Chapter

Annex V Role of Capital Markets in Financing Chinese Enterprises

Author(s):
International Monetary Fund
Published Date:
January 1994
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The development of securities markets in China has become one of the most visible aspects of that country’s 15-year reform program. Drawn by the lure of double-digit growth rates in the most populous country in the world, foreign firms and investors rushed to establish a presence in China. Foreign direct investment commitments soared to $100 million in 1993, while portfolio investors responded eagerly to opportunities to invest in mainland Chinese firms. Equity placements on the Stock Exchange of Hong Kong (SEHK) amounted to $1.1 billion in 1993. International bond issuance increased to $2.9 billion, compared with $1.3 billion in 1992 and only $0.4 billion between 1989 and 1991. Demand for securities issued by Chinese enterprises was even stronger within China as individual Chinese, once given opportunities to invest in assets whose returns were market determined, proved eager to do so.

This annex examines the development of Chinese securities markets from their beginnings in the early 1980s. The Chinese approach to reform in the financial sector, as in other sectors, has been one of cautious experimentation, gradual relaxation of control, and decentralization of responsibility. Recently, however, it became necessary to retrench temporarily as the pace and direction of recent market activity exceeded the authorities’ intentions.1

Development of Securities Markets in China

Although government bonds had been issued between 1952 and 1958, the systematic development of a bond market in China began in the early 1980s, when the Central Government recognized that an alternative to central bank financing would be needed to minimize the inflationary consequences of budget deficits. In 1981, the Government issued Y 4.9 billion in ten-year Treasury bonds (Table 21). These were allocated to state-owned enterprises, collectives, and local governments, which then passed them on to individuals through compulsory subscriptions.

Table 21Issues of Securities in China(In billions of Chinese yuan)
19811982198319841985198619871988198919901991Total
State bonds4.8664.3834.1584.2536.0616.25111.78718.88818.72523.41628.000130.788
Treasury bonds4.8664.3834.1584.2536.0616.2516.2879.2165.6129.32819.90080.315
Ministry of Finance notes6.6077.1096.50020.216
Construction bonds3.0653.065
Key construction bonds5.5005.500
Special bonds4.3703.2391.6009.209
“Inflation-proof” bonds8.7433.74012.483
Financial institution bonds0.5003.0009.00015.5008.3197.05516.42059.794
State investment bonds9.5009.500
Financial bonds0.5003.0006.0006.5006.0666.4406.69135.197
Capital construction bonds8.0001.4590.0029.461
Key enterprise bonds3.0001.0000.7940.6150.2275.636
Enterprise bonds10.0003.0007.5417.52612.63724.99665.700
Local enterprise bonds110.0003.0003.0001.4834.93311.52533.941
Short-term borrowing certificates1.1722.9725.01510.44419.603
Interenterprise bonds3.3693.0712.6893.02712.156
Certificates of deposit---5.92614.18050.35342.685113.144
Stocks11.0002.5000.6620.4282.9527.542
Total4.8664.3834.1584.2536.56119.25124.78750.35549.41293.889115.053376.968
Sources: Data provided by the Chinese authorities; Almanac of China’s Finance and Banking (Beijing: China Financial Publishing House, 1992); Chen (1991); and IMF staff estimates.

In 1985, issuing privileges were extended to financial institutions as a means of supplementing the funds provided by the Ministry of Finance. These bonds were issued in shorter maturities—between one and five years—and with higher interest rates than those on Treasury bonds. Subscription to these bonds was usually voluntary, although local governments occasionally resorted to forced allocation methods similar to those employed to distribute Treasury bonds. From the mid-1980s, the range of bonds broadened, as different types of bonds were introduced—each issued by a different group of institutions and often targeted to different investors—to finance particular kinds of activities. In 1988, the first bonds issued directly by the Ministry of Finance and placed with financial institutions appeared.

The issuance of corporate bonds progressed much more slowly than that of government bonds and financial bonds. As a result of the financial reforms introduced in the early 1980s, it became more difficult for enterprises, particularly those outside the state sector, to obtain bank financing for investment or for working capital. Approval for enterprise bond issues was first made in 1982 on a very limited basis. Initially, the enterprise bond market was only loosely regulated, a situation that allowed enterprises to promise interest rates much higher than those paid on bank deposits. This led to a drain of resources away from the banks and caused the People’s Bank of China (PBOC) to respond with regulations in 1986; these required that enterprise bonds be approved by the PBOC, subject to an overall quota and a 15 percent ceiling on their interest rates. Enterprise bonds had relatively short maturities of two or three years and were usually issued to the enterprise’s employees—often by forced subscription—and were nontransferable.

Through the mid-1980s, as inflationary pressures built up, resistance to the forced allocation of Treasury bonds with negative real interest rates grew, particularly since some nongovernment issuers, especially enterprises, greatly increased the interest rates they paid on their bonds. Consequently, the Ministry of Finance was induced gradually to reduce the maturity of Treasury bonds, first to five years in 1985 and then to three years in 1988, and to increase the interest rates (Table A15).2 Even in 1985 however, these rates still compared unfavorably to the rates paid on bank deposits.

As a result of the widening of bond issuing privileges, the amount of bonds issued each year rose substantially after 1985 (see Table 21). However, Treasury bonds became a smaller proportion of total issues as they were supplanted by bonds issued by financial institutions and enterprises, in particular certificates of deposit. That being said, enterprise bonds still amounted to only 15 percent of total securities issued up to the end of 1990 (or 11 percent of the outstanding stock at year-end).

Chinese equity markets also have their roots in the reforms initiated in 1979. As part of the Government’s policy of financial decentralization, enterprises were given limited permission to issue shares. These securities had several unusual characteristics. For one thing, they frequently offered a guaranteed minimum annual rate of return. In principle, this return would consist of some fixed rate plus a share of the firm’s profits. However, in practice, most enterprises simply promised the maximum allowable rate of return and in some cases were able to provide much greater returns. During 1985–86, returns of 20–40 percent a year (four to six times the annual rates of interest on bank deposits or government bonds) were common, and in 1988 some enterprise equities earned 50–100 percent. A second characteristic of shares in the earlier years was that they carried a maturity date, usually between one and five years, and their holders frequently had the option of early redemption. Finally, enterprise shares generally carried no ownership rights.3 Consequently, these securities were more like bonds or preference shares with an embedded redemption option than straight equities. A further complicating factor was that in many cases shares, like bonds, gave investors special advantages such as priority in obtaining enterprise-provided housing or health care.

Central control over the equity market was first exerted in 1984 when the Central Government approved share issues on an experimental basis in five cities. In the same year, the municipal government in Shanghai—which was not one of the approved cities—permitted state-owned enterprises to issue shares. This made it easier for state-owned enterprises in these locations to issue equity, and as credit was tightened in late 1984 and in 1985, this became a more common means of raising capital.

Most shares, even those issued publicly rather than placed privately, were purchased by state and collective enterprises. Hence, effective state ownership was maintained.

Secondary markets for debt and equity developed slowly. In the early 1980s, all securities were officially nontransferable. After 1985, Treasury bonds could be discounted at the PBOC or used as collateral for loans. However, since these bonds were unattractive as investment vehicles, a thriving illegal market soon developed in which individuals who had been forced to purchase bonds sought to sell them. Since bonds held by individuals were in bearer form, speculators could purchase them at steep discounts, hold them to maturity, and then redeem them for substantial profits. Similarly, early enterprise bonds were mostly nontransferable; however, some issues included a tranche that was made available to individuals on a voluntary basis, and these were transferable.

Officially sanctioned securities trading did not begin until August 1986, when a secondary market was established on an experimental basis in Shenyang. This was an OTC market in which two corporate bonds were available for trading at prices determined on a daily basis by the authorities. However, the market was quite illiquid because of the lack of supply. Since enterprise bonds, like equities, offered fringe benefits to investors, there was little incentive to sell them once they were acquired.

An official market in government debt securities was established on a trial basis in seven cities in April 1988. This experiment proved so successful that it was extended to more than 60 cities by June 1988 and the range of securities eligible for trading was expanded to include key construction bonds, enterprise and financial bonds, shares, commercial paper, and certificates of deposit. Turnover of Treasury bonds in 1988 was Y 2.4 billion (Table 22). The legitimization of trading led to the creation of a number of securities companies and a renewed drive to recognize securities markets throughout the country. However, the events of June 1989 resulted in a temporary freeze on securities market development. It was not until late in 1990 that the central authorities resumed their experimentation with securities, and it was only in March 1991 that securities trading was legalized throughout the country.

Table 22Transactions in Debt Securities in China(In billions of Chinese yuan)
19871988198919901991Total
State bonds2.4212.12911.59437.01753.161
Treasury bonds2.3832.09410.48933.95548.921
Ministry of Finance notes
Construction bonds0.0180.0050.023
Key construction bonds0.0380.0170.0100.0290.094
Special state bonds
“Inflation-proof” bonds1.0903.0334.123
Financial institution bonds0.0120.0700.0630.0971.2131.455
State investment bonds0.0090.0260.2160.251
Financial bonds0.0120.0700.0460.0460.7810.955
Capital construction bonds0.0060.0250.2160.247
Key enterprise bonds0.0020.002
Enterprise bonds0.0920.1160.0850.1403.1773.610
Local enterprise bonds0.0920.1160.0790.1062.1632.556
Short-term borrowing certificates0.0060.0341.0141.054
Certificates of deposit0.0130.0120r0420.1020.169
Total0.1042.6202.28911.87341.50958.395
Source: Almanac of China’s Finance and Banking (Beijing: China Financial Publishing House, 1992).

Although the authorities had allowed secondary markets for government securities to be established, they had not allowed a truly national market to develop. While individuals were free to trade eligible bonds in any one of these cities, they were not permitted to transfer bonds from one trading center to another until October 1990.4 As a result of different market conditions around the country, large differences in prices for the same issues developed. A comparison of the market prices of the five-year Treasury bonds issued in June 1986 in the ten most active trading centers during 1990 reveals that the yields to maturity differed greatly between these trading centers. The difference between the highest and lowest yields ranged from a low of 221 basis points in April to a high of 716 in December.

Official secondary markets for equity also took form in 1986. In September 1986, the Shanghai branch of the Industrial and Commercial Bank of China (ICBC) opened a securities trading counter and offered to buy and sell enterprise shares at transaction prices set each day by the municipal government. However, there were practically no sellers. In 1987, when six equities with a total value of Y 60 million were available, turnover reached only Y 6 million.5 By the end of 1988, there were 33 trading centers in Shanghai, trading seven enterprise shares and eight bonds. Turnover in that year was Y 535 million, although equity trading was only Y 11 million. Even in 1989, when total turnover reached Y 803 million, equity trading was still only a small share. In late 1990, the Central Government decided that it would extend the stock market experiment throughout the country, not by giving approval for a large number of exchanges to open, but by concentrating activity in a small number of centers and by providing investors around the country with access to that market. The first recognized stock market was in Shanghai, where the exchange opened officially on December 19, 1990 with seven equities, five state bonds, eight enterprise bonds, and nine financial bonds. The total value of equity issued by these seven enterprises amounted to Y 235.9 million, of which the state share was Y 156.5 million, institutions held Y 16.3 million, and individuals held Y 63.1 million. Only the last amount was available for trading on the exchange. Combined turnover in bonds and equity in Shanghai reached Y 2.7 billion in 1990.

The Shenzhen Securities Market began operations with the initial public equity offering in April 1987 of the Shenzhen Development Bank (SDB). Following official approval for securities trading in 1988, an OTC market for SDB shares emerged in Shenzhen. Turnover of both bonds and equity was only Y 4 million in 1988. By 1989, four more enterprises had issued shares and two more brokerage firms had opened up. Interest in securities waned as a result of an increase in deposit interest rates and a 20 percent tax on securities trading imposed by the Shenzhen government. However, later in that year, the SDB reported unusually strong profits and paid a dividend of Y 10 per share, which raised great public interest in equities. Turnover in equities in Shenzhen in 1989 was Y 23 million, and in 1990, with the addition of more issues, turnover jumped to Y 1.8 billion. The official OTC market could not handle the sudden increase in volume, and a large curb market emerged. In response to this, the municipal government opened a centralized trading center, which began trading in equities on December 1, 1990. The Shenzhen Stock Exchange did not receive official recognition until April 14, 1991 and opened officially on July 3, 1991 with five enterprises listed. These five enterprises had issued Y 270 million of equity, of which only Y 91.7 million was held by individuals and therefore available for trading.

At the end of 1991, there were 9 stocks and 28 bonds listed on the Shanghai exchange, with a total capitalization of Y 2.9 billion. The Shenzhen exchange had 6 stocks listed, with a capitalized value of Y 7.4 billion. Despite liquidity problems and high volatility, the market continued to grow in terms of issues and capitalization through 1993. At the end of the year, there were 183 issues of both A and B shares listed on the two exchanges with a combined value of Y 347.4 billion ($39.9 billion).6 New issues of shares reached Y 644 million in 1991, Y 7.15 billion in 1992, and Y 29.5 billion in 1993. Turnover in both classes of shares was Y 331.9 billion ($38.5 billion) in 1993, most of which was in A shares, despite a decline in turnover during the middle two quarters. During most of the year liquidity in the B share market was extremely low. At the end of February 1994, there were 234 companies listed—including 45 B shares—with a combined capitalization of Y 416.7 billion.

Steps toward the creation of a national securities trading network came with the introduction of the Securities Trading Automated Quotation System (STAQS).7 The STAQS came on line on December 5, 1990, and provided a satellite computer link for 17 securities companies in six cities. STAQS provides on-screen pricing information and a centralized clearing and settlement system and is unique among securities markets in China in that it adopted the market-maker trading structure. At the end of 1991, the five circulating Treasury bonds—those issued between 1986 and 1990—were listed on STAQS. STAQS helped to narrow but did not eliminate the price differences between the regions. Also in 1990, Treasury bonds were listed on the Shanghai Securities Exchange (SSE).8 In October 1993, turnover in the five-year 1992 bond on STAQS was Y 133 million, while trading in Wuhan, the most important regional trading center, amounted to Y 22.4 million, and turnover in SSE was Y 19.9 million.

Recently, a system similar to the STAQS has been established under the auspices of the PBOC and with the support of the specialized banks and the three national securities companies. The National Electronic Trading System (NETS) was officially opened in June 1993 to provide a nationwide electronic trading system for stocks and bonds. Trading is based on an order-driven, book-entry system in which orders are relayed through a network of more than 100 satellite-linked ground stations. At present no bonds are traded, only institutional shares, in which the market is relatively illiquid.

The development of a secondary bond market and particularly the creation of the STAQS system, which allowed for the issuance of bonds on a paperless, book-entry basis, facilitated an increase in government bond issues. In 1991, Treasury bond issuance doubled to Y 19.9 billion, compared with Y 9.3 billion in 1990. The 1991 Treasury bond issue is important because it represented the first attempt to distribute government debt to individuals through voluntary purchases. A syndicate of 70 financial institutions was appointed to market Y 2.5 billion of the planned Y 10 billion amount to be issued to households.9 The bond issue was successful and the syndication method was repeated in 1992 when a total of Y 40 billion was issued.

The government bond market suffered a setback in 1993 as a result of the availability of more attractive returns in other markets—particularly the equity market. In March, the Ministry of Finance decided to issue, by voluntary subscription through a syndicate of 91 financial institutions, Y 30 billion in three- and five-year Treasury bonds, at interest rates of 10 percent and 12.52 percent, respectively. However, by the end of the subscription period in April, only about Y 4 billion of the issue had been taken up, and by the end of May only Y 8.3 billion had been sold. Investors were increasingly drawn to the equity markets (in which capital gains were much higher than bond yields), to financial and enterprise bonds issued by local governments and nonbank financial institutions, and to deposits, all of which paid much higher rates of interest. As a result, the Ministry of Finance raised the interest rates and offered holders of the five-year bond the option to cash in after only three years (Table A15). Still, demand did not increase sufficiently, and the Government was forced to return to forced subscriptions. Regional and local governments were assigned quotas of bond subscriptions and were told that new equity issues would not be approved until they met their quota. Employees of state enterprises and government offices were then forced to purchase bonds (Y 5 billion) as were employees in private enterprises (Y 3 billion); institutional holders of maturing Treasury bonds were forced to roll them over into the new issue (Y 16 billion).

In 1993, the PBOC issued short-term financing bills for the first time. Another innovation in the domestic bond market in 1993 was the issue of bonds denominated in foreign currency. In June, the National Metallurgical Import and Export Company issued $40 million in one- and two-year bonds. In July, the China Investment Bank issued $50 million in one-year bonds. In the same month, the Ministry of Finance announced the adoption of a primary dealer system, to which 19 institutions-including only one bank—had been appointed. These dealers would be required to make a market in Treasury bonds.

For 1994, the Government has announced plans to sell about Y 100 billion in bonds with maturities between six months and ten years. Sales of long-term bonds—eight and ten years—are for the first time to be conducted through auctions. About Y 15 billion in short-term bonds—with maturities of less than one year—were sold through a syndicate of 35 financial institutions led by the ICBC by March 1994. Two-year bonds carry a 13 percent coupon, while the three-year bonds carry a rate of 14 percent—the three-year deposit rate plus 1 percent—which exceeds the forecast 10 percent inflation rate. Despite the fact that these yields are below the actual urban inflation rate, sales of Treasury bonds have been brisk. The target volume of two-year bond sales was actually met ahead of schedule.

Futures exchanges were first officially recognized in 1992 in Shenzhen. Since then, at least 30 recognized commodities futures exchanges have been established. Financial futures have also been introduced. In January 1993, the SSE listed its first futures contracts on government bonds, but the market was limited to the members of the exchange. In October participation was opened up to anyone, and turnover increased greatly to a daily average of Y 30 million.10 However, bond futures are also traded on the Beijing Commodity Exchange, where turnover is reportedly much higher.

Recent Developments in External Financing

China’s access to international bond and equity markets increased markedly in 1993, emulating the recent experience of many other developing countries. The supply of resources has shifted from commercial banks to the securities markets. Commercial banks’ lending to developing countries has been constrained in some countries by capital weakness arising from losses on loans to other groups of borrowers, slow growth in deposits, and the capital constraints imposed by the implementation of the Basle capital adequacy guidelines.11 As a consequence, banks have generally become more interested in loans that have lower capital requirements (such as short-term credits and officially guaranteed or structured lending) and in fee-generating, off-balance sheet business, such as underwriting the issuance of bonds. Moreover, some market participants noted that some banks had by the end of 1992 reached their internal limits on credit exposure to Chinese borrowers.

This combination of factors has been reflected in increased interest rates and shorter maturities on bank loans to China. Interest rate spreads appear to have increased by some 25–50 basis points during 1991–93 to around a yield of LIBOR plus 95 basis points. At the same time, average maturities in 1993 fell to 5 years, from 5.8 years in 1992 and over 10 years in 1991.

Bond Financing

China first issued a foreign bond in 1982 and was quite active up to 1989. In 1987 and 1988, various International Trust and Investment Corporations (ITICs) and banks raised $2.3 billion, with placements denominated in deutsche mark, yen, and dollars. The terms were in fact better than those achieved recently by Chinese issuers: interest rates were near LIBOR and maturities were rarely below seven years. Only one bond was issued in 1989, which raised $163 million. No bonds were sold in 1990, and in 1991 China resumed borrowing with two issues worth a combined $273 million. In 1992, activity picked up, with $1.3 billion in new bond issues (Table A16). At the end of 1992, international bond placements stood at about $6 billion and constituted approximately 10 percent of China’s total external medium- and long-term debt, a ratio that has remained relatively constant over the recent past.12 However, in 1993 China stepped up its external financing from the international bond markets, placing close to $3.0 billion.

Prior to 1993, China’s borrowing from international bond markets was undertaken exclusively by the so-called ten windows, which consist of the ITICs and certain financial institutions. The ten windows’ monopoly of the issuance of bonds in the international markets has been led by the China International Trust and Investment Corporation (OTIC) (25 percent of total Chinese bond issuance in 1992–93) and the Bank of China (BOC) (17 percent).13 The ten windows act as intermediaries, borrowing abroad with the advantage of an (implicit) government guarantee and then on-lending to domestic borrowers. Authorization for even these public sector institutions to borrow has been stringently regulated by the State Administration of Exchange Control (SAEC)—China’s debt management supervisor.

In order to prevent lenders in the market becoming overexposed to the same borrowers—and therefore increasingly reluctant to lend—the ten windows have attempted to diversify their investor base since China’s re-entry into the market in 1992. Although most borrowing has previously been concentrated in the Japanese domestic market—73 percent in 1992 and 43 percent in 1993—reflecting the familiarity of those investors with the Chinese market, the investor base has been diversified through re-entry into several major international bond markets.

The ten windows system has been recognized by the authorities as being limited, since the repetitive use of borrowers may eventually reach the limit of investor demand. Moreover, the balance sheets of the ten windows, in many cases, are in poorer condition than those of some of the enterprises seeking to access the international capital markets, and the ten windows’ on-lending to domestic enterprises has reportedly been inefficient. In addition, as the number of bond issues multiplies, the case-by-case approval by the SAEC has also become cumbersome.

Meanwhile, nonstate enterprises have reportedly placed unauthorized issues privately with regional investors, especially in Hong Kong. The volumes are understandably hard to calculate, but the terms are reportedly much less favorable than those for the ten windows. For example, Hong Kong-based Guangdong Enterprises—which reportedly issued the first Chinese bond in the U.S. market not to carry a government guarantee—paid a spread of 300 basis points on its Rule 144a ADR in December 1993.

From 1993, the authorities planned to experiment with a more pragmatic approach, including the necessary first steps to giving enterprises direct access to the international bond markets. Following the lead of many other developing countries, especially in Latin America, the Chinese authorities intend increasingly to allow direct access by the enterprises themselves—rather than through the ten intermediaries—and will use sovereign issues to establish benchmarks against which these enterprises’ issues can be priced. In this regard, the Government entered the market directly in 1993 and early 1994 after a six-year absence and set three benchmark issues (Table A16).14 Under the new approach, borrowing entities will be screened by an internal rating agency—ostensibly to provide potential lenders with better information—and then be provided a borrowing quota. To test the new approach, in 1993 OTIC was allowed to borrow up to a fixed limit without requiring case-by-case approval from the SAEC. To date, however, the SAEC has not opened up access to nonpublic enterprises, and at this initial stage access to the international markets continues to remain under the control of the authorities.

The Chinese authorities expect to place more emphasis on bond financing relative to bank financing, in view of the lower interest rates on bonds and the availability of longer maturities, which they believe to be more appropriate for their prospective infrastructure development.15 The spread over government instruments of comparable maturity for most Chinese issues has been consistently tight, at about 100 basis points. Maturities have averaged 5.7 years and have exceeded the average maturity on uninsured bank credits of five years. Moreover, there is potential for lengthening maturities. For the group of developing country borrowers, average maturities in the bond market for (unenhanced) bonds—7.1 years—exceed those in the credit markets for uninsured credits—4.9 years; furthermore, the range is wider in the bond market.16 The authorities place a special emphasis on the U.S. market, as they view it as the deepest market and most likely to produce the longest maturities, a fact already established by the recent elongation of maturities in the dollar market, to seven years in November 1992 (People’s Construction Bank of China (PCBC)) and to ten years in July 1993 (CITIC).

Equity Financing

The stock markets were transformed in February 1992 with the issues of class B shares in Shanghai and Shenzhen.17 These shares are reserved for foreign investors; they are denominated in U.S. dollars in Shanghai and in Hong Kong dollars in Shenzhen. In all other respects, they are identical to the class A shares reserved for mainland Chinese investors. The listing of B shares attracted the attention of international investors. The opportunity to invest in Chinese companies and thereby to benefit from the opening up of the Chinese economy proved to be highly attractive. By the end of 1992, 18 issues of B shares had been listed on the two exchanges, compared with 52 issues of A shares. In Shanghai, of the total capitalization (including bonds of Y 55.8 billion at the end of 1992), Y 3.1 billion was in A shares and Y 800 million in B shares. In Shenzhen, the corresponding figures were Y 48.3 billion, Y 2.6 billion, and Y 416 million, respectively. Enthusiasm for investment in Chinese equities was bolstered by the remarkable returns: an index of all Chinese equities—A and B shares combined-gained over 200 percent in the final quarter of 1992 alone, far outstripping returns in all other emerging markets.18

By early 1993 international investors apparently began to reconsider their headlong rush into B share investment. There were some reports that these investors were concerned about the adequacy of information disclosure and about the uses to which the funds that had been raised were being put. In addition, it was well known that the Chinese authorities were preparing to list nine enterprises on foreign stock markets where information disclosure requirements were more demanding. By the end of the first quarter of 1993, liquidity in B shares, never very high to begin with, declined, and with it average prices also fell (Chart 10).

Chart 10.Selected Stock Exchange Indices in China and Hong Kong, 1993–February 1994

(January 2, 1993 = 100)

Source: Bloomberg Financial Markets.

The initial euphoria, occasioned by what was for many people the first opportunity to invest in equity since 1949, and the remarkable capital gains recorded in 1992 resulted in a surge of investment in late 1992 and early 1993. Of particular concern to the authorities was the fact that funds were being diverted from the banking sector—often by the banks themselves—into securities and real estate investment through bank-affiliated trust and investment companies and securities companies. The drainage of funds became so serious that shortages of working capital in the state-enterprise sector became widespread, and funds were unavailable to pay farmers for their crops. The authorities responded in early July with a 16-point austerity program in which banks were ordered to cease their involvement with securities markets and securities companies and to call in loans made for unauthorized investments in real estate and securities.

After a modest increase in the first half of 1993, the overall trend in the A share markets was downward in the second half. This more than offset the increase in B share prices after the authorities stepped in to strengthen regulation in May.19 As a result of these conflicting effects, at the end of 1993, the composite market index showed only a 7 percent gain over 1992, the worst performance among the emerging markets being followed by the IFC—a marked contrast to 1992. Prices of both A and B shares fell in the first quarter of 1994, resulting in a 20 percent decline in the market index.

Reflecting the problems affecting the B share market and the domestic credit market, many enterprises reverted to unauthorized listings (“backdoor listings”) on the SEHK. Backdoor listings are takeovers by Chinese enterprises of publicly quoted Hong Kong companies. The primary incentives for such takeovers were that a Hong Kong listing enabled the enterprise to raise financing through new rights issues and that a Chinese enterprise could halve its effective tax rate by setting up a joint venture with the overseas-registered entity that it controls.20 Initially, most backdoor listings were undertaken by well-established and powerful mainland enterprises, such as China Resources, China Travel, China Overseas Land and Investment, and OTIC, which are referred to as “red chips.” Market participants have estimated that Chinese companies injected HK$21 billion into Hong Kong during 1991–93 through 29 listings (with a current market capitalization of HK$100 billion or $13.2 billion). The largest are OTIC Pacific (HK$15.4 billion) and Guangdong Investment (HK$1.8 billion), a property developer.

The Hong Kong and Chinese authorities did not initially discourage these practices. However, many other enterprises that followed suit had more muddled accounts without clear title to mainland assets and poor standards of investor disclosure. In many cases, it was not clear if the resources raised from rights issues were eventually used for their intended purpose. There was also concern that enterprise assets were being transferred to the Hong Kong companies to protect the assets from a weakening of the yuan. Moreover, the extent of questionable takeovers—many of which were based on inflated real estate property in China—started to tarnish the reputation of the SEHK and led to unauthorized transfers of assets out of China.

On May 11, 1993, the Hong Kong authorities prohibited unlisted companies from taking control of listed firms in order to obtain an automatic listing. In August, newly listed firms were prohibited from making rights issues for 12 months after obtaining their listing and, in September, the minimum market capitalization for new issuers was increased from HK$50 million to HK$100 million, of which one half has to be in public hands.

The tightening up on backdoor listings in mid-1993 coincided with the listing on the SEHK of shares issued to foreign investors by mainland Chinese enterprises—H shares. On June 19, 1993, representatives of the Hong Kong and Chinese regulatory authorities and stock exchanges signed a Memorandum of Regulatory Cooperation, which paved the way for listings by nine selected Chinese companies after they met its standards for primary listings. The memorandum requires (i) the full, accurate, and immediate disclosure of information relevant to investors; (ii) action to be taken against insider trading; and (iii) the supervision of trading and settlement. Of key concern were a higher standard of disclosure requirements, which were to be cross-checked by international auditors for compliance with international accounting standards, and the possibility of recourse to arbitration in Hong Kong, based on Hong Kong legislation, both of which were considered to be the main misgivings of foreign investors concerning the B share market. The initial listings reportedly required hundreds of thousands of hours of work by international accounting firms to construct acceptable financial accounts and to separate the noneconomic activities (schools, hospitals, and so on). Obtaining adequate investor protection also required addendums to the listing firm’s rules of incorporation in order to redress inadequacies in China’s company laws.

Between July 1993 and May 1994, nine Chinese firms issued H shares in Hong Kong exchange, raising $1.5 billion (Table 23). Reflecting the gradual and experimental role of other reforms, the firms chosen for initial H share listings represented some of the highest-quality Chinese enterprises, mostly companies in heavy industry with good track records, comparatively good management, and high growth potentials.21

Table 23Chinese H Shares
IssuerLaunch

Date
Times Over

subscribed
No. of

Shares Issued

(In millions)
Value

(In

millions

of Hong

Kong

dollars)
Value

(In

millions

of U.S.

dollars)
Price at

Launch

(In Hong

Kong

dollars)
Price at

Close of

First Day

Trading

(In Hong

Kong

dollars)
Price on

Mar. 11,

1994

(In Hong

Kong

dollars)
Discount

to A

Share on

Mar. 11,

1994

(In

percent)
Market

Capitalization

on Mar. 11,

1994 (In millions

of Hong Kong

dollars)
Liquidity

on

Mar. 11,

19942

(In

percent)
Volatility

from

Launch3

(In

percent)
Tsingtao Brewery
Company Ltd.July 1993110.50317.60889.00115.002.803.608.20-27.002,619.900.403.64
Beiren Printing
Machinery
HoldingsJuly 199325.00100.00208.0040.002.082.754.40437.500.504.04
Guangzhou Shipyard
International
CompanyJuly 199377.00157.00327.0039.002.082.403.9024.00609.200.404.14
Shanghai
Petrochemical
Company1July 19931.201,680.002,648.00343.001.581.612.8020.004,651.100.403.63
Maanshan Iron and
Steel Company1Oct. 199315.001,732.903,934.00509.002.273.653.901.006,706.800.503.11
Kunming Machine
Tool PlantDec. 1993627.0065.00129.0017.001.985.803.90-10.00250.300.404.13
Yizheng Joint
Corporation of
Chemical FibreMar. 199410.001,000.002,380.00307.002.382.422,380.00
Tianjin Bohai
ChemicalMay 19940.26340.00408.0052.651.201.10
Dongfang Electrical
MachineryMay 199415.00170.00481.1061.702.833.17
Total11,404.101,484.3517,654.800.40
Sources: Euroweek; International Financing Review; and IMF staff estimates.

The Hong Kong and Chinese authorities recently announced the next group of enterprises (22 in total) for international listings, with 4 envisaged to have primary listings on the New York Stock Exchange (NYSE) and the other 18 on the SEHK. Though the first nine listings had an even geographic distribution, the subsequent H share listings appear to be more explicitly based on economic criteria, favoring especially infrastructure development—for example, the power generating sector. Once again, this second set of enterprises contains some of the highest quality firms in China. The attractions of the NYSE over the SEHK for Chinese companies are reportedly the much higher price/ earnings ratios that Chinese companies have obtained on the former—which permits them to raise funds more cheaply—as well as intangibles such as the scarcity value and prestige of a NYSE listing. The highest quality enterprises are expected to list on the NYSE, specifically two power supply companies and two regional airlines.

Major constraints on the number of firms that can be listed include the legal framework—a national securities law has yet to be passed—and the speed of adoption of appropriate accounting and disclosure standards. The latter problem may be alleviated by China’s new accounting standards, which are reportedly not much different from international standards. As the enterprises adopt these new standards, it will be easier for them to meet the listing requirements of the SEHK.

Though investor interest in Chinese equity has been heightened in the past two years, it has focused on indirect or diversified channels. Most investment in China is from retail investors (such as country funds), with institutional investors having shown the greatest enthusiasm for the NYSE listing of the Shanghai Petrochemical ADR. Country funds have three main channels for investing in China—H shares, B shares, and companies controlled by mainland Chinese corporations (backdoor listings and red chips) or companies closely related with Chinese interests. There are about 40 country funds that invest in China—all of which were established in the past two years—with a total of some $1.5–2.0 billion of assets under management. The B share listings have a market capitalization in the order of $5 billion, with average daily turnover varying from the high of $13 million to very low levels. Only about one fifth of fund managers invest more than 40 percent of their assets in B shares, whereas some three fifths invest over 40 percent of their assets in Hong Kong China plays. The preference for investing in China through companies listed in Hong Kong reportedly reflects the quality of the company managers, a familiar accounting system, and the perception that the local intermediaries have a comparative advantage in monitoring the quality of the investments.

Hong Kong’s role as conduit for investing in China arises from the fact that most foreign direct investment in China and most external bank credits are advanced by Hong Kong enterprises—reportedly in search of a low cost manufacturing base—and banks based in Hong Kong. Foreign direct investment to China almost tripled in 1992 to $12.0 billion and for the first time exceeded loan financing; for 1993 it is estimated to have increased further to an estimated $26 billion in disbursements and over $100 billion in commitments. In 1992, foreign direct investment from Hong Kong amounted to $7.7 billion (64 percent of the total).22

The Chinese Approach to Securities Market Development

Despite appearances to the contrary since the beginning of 1993, the development of securities markets has been a relatively gradual one in China. In the early stages, the authorities reacted to developments in the markets rather than anticipating or leading them. For example, official approval of the issue of enterprise securities was given only after a large number of enterprises had done so on their own initiative; secondary markets for securities were recognized only after unofficial curb markets had been operating for some years; and securities were traded on the Shanghai and Shenzhen exchanges long before they were officially opened in 1990 and 1991. Since 1990 the authorities have been more active in guiding market developments. New initiatives include official recognition of secondary markets for bonds and equity and efforts to create a national market. The Central Government has consistently attempted to maintain strict control over issuance by means of quotas for new share and bond issues by enterprises.

Banks’ Involvement in Securities Markets

Overall, the securities markets remain relatively small as sources of funds. The data up to 1991 show that the substitution of securities issues for bank loans has been very modest. The ratio of securities issues by enterprises (enterprise bonds plus stock issues) to bank loans to enterprises rose from 0.4 percent in 1987 to 1.5 percent in 1991. The total stock of securities outstanding at the end of 1992—Y 330 billion—represented only 11 percent of all financial assets, although that proportion is increasing at a rate of 1 or 2 percentage points a year.

Until recently, banks were intimately involved in the securities markets. Many of the securities firms were bank subsidiaries or affiliates, and the markets were regulated by the central bank. In early 1993, however, when it became apparent that this mixing of banking and securities activities was resulting in the diversion of credit away from the productive sectors of the economy, the authorities introduced regulations providing for a complete separation of the industries. Banks had to close or sell their securities subsidiaries and call in “speculative” loans, 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 had an effect on liquidity in the secondary market. Individuals must put cash up front for securities they purchase and must retain minimum balances in accounts with securities firms. The firms themselves must keep relatively large balances in their accounts with the exchanges in order to finance their proprietary trading activities and to protect themselves against settlement failures.

The Approach to Equity Market Development

In China, the selection of issuing firms thus far has been determined on an administrative basis. Rather than simply having to meet the exchange’s listing requirements and some national regulatory standards, Chinese firms that want to list must be transformed into joint-stock companies have their land and other assets valued by the State Assets Bureau and State Land Administration and have their financial statements audited and prepared according to international standards. They then must apply to the local government for approval to issue shares, and if that is successful, they apply to the China Securities Regulatory Commission (CSRC), which re-examines the application (in part to ensure that the exchange’s listing requirements have been satisfied). One of the conditions of eligibility is that the company has earned positive profits for the three preceding years. Applications by enterprises owned by the Central Government for bond issues are examined by the PBOC and the State Planning Commission, whereas applications from private enterprises or enterprises owned by local governments are examined by the relevant local government.

The Central Government has a quota of A share listings for the country as a whole (this may be subdivided into quotas for different exchanges), which allows it to control market development. Compared with an estimated Y 10.9 billion in new issues in 1992, the quota in 1993 was Y 5 billion, and that for 1994 is Y 5.5 billion. Subject to this limit, approval will be given for one or two listings from each province or municipality on each exchange. The recent weakness in the markets has delayed scheduled issues, with the result that some issues that have been approved for 1994 may not be marketed until 1995. There is no quota for B shares, but the approval process is a little more complicated (at the very least enterprises have to prove a need for foreign exchange). There are also other mechanisms by which the center can control these issues—for example, in 1993 B share issues from provinces that had not taken up and distributed their allotment of Treasury bonds were prohibited.

The marketing of approved issues differs from practices followed elsewhere. A shares are underwritten by a securities firm—usually a domestic firm, but often with a foreign firm as an advisor—which sells share-order forms in which the holder applies to purchase a fixed number of shares. The price is generally not known at this stage. This modified book-building system allows the underwriter to gauge market demand for the issue and to better price the shares. In fact, public offers have generally been greatly oversubscribed, so the successful applications have been selected by lottery, and the underwriter bears minimal risk. Although the Government no longer sets the issue price—as the PBOC had done in the past—it apparently still has influence over the determination of the issue price. By contrast, B shares are generally marketed by private placement, most often in Hong Kong.

Because of their different investor base, A and B shares have very different liquidity characteristics. For example, B shares generally are more thinly traded. As a result, prices of A and B shares for the same company (which differ only in their investor base and currency risk, but not in dividend or shareholder rights, and so on) frequently have very different prices. For example, on March 16, 1994, B shares in Shanghai traded at a 62 percent discount to the price of the same companies’ A shares, while in Shenzhen the discount was 39 percent. For individual companies, the discounts reach as high as 84 percent, while only one company’s B shares traded at a premium. It is not uncommon for developing countries to discriminate between foreign and domestic investors in their stock markets, but China may be alone in having the shares reserved for foreign investors trade at a discount.

In addition to strong “investor sentiment” pressures, one possible explanation for the B shares discount is that the required return for Chinese investors may be lower than for foreign investors because they have fewer alternative investment opportunities.23 While the B share discounts for a selection of companies during March 1992–March 1993 did not respond to international interest rates and risk premiums, they do appear to be significantly correlated with the premiums on shares reserved for foreigners in Singapore and Thailand. As the discount on B shares falls, the premiums on foreign shares in Singapore and Thailand rise. This suggests that foreign investment in China may be motivated by similar factors as investment in these other two markets.

The segmentation of the equity market into A, B, and H shares is a distinguishing characteristic of securities market development in China. As mentioned earlier, although discrimination between domestic and foreign investors is not unusual—this occurs, for example, in Singapore and Thailand—the unique feature of the Chinese approach is that these classes of market differ in their information requirements. Thus, it was recognized early on that issuers of B shares would have to provide better information to the market than would issuers of A shares, and that H share issuers would need to disclose even more information. Thus, issuers of B shares have to prepare financial statements according to international accounting standards, which is not required of issuers of A shares. Moreover, issuers of H shares, have the added responsibility of meeting listing requirements on the SEHK, which has stricter information disclosure requirements than the two Chinese exchanges.

The informational asymmetries reflected the recognition that international investors would not be prepared to invest in companies in which they did not have sufficient information (which was felt to be the case for the A shares). The local regulations in Shanghai and Shenzhen, for example, did not require issuers of A shares to use international accounting standards. The rules for B share issues were more demanding, and the regulators accepted foreign advice that accounts prepared according to Chinese standards would not then have been acceptable to foreign investors. The standards for H shares were set by the SEHK and are generally recognized to be the strictest.

The experience during 1993 has demonstrated that investors generally prefer markets with better disclosure. Foreign investors, with a choice of purchasing B or H shares, have gravitated toward the latter. Initially, when only B shares were available, the international investment community showed considerable interest in these shares, 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 of them had misused the funds they had raised by speculating in real estate or securities markets, or simply by on-lending the foreign exchange. By the end of June, B share liquidity had all but disappeared. The emergence of Chinese companies listing on the SEHK, beginning in July, provided a superior alternative to B shares, and international investors quickly turned their attention to that market. With one exception, H share issues have been very well received in the primary market, and the secondary market for these shares has been very liquid since their listing.

A second element of the Chinese authorities’ approach to stock market development is their decision to pick which firms will issue shares on the two regulated markets, subject to an overall quota and a concern for regional equity. The selection of H share issuers is not subject to a quota; however, the choice of companies is almost entirely made by the central authorities at the highest level. Rather than letting the market determine the issuers, subject to some minimum standards contained in securities and company law and in the exchange’s listing requirements, the authorities 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 might not have been feasible. Perhaps more important in the authorities’ opinion, there was a need to maintain control over the liberalization process. This is consistent with the general approach to reforms in China in which measures are implemented on a trial basis at first.

Suffice to say that given the large structural changes under way and the nature of the remaining distortions, it would not be easy for an outsider to identify the most profitable or best-managed firms. Local authorities may in fact be in the best position to do so. Government intervention of this sort may resolve a marked information asymmetry between domestic firms and foreign investors.

This strategy could run into trouble if non-economic factors, such as a desire to spread listings geographically, were to receive too much attention in the selection process. This could result in firms being allowed to issue shares, despite the fact more profitable firms in the same industry located elsewhere could not.

Corporate Governance

Another motivation for the development of corporate securities markets is to create a system of corporate governance that does not rely on bureaucrats. A first step in this process is to remove the enterprises from direct government control. Thus, the authorities have encouraged enterprises to transform themselves into joint-stock companies with majority (initially usually 100 percent) state ownership, but with independent management.24 To date, more than 13,000 enterprises have taken on this status—9,500 in 1993 alone.

The second step is to allow enterprises to obtain their own financing. While the largest enterprises can still rely on fairly automatic bank credit, smaller ones would have to negotiate terms with the bank. Moreover, the intent has been that these loans should be repaid. In addition, subject to the approval of regulatory authorities, firms are allowed to issue debt and equity securities to the public. However, so far, equity issues have generally comprised less than 30 percent of the enterprises’ enlarged capital.

Having released enterprises from direct bureaucratic control, the Government has recognized that some new source of discipline for managers must be found. It hopes to obtain this discipline from a reformed banking sector and from the securities markets. In assessing the scope for securities markets to exercise discipline, several factors need to be taken into account.25

Consider first the contribution of the banks. Banks can impose financial discipline on firms primarily through the requirement to make regular payments on loans. If a firm does not obtain a regular cash flow from the investments financed by the borrowed funds, they may be unable to service the debt and be forced into bankruptcy. If bankruptcy is costly to managers, they will have an incentive to ensure timely service of their debts. Moreover, this obligation may mitigate any incentive managers may have to divert enterprise resources to their own personal uses.

Banks also have access to fairly detailed information on the financial condition of the firm—both as a condition for making or renewing a loan and from observing the firm’s cash flow through its current account, which is often required to be maintained at the lending bank. Of course, banks will only enforce this discipline if they themselves face a cost to 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 beyond their control, and since banks face no apparent penalty from accumulating bad loans, they have 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 accounts—effectively capitalizing unpaid interest—than force bankruptcy and closure of the firm.

Equity markets provide an alternative—and complementary—source of discipline through two possible avenues. In the first place, since shareholders own a claim to the firm’s residual profits, they have an incentive to monitor the management of the firm and to ensure that the most profitable investments are undertaken in order to maximize the value of their shares. The second source of discipline derives from 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 the market price of the equity, then the firm may find it more difficult to find new investors. If the price falls by a large enough amount, a rival manager may attempt a takeover, believing that he is more capable of managing the firm efficiently. 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. Investors need reliable information about the firms in which they are investing if they are to be able to closely monitor the firms’ activities. 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 one individual has a large enough stake to compensate himself for the monitoring costs that would be incurred before effecting any change in management. Rather, it is possible that any indication of poor performance would result in a sale of shares. However, takeover regulations are drafted in a way that makes it difficult to rely on this mechanism for disciplining poor managers. Investors must make a public announcement when their stake reaches 5 percent of a firm’s outstanding shares, and at every 2 percent increment thereafter. Moreover, the investor is barred from trading in that stock for two days after each announcement. Foreigners cannot mount a takeover through the secondary market because they are barred from purchasing any shares other than B and H shares, which generally amount to no more than 30 percent of the firm’s capital.

Under present conditions, therefore, the main source of discipline is likely to come from the actual listing process itself. Both the authorities and Chinese and foreign securities houses report that preparing audited financial reports in line with international accounting standards and restructuring the operations of state-owned enterprises are highly instructive to management.

Supervision and Regulation of Domestic Capital Markets

The regulation of securities markets was rearranged in early 1993, which resulted in greater centralization and rationalization. Prior to April 1993, the PBOC took the initiative in developing and regulating securities markets through its securities regulatory office in Beijing. In this they were supported by the Ministry of Finance and the State Council for the Reform of the Economic System (SCRES). Because of the speed with which securities market activities emerged in centers all across the country, these responsibilities were soon decentralized. The local municipal governments and PBOC branches had 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—secondary market trading and issuance of a new kind of security—came long after the local authorities had approved them.

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—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 SCRES, 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 operate as self-regulatory 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 being drafted. These regulations prescribe issuing requirements—among others, the requirements that companies show at least three consecutive years of profits prior to issue and that intangible assets represent less than 20 percent of total assets—and acceptable practices in the primary and secondary markets. They specify the operating requirements for securities firms and explain how the firms will be supervised. They also include penalties for securities fraud and cover mergers and acquisitions.

The PBOC has retained its role of licensing securities firms, but the CSRC sets the conditions of eligibility and capital requirements and supervises the daily operations of these firms. 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.

Issues in External Financing

The Chinese authorities have chosen to list firms in Hong Kong rather than access international markets through issues of ADRs/GDRs—as is common in many other developing countries (see Annex IV). Both these vehicles, direct listing and ADRs/ GDRs, raise an issue’s liquidity and concomitantly its price through the broadening of the investor base, the reduction in settlement time and risk, the introduction of trade and settlement according to international standards and more established currencies, and the avoidance of foreign investment restrictions. However, ADRs/GDRs differ from direct placements in international markets in that they provide extra liquidity to the domestic market and not just the individual issue.26 However, this route is made more difficult by the more rigorous accounting and disclosure standards required for a public listing of an ADR/GDR. Moreover, China has a close relationship with Hong Kong, which may increase the attraction of listing there rather than elsewhere.27

The pricing of Chinese equities highlights the market’s concerns with the B share market. During 1993, the IFC’s Asia investable index, the Hang Seng stock market index, and Standard Charter’s B share index increased by 98 percent, 119 percent, and 35 percent, respectively. An index of red chip firms outperformed the Hang Seng index until the introduction of H shares in July 1993, with the former rising by 40 percent, compared with a 30 percent increase in the Hang Seng index. The Hang Seng and the B share indexes were substantially more volatile than the IFC index during 1993. Moreover, liquidity is relatively equal among all the China plays except for the B share market, where liquidity has been lower.

Broadening the analysis to include H shares is complicated by the relatively small period for which they have been issued, as well as by the upheavals in the Hong Kong market during this period. The first H share was issued in July 1993, while the largest H share started trading only in November 1993. The Hang Seng soared to record heights during the last quarter of the year and turned sharply downward in early January 1994. Nevertheless, an H share index greatly outperformed the Hang Seng index over November 3–December 31, 1993, but fell slightly more than the Hang Seng over December 31, 1993–March 3, 1994.28

In the short run, China’s access to the international securities markets, especially by entities carrying government guarantees in the bond markets, will be facilitated by the absence of debt-servicing difficulties in recent years and the opening of the economy under the reform program—along with the concomitant economic development. In recognition of these positive aspects, the major credit rating agencies having granted China an investment grade status. In setting this rating, Standard and Poor’s cited China’s demonstrated record and long-term prospects for strong economic growth, moderate external debt burdens, and cautious policy approach to managing economic development. Reconfirming the positive outlook, Moody’s upgraded China from Baal to single A in September 1993.29 These sovereign ratings exceed those of most other developing countries, other than a few of the other dynamic Asian economies. As the rating of a country’s non-sovereign issues cannot exceed their respective sovereign rating, China’s high rating should facilitate access by qualified enterprises to the markets when this is authorized. It is interesting to note that industrial country corporations with similar ratings can borrow at yields some 150 basis points over government paper of 20–25 years maturity, which—based on an extrapolation—is comparable to China’s spreads on issues by the ten windows.

The ten-year bonds issued prior to 1985 actually had an effective maturity of seven and one half years, since the maturity date of a certificate was determined by lottery, with 20 percent of each issue maturing in each year after the fifth year following issue.

Although in some cases, the purchase of a certain large number of shares gave the investor the right to nominate a member of the board of directors.

Data on trading activity in Shanghai and Shenzhen prior to 1991 are from Hu (1993), Chapter 3.

Data from International Finance Corporation (1994). The distinction between A shares (which are reserved for mainland Chinese investors) and B shares (which are reserved for non-Chinese investors) is discussed below.

In September 1990, the PBOC headquarters set up a Quotation Center for government securities, which provided on-line pricing information to securities dealers. However, it never provided a trading facility and has subsequently been overtaken by the STAQS.

Renamed the Shanghai Stock Exchange in October 1993.

The interest rate was set at 1.5 percentage points above the deposit rate. Interestingly, the same year’s Y 2 billion Ministry of Finance note issue was distributed through forced allocations.

Bond futures were listed on the Shenzhen exchange in March 1994.

For example, Japanese banks have reduced considerably their lending to developing countries. See Goldstein, Folkerts-Landau, and others (1992) for a discussion of the Basle accord and the treatment of exposures to developing countries.

Foreign commercial banks and official (multilateral and bilateral) creditors have been the major source of external borrowing to date. At the end of June 1993, medium- and long-term debt stood at $16.7 billion to banks and $22.3 billion to official creditors, constituting about 25 percent and 34 percent, respectively, of the medium- and long-term debt at mid-1993.

External debt is guaranteed by the ten windows and local governments, and not by the Central Government (except for what it borrows directly).

At this stage, it was also announced that CITIC would no longer borrow on behalf of the Government.

The authorities have viewed official financing to be inflexible as its disbursement is conditional on various criteria—often linked to the use of the resources—despite its concessional terms.

For export credit agency-insured or for cofinanced credits from international financial institutions, the average maturity for credits of 12 years is longer than for bonds, with the average for all loans—7.3 years—approximately equal to the average on unenhanced bonds.

Only equity placements by companies based in China are considered as international equity placements, thus excluding international issues through special purpose vehicles (e.g., Bermuda-based subsidiaries) and secondary share listings. Notable examples of such exclusions are the New York Stock Exchange listings of Brilliance China Automobile (October 1992), China Tire (June 1993), and Ek Chor (July 1993). Other excluded secondary listings include those in Melbourne and Toronto.

IFC Emerging Markets Data Base.

An additional push to the B share market was given by the SEC assurance that U.S.-based investment funds could invest in China.

Much of this capital is then recycled back to China in the form of direct investment. However, the extent of the financial linkages is hard to disentangle as Hong Kong maintains no balance of payments statistics.

All but one H share listing were issued through a fixed-price offering and were usually heavily oversubscribed.

Of the remaining $4.3 billion, $0.7 billion came from Japan and $1.1 billion from Taiwan Province of China.

See Bell and others (1993) for a discussion of the history of enterprise reforms and especially the concept of ownership in China.

The role of banks and securities markets in providing a market-based corporate governance mechanism is discussed in Blommestein and Spencer (1993).

Judging by the market’s reaction to the prospects of level one ADRs for Shanghai B shares, this vehicle could prove to be useful in providing liquidity to the B share market; the Shanghai B share market was buoyed for several months at the beginning of 1993 by the prospects of ADR issues.

Hong Kong is supposed to retain nominal financial independence for another 50 years following its transfer to China in 1997.

The H share index is based on the Tsingtao, Shanghai Petrochemical Company, and Maanshan Iron and Steel issues weighted by their respective market capitalization.

Moody’s also upgraded three financial institutions (BOC, CITIC, and PCBC) to A3 in December 1993. Standard and Poor’s rates China a BBB, though the rating was upgraded from stable to improving.

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