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China's Road to Greater Financial Stability

Chapter 11. Capital Markets and Financial Stability

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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As a result of years of efforts, China’s capital markets have grown in size and capacity. They are playing an increasingly important role in supporting national economic and social development. By the end of September 2012, there were 2,489 listed companies on China’s stock markets with a combined RMB 21.39 trillion (US$3.37 trillion) in terms of market capitalization, the third highest worldwide. The outstanding amount of bonds under custody reached approximately RMB 23.06 trillion (US$3.64 trillion) (Appendix Table 11.1), also ranking third worldwide after the United States and Japan. The volume of commodity futures traded in China has been ranked as the highest in the world for two consecutive years (Appendix Table 11.2).

The Capital Market Setting

The market framework in China currently includes equity, bond, and futures derivatives markets, which are described in turn below.

Equity market: Having established a multilayered institutional framework consisting of the Main Board, Small and Medium-Sized Enterprise Board, Growth Enterprise Board (GEB), and Stock Transfer Agent System, the Chinese equity market is now helping meet the basic equity financing needs of different economic constituents.

Bond market: The bond market offers a wide range of instruments, including Treasury bonds, local government bonds, central bank bills, corporate bonds, foreign bonds, short-term financing notes, asset-backed bonds, medium-term notes, and collective bonds for trading in interbank markets and exchange-traded markets. Table 11.1 shows the combined volumes issued and traded in the first half of 2012.

TABLE 11.1Combined Market Capitalization by Market(In hundreds of millions of renminbi)
Main boards (Small and Medium-Sized Enterprise Board included)205,563.71
Growth Enterprise Board8,383.66
Stock Transfer Agent System342.85
Source: China Securities Regulatory Commission.Note: Data valid as of September 28, 2012.
Source: China Securities Regulatory Commission.Note: Data valid as of September 28, 2012.

Futures derivatives market: Based on the vibrant growth of commodity futures, which has enabled China to be ranked number one in terms of combined trading volume, the financial derivatives market has started to grow. There are currently 28 commodity futures products in China. At present, the only financial futures product listed for trading, however, is the CSI 300 Index Futures, which has become one of the most actively traded futures products (Table 11.2). In addition, China is in the process of studying the possibility of launching T-bond futures.

TABLE 11.2Various Service Providers in the Capital Markets, end-August 2012
Service ProviderNumberAsset Size (in hundreds

of millions of renminbi)
Securities companies11416,434.11
Futures firms161429.43
Fund management companies7331,136.21
Securities investment advisors88NA
Custodian banks18NA
Securities rating agencies6NA
Source: China Securities Regulatory Commission.Note: Assets of fund management companies refer to assets under management; NA = not applicable.
Source: China Securities Regulatory Commission.Note: Assets of fund management companies refer to assets under management; NA = not applicable.

There has been steady progress in the opening up of the capital market. By the end of August 2012, 1,024 China-concept companies were listed on foreign exchanges; 174 domestic companies were listed abroad, raising US$184.021 billion; 181 foreign firms were granted Qualified Foreign Institutional Investor (QFII) status; and 32 fund management companies obtained Qualified Domestic Institutional Investor (QDII) status and 67 QDII fund products were approved. By the end of 2011, foreign shareholders had taken up 2.87 percent of the aggregate market capitalization in the A-shares market valued at RMB 614.124 billion in total (Table 11.3).

TABLE 11.3A-Shares Held by Foreign Shareholders, end-2011(In hundreds of millions of shares and renminbi)
ShareholderNumber of


Percent of


Market Capital
Qualified Foreign Institutional Investors168.861,777.680.83
Overseas shareholders298.743,520.431.65
Joint ventures and wholly foreign-owned enterprises117.64843.120.39
Source: China Securities Regulatory Commission.
Source: China Securities Regulatory Commission.

Supervision of the capital markets has become multifaceted, with a regulatory and supervisory framework that covers markets, investors, fund managers, financial products, and service providers.

Guidelines for Market Development

Through a series of carefully crafted reforms, China’s capital markets have blazed a unique trail of development consistent with both market principles and growth imperatives. The reforms have included the following:

  • Market-based approach. The policy intent is to create the right incentives for market entities with adequate checks and balances in place. Capital market reforms aim at developing a market-based mechanism in securities and futures markets with information disclosure rules at its core.
  • Rule of law. A wide spectrum of rules and regulations has been implemented. These cover areas such as market making, new products, investment and financing, mergers and acquisitions and restructuring, asset management, supervision, and enforcement. A legal system is in place to allow securities contracts to be written and enforced.
  • Principle of transparency. Strong emphasis has been given to accountability standards for listed companies, securities firms, and fund management firms. Several initiatives have been undertaken to make information relating to legislation, investigation and enforcement, routine supervision, and granting of administrative licenses publically available. A market integrity record database is currently under development.
  • International reach. The process of Chinese companies “going global” and the Chinese market attracting foreign investment has been accelerated. This has further opened up China’s capital markets.

Role of Capital Markets in Economic Development

To push economic reform forward, China has promoted the shareholding system, established the basic framework for modern corporate governance, and increased reliance on market-oriented capital allocation systems. New investment and financing channels have been fostered and banks are no longer the only source of financing. This is forcing financial institutions, including banks, to upgrade their business models and competitiveness, thus improving the overall resilience of China’s financial system.

To support sustainable economic development, China’s capital markets offer a viable intermediation channel to transform savings into investments. This has helped support the rapid development of infrastructure, pillar industries, and high-tech sectors. In order to encourage innovation, capital markets in China today provide a platform for new firms to grow. This is helping private capital formation, including venture capital and private equity funds, so as to boost capital generation and capital preservation within China. Considerable attention is also being given to promoting public awareness about capital market concepts, securities contracts, enforcement, transparency, and market integrity.

Current Issues in China’s Capital Markets

Despite the progress outlined above, China’s capital markets face several complex challenges. The markets still lack depth and are unable to fully meet the needs of the real sector as China transitions away from a fully planned state system into a market-based system.

Small Share of Capital Markets in the Financial System

China’s economy remains highly dependent on indirect modes of financing. Direct financing via equities and bonds is still relatively small. Of the overall financing of the economy in 2011, loan and acceptance bills accounted for 86 percent, while equity and bond financing made up only 14 percent (Figure 11.1). In terms of financial assets, as of end-2011, outstanding bank loans made up 54 percent, while aggregate market capitalization and outstanding bonds accounted for only 26 percent, numbers significantly lower than those in most developed markets (Figure 11.2).

Figure 11.1Breakdown of Overall Funding Provided to Real Economy in 2011

(In percent)

Source: China Securities Regulatory Commission.

Figure 11.2Breakdown of Financial Assets as of end-2011

(In percent)

Source: China Securities Regulatory Commission.

With respect to financial investments by individuals, bank deposits accounted for 64 percent, while investments in bonds, equities, and funds made up less than 14 percent (Figure 11.3). In contrast, residents in developed markets place almost 70 percent of their assets in capital market instruments. China’s financial system thus remains dominated by commercial banks, which gives an obvious advantage to large enterprises and government-related companies and limits access for small and medium-sized enterprises (SMEs), microenterprises, and new ventures.

Figure 11.3Breakdown of the Financial Assets Owned by Chinese Residents as of end-2010

(In percent)

Source: China Securities Regulatory Commission.

Concerns over the Internal Structure of Capital Markets

Several structural imbalances exist in China’s capital markets that require policy attention. First, the development of the bond market is lagging. In September 2012, the combined stock market capitalization reached RMB 21.39 trillion and outstanding bonds under custody stood at around RMB 23.06 trillion (Figure 11.4). However, in most mature markets the bond market generally exceeds the stock market in volume. Furthermore, in China, government debentures, including T-bonds, local government bonds, central bank bills, and bank debentures, account for the majority of the bond market. For instance, as of end-2011, government debentures accounted for 76 percent of total trading volume of the bond market, while corporate debentures constituted only 24 percent.

Figure 11.4Market Capitalization of Stocks and Bonds

(In trillions of renminbi)

Source: China Securities Regulatory Commission.

Second, China’s equity market is not yet deep enough to cater to diverse demands. In markets such as the United States, there are main boards (New York Stock Exchange) that serve large and medium-sized enterprises, and boards like the NASDAQ, which target small and medium-sized high-tech companies. There are also the over-the-counter (OTC) markets such as the OTC Bulletin Board and the Pink Sheet Market, and the Gray Market on an even lower level. However, China’s markets consist only of the Main Board, SME Board, GEB, Stock Transfer Agent System, and regional equity trading markets, which are far from adequate for China’s financing needs, especially in the SME and microenterprise sector (Figure 11.5).

Figure 11.5Equity Market in China

(Numbers of companies listed on the respective markets)

Source: China Securities Regulatory Commission.

Note: Amounts are as of December 31, 2011. GEB = Growth Enterprise Board; SME = small and medium-sized enterprises.

The futures and derivatives markets are also underdeveloped, with insufficient investment and risk management controls. Compared with the mature markets, China’s derivatives markets have a lot of room for improvement. Although China has the world’s largest trading volume in commodity futures, it has only 28 futures products—similar to the numbers of futures products in the United States in the 1950s. Moreover, price discovery in China is not effective enough for the development of reliable benchmarks and hedging products.

A fourth factor pertains to the imbalanced investor base. In China, professional institutional investors in A-share markets account for 15.4 percent of total market capitalization, while the percentage in mature markets can be as high as 70 percent. Individual investors in A-share markets are not sophisticated enough to trade rationally. While they hold 26.4 percent of total market capitalization they contribute 85 percent of the trading volume (Figures 11.6 and 11.7).

Figure 11.6Breakdown of Shareholders in the A-Share Markets as of end-2011

(In percent)

Source: China Securities Regulatory Commission.

Figure 11.7Breakdown of Transactions in the A-Share Markets by Investor Category, 2011

(In percent)

Source: China Securities Regulatory Commission.

Finally, fund raisers are dominated by large and medium-sized enterprises, which constitute the large majority of listed companies in China. Listing thresholds are still very high, even at the GEB, making it almost impossible for small businesses and microenterprises to list. According to China’s definition of SMEs, of the 2,400 listed companies, less than 400 issuers are from the SME and microenterprise sector. Given that there are over 12 million SMEs in China, this level of capital market access remains narrow.

Recent Reform in China’s Capital Markets

It has become imperative to solve the structural imbalance in China’s capital markets. This is crucial to help accelerate structural adjustment and industrial transformation. A multipronged approach is needed to adjust the market structure and widen and deepen the domestic capital markets.

The first priority is to increase the share of direct financing. Bank-based financing can meet only certain specific types of financing needs. The capital markets, however, are capable of meeting a much wider range of investment and financing needs with diversified risk profiles.

The second priority relates to establishing multilayered capital markets. Apart from the equities markets, China is seeking to develop a properly developed bond market. The aim is to unify the supervisory standards for bond issuance and place emphasis on the development of corporate bonds, as is being done in the pilot program for SME private placement bonds. Furthermore, by reforming the stock issuance and delisting systems, China is encouraging listed companies to pay higher dividends and enhance their corporate governance. The OTC market is also growing and the plan is to establish such a market under a unified national supervisory system. This will help guide the healthy development of the regional equities trading markets. In addition, more financial derivative products are being introduced. China has listed silver futures for trading and is conducting research on the launch of crude oil futures and T-bond futures. Meanwhile, plans are afoot to launch stock index options, stock options, and swaps.

Promoting institutional investors is yet another priority. The China Securities Regulatory Commission (CSRC) is devoted to serving and developing institutional investors. On the basis of fund management business, the scope of investment will be enlarged to nurture the wealth management industry, offering a broader spectrum of wealth management services to investors onshore. Entry barriers relating to professional institutional investors from overseas are being removed. The goal is to have a fair and efficient platform for investment by corporate pension funds, social security funds, housing providence funds, public pension funds, and wealth management schemes managed by insurance companies, trust companies, and banks.

Priority is also being placed on offering differentiated investment and financing instruments. China’s capital markets are currently focused on publicly offered products. In the future, efforts will also be made to push for the development of privately offered markets. Such markets can provide more investment opportunities to institutional investors with higher risk tolerance, and they can also create financing channels for high-risk fund raisers. These measures will speed up the financing process and lower the overall financing cost. Of course, in developing a privately offered market and derivatives markets, the investor suitability principle has to be adopted. The CSRC has carried out a number of experiments in this regard with the stock index futures and the GEB market. The CSRC has also recently founded an Investor Protection Bureau to secure investor interests (Table 11.4).

TABLE 11.4Capital Market Priorities and Reform Measures
Key Reforms to Balance the Development

of Different Markets
Reform Measures Already

Implemented or Being

Indirect financing Direct financing
  • General objectives of the reform
Exchange markets Over-the-counter markets
  • The New Third Board
  • Regional over-the-counter equity trading markets
Equity financing Bond financing
  • Small and medium-sized enterprises’ private placement bonds
  • Unified supervisory standards on bond issuance
  • Linkage between interbank markets and exchange markets
Public offering Private placement
  • Small and medium-sized enterprises’ private placement bonds
  • Equity trading markets for nonpublic offerings
  • Privately placed securities investment funds and price-earnings ratios brought under supervision
  • Investor suitability arrangements
Domestic capital markets International capital markets
  • More enterprises listed overseas
  • Foreign enterprises allowed to list in China
Financing of large and medium-sized enterprises Financing of small and medium-sized enterprises and microenterprises
  • Small and medium-sized enterprises’ private placement bonds
  • Over-the-counter markets
  • Private equity/Venture capital
Individual investors Institutional investors
  • Gradually introducing corporate pension funds, social security fund, housing providence fund, and public pension funds, etc., as equity investors
  • Expanding the scope of fund investment and developing wealth management business
  • Relaxing the thresholds of QFII qualification
Domestic investors Overseas investors
  • Increased number of QFIIs
Commodities Derivatives
  • Silver futures, crude oil futures, T-bond futures
  • Stock index futures, stock options and swaps
No investor suitability arrangements With investor suitability arrangements
  • CSRC establishing Investor Protection Bureau
  • Investor suitability arrangements
Source: China Securities Regulatory Commission.Note: CSRC = China Securities Regulatory Commission; QFII = Qualified Foreign Institutional Investor.
Source: China Securities Regulatory Commission.Note: CSRC = China Securities Regulatory Commission; QFII = Qualified Foreign Institutional Investor.

Impact of China’s Capital Markets on Financial Stability

The stock market constitutes the major market segment in China, while other markets remain small in scale. China’s individual investors are not mature enough, and many of them tend to speculate and flip stocks. Meanwhile, the A-share market in China lacks a short-selling mechanism and hedging tools and is therefore more vulnerable to market instability and dramatic price swings. Moreover, financial services firms in the capital markets also see wide fluctuation in profitability, which affects overall development of the financial industry.

Nevertheless, systemic risks in the capital markets remain relatively low for several reasons:

  • Low leverage ratios. This is true for the leverage ratios of both service providers and investors. Securities firms have a leverage ratio of 1.4, which is onetenth that of their counterparts in Europe and the United States. According to available statistics, the outstanding stock purchased through securities lending is only RMB 55.8 billion, with an average guarantee rate of 2.81.
  • Segregation of investment and commercial banking. In China, investment banking services and other capital market services are separated from the services of commercial banks. Banks are not allowed to operate across sectors. Securities firms are allowed to operate businesses limited to the capital markets, and there is no direct contagion risk between capital markets and commercial banks.
  • Low overall valuation of the A-share market. Over the past 10 years, the average price-earnings ratio of A-share markets has dropped from 50–60 to 11. As of end-September 2012, the price-earnings ratio of the Shanghai Composite Index stood at 11.25, while the S&P 500 Index, DAX, and Nikkei 225 Index had ratios of 14.67, 13.84, and 21.80, respectively. Compared with other markets around the world, and taking into account the long-term growth rate of China, the current valuation of A-share markets remains quite low. In fact, its valuation has already hit a historical low, not only far below its peak in 2007 but also lower than the two troughs witnessed in the aftermath of the financial crisis in October 2008 or prior to the nontradable shares reform in May 2005 (Figure 11.8). The risk of a dramatic decline over the medium term has thus declined.
  • Stronger capital market supervision. An overhaul of the securities industry was launched in 2004 with the closing of 31 securities firms. Since then, the CSRC has strengthened its supervision over securities firms and different capital market segments. With overall risks in the capital markets running low, now is an opportune time to push for reforms. It is true that financial innovation may bring new risks, but an in-depth reform of the capital markets would require a higher risk tolerance and a better balance between market innovation and more intensive market surveillance to prevent systemic risks.

Figure 11.8Month-end Average Price-Earnings Ratio of Shanghai Stock Exchange

Source: China Securities Regulatory Commission.

While it is true that the capital markets in China now have certain negative effects on the stability of the overall financial system, the reason does not lie in the inherent risks of the capital markets but rather in the fact that China’s capital markets are thin and underdeveloped. As a channel for direct financing, these markets provide a platform that can lower the cost of funding and diversify risks within the financial system. Proper capital market development will help reduce risk concentration, help the country alleviate the negative impact of the financial crisis, and improve the resilience of China’s financial system.

APPENDIX TABLE 11.1Bonds under Custody in China’s Bonds Markets in August 2012(In hundreds of millions of renminbi)
Bond typeAmount

under Custody
Bond TypeAmount

under Custody
Government bonds78,107Collective bills161.0
Central bank bills16,130Foreign bonds40.0
Financial bonds86,994Corporate bonds4,331.9
Government-backed bonds2,940Convertible bonds1,218.2
Enterprise bonds20,496Warrant bonds796.2
Short-term financing notes10,775Small and medium-sized enterprises’ private31.3
Asset-backed securities82placement bonds
Medium-term notes22,395Total244,497.6
Source: China Securities Regulatory Commission, Monthly Statistics of China’s Securities Markets (Issue 8, 2012).
Source: China Securities Regulatory Commission, Monthly Statistics of China’s Securities Markets (Issue 8, 2012).
APPENDIX TABLE 11.2Trading in China’s Futures Derivatives Markets, 2011
Commodity FuturesFinancial Futures
Trading volume (10,000 lots)Turnover (hundreds of millions of renminbi)Trading volume (10,000 lots)Turnover (hundreds of millions of renminbi)
Source: China Securities Regulatory Commission, Monthly Statistics of China’s Securities Markets (Issue 6, 2012).
Source: China Securities Regulatory Commission, Monthly Statistics of China’s Securities Markets (Issue 6, 2012).

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