As China's Securities Regulations Are Modernized, Its Profit Potential Will Soar

Money Morning Investment Director Keith Fitz-Gerald has been leading an investment trip through China, taking in that country’s culture and scenery, as well as its investment opportunities. Here is Part V of a short series detailing his observations and discoveries.

The question came to me as I was standing on the floor of the Hong Kong Stock Exchange here. I’d be willing to wager that quite a few investors - both within China and back in the United States - are wondering about this, as well.

Here it is: Will China implement a long-rumored capital-gains tax, and risk (another) major sell-off as a result?

Only Beijing’s inner circle knows for sure, and that only stokes investor speculation. The uncertainty can lead to rampant, knee-jerk sell-offs each time the scuttlebutt of an "imminent" tax surfaces. And those rumors have been surfacing over and over again - since 1994. That’s the year that Beijing’s Ministry of Finance pronounced that income derived from stock trading was exempt from personal income taxation.

That means that billions of dollars have changed hands - tax-free - as far as Beijing is concerned. For westerners accustomed to normal taxation and mature financial markets, this is almost incomprehensible. Yet, for the Chinese government it makes sense. Not only does this tax-free status encourage active market participation from Chinese consumers who otherwise would almost certainly not bother, but it also attracts foreign assets to a market like a porch light attracts moths on a hot summer night.

This foreign capital has had two beneficial effects. It helps ensure that there’s an active market that’s always awash in liquidity. And it’s probably also helped China keep its economic growth rate at around 9% per annum, many economic experts and other commentators say.

But what’s good for the goose is not good for the gander. Turns out that as much as 40% of the profits reported at the corporate level on the Shanghai and Shenzhen stock exchanges in 2007 were derived from investments in other publicly traded companies - and not from ongoing operations in their "core" businesses.

No wonder western investors are scratching their heads in amazement at the volatile stock prices. Not only are huge chunks of the market driven by individual investors who don’t have to report their activities, but also corporations and other investors - many of who have transformed securities manipulation into a new art form - have been able to trade with relative anonymity for years.

That changed in November, when China’s Ministry of Taxation required investors to report income derived from stock trading even though it remains untaxable. Understandably, smaller investors fear that this is another "Big Brother" scenario like so many others that they’ve seen through the years. And corporations are being dragged - kicking and screaming - into a new era of greater visibility and more-complete financial transparency.

And that brings us full circle.

By western standards, China’s markets are still highly primitive on many different levels - including those related to individual reporting requirements. Yet they remain full of promise, too. And the increasing regulation - including the new reporting requirements we’ve detailed here - are another in a long and ongoing series of steps needed to bring China’s securities markets up to global standards.

Those changes are all very positive. And they’re ongoing. That’s why we have faith in the long-term potential for China’s stock market. And that’s why we believe you should, too.

Comments

[Mr.A.K.]

Taking into consideration that all the brokers in the market are owned by Beijing, the brokerage fee charged for every trade looks equal to tax .