* Regulators preparing pilot scheme for preferred share issuance
* Investors pleased that common stock won't be diluted
* Banks could use it to recapitalise as early as 2014
* Plan ensures continued state dominance in listed firms
By Lu Jianxin and Gabriel Wildau
SHANGHAI, Sept 17 (Reuters) - Plans to let Chinese listed firms issue preferred shares will help cash-starved companies raise capital but do little to reduce state domination of listed firms, leaving a major distortion in China's stock market unaddressed.
China's main stock index has risen 8 percent since Aug. 23, as investors cheered the prospect of listed firms being empowered to raise more cash without diluting existing shareholders - and the possible retreat of the state from direct meddling in the stock market.
Investors have long complained that too many listed firms are required to sacrifice profitability in favour of wider policy priorities, and many viewed the introduction of preferred shares as a way for the government to convert its massive holdings of traded shares into inert preferred shares, diluting government influence while increasing the value of other investors' holdings.
But market watchers say the latter hope is misplaced.
"While the impact of the preferred share scheme is apparently limited, investors have used it as an excuse to push up share prices as valuations of China's equity market are now lingering near historical lows after years of weak performance," said Zheng Weigang, head of investment at Shanghai Securities.
Preferred shares pay fixed dividends and enjoy seniority over common stockholders in the event of bankruptcy. But in other respects they have limited impact on common shareholders. They typically do not trade on the open market, carry no voting rights, and do not dilute net profits attributable to shareholders.
China's securities regulator confirmed the preferred share plan last week, but the market is still awaiting detailed rules.
Zhou Xiaochuan, the governor of the People's Bank of China, wrote in a recent article that preferred shares alongside other hybrid capital instruments could play a useful role in offering companies new fundraising alternatives.
"The preferred share scheme will be a compromise to let listed companies recapitalise while avoiding complaints from investors about too much corporate financing," said Zhang Gang, a senior analyst at Central Securities in Shanghai.
"Regulators appear to be testing waters for investor reaction, but details appear to have not yet been worked out."
Market players expect banks to take the lead in issuing preferred shares on a trial basis as early as in the first half of 2014, as they need to meet tougher rules on capital adequacy in line with the new global standards known as Basel III.
Local media have tipped Shanghai Pudong Development Co as a potential first bank to issue preferred shares. Among state-controlled giants, Agricultural Bank of China confirmed to Reuters last month that it was working on plans to sell preferred shares.
Twelve of China's 17 listed banks have also announced plans to raise around 425 billion yuan ($69.5 billion) through subordinate debt that counts as regulatory capital under China's version of the Basel III rules.
Beyond banks, market players see steel and energy companies as other likely sellers of preferred shares.
Chinese equities have historically disappointed investors, as returns vastly underperformed the growth of China's macroeconomy. A key problem is distortions created by a corporate governance structure still dominated by the state.
But recent talk of preferred shares raised hopes that they could be used to reduce state control.
Apart from the plan to let firms issue new preferred shares, rumours have also circulated that some existing state-owned shares could be converted to non-voting preferred shares, thereby reducing the state's voting share.
But this would mark a reversal from previous reforms completed only a few years ago.
In a three-year reform programme launched in 2005, aimed at removing a decade-old share overhang that had weighed on stock values, state shareholders offered their non-state counterparts cash or new shares as incentives to convert their previously non-tradable shares into freely floating stock.
"It's impossible for state shareholders who have paid compensation to investors to convert previously non-tradable shares into ordinary shares to allow these shares to be converted back into non-tradable preferred shares," said Zheng of Shanghai Securities.
That means China's preferred share scheme will remained confined to new issues only, analysts say; the scheme will limit fresh fundraising via common share issuance but will not impact state dominance.
Finally, analysts point out that Beijing has not formally or informally repudiated its strategy of maintaining control of strategic sectors like energy and finance. It may or may not ultimately adjust the structure of its shareholdings, but this is not the same as giving up control. ($1=6.12 Yuan) (Editing by Pete Sweeney and Chris Gallagher)