It's not China's IPO system, stupid!: Wei Gu

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

By Wei Gu

HONG KONG (Reuters) - Chinese IPOs regularly produce dot-com sized first-day "pops". What is to blame: underpricing by issuers, abundant liquidity or over-zealous investors?

Traditionally, the public has believed that systematic underpricing was responsible. But with two IPOs this week immediately doubling from what were generally seen as deliberately high offering prices, the finger of suspicion has turned toward liquidity and investors' animal spirits.

China's IPOs have a reputation for offering easy and quick killings, so retail investors and even corporations are eager to participate. The allotment is usually decided by the amount of cash put down, with the biggest bids standing a better chance. This means that small retail investors generally get marginalized which, in turn, is why they get cross about the underpricing of hot IPOs.

Determined to reduce the size of first day pops and to give small investors bigger access, the regulator recently revamped the IPO system. Beijing started to limit the number of shares each bidder can buy, asked institutional investors to be more serious with their bidding so they cannot give artificially low prices, and added a new circuit-breaker rule for newly listed shares so they will be suspended for 30 minutes after rising 20 percent.

Those measures have achieved little. Drugmaker Guilin Sanjin Pharmaceutical Co. 002275.SZ was priced at an aggressive 30 times 2009 earnings, roughly in line with its peers in the secondary market (which was itself high compared with the 20 times multiple which they traditionally enjoyed.)

Despite the expensive valuation, Guilin Sanjin was heavily oversubscribed -- by 584 times. When they opened for trading on Friday, shares zoomed as much as 100 percent. Another IPO, industrial cable maker Zhejing Wanma (002276.SZ) also nearly doubled its offering price today.

The logical explanation is abundant liquidity -- China's 2009 new bank loans tripled the level achieved during the first half of 2008. The spike can also be blamed on the limited supply of new stocks. The authority suspended capital-raising activities last year to prevent the market from weakening further.

China's stock market has no shortage of speculative behavior for IPOs. When CAMC Engine (002051.SZ) came to the market in 2006, it surged as much as six times on the first day, before it fell by its daily limit of 10 percent for five consecutive days afterwards. It has never come back to the high point hit on the first day of trading.

This kind of volatility is exciting, but can lead to big misallocations of capital. Think of what happened in the United States during the dot-com boom. Of course, in America, the market ultimately solved the problem. Too many ropey IPO candidates sought a listing, investors became jaded and ultimately there was a reversion to mean.

In China, it is hard to expect market forces to work their way through the system. The problem is the regulator still decides for investors when IPOs should come to the market and at what price. That kind of heavy-handed approach emboldens speculators as they believe the government will not allow the IPOs to fall below their offering prices.

If the stock market is to perform its role in allocating capital efficiently, this may be one area in which capitalism needs to be a little less managed. Instead of coming up with even more new rules to regulate investor behavior, a better approach would be for the regulator to do less. -- 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. -- (Editing by Martin Langfield)