In the aftermath of the mid-19th-century Opium Wars, China's port cities were increasingly under foreign influence or control. Under the banner of the "Self-Strengthening Movement," Chinese reformers sought to adopt Western ideas as a means of putting China on a stronger footing vis-?-vis foreign powers. One such concept was the financing of companies through tradable stock.

In the 1860s, reformer Yung Wing, the first Chinese to graduate from an American university (Yale '54), proposed the equity financing of a Chinese steamship line. This idea took form in 1872 with the founding of the China Merchants' Steamship Navigation Company, based in Shanghai. Soon, other equity-financed firms were established and stock trading became a growth industry in the city.

Such companies were operated in accordance with a slogan of "Official Supervision and Merchant Management." This meant they were subject to a high degree of involvement by officials of the imperial government, which added an element of unpredictability as firms navigated the bureaucratic maze of permits, fees, loans and official patronage or disfavor.

In the early 1880s, the nascent Shanghai stock market experienced its first boom and bust, driven largely by speculation in mining shares. The number of publicly traded firms jumped from 10 to 29 and then dropped to 12. The market at this time operated on an over-the-counter basis with much participation by Chinese investors. The collapse cut share prices roughly in half and dampened Chinese interest in stock trading for years, as evidenced by a drop-off in coverage of the subject in Chinese-language newspapers.

However, Shanghai's stock market continued to develop, with growing involvement by foreign investors. Trading increasingly occurred on organized exchanges. The first of these, the Shanghai Share Broker's Association, opened in 1891, forming the nucleus of what would become the Shanghai Stock Exchange. The heavy participation by foreigners stirred some resentment among the Chinese. In 1904, China's Ministry of Commerce revamped the commercial code to promote the development of domestic companies and make it harder for foreign investors to take control.

The imperial Qing dynasty came to an end in 1911, and at the start of the following year China officially became a republic. Power over the next few decades would flow back and forth between the central government and regional warlords. Shanghai's equity market showed some resilience to political turmoil, however. Booms in cotton and rubber shares buoyed the market in the 1920s and trading continued through the 1930s even as the invading Japanese army spread through northern China.

In early December 1941, Japan's attacks at Pearl Harbor and elsewhere spread war throughout the Pacific. On Monday, Dec. 8, Japanese forces occupied Shanghai. The previous Friday would be the market's last trading day until 1946.

The revival of the market after World War II was short-lived. In 1949, China's Communists won the country's civil war and established the People's Republic of China. Many Chinese brokers and bankers fled to Hong Kong, further spurring the development of capital markets that had existed in the British colony for decades. A stock market would also develop in Taiwan in the 1950s under the exiled Nationalist government. But on the Maoist mainland, stock trading was abolished along with capitalism in general.

A Market Reborn

In 1978, with Chairman Mao dead and hard-line Maoists in political eclipse, China began experimenting with economic reforms. Stock trading did not immediately appear on the agenda, as early reforms focused on more basic matters such as allowing farmers to sell crops grown on household plots rather than collective land. By the mid-1980s, though, some state-owned companies were edging toward making equity offerings.

A milestone was reached in November 1984 when the Shanghai Feile Acoustics Company issued shares. Soon, over-the-counter share trading was under way in a room at the Shanghai Trust Company. In 1986, John Phelan, chairman of the New York Stock Exchange, visited this nascent operation and pointed out that his sprawling institution had begun without even so much as a room, under a Wall Street buttonwood tree in 1792.

The desirability of securities markets, and how far and fast to go in developing them, were subjects of contention among Chinese officials. A sign that market-oriented reformers were gaining sway came in 1987 when the Thirteenth National Party Congress declared stockholding "a legitimate form of property distribution in socialist enterprises."

The crackdown on political dissent following the 1989 massacre of protestors in Tiananmen Square brought new uncertainty to the investment climate. Yet Chinese officials demonstrated their continued interest in economic, if not political, reforms by permitting the opening of two formal stock exchanges. On Dec. 19, 1990, the Shanghai Stock Exchange commenced operation for the first time in over 40 years. That same month, officials of the city of Shenzhen announced plans for their own exchange, which became operational the following July.

China's top leader Deng Xiaoping, visiting Shenzhen in 1992, made a statement about equity markets that, with some hedging, pointed the way to continued development: "Are securities and the stock market good or bad? Do they entail any dangers? Are they peculiar to capitalism? Can socialism make use of them? We allow people to reserve their judgment, but we must try these things out. If after one or two years of experimentation, they prove feasible, we can expand them. Otherwise, we can put a stop to them and be done with it. We can expand them all at once or gradually, totally or partially. What is there to be afraid of?"

In subsequent years, China's stock market expanded rapidly and worries that officials might "put a stop" to it faded. Indeed, it became clear the government relied on the market for funds to keep state-owned enterprises afloat. At the same time, the high degree of state ownership and involvement in Chinese industry would remain a factor adding to the uncertainty facing investors in the market, as companies' prospects can be buffeted by the decisions of a secretive bureaucracy. It's a challenge that would have been familiar to investors in China's first stock market in the late 19th century.

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Rioting for Shares

In August 1992, riots broke out in Shenzhen over a botched lottery system set up to handle huge demand for a series of initial public offerings at the city's stock exchange. Thousands of people, some peasants from distant provinces, lined up in the streets for application forms to get a chance to buy shares in newly listed stocks. As the forms ran out, rumors flew that the police were hoarding the papers for themselves.

As the crowd grew rowdy, the police set up barricades and then moved in with electric cattle prods and bamboo canes. Further enraged, the crowd descended on municipal offices the next day and was dispersed with high-pressure hoses and tear gas. The authorities made some conciliatory moves, promising to increase the number of applications and look into alleged irregularities. The situation calmed down.

The riots showed two disparate things about China's emerging stock market: One, that there was work to be done in building sound procedures and institutions. And two, that the country had some serious pent-up investor demand waiting to be tapped.

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A Hong Kong Career

Hong Kong's development as a major stock trading center owes much to Noel Croucher (1891-1980), a broker and exchange official who led a colorful and turbulent life.

Croucher was born in England and came to the British colony around 1905. He started out poor, working his way up from office clerk. He became a prot?g? of a financial titan named Sir Paul Chater after warning the older man -- impertinently but correctly -- that some shares he demanded to buy were a bad investment.

Over the next few decades, Croucher became ever-more successful, establishing his own firm and becoming commodore at the yacht club. But his humble origins made him an outsider to the colonial elite. He would become one of the colony's most generous philanthropists, but was considered by some to be a personal tightwad.

Japan attacked Hong Kong in 1941 and Croucher spent World War II in a Japanese prison camp. Reportedly, the camp commander asked him for financial tips. After the war, Croucher worked to combine the two pre-war bourses into a unified Hong Kong Stock Exchange, becoming that institution's chairman.

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