Chinese stock market regulators tried on Tuesday to ease the impact on investors of a new plan to sell part of the state's huge equity holdings, while the market continued to take a cautious approach to the scheme.

One of the four companies taking part in the pilot programme to sell state shares announced substantial compensation to existing investors for the likely dilution of their stakes.

Meanwhile, a state newspaper said the regulator might freeze new initial public offerings for some months to prevent flooding the market with new shares.

The measures reflect the regulator's previous experience of trying to unwind the state's equity holdings, which account for about two-thirds of the equity of listed Chinese companies and which have long been an obstacle to development of the domestic market.

Four years ago, reformist officials at the China Securities Regulatory Commission (CSRC) unveiled a plan that appeared to solve two pressing problems. They intended to sell non-tradeable shares in listed companies, thereby reducing government influence and improving corporate governance, while at the same time using the money raised to help fund the creaking pension system.

But they abandoned the proposal when the stock market fell by about a third because investors took fright at the prospect of a wave of new shares. A similar fall in the market this month could scupper the new reform.

This time the regulator's response has been to outline a much less dramatic plan. Beginning with a pilot programme involving a limited number of companies, the state shares are to be sold only in small chunks and after shareholders have given their approval. The first four companies chosen are mid-size groups.

On Tuesday brought new signals that the regulators would try to implement a gradual, managed process of releasing new shares on to the market. The China Securities Journal reported that the regulators were likely to suspend domestic IPOs for the next two months. The CSRC would not comment on the report, but it is likely to ease concerns about the supply of new equity over the next few months.

Meanwhile, in an effort to ease concerns about dilution, Sany Heavy Industries, one of the four companies that has announced it will sell state shares, said its existing holders of tradeable shares would receive three shares and Rmb8 (about $1) in cash for every 10 shares. It is not yet clear whether other companies will do the same.

The measures appear to have had some impact on market sentiment. The initial reaction from investors had been to push the Shanghai composite index down 2.4 per cent to its lowest level in six years on Monday the first day of trading since the plan was announced. However, although the market fell again in early trading on Tuesday, it closed 0.5 per cent higher. “It will be a case of short-term pain, long-term gain,” said Stephen Green, an economist at Standard Chartered in Shanghai. “If you are going to try and address this issue, then they are going about it the right way.” It was highly unlikely there would be a sustained drop in the market as a result of the share-sale programme, he said.

Zhao Danyang, a fund manager at Guotai Junan Asset Management in Shenzhen, said the trial reform was a long-term positive for the stock market. “But the corporate governance structure can't be improved overnight. It takes time.”

However, the plan still has many critics. Compensation for existing shareholders is a controversial issue and will reduce the funds available to the pension system. Moreover, the government has yet to signal whether it will relinquish control of most listed companies.

Zhang Weixing, chief analyst at China Huadian Investment Consulting in Beijing, said the plan had been devised by a narrow group of officials detached from market realities. “I still believe the trial programme will end in failure,” he said