Traders seen working at terminals at the Shanghai Stock Exchange in Shanghai, China on Wednesday, 28 Feb. 2007. Asian stocks fell the most in more than eight months, extending a global selloff sparked by the biggest plunge in Chinese shares in a decade. Sony Corp. and BHP Billiton Ltd. led declines. Photographer: Qilai Shen/Bloomberg News

In China, stagging pays. This week’s Rmb10bn (US$1.6bn) flotation delivered a 60 per cent return to investors in just three days; on average this year’s 75 or so deals rose by an average of 178 per cent in the first 10 trading days, according to HSBC.

Welcome to the visible hand of government. For all Beijing has determined to push ahead with market reforms, government intervention remains alive and well in that most capitalist enclave, the stock market.

Most recently, at an annual parliament session this month, Premier Li Keqiang again pledged to push ahead with reforms that would allow market forces to determine which companies can sell shares and at what price.

Yet just days later Orient Securities’ initial public offering was handing out its bounty, rising limit-up 44 per cent on Monday, followed by 10 per cent rises on Tuesday and Wednesday, the post-debut daily limit.

“There’s no doubt this is the result of policy,” said Xiao Shijun, equity strategist at Guodu Securities in Beijing. “In late 2013 the market wasn’t doing well and regulators wanted to throw secondary-market investors some benefits.”

By forcing issuers to sell shares at a discount to market prices, analysts say, the rules have delivered risk-free profits to investors who win allocations through a lottery system. These profits represent lost funds for issuers and lower fees for underwriters.

The government knows change is needed. The China Securities Regulatory Commission (CSRC) issued new rules at the end of 2013 aimed at promoting more reasonable pricing as it prepared to end a 15-month freeze on domestic IPOs.

CSRC’s regulations do not technically cap IPO prices but they require companies to issue a “special risk notice” if they offer shares at a price/earnings ratio higher than the market average for industry peers. The message from regulators is clear: deals will not be approved if the price is too high.

The current system “has caused market inefficiency as investors flock to IPO subscriptions to benefit from the valuation gap” between primary and secondary markets, HSBC equity strategist Steven Sun wrote in a recent report.

Chinese IPOs

Dozens of fund products focused on new shares have launched in recent months as regulators have quickened the pace of IPO approvals amid the Shanghai market’s surge to near seven-year highs.

Mutual fund managers, who enjoy preference in the IPO subscription lottery, like the current system.

Chart: China IPO PE comparison

“The new issuance system has been effective at restraining the problem of high IPO prices, while also leaving the secondary market considerable space for profit-taking,” said Zhou Ping, who manages an IPO-focused fund at GTJA Allianz Funds, a German-Chinese joint venture fund house.

But the distortions in other parts of the financial system are glaring. Short-term interest rates regularly jump in advance of big IPOs, because investors must borrow funds to participate in the lottery. Orient’s IPO was 90 times oversubscribed, meaning more than Rmb900bn in funds were frozen for about a week.

The previous system, in which IPO approvals were restricted but pricing was free, also created distortions.

For years issuers and underwriters exploited the structural shortage of new shares caused by regulatory bottleneck restricting the IPO flow. Even at high prices, the trickle of new shares that managed to reach the market was greeted with ferocious demand.

In periods of market weakness, this led to a demoralising pattern in which new shares were issued at high prices and then rose further in the first few trading days, only to drop below their issue price within a few months once broader market conditions overtook initial enthusiasm.

Concerns also rose that small companies often raised more money than they could usefully invest in their core businesses, leading them to speculate in real estate and lending through the shadow banking system.

As part of a landmark economic reform approved at a meeting in November 2013, top Communist party leaders pledged to eliminate the approval requirement for IPOs. The CSRC has said it will relinquish its approval authority and allow stock exchanges to manage a streamlined registration process, in which the timing and pricing of IPOs will be left to the market.

Local media have reported that the registration system could be introduced later this year. But analysts caution that the exchanges are themselves controlled by the regulator.

“A registration system is the clear direction policy makers have set, but there’s going to be a transition period,” said Mr Xiao.

Additional reporting by Ma Nan in Shanghai

Twitter: @gabewildau

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