REFILE-CHINA MONEY-IPO crackdown reduces manipulation, but raises moral hazard

Wed Feb 19, 2014 10:00pm EST

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(Corrects surname in paragraph 8 to Fuhrman from Furhman)

* Issuers, underwriters failing to price IPOs properly

* Retail investors prefer short-term, small-cap gambles

* Reforms to preferred shares, market-driven system may be delayed

* Net issuance may miss expectations in 2014

By Lu Jianxin and Pete Sweeney

SHANGHAI, Feb 19 (Reuters) - The worrying spectre of insider trading in China's IPO market has prompted regulators to tighten control and Beijing may now be forced to scale back the pace of reform.

The China Securities Regulatory Commission (CSRC) let initial public offerings resume in January after a 14-month hiatus, but traders say the authorities are concerned the market is being exploited by connected stakeholders ensuring generous cashouts for insiders.

The CSRC has tightened up rules on IPO pricing, and also stands accused of intimidating some firms into "voluntarily" suspending their listings, despite verbal commitments to stop meddling in the market -- an accusation it denies.

"I think this is a total retreat in comparison to other areas of reform in China," said Ding Yuan, professor at the China Europe International Business School in Shanghai who also runs a mutual fund investing in domestic equities.

Ding said that instead of giving markets a "decisive role" as promised, January saw the "most heavily intervened IPO in the history of China". Drug maker Jiangsu Aosaikang apparently delayed its IPO over concerns the listing was overpriced.

"People may have felt like the IPO wasn't politically correct, but it was totally legal. (Aosaikang) followed the regulations to the letter. For me that proves the soap opera we are seeing will continue."

REGULATING OR MEDDLING?

The problem of price manipulation during IPOs is one Beijing has struggled with for years. Ironically, some market-driven reforms may have exacerbated the problem.

"Look closely at companies that have gone public this year in China. They include ones from industries, or with P&Ls (profit-loss ratios), that previously CSRC would not allow to IPO in China," said Peter Fuhrman, chairman of China-focused international investment bank China First Capital in Shenzhen, who is optimistic regarding the CSRC's commitment to reform.

"To have a private sector company with downward-drifting net income successfully IPO in China was heretofore unthinkable. Hence, it is already far more of a market-driven system."

By allowing financially weaker companies to list, and at the same time making it easier for their owners and cornerstone investors to cash out on the primary market for the first time, the CSRC may have inadvertently encouraged overpricing.

MORAL HAZARD

That strategy was nipped in the bud by the new guidelines locking PE ratios within range of industry peers; some even priced themselves at discounts.

The price controls reduce the incentive for collusion to manufacture artificially high prices, and theoretically that benefits retail investors too, as it means more potential upside to the shares once they begin trading publicly.

But Ding of CEIBS said the strong hand of regulation disincentivises risk taking. "If you always treat a child like a child, it will never become an adult."

And by signalling to retail investors that the CSRC will protect them from price downsides, it is adding the same moral hazard to the stock market that distorts bonds and real estate.

The question remains how to encourage investors to invest in long-term growth instead of gambling on volatility. Unfortunately, Chinese exchanges remain some of the world's worse-performing, still down more than 60 percent from a peak in 2007, making such strategies a tough sell.

The problem is illustrated by the wide gap in PE ratios. The average PE ratio for the Shanghai exchange, heavy with large-cap firms, stands at 11 times of 2012 historical earnings. Smaller firms listed in Shenzhen are in comparison nearly three times more expensive by the same measure.

But even though they may be more expensive, speculating on small-cap listings continues to pay off.

Nearly all the 39 firms which debuted on China's smaller Shenzhen exchange in January maxed out their 44-percent limit-up on debut, and continued hitting the 10-percent upward daily limit over several days. Most of them have more than doubled in value since listing despite relatively high average price-to-earnings ratios.

In contrast, Shaanxi Coal Industry Co in Shanghai, China's largest listing since March 2012, fell back to near its IPO price within four days after listing, forcing the parent to buy back shares to support prices.

Traders say the setbacks will most likely restrain China's IPO market in 2014 from reaching earlier projections. PwC in January estimated Chinese firms could raise 250 billion yuan ($41 billion) from listings in Shenzhen and Shanghai this year.

($1=6.07 Chinese yuan) (Editing by Jacqueline Wong)

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