China's domestic capital markets in the new millennium
By Anthony Neoh
Part I
The essential challenge
(21 August 2000) This is an article—I am afraid a somewhat long article—about some of the issues which will govern economic growth in my country, the People's Republic of China. I hope it will help those interested in China's future understand some of the problems we face.
For a country that has experienced a sixfold growth in its gross domestic product in 20 years and is still growing at the rate of over 7 percent a year, it’s difficult not to feel optimistic about its long term future. But at the dawn of the millennium, let us take a moment to consider what needs to be done to achieve, long-term sustainable growth. Failure to achieve this is in fact not an option.
In the coming years, the public expenditure needed to finance infrastructure, education, public heath, social welfare and other forms of modernization will be immense. Added to this is the need to provide a safety net for a population that will continue to age: current demographic projections show that one in four persons in our population will be over 60 by the year 2050. 2
It is well possible that life expectancies (already 71 years at present) will be higher and so, more resources will be needed to sustain a large retired population who will live longer. Taxes collected by the central government (including fees, customs 3 and other duties) represent about 13 percent of the GDP.
Other income accrues to the Government in the form of profits from state-owned enterprises (SOEs). However, it is uncertain whether SOE profits will provide the shortfall that is needed. The only way in which the revenues needed to balance future public budgets could be earned is through economic growth.
The challenge for any economy to maintain a high rate of growth is the improvement of its ability to allocate the economy's savings into investments capable of growth. The advanced economies have been able to achieve this goal with a high degree of success. The fact that the U.S. has been able to achieve a growth rate of over 6 percent in 1999 has generally been attributed to the fact that a high proportion of the country's savings have found their way to growth investments.
All developing economies aspire to achieving the same degree of success as the advanced economies in enabling savings to find their way to companies capable of growth. The fact that our country has achieved nearly a sixfold growth in our GDP since 1978 has been due to unleashing productive forces otherwise locked up in the past.
But as we have found in the past 10 years, a very substantial proportion of the nation's savings has not found its way to businesses capable of long term, sustainable growth. If we are to maintain our rate of growth, we must find a way to ensure that the bulk of the nation's savings do go to businesses that deserve the money. Only an efficient capital market will ensure that this will happen. To see how we might achieve this goal, let us first take stock of what has been achieved so far.
The capital markets in context
The domestic capital markets have since the 1950s been operating with government bonds and a very small number of financial institutional bonds. The important component of the capital market, namely the stock markets, did not begin life until the 1980s when provincial legislatures began to experiment with company regulations and companies chartered locally began to issue shares which were then sold to the public.
Shares issued to the public must have a method by which they may be sold. Thus, securities dealing centers began to sprout across the country. These securities dealing centers had only minimal quotation, clearing and settlement facilities. There was therefore little price transparency and little protection for brokers and their clients.
The Shenzhen and Shanghai Stock Exchanges began operations in 1990 and due to their superior technology, were able to handle increasing volumes and ensure good price transparency. The clearing and settlement systems associated with these exchanges showed too that they could cope with the increasing volumes over the years, and thus they have attracted the bulk of the business.
The total market capitalization in these two exchanges have now reached some 3 trillion renminbi, but the liquid market capitalization is about a third of this capitalization, since two-thirds of the shares of the 649 listed companies in these exchanges are unlisted and may not be traded. Rmb 1 trillion represents about 12.5 percent of the gross domestic product (GDP).
In G-10 countries the market capitalization of their stock markets now represent well over 100 percent of their GDP. Thus, the domestic stock market in China has been playing a comparatively small role in capital formation in our country.
The capital of business enterprises in our country have therefore come from either direct capital investments or bank lending. Total bank loans in 1998 were Rmb 8.6 trillion, representing 109 percent of the GDP. It is more than the 89 percent for G-10 countries that, however, have average stock market capitalizations well over this figure.
This shows that G-10 countries have been using their capital markets to a much greater extent than we have. They have more developed financial markets, and that is why they have been able to allocate their capital more efficiently.
Bank financing does not work generally work efficiently unless accompanied by a high degree of transparency. It must be noted that banking relationships are confidential and problems therefore do not emerge until a client is unable to repay his loans. Often, this comes too late for remedial actions.
The problem of Guangdong International Trust and Investment Company (GITIC) was an example of bankers not being able to detect problems at an early enough stage. All countries now engaged in banking reforms have encountered similar problems and the World Bank has particularly highlighted the Chilean banking reforms as an illustration of the difficulty of banking problems coming to light at an early stage and an example as to how such problems might be effectively tackled.
The Chileans had a massive banking problem in the 1980s. They regained the credibility of their banks by adopting aggressive market value accounting and mandatory external audits of their banks: two independent private public accounting firms must audit each bank each year and their reports must be published. The Superintendent of Banks is required to publish in a national newspaper three times a year a detailed report on each bank's compliance with capital requirements and ratings of the bank's assets (representing estimates of the probabilities of loss on those assets)4.
The Chilean banking reforms have now become the benchmark against which all other banking reforms in emerging markets are judged.
But more importantly, they illustrate how transparency can contribute positively to confidence. If the banking relationship can be made more efficient through the application of transparency, capital markets will be able to achieve even more. Efficient capital markets are driven by transparency as listed companies must comply with continually improving standards of financial and non-financial disclosure.
This, in turn, ensures that problems stand an even better chance of early discovery. This degree of public scrutiny tends to make managers more alert to potential problems and thereby make businesses more efficient and more capable of growth.
At the same time, the market forces managers to exploit synergies or reduce inefficiencies through mergers and acquisitions of businesses. In short, efficient capital markets enable good businesses to grow and bad business to either be absorbed or fail. The aggregated effect of these activities translate into growth for the whole economy.
There have been many detailed empirical studies of the role capital markets play in economic growth5. These studies conclude that capital markets do positively contribute to economic growth and the markets with the better transparency and investor protection features tend to contribute more to growth of the economy.
A recent empirical study revealed strong evidence that the reason why capital markets contribute to economic growth is that efficient capital markets assist in efficient allocation of the community's resources. In countries where there are developed capital markets, industries that are rising get far more capital than industries that are in the wane. 6
Judged against these studies, it is clear that our markets have far to go before we can achieve the efficient capital allocation. Just a cursory review at the state of the over 900 companies listed in our two exchanges will remind us that there are too many businesses which are not capable of long-term, sustainable growth.
In fact, an increasing number has incurred losses for three years running. In 1999, about a third of our listed companies have qualified auditors' reports on their financial statements.7 Some 200 "listing quotas" allocated in the quota system are still waiting to be processed. In the past six months, 51 companies have listed, averaging at 8.5 per month.
At this rate, it will take 24 months for these 200 to list. Additional companies are being added to this list all the time. How can we ensure that these companies get their capital within reasonable time and how can we ensure that the companies given access to the capital markets deserve the money they get? The answer to these and other questions will lie in at least the needed structural reforms set out in the next section.
The next challenges
These 11 reforms are by no means exhaustive but if they are effectively implemented, we should be well on our way to ensuring that we have an efficient capital market:
Strengthening regulation of securities firms;
Determining access to the capital markets by market principles;
Establishing good corporate governance practices;
Developing a complete acquisitions and mergers regime;
Rationalizing the many classes of shares in our stock markets;
Rationalizing the company law;
Rigorous application of accounting and auditing standards;
Improving investor protection;
Developing a much larger institutional investor base;
Plan for integration of financial services and the development of new financial product; and
Develop a strong and coordinated regulatory structure in the financial services.
Strengthening regulation of securities firms
In any capital market, the intermediary takes central role. It is through the intermediary that transactions are conducted and capital is raised in the market. The intermediary is therefore the gatekeeper of the market. All markets place upon this gatekeeper the duty to ensure that market rules are complied. The major markets such as those in the U.S. and London have grown and prospered through the development of good rule compliance cultures by their intermediaries.
These cultures7 have in effect become market ethics and it is the consistent application of such market ethics which have created widespread confidence, and hence, widespread use of these markets. If we aspire to have a major capital market, as we must, in order to sustain our economic growth, then we must ensure that our regulatory regime for securities firms is strengthened.
At present, there are some 90 securities firms and over 200 securities dealing storefronts run by investment trust companies. The latter will have to be divested from their parents and either become securities firms by themselves or be absorbed by securities firms. The "Securities Law" in fact provides for the licensing of securities firms and for the establishment of adequate risk management in securities firms. In particular, the Law mandates segregation of client assets (including client monies) from the assets of the firm).
The Law, however, leaves the details to administrative regulations. Much work has been done in drafting the detailed regulations, which should soon see the light of day. The regulation will represent a start by providing a more detailed basis by which securities firms will be regulated. To build on this start, the following will be needed:
1. Building rules in accordance with internationally accepted standards, to ensure that securities firms have sufficient capital to deal with the risks they assume on a continuing basis;
2. Building a reporting system that requires securities firms to report periodically, their capital position and their risks to the regulator;
3. Building a monitoring system in the regulator's office to capture firm and systemic risks; and
4. Building an inspection and advisory system to ensure that securities firms are in compliance.
Compliance with the Securities Law and detailed implementing rules will require a determined effort on the part of all securities firms and the regulator. But more fundamentally, that will require all securities firms to have the necessary capital to ensure that client assets are paid into segregated accounts and that all current risks are covered.
Furthermore, capital is needed for growth and innovation. Recent rules which allow securities firms to borrow from banks on the security of listed shares owned by them will assist in easing the cash flow of qualified securities firms, but that is no substitute for equity and other forms of long term capital. A few securities firms have now raised substantial capital to enable them to operate a sufficient cushion for the risks they assume.
However, in order that they might grow and innovate, particularly in the face of competition from large and well-capitalized international firms, those qualified under the company law for access to the capital markets, should be given the opportunity to do so. 10