Why China's "start-up" bourse won't produce a Microsoft

HONG KONG (Reuters) -China hopes a new stock exchange, an incubator for start-up companies, will transform the nation into a global technology heavyweight after it is launched this year. But Beijing may have another think coming.

Intellectual property protections lack teeth and stifle innovation while inconsistent regulations don't do enough to prevent fraud. What's more, investors are already choking on a flood of new share offers that helped push China's share index down 34 percent in the first quarter this year.

A start-up market, which could be launched later this year, would provide a much-needed venue for China's small enterprises, which have been largely shut out of traditional funding sources such as banks and the main stock market.

But a second board, instead of attracting up-from-the-ground technology companies, is likely to be dominated by firms from traditional industries. Most Chinese companies still compete on cost, and few can afford to invest in cutting-edge technology.

Start-up boards in most countries wither and die, with Nasdaq being a bright exception.

The success of start-up markets hinges on whether a country has a rich culture of innovation that fosters entrepreneurs and a sophisticated financial system that encourages commercialization of technology. China has neither.

"It is useless just putting a market out there," said Steven Sun, a strategist at HSBC. "The market will probably just become a bank for small enterprises."

China does boast some big technology firms, such as Baidu (BIDU.O) and Sina (SINA.O). But they have listed on Nasdaq, attracted by its large base of technology-savvy investors.

China's more established tech companies are likely to continue to go abroad for global recognition. Many of them have to, precisely because they are funded by foreign venture firms, which ultimately have to exit through overseas markets to take profits on their investments.

Because of that dynamic, China is competing against Israel to become the world's largest exporter of technology companies to the Nasdaq market.

Most likely, China's start-up market will look similar to its main board, but with lower listing standards.

Companies currently need to have a track record of three profitable years to list on the main board, but just two years for the growth board, or one year if they meet other standards.

The lower standards raise concerns about possible fraud. Start-up companies, being smaller by nature, are vulnerable to stock manipulation. Speculation and securities fraud are already rampant on the main board. What will happen if Beijing lowers its threshold for the growth market?

Even venture capitalists, who would benefit from a new channel to take profits, are not enthusiastic about the launch of a growth market.

"After a few scandals, investors will lose faith in the growth market," said Jin Chen, a partner at a CMHJ Partners, a Chinese private equity fund.

The introduction of the new market now looks ill-timed as well. The main board has plunged 40 percent from its October peak, and investors are jittery about any more capital-raising.

China plans to introduce 100 companies to the growth market this year. At least the size of the new offerings will be limited, though, with the total amount to be raised accounting for less than a third of the capital raised by one single company, PetroChina (601857.SS).

Nevertheless, the growth market is likely to see heavy trading and will compete with the main board for liquidity.

It's worth remembering that after China introduced a market for small-and medium-sized companies, a bubble immediately developed there while the main board, with trading volumes drained by the new market, slumped into a two-year bear market.

Yet, by proceeding with the small-cap market despite the market downturn, Chinese regulators are demonstrating their determination to develop multi-layered capital markets.

At least there is a positive side to the current weak investor sentiment: Speculators may be less daring now, so the growth market's debut may not suffer from wild swings.

"If the regulators always look at the stock indexes for the best timing, then the task of introducing a new market will never get done," said Jerry Lou, a strategist at Morgan Stanley.

In any case, don't expect giants to emerge from the start-up market. Out of more than 40 start-up boards globally, only a handful such as the Nasdaq, London's AIM, Japan's Jasdaq, Korea's Kosdaq, and Canada's TSX-X are doing well.

Many fund managers have dismissed Hong Kong's GEM market as a failure because it is full of "penny" stocks despite a lot of hype at the beginning.

Why, if such markets fail to flourish in most countries, would one do well in China where other market and business handicaps abound?

China is the only country among the top 10 largest economies that does not have a growth board. That is probably for a good reason, and the country might do just fine without it.

Wei Gu is a Reuters columnist. The opinions expressed as her own.

(Editing by Ken Wills)

(At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund.)