CHINA’S securities markets have expanded rapidly over the past several years, attracting considerable attention from foreign investors. Nonetheless, both their role in the domestic financial system and their reliance on market mechanisms remain limited.
In less than a decade, securities markets in China have emerged from near irrelevance to play a prominent role in the economy’s transformation. This phenomenon represents the culmination of a gradual process of experimentation initiated by the Chinese authorities. Bonds and equities began to be issued only in the early 1980s—although some government bonds had been issued during the mid- 1950s—but both types of instruments initially differed sharply from conventional securities. For example, ownership of enterprise bonds and equities often provided special benefits—such as privileged access to housing—and enterprise shares carried no real ownership rights. Initially, trading in bonds and shares was not permitted; secondary-market trading in a few securities began, on a very restrictive basis, in 1986; and China’s two main securities exchanges in Shanghai and Shenzhen were officially opened in 1990 and 1991, respectively.
Despite this very late start, by the end of 1994, the two recognized equity markets in Shanghai and Shenzhen had a combined capitalization of $43.5 billion (Chart 1), which was roughly equal to the capitalization of stock markets in Argentina and Indonesia, and accounted for 2.4 percent of the capitalization of all emerging equity markets monitored by the International Finance Corporation, the private sector arm of the World Bank Group. Similarly, government treasury bond issuance increased tenfold between 1990 and 1994, reaching Y 113 billion (yuan) last year, and is projected to reach Y 150 billion in 1995. As China’s domestic securities markets have developed, the Government has made increased use of external capital markets. External bond issues raised $4.1 billion in 1994, compared with $400 million during 1989–91; and between mid-1993 and the end of 1994, issues of shares in Chinese firms that were listed in Hong Kong raised $2.4 billion. In addition, two Chinese firms, Huaneng Power and Shandong Huaneng, have listed American Depository Receipts (ADRs) on the New York Stock Exchange.
Chart 1Stock market capitalization in China
Source: International Finance Corporation.
At the same time, however, the development of China’s securities markets has been somewhat erratic. Liberalization has sometimes led to excesses, which, in turn, have led the authorities to reverse course, at least temporarily.
So far, only about 300 firms have listed shares on the recognized exchanges in Shanghai and Shenzhen. That so few have been listed is a reflection of the cautious approach to market development that has been adopted by the authorities. Chinese equity markets are highly segmented. Three types of shares are currently issued by Chinese enterprises: A shares, which are denominated in yuan and held only by Chinese nationals; B shares, which are denominated in foreign currency—US dollars in Shanghai and Hong Kong dollars in Shenzhen—and intended for foreign investors only; and foreign-currency-denominated shares issued to foreign investors and listed on foreign exchanges—for example, the H shares listed on the Stock Exchange of Hong Kong (SEHK). (See box.) A shares are by far the largest segment of the equity market, with a capitalization value of about $43 billion at the end of October 1994. At that time, the value of listed B shares was about $2 billion, and H share capitalization was only slightly higher, at about $2.6 billion.
a Canadian citizen, is an Economist in the Capital Markets and Financial Studies Division of the IMF’s Research Department.
The mechanisms used to determine which firms will be permitted to issue securities are also unique to China. Rather than relying on market mechanisms to determine the cost of capital in bond and equity markets by allowing all firms that want to raise capital to negotiate with securities firms, the Chinese authorities have themselves decided which firms will be allowed to issue shares. Chinese firms wishing to list shares must have their land and other assets valued by the State Assets Bureau and State Land Administration. They then must apply to the local government for approval to issue shares, and if their application is approved, they apply to the China Securities Regulatory Commission (CSRC).
The central government sets a quota for A share listings for the country as a whole (which may be subdivided into quotas for different exchanges) in order to control market development. Compared with an estimated Y 10.9 billion in new issues in 1992, the quota was Y 5 billion in 1993 and Y 5.5 billion in 1994. Subject to this overall limit, approval is given for one or two listings from each province or municipality on each exchange. However, the authorities have, on a number of occasions—most recently in July 1994—postponed planned issues in order to support the market.
There is no quota for B share listings, but the approval process is more complicated (with enterprises having to prove, at the very least, a need for foreign exchange) and more tightly controlled. There are also other mechanisms by which the authorities can control these issues. For example, in 1993, B share issues from provinces that had not taken up and distributed their allotment of government treasury bonds were prohibited.
The selection of H share issuers is not subject to a quota, but is made almost entirely by the central authorities. The emphasis in the selection process has been on choosing very large enterprises that have significant capital needs and generate sufficient foreign exchange earnings to be able to pay dividends in foreign currency. The authorities have also chosen firms that were already known internationally, such as Tsingtao Brewery, which was the first enterprise to list H shares.
The Chinese authorities have clearly demonstrated that, rather than letting the market determine the issuers, subject to some minimum standards contained in securities and company law and in the stock exchanges’ listing requirements, they are determined to follow a strategy of “picking winners.” To a certain extent, this approach was dictated by the absence of adequate disclosure, market regulation, and market-determined prices for competing assets. Since China did not have a market economy, a market-based approach to equity issues may not have been feasible.
Perhaps a more important reason is that, in the authorities’ opinion, there was a need to maintain control over the liberalization process. This is consistent with the general approach to reforms undertaken in China, which provides for changes to be implemented on a trial basis. Government intervention of this sort may, in fact, resolve a marked information asymmetry between domestic firms and foreign investors. The tight control over the issuing and pricing decisions that has been exercised by the authorities may also help to ensure a certain minimum quality of issues to protect novice investors from fraud and market manipulation, and thereby reduce the possibility of scandals that might turn popular sentiment against the future development of these markets. This strategy could run into trouble, however, if non-economic factors, such as a desire to spread listings geo-graphically, were to receive too much attention in the selection process, which could result in some firms being allowed to issue shares while other, more profitable firms in the same industry were not.
In addition to diversifying enterprises’ sources of financing, another reason for developing corporate securities markets was to create a system of corporate governance that does not rely on bureaucrats. The first step in this process is to remove enterprises from direct government control by encouraging them to transform themselves into joint-stock companies with majority (initially, usually 100 percent) state ownership, but with independent management. The second step is to allow enterprises to obtain their own financing. While the largest enterprises could still rely on fairly automatic bank credit after becoming joint-stock companies, smaller ones would have to negotiate terms with the banks. Moreover, the authorities expect these loans to be repaid. In addition, subject to the approval of regulatory authorities, firms are allowed to issue debt and equity securities to the public. Thus far, however, equity issues have generally represented less than 30 percent of enterprises’ enlarged capital.
The Government has recognized that if it released enterprises from direct bureaucratic control, some new source of discipline for managers would have to be found. It hopes that a reformed banking sector and securities markets will meet this need. In principle, banks can impose financial discipline on firms primarily by requiring them to make regular payments on loans. If a firm does not obtain a regular cash flow from the investments financed with the borrowed funds, it may be unable to service the debt and be consequently forced into bankruptcy. Banks also have access to fairly detailed information on the financial condition of a borrowing firm—both as a condition for making or renewing loans and from observing the firm’s cash flow through its current account, which often must be maintained at the lending bank.
Foreign investment in Chinese shares
Although discrimination between domestic and foreign investors is not unusual in developing countries, China’s approach to issuing stock is unique, in that requirements for disclosing relevant information to potential investors vary according to the type of share. These distinctions reflected the authorities’ recognition that foreign investors would be unwilling to invest in companies about which they did not have sufficient information. Thus, issuers of B shares, which were first issued in February 1992, have to prepare financial statements according to international accounting standards, while issuers of A shares do not. Moreover, issuers of H shares, which were introduced in July 1993, also must meet the requirements for listing shares on the SEHK, which has stricter information disclosure requirements than either of the two principal Chinese stock exchanges.
Given the choice of purchasing B shares or H shares, foreign investors have gravitated toward the latter. Initially, when only B shares were available to them, international investors showed considerable interest in these, and turnover, while initially low, appeared to be improving. However, in the spring of 1993, when enterprises that had issued B shares began reporting their 1992 results, some of these firms chose not to prepare their reports according to international accounting standards, thus violating B share regulations. Moreover, it soon became apparent that some firms had misused the proceeds of B share issues by speculating in real estate or securities markets, or simply by on-lending the foreign exchange they received. By the end of June 1993, B share liquidity had all but disappeared and prices fell sharply (Chart 2). The emergence of Chinese companies listing on the SEHK, beginning in July 1993, provided a superior alternative in the form of H shares. These issues have generally been well received in the primary market, and the secondary market for them has been quite liquid since their listing.
Chart 2Selected stock exchange indexes in China and Hong Kong
Source: Bloomberg Financial Markets.
Of course, banks will only enforce this discipline if they themselves suffer the consequences of bad lending decisions. At this point, the only domestic financial institutions that have lent to the state-owned enterprises are themselves state owned. Since their cost of funds and lending interest rates are largely beyond their control, and since banks face no apparent penalty for accumulating bad loans, they have only a limited incentive to enforce their lending contracts. For example, although a bankruptcy act was passed in 1988, by the end of 1993 only 20 petitions for bankruptcy had been brought to court. Bank managers acknowledge that they would rather carry a bad loan on their books—effectively capitalizing unpaid interest—than force bankruptcy and closure of the firm.
Equity markets provide an alternative—and complementary—source of discipline, which may be exerted through two possible mechanisms. First, since shareholders own a claim on the firm’s residual profits, they have an incentive to monitor the management of the firm and to ensure that it undertakes the most profitable investments in order to maximize the value of shares. Second, discipline can be exerted by the marketability of the shares. At the very least, if shareholders become dissatisfied with the performance of the firm, they can sell their shares. If this results in a significant decline in their market price, the firm may find it more difficult to obtain new investors. If the price falls by a large enough amount, rival managers who believe they are more capable of managing the firm efficiently may attempt a takeover. Thus, managers for whom the loss of their position would be costly have an incentive to avoid this by managing the firm as efficiently as possible.
Equity markets in China face several constraints on their disciplining role. The market available only to domestic residents—that in A shares—seems so far to have been driven more by liquidity than by enterprise performance. Investors need reliable and timely information about the firms in which they are investing if they are to be able to closely monitor firms’ activities, and such information is generally not provided. Moreover, since private institutional investors have not yet emerged as significant shareholders, the shares the public holds are widely dispersed; it is not clear, therefore, that any individual stockholders have a large enough stake to compensate themselves for the monitoring costs they would have to incur to determine whether any change in a firm’s management was warranted. In current circumstances, however, it is possible that any indication of poor performance would result in a sale of shares. Further, takeover regulations are drafted in a way that makes it difficult to rely on this mechanism for disciplining poor managers.
Consequently, the main mechanism through which equity markets can currently exert discipline on firms is the listing process for shares. Both the regulatory authorities and Chinese and foreign securities houses report that as firms prepare prospectuses and conduct financial audits, they introduce international accounting practices and upgrade their financial expertise. Preparations for stock listings also require firms to rationalize their operations and separate nonproductive activities, such as the provision of housing, from productive ones. Such exercises force management to pay greater attention to the profitability of each of their firm’s activities—something that was much less important when their sources of finance were virtually assured.
Bank credit and securities
The Chinese authorities have struggled to work out an appropriate relationship between the banking and securities industries. So far, securities markets have been a considerably smaller source of funds than the banking sector, and the ratio of funds raised by enterprises through securities issues to their total bank borrowing has increased from less than 1 percent in 1987 to only 10 percent in 1993. Indeed, an important reason why the authorities have emphasized the need for domestic bank reform is because they recognize that banks are likely to remain the primary source of outside financing for enterprises for the indefinite future.
A second aspect of the relationship between banking and securities is the use of bank credit to finance securities activities. Until early 1993, banks were intimately involved in the securities markets, since most securities firms were bank subsidiaries or affiliates and the markets were regulated by the People’s Bank of China (PBOC). Then, however, the authorities became concerned that this mixing of banking and securities activities was resulting in the diversion of credit away from the productive sectors of the economy and was exposing banks, which had little or no prior experience in securities markets, to new sources of risk. They therefore introduced regulations providing for a complete separation of the industries. Banks had to close or sell their securities subsidiaries and call in the loans they had made to securities firms and investors, and they were forbidden to have any further involvement with securities markets. As a result, there is, for example, no margin lending, and securities firms and exchanges are not permitted to seek insurance from banks in the form of lines of credit. This, of course, has reduced liquidity in the secondary market.
A lack of liquidity could also increase the probability of a settlement failure, as well as knock-on failures in other institutions, because the resources available to any one member of a stock exchange will be lower in the absence of bank credit lines. In the end, the authorities have to weigh the likely incidence and costs of these different types of risk against the risk of securities market developments affecting the flow of credit or impairing the health of the banking industry.
Concerns about illiquidity and declining prices in the A share market led the CSRC to propose, in July 1994, that banks be allowed to lend to securities firms, and that joint Sino- foreign investment companies be established to manage mutual funds through which foreign funds could be invested in A shares. The announcement of these proposals resulted in an immediate and rapid increase in A share prices (Chart 2). However, when other government agencies, including the PBOC, made their opposition to these proposals known, prices fell almost as rapidly. To date, neither of these proposals has been adopted.
Chinese securities markets have been constrained since their beginnings by the apparent lack of a coherent government strategy for market development and an inadequate regulatory structure. A national company law, which formalized such basic concepts as limited liability and the definition of a joint-stock company, was passed only in late 1994, and similar legislation to implement national regulations for securities companies and markets is still missing, despite years of discussion. As a result, there has often been considerable uncertainty about the legal requirements for issuing and trading securities, and enforcement of even local regulations has generally been weak.
Initially, the PBOC had taken the initiative in developing and regulating securities markets through its securities regulatory office in Beijing. Because of the speed with which securities market activities emerged in centers all across the country, these responsibilities had been decentralized at an early stage. The local municipal governments and PBOC branches came to have the most important direct supervisory roles. The PBOC licensed securities firms and markets and approved new listings, while the local authorities were responsible for regulating the markets. In most cases, central government approval for a particular development—for example, secondary-market trading or issuance of a new kind of security—came long after the local authorities had approved it.
As a consequence of the decentralized regulatory structure, various markets formulated their own rules and regulations and created parallel systems for trading, clearing, and settlement. This duplication of effort made clear the need for a consistent, central regulatory structure. This was created in October 1992, when the State Council decided to centralize regulation. A two-tier structure was established—including both the State Council Securities Policy Committee (SCSPC) and its executive arm, the CSRC—and became operational in April 1993. The SCSPC consists of representatives of 14 government ministries, including the Ministry of Finance and the State Council for the Reform of the Economic System, and is primarily responsible for drafting securities laws and regulations (or authorizing the CSRC to do so) and for formulating guidelines and rules governing securities market development. The CSRC is responsible primarily for implementing regulations and for supervising securities firms and markets. The exchanges continue to set their own listing requirements and to operate as self-regulating agencies.
The CSRC began operations in April 1993 by issuing the Interim Regulations on the Administration of the Issue and Trading of Shares, which replaced the provisional regulations promulgated by the various local authorities—particularly in Shanghai and Shenzhen—and formed the foundation for future national legislation, which is still in draft form. These regulations prescribe issuing requirements and acceptable practices in the primary and secondary markets. They also specify the operating requirements for securities firms, explain how these firms will be supervised, include penalties for securities fraud, and cover mergers and acquisitions.
The PBOC has retained its role in licensing securities firms, but the CSRC sets the conditions of eligibility and capital requirements and supervises these firms’ daily operations. Similarly, the Ministry of Finance licenses accounting firms and their professionals, but the CSRC sets the eligibility requirements and supervises their activity. The Ministry of Justice licenses lawyers, but the CSRC monitors their securities activities. The CSRC also monitors listed companies’ compliance with reporting and other requirements.
The speed with which securities markets, and equity markets in particular, have developed in China has been remarkable, and these markets have attracted deserved attention by the international investment community. However, they still form a relatively small part of China’s financial system. The continued segmentation of the equity market constrains liquidity in the secondary markets and limits the extent to which the largest segment of the market—that for A shares—can make use of the analytical tools and trading practices used in the industrial country markets.
The approach to securities markets development has followed the same trial-and-error model employed in other aspects of China’s reform process. The result has been an uncoordinated process in which enterprises and individuals take advantage of new opportunities to invest in and trade assets with market- determined returns at the expense of other sectors that are still regulated. In some instances, the authorities have exerted pressure to promote liberalization of these other sectors—for example, to increase interest rates on bank deposits or to introduce partial inflation indexation of these rates. At other times, however, the response has been to crack down on the deregulated sector, as was done in the spring of 1993. In the absence of a clear, coordinated strategy formulated by the central government and having firm legal foundations, further securities market development will be restrained by uncertainty about how the authorities will respond the next time they feel that securities markets are developing too rapidly.
This paper is based on “The Role of Capital Markets in Financing Chinese Enterprises, “which is Annex V in International Capital Markets: Developments, Prospects, and Policy Issues, International Monetary Fund, Washington, 1994.