VI China’s Emerging Capital Markets
- International Monetary Fund
- Published Date:
- January 1994
While still in its early stages, the growth of capital markets in China will rank as one of the important financial events of the 1990s. The first recognized stock exchange was officially opened in December 1990 in Shanghai, followed in April 1991 by the Shenzhen Stock Exchange. At the end of 1993, the value of equity listed on these two exchanges was about $40 billion, similar in size to the Argentine and Turkish exchanges, and comprising roughly 3 percent of the value of all “emerging markets.” Of the approximately 100 stocks listed on the Shanghai Stock Exchange (SSE), almost 90 percent are A shares (equity shares denominated in yuan and reserved for Chinese residents) and about 10 percent are B shares (equity shares denominated in foreign currency and reserved for foreigners). A shares have so far tended to be much more liquid than B shares. Seven of the most internationally well-known Chinese enterprises (Tsingtao Brewery, Shanghai Petrochemical, Maanshan Steel, and four others)—representing about $3 billion in value-have been listed on the Stock Exchange of Hong Kong (SEHK), and others will be listed later in 1994; shares listed in Hong Kong are known as H shares. In October 1993, a Chinese enterprise was listed on the New York Stock Exchange for the first time. At the same time, over 4,000 Chinese companies are reported to have issued unlisted shares that are informally traded in numerous curb markets in all the major cities. The first mutual fund was recently approved by the People’s Bank of China. While enterprise bonds and equities had been issued and traded since at least the mid-1980s, trading in debt securities—mostly issued by the Central Government and state financial institutions—was officially permitted only after 1986, and promoted by the development of a national OTC market in late 1990. At least three government bonds and 27 enterprise bonds have been listed on the SSE, and futures contracts for government bonds are being actively traded on the exchange.
One of the main reasons why the development of securities markets in China is of such wide interest is that it illustrates some of the challenges faced by developing country authorities—especially those from transforming economies where private ownership has to be re-established—as they attempt to coordinate these markets into the overall reform effort.
One such challenge is to keep the pace of liberalization of capital markets under control so that it is consistent with the ongoing task of stabilization of the domestic economy. As in other areas of reform, the Chinese authorities introduced capital markets on an experimental basis, hoping to learn from experience and to ensure that change came gradually and incrementally. Securities markets were therefore first introduced in only a few regions. Despite this cautious approach, there were periods in which market developments temporarily outstripped the authorities’ efforts to control such activity. This problem came to a head in the winter of 1992–93 when, against the backdrop of general overheating in the economy, speculation by Chinese investors contributed to a decline in bank deposits and to the diversion of funds from investment by state-owned enterprises to securities and real estate transactions. A decline in liquidity in the rural and state-owned enterprise sectors led authorities to respond by including, in their overall stabilization program, measures forcing the recall of all “speculative” and other unauthorized loans and the complete separation of the banking and securities industries. There had clearly been a tendency on the part of some issuers to flout official regulations. Once economic agents become initiated into the possibilities of raising funds outside the banking system and of obtaining market-determined rates of return, it can be problematic to rein in the scale of these activities or to keep them contained within officially sanctioned channels.
The authorities introduced significant improvements in the regulation of securities markets in 1993. On the institutional side, the new State Council Securities Policy Committee and its executive arm, the China Securities Regulatory Commission, which was established in October 1992, assumed its place as the chief regulator and supervisor of securities markets in the spring of 1993. Thus, the regulation of bond and equity issues and trading were centralized for the first time. This provides the basis for consistent national regulation of securities markets. As a first step, interim regulations governing A shares and bonds were introduced in March 1993, and a new companies law was passed later that year. However, national securities legislation has yet to be passed by the People’s Congress.
A second challenge is how to respond to the pressures that the liberalized—or even the unauthorized-elements of the financial sector eventually place on the less liberalized elements. In this connection, the Government’s response to competition for domestic savings—increasingly from high-yielding equities and enterprise bonds that outperform bank deposits or government bonds—has been instructive. Although financial sector liberalization was begun at a relatively late stage in China’s reform process, when these competitive pressures emerged, the Government often opted not to clamp down on these liberalized markets but, for the most part, to instead hasten the liberalization of the controlled financial sector. Although the Central Government has sometimes sought to limit competition, for example, by restricting interest rates on nongovernment bonds and more recently by restricting access to credit by securities market participants, the more common response has been to make bank deposits and government bonds more attractive. For example, over time the Government has reduced the maturity of treasury bonds and increased their returns; in addition, the policy of distributing bonds by forced allocations to institutions and individuals was ended in 1991. In 1989 and 1990, the Government issued indexed bonds, and in 1993, when disappointing sales of treasury bonds led the Government to reinstate forced distribution, this policy was combined with an increase in interest rates and the introduction of even shorter-maturity bonds. At the same time, bank deposit rates were increased on two occasions, and a policy of partial indexation was announced.
A similar pattern emerged in the policy toward external financing. China has long relied on Hong Kong as a source of external financing, usually in the form of bank loans or direct investment. However, in the early 1990s, if not before, enterprises, particularly in the south, reportedly began purchasing controlling stakes in Hong Kong companies; they thereby obtained “backdoor” listings on the SEHK. At first the authorities in Hong Kong and China seemed to look the other way, but it soon became apparent both that there was a pressing need for foreign capital in China and that foreign investors saw investment in Chinese enterprises as an attractive opportunity. Thus, in order to regulate access to foreign equity capital, and to correct some of the improprieties that had accompanied the surreptitious access to foreign markets, the Chinese authorities introduced B shares, and then, in part to allay concerns over disclosure and market regulation, H shares. Hence, it could be argued that the unregulated backdoor listings ultimately resulted in a change in the old policy of prohibiting sales of equity abroad.46 The Hong Kong authorities also tightened the rules that had allowed the abuse of backdoor listings by increasing disclosure requirements and by delaying approval of new rights issues. Similarly, partly in response to unauthorized external borrowing, and partly because of inefficiencies in the old system, the practice of restricting access to international bond markets to only a few financial institutions—the “ten windows”—has recently given way to a policy of allowing a broader range of approved borrowers.
A third challenge is to use the development of securities markets as an instrument for absorbing international financial techniques and practices into the economy, and as a source of discipline for enterprise governance. The Chinese authorities are counting on securities markets—in particular, equity markets—to encourage enterprises to improve both their accountability and their operational efficiency. At the very least, the need to prepare a prospectus introduces international accounting practices and, in many cases, emphasizes the importance of profitability. Preparations for stock listings also require the rationalization of operations and the separation of nonproductive activities-such as the provision of housing—from the core production operations.
The approach adopted by the Chinese authorities toward disclosure in securities markets is especially noteworthy. Rather than settle on one absolute standard of disclosure and wait until most enterprises had met it, they opted instead for a multilevel disclosure policy. More specifically, those internationally well-known enterprises that could meet the highest disclosure standards were selected for listing on the SEHK or the New York Stock Exchange. Those enterprises that were somewhat less known outside of China and could meet only a somewhat less rigorous disclosure standard were selected for B share listings. Moving further along the disclosure spectrum were enterprises offering just A shares. Although the authorities have since improved accounting and disclosure requirements for all issuers of securities, and while all investors would presumably prefer more disclosure to less, some segments of the investor base were demonstrably willing to live with different disclosure standards from others. By drawing on demand from different investor bases, China was able to move forward on securities issuance more rapidly than if all enterprises were held to the highest standard.
Securities markets are also expected to provide an ongoing source of corporate governance and to encourage continued restructuring and improvements in efficiency. But there are several reasons why these goals are likely to be realized more over the long term than in the immediate future. In the first place, the market available only to domestic residents—A shares—seems so far to have been driven more by liquidity than by enterprise performance. Second, even if domestic investors were keen on monitoring enterprise operations, they are so widely dispersed that the costs of monitoring would likely outweigh any benefits that would accrue to any one individual. Third, the way takeover legislation has been written has seriously constrained the market as a source of discipline. Even foreign investors, who might be considered a more reliable source of discipline (in the short term) because they have more experience with evaluating equity markets, are hampered somewhat by questions over the information available about listed firms. Moreover, as long as foreign investors are barred from the A share market, they cannot acquire majority stakes in any of the listed enterprises.
A fourth issue in organizing domestic capital markets is whether to separate banking and securities markets, and if so, how best to delineate that separation. Here, there is a potential concern that banks may allocate an unduly large share of their assets to speculative activities and thereby expose themselves to large losses if they are permitted to participate in securities markets directly or even through subsidiaries. Another approach, which is more restrictive and which has in fact been adopted by the Chinese authorities, is to forbid banks from extending credit to participants in securities markets. In the first instance this policy, which has always been present but which was rigorously enforced under the 16-point program, ensures that funds are channeled only to their intended destinations. However, this policy also prevents bank lending from fueling a speculative bubble, which when it collapses, would involve the banks in large losses. On the other side of the ledger, however, a reduction in liquidity would probably increase the cost of transactions in the stock market because investors will have to pay the full value of their purchases up front and securities companies will have to hold greater reserves in order to protect themselves against settlement and default risk. A lack of liquidity could also increase the probability of a settlement failure, as well as knock-on failures in other institutions because the resources available to any one member of an exchange will be lower in the absence of bank credit lines. In the end, the authorities have to weigh the likely incidence and costs of these different types of risk.
A fifth issue is how to choose the firms that are to be listed on the stock exchange. Unlike most other countries, China decided to have the securities market regulators and other government agencies select the firms that will be able to list either H, B, or A shares. What makes this procedure somewhat controversial is that this selection is based, at least in part, on noneconomic considerations, such as a concern for regional equality. On the other hand, the authorities appear to have deliberately chosen the most profitable, and often the largest, firms in the state sector. Moreover, after a long history of central planning and price controls, it may be that foreign specialists would have no comparative advantage, relative to the authorities, in picking enterprises with the best growth prospects.
Yet a sixth issue is how much to rely on securities markets as a source of finance relative to alternative sources. On the domestic side, it is well to note that compared with bank financing, securities markets have remained marginal as a source of funding in China. The value of new bank loans in 1993 was fully ten times the value of bond and equity issues. Indeed, the main reason why the authorities have pushed the need for domestic bank reform so hard is that they recognize that banks are likely to remain the primary source of outside financing for enterprises over the indefinite future.
As regards external financing, China’s involvement in international securities markets has followed the pattern of other developing countries in recent years. In response to wider spreads and shorter maturities on commercial bank loans, the authorities deliberately followed a strategy of making more extensive use of international bond markets. After raising $1.3 billion in 1992, Chinese borrowers raised $2.9 billion in 1993. In raising these funds, Chinese borrowers broadened their investor base by accessing a wider range of market segments and by placing issues in a larger number of currencies. The Chinese Government has an investment-grade credit rating, reflecting the absence of debt-service problems in recent years, as well as its relatively low level of external debt. Consequently, spreads on bonds issued by Chinese borrowers were significantly narrower than on those issued by many other developing countries.
Nevertheless, equity investment by foreigners emerged as the dominant external source of financing in 1993, and foreign direct investment commitments mushroomed to over $100 billion. Most visible was portfolio investment through purchases of B and H shares and through country funds. Many individual share offerings have been oversubscribed. For retail investors, the easiest path to acquiring equity in Chinese enterprises was through investment in country funds devoted to China. There are currently some 40 funds, with total assets approaching $2 billion, that invest in “red chips” (i.e., SEHK listings of mainland firms, including both the H shares and the backdoor listings), in B shares, and in some cases, in other stock markets in the region. Most of these funds are heavily weighted toward Hong Kong “China plays” rather than B shares, because disclosure and market regulation are viewed at this stage as stronger in the former.
Another interpretation is that B and H shares were issued primarily to raise foreign funding for the restructuring of enterprises.