How China is Manipulating its market ?

At what cost it is sustainable ?

Investors in China's stock market have seen a remarkable year, with the Shanghai Composite Index rising by 12% from its multi-year low in February, despite a recent dip. This rally is a welcome relief for President Xi Jinping, as retail investors own at least 80% of the market. Previous market downturns had caused significant distress, raising concerns about China's economic future. The recovery is viewed by many as a sign of good governance and fortune.

However, a significant part of this rally is due to the intervention of the “national team,” a group of state-owned institutions that purchase tens of billions of dollars' worth of shares whenever the market wavers. For Xi, the cost might seem justified, but these state interventions have also introduced several distortions in the market, particularly by curtailing the boom in initial public offerings (IPOs). With fewer exit opportunities for private investors, state capital's dominance has increased, potentially stifling the growth of China’s most innovative firms.

Over the past decade, Xi Jinping has steered financial markets to be as much guided by government policy as by price signals and market forces. He has shifted capital from previously booming sectors such as consumer-internet services and fintech to preferred industries like chipmaking, artificial intelligence, and high-end manufacturing. Thousands of state funds have invested in these areas, becoming a major force in Chinese venture capital (VC) and private equity.

For a time, public markets flourished under Xi’s guidance. In 2019, he established the Star Market, a dedicated tech share market, followed by a new stock exchange in Beijing for small firms in 2021. Regulatory changes made it easier for companies to list, making China the world’s hottest IPO market by 2022, with companies raising 587 billion yuan ($81 billion) that year.

But this progress halted abruptly. China’s stock markets started declining in the second half of 2023 and plummeted in early 2024. In response, regulators began emphasizing the need for an “investor-friendly” market, which translated into allowing fewer IPOs to support existing share prices. Consequently, only five Chinese companies listed on domestic exchanges in April 2024, compared to 35 in April 2023. The IPO market raised 80% less capital in the first four months of 2024 than in the same period the previous year.

Those companies that do manage to list face intense scrutiny. In addition to on-site inspections, regulators now review companies' past business deals and scrutinize executives’ bank accounts. This rigorous oversight led at least 80 companies to withdraw their IPO applications in the first quarter of 2024.

These changes have ripple effects throughout the capital allocation chain. With IPOs becoming harder to achieve, investors in unlisted firms have fewer exit options. As a result, the value of sales by Chinese private-equity investors fell from $89 billion in 2022 to just $46 billion in 2023. This decline in valuations has made fundraising more challenging, making investors more cautious about deploying their capital.

State-backed funds, once meant to blend market forces with government policy, now dominate the markets. A state investment manager noted that while private capital has retreated due to the lack of exit options, state capital continues to flow. These state investors, though sensitive to losses, do not have private backers demanding quick returns and can afford to wait longer for returns.

“If venture-capital funds want to survive, they have to find a way to get money from local governments,” concluded Robert Wu, a Chinese investor, in a recent blog post. However, the objectives of private and state capital often conflict. While officials may seek returns, they also prioritize employment and tax revenues for their regions. Moreover, state funds impose heavy requirements and paperwork on their investees. Wu suggests that VC funds should treat startups as clients, but once state money is involved, the startups must serve their investors, subverting the industry’s logic.

Another issue is the increased focus on state-favored industries. Restrictions on IPOs have led many to believe that only companies promoting government policy will be allowed to list. Consequently, investors are flocking to areas like flying taxis, near-space industries, and machine-brain interfaces, dubbed “new productive forces” by Xi, who hopes these industries will drive economic growth.

The impact on China’s innovation hotspots has been significant. PitchBook, a financial database, recently ranked Hefei, a city in China’s hinterland, as hosting the world’s fastest-growing startup ecosystem for the past six years. Various industries, from biotech to semiconductors and AI, have emerged there, far from established hubs like Shanghai and Hangzhou. However, Hefei scores last in the number of successful investor exits. VC firms made 735 investments there between 2017 and 2023, but only 23 exits.

This trend is not limited to Hefei. Of the ten cities at the bottom of PitchBook’s exit ranking, eight are Chinese. As China’s economic growth slows and IPOs become more challenging, the valuations of companies in these regions look particularly vulnerable, as do their funding prospects. Xi aims to inspire the world’s most innovative companies while keeping private investors and average citizens content. However, in this balancing act, someone must inevitably lose.

As China navigates this delicate balancing act, the consequences of its market interventions are becoming more apparent. While the government’s efforts to stabilize and stimulate the market have provided short-term relief, the long-term implications could be detrimental to the innovation ecosystem and overall economic growth.

The Impact on Innovation and Private Investment

China’s stringent control over IPOs has led to an increased focus on state-backed industries. This selective approach means that only companies aligned with government priorities, such as those in AI, high-end manufacturing, and new productive forces, are given the green light to list. This favoritism marginalizes many innovative startups that do not fit into these categories, potentially stifling broader technological and economic advancement.

Private investors, facing fewer opportunities for exits, are becoming more cautious. The dramatic drop in private-equity sales from $89 billion in 2022 to $46 billion in 2023 illustrates this wariness. Investors are finding it harder to realize returns on their investments, making them less willing to commit capital to new ventures. This reluctance, in turn, hampers the ability of startups to secure the necessary funding to grow and innovate.

The Dominance of State Capital

State-backed funds, originally intended to complement private capital, are now dominating the market. This shift alters the dynamics of venture capital and private equity. State investors, unlike their private counterparts, do not face the same pressure for quick returns and can afford to take a longer-term view. However, their involvement comes with strings attached, including extensive paperwork and stringent requirements.

Private venture-capital (VC) funds, as noted by Robert Wu, now find themselves compelled to align with government interests to survive. This alignment often means prioritizing state objectives over pure market-driven goals, which can lead to inefficiencies and misallocation of resources. Startups that receive state funding must cater to their investors' demands, which might not always align with their growth strategies or market needs.

Regional Disparities and Economic Vulnerabilities

The uneven development across China’s regions is becoming more pronounced. Cities like Hefei, despite their rapid growth in startup ecosystems, struggle with investor exits. This challenge is not unique to Hefei; many Chinese cities face similar issues, with eight of the ten lowest-ranked cities in PitchBook’s exit ranking being Chinese.

As the economic growth rate decelerates and IPO opportunities dwindle, companies in these regions find themselves in precarious positions. Their valuations and funding prospects are particularly vulnerable, which could lead to a slowdown in innovation and economic diversification.

The Road Ahead

China’s strategy of using state interventions to manage its capital markets is a double-edged sword. On one hand, it provides immediate stability and supports strategic industries. On the other, it creates distortions that could impede long-term economic growth and innovation. The challenge for China is to find a balance between government control and market freedom.

For Xi Jinping, the goal is to maintain control while fostering a robust and innovative economy. However, the heavy-handed approach risks alienating private investors and stifling entrepreneurial spirit. To sustain long-term growth and innovation, China will need to recalibrate its policies to encourage more private investment and ensure that market signals, rather than state mandates, drive economic activity.

In summary, China’s attempt to prop up its stock market through state intervention and restrictions on IPOs has led to short-term gains but also introduced significant market distortions. The dominance of state capital, the challenges faced by private investors, and the regional disparities in innovation highlight the complexities of this approach. As China moves forward, finding a sustainable balance between state control and market dynamics will be crucial for its continued economic development and global competitiveness.