Despite uncertainty, some still see promise with China

Recent weeks have seemed a case of one step forward, two steps back in the evolution of China's A-shares market from retail-dominated casino to an institutional engine of corporate finance and price discovery.

From a longer-term perspective, however, it could be two steps forward, one step back.

The Shanghai Stock Exchange composite index ended the week at 3,160.17, down almost 40% from a June 12 high of 5,166.

The government, meanwhile, has continued to stumble in its attempts to short-circuit that sell-off, which has persisted for 10 weeks — following a 150% surge during the preceding year.

Its latest moves have escalated to include arrests, detentions and public confessions.

Away from the show trials, though, regulators have been accelerating steps that promise to strengthen the local market's institutional investor base over time.

On Aug. 24, regulators announced the country's public pension funds, with more than 3.5 trillion renminbi ($550 billion) in assets, will be allowed to invest up to 30% of their portfolios in domestic equities, easing rules that had restricted them to bank deposits and local government bonds.

At a subsequent news conference, You Jun, vice minister of China's Ministry of Human Resources and Social Security, estimated 30% of 2 trillion renminbi in public pension money — or roughly $100 billion — could find its way to domestic stocks.

That followed a move by the China Insurance Regulatory Commission lifting the equity allocation ceiling for local insurance companies to 40% from 30%.

And on Aug. 31, the China Securities Regulatory Commission and other regulators urged listed companies to consider steps, including mergers and acquisitions, boosting dividends and share buybacks, to make their shares more attractive to investors.

For now, with China's leadership seemingly behind the curve in responding to a significant slowdown in the country's torrid growth of recent decades, investors are accentuating the negative.

Amid growing pessimism that China's economic overseers might not prove “capable of controlling this crisis,” many investors who had been intrigued by the market as it rallied during the 12 months through June have decided it's “not worth the effort” for now, said Qi Wang, Hong Kong-based partner and advisory director with MegaTrust Investment (HK).

The latest monthly data on quotas under China's qualified foreign institutional investor program showed total quota capacity edging up $100 million to $76.7 billion in August, with a lone award of $400 million to BlackRock Inc. offset by 10 other QFII holders returning a combined $300 million in quotas granted in previous years.

Among them, Columbia University returned $44 million of an $85 million quota. Scott Schell, a New York-based spokesman for the university, said officials declined to comment.

Another QFII holder, Singapore-based APS Asset Management, saw its quota go to $230 million from $243 million. Wong Kok Hoi, the firm's founder and chief investment officer, noted in an e-mail that under the QFII program's rules, “when our investors redeem and repatriate capital, the QFII quota (has) to be returned.”

Even so, Mr. Wong pointed to the reforms in August that have opened the door for local pension investments in stocks as something “very positive” for the “long-term capital development” of a Chinese equity market where retail investors trading on “rumors and stories” still account for 80% of turnover.

In the short term, the amount of pension money in play, at roughly 1% of the A-shares market capitalization, isn't likely to have much impact, predicted one Hong Kong-based analyst, who declined to be named.

But that pension pot is destined to grow. A June 2014 report on China's pension system by Hong Kong-based Macquarie Capital Securities Ltd. predicted the country's overall pension system assets could rise to RMB31 trillion by 2023 from RMB5.4 trillion at the end of 2013 — a compound annual growth rate of 19.2%. Scott Russell, the report's main author, couldn't immediately be reached for further comment.

“Over the long term, the Chinese government wants the market to be more institutional,” and bringing in institutional investors like pension funds will be “good for the country and the stock market,” predicted APS' Mr. Wong.

Government officials said they'd work to put the necessary guidelines in place for pension funds to invest in the stock market as soon as possible, although some market participants predicted it would take up to a year before that money would find its way into the market.

It will take time as well for the country's institutional investor base to mature, predicted a second Hong Kong-based analyst, who likewise declined to be named. “It's important to remember that not every "institutional investor' in China invests like institutional investors you see elsewhere,” he said.

At the end of the day, more institutional participation will only matter to the extent that domestic institutions are rational and value-driven when they invest, agreed Ken Wong, a Hong Kong-based China portfolio specialist with Eastspring Investments (Hong Kong) Ltd.

The long hoped for infusion of foreign capital could begin sooner.

MegaTrust's Mr. Wang noted that Vanguard Group Inc.'s $70 billion emerging markets exchange-traded fund and index fund could begin as early as this month following through on its pledge to phase in a 5% allocation to A shares over a 12 month period, which — at more than $3 billion — could be the market's first big dollop of passive overseas money, with more likely to follow.

Vanguard spokeswoman Linda Wolohan declined to comment on when the firm's emerging markets ETF/index fund will begin phasing in that weighting, but confirmed the move to add A-shares exposure will begin before the end of 2015. n