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Anjali Kumar
Kwang Jun
Anthony Saunders
Susan Selwyn
Yan Sun
Dimitri Vittas
David Wilton
FINANClAL TIMES Financial Publishing
Asia Pacific
Published by FT Financial Publishing Asia Pacific
An imprint o f Pearson Professional Asia Pacific
Suite 1808
Asian House
1 Hennessy Road
Wan Chai
Hong Kong
Tel: (852) 2863 2600
Fax: (852) 2520 6646
Internet: [email protected]
Web: www.pearson-pro.com.hk
O 1997 The World Bank
Conditions o f Sale
All rights reserved. No part of this publication may be reproduced, stored in a retrieval
system, ortransmitted, in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise, without the prior written permission of the Publishers.
No responsibility for loss occasioned to any person acting or refraining from action as a
result of the material in this publication can be accepted by the Author or Publishers.
First edition 1997
Printed in Hong Kong
ISBN 962 661 048 4
Publisher's note
The findings, interpretations and conclusions expressed in this study are the results of
research supported by the World Bank, but they are entirely those of the author and should
not be attributed in any manner to the World Bank, to its affiliated organisations, or to
members of its Board of Executive Directors or the countries they represent.
CONTENTS
Tables in Text.
Figures in Text
Statistical Appendix
Currency Equivalents, Fiscal Year, Weights and Measures
Acronyms and Abbreviations
Acknowledgements
1. THE CONTEXT OF CAPITAL MARKET DEVELOPMENT China's Capital Markets: Central Questions
The Growth of China's Capital Markets
The Role of Capital Markets in China's Economy
2. THE REGULATORY FRAMEWORK Introduction
Principles of Securities Market Regulation: Relevance for China
The Regulatory Framework
Regulation of Securities lssue and Trading: An Evaluation
Regulation of Participating Institutions
Distribution of Oversight within the Government
Annex 2.1 China: Laws and Regulations Related to
Securities Activities
Annex 2.2 Central and Local Authorities' Approvals Required
for Listing
Annex 2.3 Central and Local Regulations: Listing Criteria
Annex 2.4 The Trading Systems
Annex 2.5 Restrictions Against Insider Dealing
Annex 2.6 Regulation of Securities Dealers
3. DOMESTIC B O N D MARKETS Introduction
The Primary Market
lssue Method
Secondary Markets in Debt Securities
vii . . .
V l l l
X
xi i
xiii
xvi
4. EQUITY MARKET PERFORMANCE
Introduction: Equity Markets and the Shareholding System
Characteristics of China's Equity Markets
The New Issue Process and Public Offerings
Stock Price Volatility and Returns to lnvestors
Market Integration: Current and Potential
Other Issues: Enterprise Debt Securities
Annex 4.1 Clearance, Settlement and Depository Systems
Annex 4.2 Technical Note on the Analysis of Equity Markets
5. INTERNA1-IONALISKrION OF CHINA'S SECURITIES MARKETS The Scope for Safe Participation in lnternational Securities Markets
lnternational Participation in China's Equity Issues
The Performance of China's Overseas Equity Listings
Opening of Fixed-Income Securities Markets
China's Access to Overseas Securities Markets
Trading in Derivative Instruments on lnternational Markets
6. INSTITUTIONAL l NVESTORS Institutional lnvestors and Securities Markets
The Insurance Industry in China
The Pension System
Housing Funds
Mutual Funds
Annex 6.1 Glossary on Contractual Savings Institutions
Annex 6.2 Institutional lnvestors in Hong Kong
7. CONCLUSIONS A N D RECOMMENDATIONS Conclusions
Suggested Policy Changes
REFERENCES
STATISTICAL APPENDIX
TABLES IN TEXT
Contribution of Capital Markets to Real Sector Investment
Government Debt Purchases: Households and Non-Households
Treasury Bill Coupon Rate, Deposit Rates and Inflation
Comparison of Coupon and Deposit Rates, and Secondary
Market Yield
Comparison of Coupon on Treasury Bills Sales by Purchaser:
Households, Enterprises, and Financial Institutions
Tradability of 1994 Treasury Bill Issues
China: Spot and Futures Trading of Bonds
Ratio of Bond Trading Value to Stock Outstanding
Trading in Repurchase Agreements
Concentration Ratios of Member Firms Trading on
the Shanghai Stock Exchange (January 1995)
Concentration of Share Trading on China's Securities Exchanges
China's Equity Markets: Underpricing of New Share issues
IPO Underpricing Worldwide
Trading on China's Equity Markets: Returns and Volatility
Chinese Companies with ADR and GDR Programmes
(December I 994)
China Closed-End Country Funds: Discounts/Premiums
Average Spread on Floating Rate Medium and
Long Term Bond lssues
China Underwriting Performance of the People's Insurance
Company of China (1 992193)
China and Other Countries: Basic Equation of
Social Pension System
China Projected Basic Equation of Social Pension System
FIGURES IN TEXT
Growth of Securities Issued and Outstanding (1 981 -1 993) 2
Volatility in China's Securities Trading 4 Growth of the Equities Market 6
Secondary Markets in China's Securities 7
China and Other Emerging Equity Markets: A Comparison (1 993) 8
Securities Markets in China's Financial Sector 11
Central Government Budgetary Deficit and Treasury Bond Issues 16
Share of Bonds in China's Overseas Borrowing 2 0
China: Composition of Outstanding Debt Issues 82
Outstanding Debt Composition Disaggregated 84
China: Trading Value of Bonds 100
Ratios of Trading Volume of Debt to Debt Stock and to GDP 101
Ratios of Debt Stock Outstanding to GDP: China and
Other Countries 102
Regional Bond Yield Differentials (1 990) 108
Yield Differentials between Treasury Bills on Principal Markets:
1994 (Shanghai, Wuhan and Shenzhen) 108 China: Secondary Market Yield Curve 11 0
China: Bond Yield, Deposit Rate and Inflation 11 1
Equity Index and Average Bond Yield 11 2
Average Daily Trading Value of Shares 122
Shanghai Securities Exchange 125
China: A Stylised IPO Process: Post-Offer to the
Beginning of Trading 130
Initial Offerings of Shanghai A and B Shares 132
Risk-Adjusted Returns to lPOs at Shanghai 135
China: Shanghai and Shenzhen Share Indices and Volume of Trade 143
Shanghai and Shenzhen: Share Price Variance 1 44 Spreads between Shanghai and Shenzhen A and B Shares 150
Discounts on Shares Listed in Overseas Exchanges 151
Private Capital Flows to China 179
China and Other Emerging Markets: Participation in
International Capital Flows 180
China and Mexico Inflows 181 Country Funds - Average Discount 193
lnternational Bond Issues by Chinese Borrowers: Currency,
Type and Maturity
China: lnternational Syndicated Loans
China: Maturities and Spreads on lnternational Syndicated Loans
China: lnsurance Premium Growth (1 986-1 992)
China: lnternational Comparison of lnsurance Premiums (1 992)
China: Comparison of the Life and Non-life Structure of
lnsurance with Selected Countries
China: lnsurance Premiums by Line (1 992)
China: Comparisions of the Performance of the lnsurance
Industry in Selected Countries
STATISTICAL APPENDIX
A l . l China: Debt Securities Issued and Outstanding
A1.2 China: Trade in Securities
A1.3 China: Securities Trading on the Shanghai Exchange in 1994
(January 1994 to January 1995)
A1.4 China: Securities Markets and the Financial Sector
A1.5 Financing of the Government Deficit: Contribution of Bond Issues
A1.6 China: Contribution of Securities Markets to Investment
A1.7 China: Overseas Debt and Capital Markets (1 987-1 993)
A2.1 China: Structure Of Securities Regulation
A2.2 Structures of Regulation in Asian Securities Markets
A2.3 Minimum Listing Requirements of Major Stock Markets
A3.1 China: Securities Trading by Region
A3.2 Monthly Transaction Volume in the lnterbank Market
A3.3 Assets of Financial Institutions Engaged in the lnterbank Market
A4.1 China: Key Characteristics of the Equities Markets of
Shanghai and Shenzhen
A4.2 China: Size and Growth of China's Equities Markets (1 991 -1 994)
A4.3 Trading Value of Equities (1 991 -1 994)
A4.4 China: Trading Volume of Securities Per Day (1 991 -94)
A4.5 Trading Value of Inter-Linked Trading Centres (Linked to Shanghai)
(January 1995)
A4.6 China: Stock Trading Centres
A4.7 Shanghai Securities Exchange: Trading Summary of
Sectoral Stocks
A4.8 Initial Public Offering Quotas (1 993)
A4.9 China and Other Emerging Equity Markets:
Relative Size and Market Liquidity (1 994)
A4.10 China and Other Emerging Equity Markets:
Growth (1 989-1 993) A4.11 China and Other Emerging Equity Markets:
Volatility (1 993-1 994)
A5.1 International B and H Share Offerings by Chinese Issuers
A5.2 China's Overseas Share Listings (Hong Kong and New York)
A5.3 Country Funds: Trends in Total Returns
A5.4 Credit Ratings of Chinese Borrowers
A5.5 Sovereign Rating Selected Developing Countries
A5.6 China: Overseas Bond Issuing lnstitutions
B5.1 Limits on Equity Participation by Foreign Investors B5.2 Foreign Exchange Controls on Portfolio lnvestment
Capital Gains and Dividends
B5.3 Taxation of Dividends and Capital Gains of Foreigners
Investing in Emerging Markets
A6.1 China: lnsurance Premium Growth (1 986-92)
A6.2 China: International Comparison O f lnsurance Premiums (1 992)
A6.3 China: Comparisons of Growth of lnsurance Penetration
A6.4 China: Comparisons of the Structure of Life and
Non-life lnsurance (1 992) A6.5 China: Comparisons of the Performance of the lnsurance
Industry in Selected Countries
A6.6 China: Assets and Liabilities of the People's
lnsurance Company (1 992193) B6.1 lnvestment Patterns of Contractual Savings lnstitutions
CURRENCY EQUIVALENTS
Currency Unit: Renminbi (Rmb)
(Nominal Official Period Average Rates)
Year Rmb per US$
1996 (January to June)
1995 1994
1993 1992
1991
1990 1989 1988
1987 1986
FISCAL YEAR
1 January - 3'1 December
WEIGHTS AND MEASURES
Metric System
ACRONYMS A N D ABBREVIATIONS
ABC
ADD
ADR
AIA
AIG
AMEX
AMSET
BAPEPAM
BOC
BOCOM
B OT
CAlC
CBOE
CD
CIB
ClTlC
C PA
CPF
CPlC
CSRC
CSTS
D M
D R
DTC
FDI
FlBV
FSD
GATT
GDP
GDRs
GlTlC
GNP
l BCA
ICBC
IEC
IFC
IF1
IMF
IOSCO
IPO
ISC
lTlC
Agricultural Bank of China
American Depository Debentures
American Depository Receipts
American lnternational Assurance
American lnsurance Group
American Stock Exchange
Association of Members of the Stock Exchange of Thailand
Badan Pelaksana Pasar Modal (Capital Market Executive Agency) (Indonesia)
Bank of China
Bank of Communications
Build-Operate-Transfer
Chinese American lnsurance Company
Chicago Board Options Exchange
Certificate of Deposit
China lnvestment Bank
China lnternational Trust and lnvestment Corporation
Certified Public Accountant
Central Provident Fund
China Pacific lnsurance Company
China Security Regulatory Commission
China Securities Trading System Corporation Ltd
Deutschemark
Depository Receipt
Depository Trust Company
Foreign Direct lnvestment
Federation Internationale des Bourses de Valeurs
Financial Sector Development Department (of the World Bank)
General Agreement on Tariffs and Trade
Gross Domestic Product
Global Depository Receipts
Guangdong Industrial Trust and lnvestment Corporation
Gross National Product
lnternational Banks Credit Agency (originally; today officially IBCA. An international
credit rating agency headquartered in London).
Industrial and Commercial Bank of China
lnternational Economics Department (of the World Bank)
lnternational Finance Corporation
lnternational Financial Institutions
lnternational Monetary Fund
lnternational Organisation of Securities Commissions
Initial Public Offering
International Securities Consultancy
lnternational Trust and lnvestment Corporation
ITS
JCR KS DA
LTS
MAS
MlCEX
MOF
MOFTEC
M O U
NASDAQ
NETS
NBFl
NIS
NSCC
NYSE
OEC D
OTC
PAlC
PASBD
PBC
PCBC
PDB
PlCC
Portal
PRC
QlB RADRs
S & P
SAEC
SC
SCRES
SCSC
SDB
SEAQ
SEBl
S EC
SEEC
SES
SESDAQ
SETC
SEZs
SFC
SFR
SHSE
lntermarket Trading System
Japan Credit Rating Agency Limited
Korean Securities Dealers Association
Local Tax Service
Monetary Authority of Singapore
Moscow Interbank Currency Exchange
Ministry of Finance
Ministry of Foreign Trade and Economic Relations
Memorandum of Understanding
National Association of Securities Dealers Automated Quotation System
National Electronic Trading System
Nonbank Financial Institution
Nippon Investor Service
National Securities Clearing Corporation
New York Stock Exchange
Organisation for Economic Co-operation and Development
Over-the-counter
Ping An lnsurance Company
Philippine Association of Stockbrokers and Dealers
People's Bank of China
People's Construction Bank of China
Pudong Development Bank
People's Insurance Company of China
An OTC cross-border clearing system
People's Republic of China
Qualified Institutional Buyers
Restricted American Depository Receipts
Standard and Poors
State Administration for Exchange Control
Securities Commission (Malaysia)
State Commission for Restructuring the Economic System
State Council Securities Policy Committee
State Development Bank of China
Stock Exchange Automatic Quotation System
Securities Exchange Board of India
Securities Exchange Commission
Securities Exchange Executive Council
Stock Exchange of Singapore
SES Dealing and Automated Quotation System Market
State Economic and Trade Corporation
Special Economic Zones
Securities and Futures Commission (Hong Kong)
Swiss Franc
Shanghai Securities Exchange
SlTlCO
SOEs
SOU
SPC
SRC
SSB
STAQS
SZSE
T Bill
T Bond
TICS
TSD A
TSE
UCC
US
YTM
Shanghai International Trust and lnvestment Corporation
State-Owned Enterprises
State-Owned Unit
State Planning Commission
System Reform Commission
Securities Supervisory Board (Korea)
Securities Trading Automated Quotations System
Shenzhen Stock Exchange
Treasury Bill
Treasury Bond
Trust and lnvestment Corporations
Taipei Securities Dealers Association
Tokyo Stock Exchange
Urban Credit Co-operative
United States of America
Yield to Maturity
ACKNOWLEDGEMENTS
This study is the outcome of an investigation of China's capital markets undertaken
jointly by the World Bank and the China Securities Regulatory Commission. Its
results are based on the findings of a preparatory visit to China in August 1994,
followed by a fully-fledged investigative study in October 1994. In addition to
discussions in Beijing, the team visited securities trading centres and market
participants at Shanghai, Shenzhen, Wuhan, Tianjin and Hong Kong.
Numerous persons have contributed to this study. The World Bank team was led
by Anjali Kumar of the China and Mongolia Department (task manager); and
included David Wilton, (bond markets) and Dimitri Vittas, (contractual savings)
of the Financial Sector Development Department; Kwang Jun (international
aspects) of the International Economics Department; and consultants Professor
Anthony Saunders (Salomon Centre, New York University; equities markets), Susan
Selwyn (International Securities Consultancy, Hong Kong; securities regulation);
and Sun Yan, (Columbia University; equity market data analysis). Edgardo
Barandiaran and others at the World Bank's Beijing office organised the work in
China, and Vikram INehru participated in the mission. Julia Li provided major
inputs on the marco framework and on equity markets; Subir Lall helped with the
analysis of China Funds and China's overseas bonds; Bo Wang helped to decode
bond data; Don Mclsaac provided the glossary on insurance; Yan Wang undertook
equity market comparisons with other countries; Cathy Song helped with mission
preparation and Adelma Bowrin undertook the considerable responsibility of report
production. The report benefited from the generous information and comments
provided by the IMF (notably Marc Quintyn and Michael Spencer) and the
excellent collaboration of the IFC (Peter Wall, Sara Ugarte, Rashad Kaldany, Ravi
Vish, Jiansheng Wang, Jun Zhang, Claudia Morgenstern), in terms of sharing data
and co-ordinating technical assistance and investigative studies.
The Chinese team was led by Fu Feng Xiang, (Vice Chairman, CSRC), and Bei
Duo Guang, Deputy Director of the International Department, and principal
counterpart to the World Bank. Numerous other persons from the CSRC
contributed, particularly, Xu Ya Ping, Nie Qing Ping, Yang Zhi Hua, Jesse Wang,
Gao Xi Qing and Song Li Ping. Zhong Rongca, Wu Qing and Yan Wen organised
and accompanied all the mission's meetings. Particularly valuable insights to the
study were provided by Ma Zhong Zhi (SCSC) and Gao Jian, (Ministry of Finance).
Particular thanks must also be extended to Liu Bo, executive vice president of the
Shanghai Securities Exchange and Cavin Xue of its data department; Zhang Ning,
of the Shanghai Municipal Government Securities Administration Office; Xia Bin,
president of the Shenzhen Securities Exchange, Lian Quan Kun, president of the
Wuhan SecuritiesTrading Centre, Vivian Gu, also of the Wuhan Securities Trading
Centre; and Hu Li Yun, of the Tianjin Securities Trading Centre. Officials from
many other agencies and institutions in China also contributed, notably, the PBC,
Ministry of Finance, CITIC, BOCOM, Pudong Development Bank, domestic
securities trading firms including Guo Tai and Wan Guo, and -the Chengxin
securities rating agency. Background papers for the report were contributed by
Zhang Bing Xun of the Securities Exchange Executive Council (SEEC), and Mr He
Dexu, of the Chinese Academy of Social Sciences.
The authors extend their gratitude and appreciation to all the officials from the
various government agencies and securities companies with whom they met. In
Hong Kong, particular thanks must be extended to lris Leung and lris Cheung of
the Hong Kong Securities Exchange, Jane Tam of the Hong Kong Securities and
Futures Commission, and many executives at jardine Fleming, jP Morgan, MerriII
Lynch, Peregrine, Sassoon, UBS, and other securities dealers.
The authors would like to thank numerous colleagues who lent support and
encouragement to this effort. lsmail Dalla and lshrat Husain of the World Bank
urged the presentation of the bond market analysis as a freestanding volume in a
study on Asian bond markets, and Andrew Sheng of the Hong Kong Monetary
Authority encouraged its presentation as part of an international seminar in Hong
Kong in June 1994. Last, thanks must be extended to Mr Nicholas Hope, Director
of the World Bank China and Mongolia Department, for his support for extending
the availability of this volume to a wider audience, through its publication in its
present form.
CHAPTER 1
China's Capital Markets: Central Questions
China first resumed the issue of domestic securities in 1981, shortly after the
launching of its economic reform programme, after a twenty year hiatus. Since
then, and especially over the last five years, the growth of China's capital markets
has been exceptional, even by Chinese standards. Market development began
with debt securities, and from 1981, when China resumed the issue of domestic
debt, to 1986, the stock of outstanding debt securities increased eightfold, from
Rmb5 billion to Rmb40 billion. Debt on issue then accelerated to nearly Rmb300
billion, by the end of 1993. The rate of growth of debt on issue over 1987 to
1993, at 31 per cent per year, far outstripped the rate of growth of GDP, of 17 per
cent per year, at current prices. From 1994 debt securities issues escalated further,
with Rmbl I 3 billion of new treasury bills in 1994 and Rmbl50 billion of planned
issues for 1995.
The growth of equities, meanwhile, has been even more remarkable. The value
of new issues increased from Rmb3 billion to Rmb30 billion between 1989 and
1993; a tenfold increase in four years (Figure 1 .l, and Appendix Table A1 .I). The
number of stocks listed grew from 14 in 1991 to 336 by the end of 1994. Market
capitalisation on the two exchanges exceeded Rmb560 billion by the end of 1994.'
Shareholding has spread rapidly among domestic investors. In October 1994, a
survey of 500 households in Beijing by the Municipal Statistical Bureau showed
that the average Beijing household had Rmb17,551 in capital assets of which
Rmbl2,800 was in bank savings, Rmb1,271 in cash and Rmb3,474 in securities.
The motivation for the reintroduction of securities issues in China, in the early
1980s, was the emergence of a budget deficit, and the need to raise financing for
the deficit. Early treasury issues aimed at resource mobilisation bore a strong
Figure 1.1 Growth of securities issued and outstanding (1 981 -1 993)
Rmb 100 Debt securities
Rmb I00 million million Equities
3.000
2,500
2,000
1,500
1,000
500
500 m m r - m m m m m m m m m m m ~ z ~ 2 2 - -
Source: State Council Securities Committee and PBC
resemblance to taxes; subscription to bonds was obligatory, and quotas for bond
placement had to be fulfilled by enterprise and by administrative district, in parallel
to tax contracts under the fiscal contracting system. Bonds were non-negotiable
and non-transferable. Early share issues had similar restrictions. Enterprises
sometimes issued shares to employees in lieu of wage or bonus payments, and
shares were not tradable. Ownership rights, especially voting rights, normally
conferred on shareholders were not encouraged to be e~ercised.~
But while the mobilisation of resources i s one of the functions of a capital market
in a market economy, capital markets have other, more specialised, functions:
aiding the efficient allocation of resources, by increasing the transparency of
pricing, of risks and returns, and assisting investors with risk-management. The
function of resource mobilisation is in fact subordinated to the effective channelling
of large volumes of resources, which can be mobilised by a variety of means, to
specific ends, and in short periods of time. The central question is, to what extent
do China's capital markets fulfil functions of aiding efficient resource allocation,
efficient pricing of risks and returns, and efficient risk management.
A first concern in this regard is, how well are capital market regulations defined
and how adequately do they provide a framework for market operations? To
what extent do these conform to international norms and are there areas which
are still ill-defined? Do they provide adequate investor protection? An
understanding of the regulatory framework of the securities market in China i s
essential for understanding issues specific to the operation of different segments
of the market, not only in terms of types of securities but also in terms of market
participants, regional structure, and oversight. This book will evaluate the present
regulatory environment, and explore the extent to which the present framework,
and in particular the role of government oversight, supports the stable and efficient
development of the market.
Can China's capital markets today fulfil their originally conceived function of
helping to finance the government's deficit? This question is of great concern to
the government today, as a major reform undertaken in 1994 was the decision to
eliminate reliance on borrowing from the central bank for the financing of its
deficit, and at the same time, reducing quasi-fiscal operations and transferring
'policy lending' to the budget. If these aims are to be realised, it is critical that the
government secures stable and additional sources of financing. In this context,
this book examines the extent to which bond markets can be developed to provide
financing for the g~vernment.~ Markets for debt securities (although currently
dominated by government issues in China) are also important for providing
appropriate leverage for enterprise financing, and the constraints on the overall
development of debt securities are investigated.
Equities markets are as important as markets for corporate debt for China's new
shareholding companies, where the notion of appropriate gearing wi l l have to be
faced as soon as the possibility of financial failure (bankruptcy) becomes real. In
this book we wil l first investigate the primary issue process in China's equity
markets, focusing on the observed phenomenon of underpricing, and next examine
the issue of secondary market instability. One feature of China's capital markets
which has disquieted both local authorities and investors is the high degree of
volatility observed in secondary markets (Figure 1.2). This i s particularly acute in
the A share market, for domestic investors. Although the bond market has not
normally displayed such volatility, there was a remarkable episode of greatly
escalated trade in China's bond futures in February 1995, accompanied by a
marked contraction of equity markets. A third feature of the equities market
examined here is the unique market segmentation of the ordinary share market
due to multiple share categories.
What is the potential for foreign investors in China's capital markets? This book
examines the extent to which China's securities markets have opened up to foreign
participation, and also the extent to which China itself is a participant in overseas
equity markets. The issue investigated is, on what terms and conditions has foreign
capital entered China, and what alternative methods are available for safely
Figure 1.2 Volatility in China's securities trading
A share indices B share indices
Index Shanghai Ashare index lndex
Shenzhen A share index 2,000 T
Treasury bond trading on the Shanghai Exchange (Jan 94 -Jan 95)
1 Source: Data provided by the Shanghai and Shenrhen securities exchanges
trade Futures trade
increasing China's capacity to participate, as an investor and as a recipient, in
international securities markets.
To what extent can the observed volatility of China's securities markets be ascribed
to the absence of institutional investors, and why have they not developed? It has
been claimed that the investor base in China is composed largely of small individual
retailers with a tendency to speculate. We examine the extent to which the nature
of the investor base, relative to other factors, is a reason for secondary market
instability, and the nature of present constraints on the development of large scale
institutional investors; specifically, insurance companies, social security and
pension funds.
Data sources and plan of the study
Data used for the analyses of securities market behaviour were obtained principally
from the exchanges of Shanghai and Shenzhen, both of which provided details of
daily trading of all listed equities and bonds from the inception of the exchanges
until mid September 1994. A similar, but more limited sample of comparative
data on bond trading, was provided by the trading centre of Wuhan. In addition,
numerous government and institutional sources provided both published and
unpublished information on other economic and capital market variables. Data
sources are cited in figures as well as annex tables. Finally, information on China's
overseas securities issues, as well as on the performance of overseas China funds
are compiled by the World Bank's International Economics Department.
The present chapter first presents an overview of China's capital markets, and
their role in the Chinese economy. The next chapter describes and evaluates the
framework of regulation and oversight for China's securities markets, and forms a
basis for the understanding of the following chapters. Chapters 3 and 4 analyse
the operations of China's bond and equities markets respectively, and Chapter 5
examines issues relating to the internationalisation of China's securities markets.
The development of contractual savings institutions, and their present and potential
contribution as participants in China's securities markets, i s evaluated in Chapter
6. Finally, Chapter 7 examines the issues raised in the preceding chapters from a
systemic perspective, across all market segments. It points out the principal
conclusions of the study and prescribes recommendations to policy makers for
strengthening the functioning of the market.
The Growth of China's Capital Markets
Diversification of primary issues
Diversification in securities issued increased rapidly from 1986 until 1993. Debt
securities in China consisted entirely of treasury bonds until 1985, and new issues
amounted to around Rmb5 to 6 billion per year. From the time of their introduction
in 1986, corporate debt issues averaged around Rmb8 billion per year, until 1990, accelerating to an average of Rmb37 billion per year over 1992 and 1993. 'There
was also a diversification in the variety of treasury bonds issued, by issuer, by end
use and by maturity. Aggregate treasury bond issues rose, reaching almost Rmb40 billion in 1992. By the end of 1992, the proportional contribution of treasury
bonds to total debt was 38.5 per cent, while financial bonds (issued by financial
institutions) and corporate bonds (issued by state enterprises) accounted for another
6.4 per cent and 43 per cent respectively (Appendix Table A1 . I ) . After 1993, the
government reduced the varieties of debt issues, and new corporate bond issues
declined to a virtual halt. The proportional role of treasury bills has rapidly
increased again, especially with the large new issues of 1994 and 1995.
In the equities market, China also introduced a bewildering variety of shares:
A shares for domestic individual investors
B shares for foreign investors (but listed and traded on domestic securities
exchanges) C shares for 'legal persons', ie, enterprises holding shares in other enterprises,
and H and N shares for overseas investors in Hong Kong and New York.
Only A and B shares are listed on the two official exchanges of Shanghai and
Shenzhen, although the number of B shares listed on the two exchanges (28 and
23, in Shanghai and Shenzhen respectively) i s well below the number of A shares
Figure 1.3 Growth of the equities market
Nos Number of listed stocks 1 BO 160 140 120 100 BO 60 40 20 0
Q1 Q2 Q.3 Q4 0 1 Q2 0.3 Q4 0 1 Q2 Q3 Q4 Q1 Q2 0 3
1991 1992 1993 1994
) Shangha~ A shares Shanghal B shares Shenzhen A shares Shenzhen 6 shares I Market capitalisation Rmb billion Annual trading value Rmb billion
~EJ Ashares B B shares Ashares B shares
Source: Shanghai and Shenzhen Stock Exchange data
(1 69 and 11 6). In terms of numbers of listings, B shares accounted for 15 per cent
of total listings. The contribution of B shares to market capitalisation and trading
value has been lower. At the end of 1994, B shares accounted for less than 3 per
cent of market capitalisation at Shanghai and Shenzhen (2.4 per cent and 2.6 per
cent respectively) and a remarkably small proportion of annual trading value (1.8
per cent and 0.7 per cent) (Figure 1.3). C shares cannot be listed on the official
exchanges, but a small number are listed and traded on China's over-the-counter
electronic trading systems, STAQS (ten shares) and NETS (7 shares).
Development of secondary markets
The development of secondary markets in securities began with the trading of
domestic debt, in 1988. From 1989 to 1990, annual trade in debt on issue increased
almost fivefold in a single year, from Rmb 2.2 billion to Rmb10.5 billion. Within
two years, by the end of 1993, annual trade in debt had further dramatically
increased, to Rmbl05 billion. Trade in equities, first permitted officially from
December 1990, accelerated even more rapidly. From Rmbl.8 billion in 1990, it
exceeded Rrnb730 billion in three years, by the end of 1993. The volume of trade
has been 25 times as high as the volume of equities on issue. In co'ntrast, in 1992,
the ratio of traded debt to debt outstanding was less than one. Until 1993, it
appeared that the primary market was clearly dominated by debt, but equities
dominated secondary markets. Equities accounted for less than a tenth of securities
on issue, but the value of trade in equities, by 1993, was five times as high as
trade in debt (Figure 1.4, and Appendix Table A1.2). Yet, shortly after, there was
an apparent reversal of this trend in early 1995, when bond trading seemingly
exceeded trading in equities fourfold (Appendix Table A1 .3).4
Figure 1.4 Secondary markets in China's securities
Rmb million
800
600
400
200
0
1 Source: State Council Securities Committee and PBC
China relative to other emerging markets
Although the burgeoning of China's equities markets occurred in parallel to many other emerging markets, the size and growth of these market in China has been
remarkable even by these standards. At the end of 1 9935, market capitalisation
in China, at US$42 billion, stood in a league comparable to the Philippines
(US$41.5 billion), Argentina (US$44.3 billion) and Chile (US$52.4 billion). China
had already outstripped some Asian countries such as lndonesia (with a market
capitalisation of US$35.9 billion), although it i s still some paces behind the more
mature East Asian countries such as Thailand (US$123 billion), Korea (US$I 58
billion) and Malaysia (US$201 billion). Average daily trading value, at US$386
million, not only exceeded Indonesia, Argentina, Chile and the Philippines, but
also exceeded Brazil (US$343 million) and Mexico (US$376 million). Relative to
the size of the Chinese economy, however, capital markets have a limited role.
Market capitalisation in China stood at 7 per cent of GDP at the end of 1993,
lower than all the above countries, although higher than other transitional
economies such as Hungary and Poland (2.4 and 3.1 per cent of GDP respectively)
(Figure 1.5).
Figure 1.5 China and other emerging equity markets: A comparison (1 993)
Number of shares Average daily trading value 1 Korea
Malaysla Thailand
Taiwan
Chile lndonesia
Philippines Argentina Hungary
Poland China
0 100 200 300 400 500 600 700
(Number)
Market CaDitalisation
Malaysia Taiwan Korea
Thailand Chile
Argentina Philippines Indonesia
Poiand Hungary
China
0 50,000 100,000 150,OW 200,000 250.000
Taiwan Korea
Malaysia Thailand
Philippines Indonesia Argentina
Poland Chile
Hungary China
(US$ million)
Turnover ratio
Taiwan Korea
Poland Thailand Malaysia
lndonesia Philippines Argentina Hungary
Chlle China
I (USS million)
Source: Calculations based on data from the IFC Emerging Markets Data Base L
Overseas investors in China's securities markets
Foreign investors have been eager to participate in the sudden and rapidly
accelerating securities markets of China in the early 1990s. From 1991 to 1994, a
total of US$1.3 billion was invested in China through its B share listings, with
each listing raising an average of US$25 million. Meanwhile, as investment in the
domestic economy accelerated, Chinese enterprises sought other means to raise
capital overseas. With the legalisation of the overseas listing of Chinese shares in
1993, larger sums of foreign capital were raised through H share issues in Hong
Kong (which at US$350 million on average, were considerably larger than B
share issues), and through the issue of shares and ADRs in New York. By the end
of 1994, Chinese companies had raised an estimated total of US$3.7 billion
overseas. Other exchanges have been soliciting the listings of Chinese companies,
notably London, Tokyo, Singapore, Melbourne and T ~ r o n t o . ~
Since 1992, the Chinese have also become active in the international market in
debt securities. Although the domestic bond market remains closed to foreign
investors, China's new overseas bond issues have grown remarkably fast. From
less than US$2OO million per year over 1989-91, the annual volume of new
overseas bond issues grew on an unprecedented scale; to over US$2 billion per
year over 1992-94. In 1994, overseas bond issues reached an all-time high, at
US$3.5 billion.
Securities market institutions and market participants
With the growth of securities on issue, a number of formal and informal trading
centres and exchanges have sprung up for the trading of securities. At the core of
the market are the two securities exchanges of Shanghai and Shenzhen, which
trade not only equities but also government and enterprise bonds, government
bond futures, mutual funds and warrants.' In addition, 1 7 regional securities trading
centres trade bonds and mutual funds, and two electronic networks, STAQS and
NETS, provide the means to trade 'C' or legal person shares and government
bonds. The largest centre for trade in government bonds is at Wuhan, and since
the listing of bonds on the exchanges of Shanghai and Shenzhen was permitted,
these, especially Shanghai, have grown to follow the Wuhan centre in rank. Bonds are also traded in over-the-counter markets in over 40 regional centres (Appendix
Table A3.1). Major trading centres have links to the trading floor in other cities;
for example Shanghai has 21 centres linked by satellite and telephone to its
exchange.
The rapid growth of capital markets has been accompanied by a sharp expansion
in the number of market participants, in the form of investors, brokers, dealers,
and underwriters of securities. Although most of the end holders of securities in
China today are individuals, the bulk of trade in securities takes place between
wholesale dealers and institutional owners. By January 1995, the Shanghai
exchange had 541 members, of whom around 500 were estimated to be from
outside Shanghai. The Shenzhen exchange had around 425 members in 1994.
Many of these are members of both exchanges, and stem from the ranks of the
large and rapidly growing number of China's non-bank financial institutions, and
a large number of the principal brokerage houses and dealers were established as
non-bank subsidiaries of banking institution^.^ Yet the number of large scale
institutional investors with investible funds based on contractual savings in China
today i s limited. Although there are now allegedly 1 9 insurance companies in
China, they are virtually all spun off from a single parent organisation which still
retains a holding company style majority or minority ownership interest in them,
and competition i s limited. The lack of funded pension and security systems has
implied that funds are not available from such sources, which form the core
clientele of capital markets in mature economies.
The Role of Capital Markets in China's Economy
Role in the financial sector
Various approaches can be applied to the assessment of the role of capital markets
in China's financial sector. First, through 'stock' estimates of the size of capital
markets relative to the size of other elements of the financial sector. In terms of
assets, this implies the measure of the assets (loans) of financial institutions such
as banks and credit co-operatives, relative to the assets held by securities
institutions. In terms of liabilities, it implies a comparison of deposits at financial institutions with the volume of securities issued. Only very broad orders of
magnitude can be estimated, because of data limitation^.^ The results are
summarised in Figure 1.6 (details are available in Appendix Table A1.4).
From these points of view, the role of capital markets in the financial sector today
appears small but has been growing. Total assets of non-monetary financial
institutions, as defined here, grew from 6 per cent in 1989 to a high of 8 per cent
in 1992, of the financial sector's assets, declining once again to 5 per cent by
1994. The pattern reflects the growth of enthusiasm for securities with the
Figure 1.6 Securities markets in China's financial sector (Rmb billion)
Assets
6,000
5,000
4,000
3,000
2,000
1,000
tal assets of financial institutions
s e t s of non-monetary financial institutions
Liabilities
Deposits at financial institutions
ecurities outstanding
ecurities (annual issues)
Note: Securities outstanding data for 1994 are estimates.
Source: World Bank and IMF data
legalisation of exchanges and high returns to equities from the end of 1990 to mid
1993. With the introduction of the 16-point programme in the latter half of 1993,
and the squeeze of credit to the non-bank financial institutions, their levels of
activity declined. By early 1994, the decline was exacerbated by the increase in
deposit rates offered in the banking sector. Data on the annual issue of securities,
compared to the liabilities of the financial sector, indicate a similar pattern and
similar relative size: (a 4 per cent share in 1989, rising to 6 per cent by 1992, and
declining to 2 per cent in 1993). Note however that the cumulative share of
securities on issue has been increasing. Both sets of estimates however clearly
reinforce the officially expressed position, that the Chinese government's approach
to the growth of capital markets has been 'experimental' and is still an experiment
on a small scale. The banking sector without doubt dominates resource flows to
the real sectors. Another possible measure of the relative size of the emerging
securities market is through alternative measures of money supply.1° Recently,
attention has been paid to the changing composition of China's broader monetary
aggregates (M,), and the increasing importance of non-monetary components of
M, (money + quasi money) or alternatively, looking at the non-monetary
components of even broader monetary aggregates, which include deposits of
urban credit co-operatives, or trust and investment corporations. These measures
suggest that these broader monetary aggregates have rapidly become less money-
like over time.
The second and more interesting question concerning the relationship between
the securities market and the financial sector i s the dynamic or 'flow' issue of the
extent to which links exist between the banking sector and securities markets,
and the impacts of these links on financial sector efficiency, systemic risks, and
on the support provided to the real sector. The question can be broken down into
a number of components:
What are the institutional links between banks and securities dealerships
To what extent do they permit the flow of funds between these institutions?
Are there any dangers of systemic risks because of the increased exposure of
banks to securities markets? Specifically, are depositors' funds at risk?" Can securities markets 'displace' bank lending, and if so, which provides a
better vehicle of finance to the real sector? l2
These are major questions and a comprehensive answer can lie only in a study
which simultaneously examines the behaviour of both the banking andnon-bank
segments of the financial system. The present response is therefore preliminary.
Firstly, the principal institutional links between the real sector, the banking system,
and capital markets are provided by members of the large group of 'non-bank financial institutions' (NBFls) (or non-monetary financial institutions, according
to the new PBC definition). NBFls include a variety of Trust and Investment
Corporations (TICs) finance companies, leasing companies, as well as insurance
companies and securities dealers. Not all these institutions participate in the capital
market, but a number of large securities dealers come from the ranks of the TICs.
Moreover, many of the TICs, and most of the largest securities dealers, were set
up as wholly or partially owned subsidiaries of China's specialised or commercial
banks. Several were bank departments and were spun off as independent
companies as their operations grew. BOCOM i s the only bank that provides
'universal' banking services, incorporating both retail banking and securities
management.13 It should be noted that China's urban credit co-operatives (UCCs)
are also participants in securities markets. UCCs lie somewhere between banks
and NBFls in a conceptual sense. While they are not permitted to take deposits
from stated-owned enterprises (SOEs) (or joint venture companies), they are
permitted to accept individual and private (collective) enterprise deposits.
Moreover, UCCs participate directly on securities markets. Of the 80 UCCs in
Shanghai at the end of 1993,26 were registered brokers of the Shanghai Securities
exchange, 58 were dealers in state bonds, and 23 were involved in the insurance
business as policy agents. TICS and securities companies can undertake a range
of capital market functions; brokerage, dealing on their own account, and
underwriting securities issues. Banks have also participated directly in certain
capital market activities, acting as 'underwriters', since 1992, for the issue of
government bonds by certificate. Bank branches have been used as the vehicles
for distribution to retail investors. 'Underwriting' in this system in reality implied
the distribution of a quota among a number of pre-selected banks, rather than any
competitive process of bidding for terms. Banks thus acted essentially as (fixed)
commission agents. l 4
In view of these close relationships, the second question, of financial flows and
systemic risks, i s clearly legitimate. Preliminary evidence gathered suggests that
administrative regulations of the PBC effectively prevent easy transfers of funds
(apart from the initial equity) from parent to subsidiary, borrowing from the parent
company, or maintaining close managerial ties. The pattern of separation employed
so far suggests the 'holding company' model, with restrictions on the transfers of
funds from parent to subsidiary. While the 'firewallst appear to be fairly effective
so far, it i s disquieting that they take the form of administrative regulations rather
than law.15 A draft law on commercial banking was prepared by the authorities
in 1994, but it made little reference to the issue of banks and their subsidiaries
operating in securities markets. Supervision i s clearly an issue (see Chapter 2).
While the PBC licenses securities dealers and other NBFls, their operations on the
securities markets are monitored by the CSRC (which can penalise them, but is not empowered to revoke their license^).'^
The principal vehicle for the transfer of funds between banks and NBFls appears
to have been the interbank market. China's interbank market, which permits surplus and deficit financial institutions to lend and borrow funds to and from
each other, has permitted the participation of banks as well as NBFls.17 The
principal instruments on the interbank market are short term loans, although since
1992, a growing repurchase agreement (repoj market i s emerging. There are two
channels of transfer; a formal channel, through PBC administered 'financial centres'
(which operate in 44 major coastal and interior cities and are equipped with
facilities for the electronic transfer of funds between them); as well as an informal
channel, of direct contacts between financial institutions.18
Although loans on the interbank market are intended to be strictly short term, for
liquidity management purposes, short term loans have tended repeatedly to
become long term, through 'roll-over' agreements, which the PBC periodically
attempts to curtail (see Chapter 2). NBFl participation on the interbank market
was virtually unrestrained prior to the 16-point programme of 1993, and was
identified as the principal source of credit 'leakages' responsible for the overheating
of the economy in 1993. A part of the credit thus 'leaked' found its way to the
securities market; the rest went to 'non-priority' investments, real estate, and other
high-return areas of the economy.
hlBFl access to the interbank market has been curtailed since the announcement
of the 16-point programme in July 1993. Restrictions have been imposed on both
the volume of their borrowing (a form of 'capital adequacy' requirement, which
requires that their total borrowing, including interbank borrowing, cannot exceed
their capital); and the term of loans. NBFls are now restricted to borrowing for a
maximum maturity of seven days, compared to four months for banks. But their
access to the market continues and their share of total outstanding interbank loans
is now estimated to be about 25 per cent. Since most NBFls are owned either by
branches of specialised banks or by local governments, these institutions have a
vested interest in their support.lq
The third question regarding the dynamic relationship between the banking sector and securities markets concerns the extent to which depositors transfer funds
between banks and the capital markets. Outside the interbank market, NBFls
certainly do compete with banks for individual and enterprise deposits, to divert
funds towards high return non-priority areas20 While funds can also be attracted for investments in securities, the first key consideration here i s that in China today
the total volume of securities issued, as well as total bank credit, i s still regulated
under the credit plan, so that the extent to which such transfers can occur i s
effectively '~apped'.~' Secondly, the extent to which funds are channelled towards
either bank deposits or other securities can be, and is, manipulated today by the
government. This is undertaken through the complex web of controls on relative
returns; controls on interest rates on bank deposits and loans, the determination
of coupon rates on government debt securities (which constitute the bulk of
securities issued), which have little reference to secondary market yields, and
through rate caps on certain securities issues (such as corporate bonds). As such,
these controls regulate the flows of funds between these segments of the financial
sector, rather than market forces. The consequence i s that the extent to which
capital markets can make a real contribution to the allocation of resources or
pricing of risks and returns is constrained. Besides, even when 'large scale'transfers
of funds have allegedly taken place from banks to capital markets, the relative
size of capital markets has been small, as demonstrated above, and the rise in
their share of financial sector liabilities has also been small. Finally, the experience
of other countries suggests that capital market growth need not 'crowd out' bank
lending, and in many cases, with financial deepening, the two grow in
As long as the relative growth of both banks and securities remains embedded in
the credit plan, the question is only of limited relevance for China.
Macro-economic role
When China first resumed the issue of domestic debt in 1981, the primary purpose
was to finance the budget deficit of the central government. In 1994, the objective
of issuing government debt to finance the budget deficit took on new significance,
due to the decisions to:
cease to resort to deficit financing through loans from the central bank, and
gradually transfer subsidies to state enterprises, hitherto funnelled largely
through commercial bank lending, to the budget.
New issues of treasury bonds in 1994 increased almost threefold over the previous
year, to Rmb113.2 billion (compared to Rmb38 billion in 1993). The amount is
particularly large in view of the fact that the total stock of outstanding treasury
bonds at the end of 1993 amounted to only Rmbl67 billion. New issues planned
for 1995 are estimated to be Rmbl50 billion. The first question raised here is, to what extent have bond issues been able to contribute, in terms of volume of
issues, to the financing of the government's budget deficit?
As Figure 1.7 suggests, the contribution of bond issues to the financing of the
budget deficit in the past has not been very large. Measurement difficulties preclude
a precise measure of the proportion of treasury bond issues used for this purpose,
Figure 1.7 Central government budgetary deficit and treasury bond issues
I --
I
Net issues of treasury bills I Overseas Bond Issues
Source: World Bank and IMF data 1
especially as in earlier years, bonds were frequently earmarked by purpose, and
linked to construction projects or 'key investment' projects. A broad comparison
of orders of magnitude is presented here (details of definitions and data used are
in Appendix Table A1.5). Looking first at the visible budget deficit, net issues of
treasury bonds (gross new issues less annual redemptions) have had a highly
variable volume, relative to the size of the overall deficit; over 50 per cent as
early as 1988 and 1989, when net annual issues were Rmbl7 and Rrnb21 billion
respectively. In 1990 and 1992, the relative size of bond issues fell to around a
third. But in 1994, the estimated end-of-year visible deficit was Rmb85 billion,
and (gross) new issues of treasury bonds amounted to Rmb113.2 billion; or around
133 per cent of the current year's deficit.
Taking account of quasi-fiscal operations of transfers to state enterprises, which
should in a conventional accounting framework be financed through the budget,
but which have instead been financed through PBC lending to the banking system, we can estimate the consolidated central government budget deficit.23 If, at a
lower bound, 60 per cent of PBC lending to the banking sector is estimated to
cover the financing of 'policy loans', the (consolidated) deficit increases, and the
size of annual treasury bond issues compared to the (consolidated) deficit
consequently falls. The annual volume of net treasury bonds issued over 1989 to
1993 has varied between 11 and 23 per cent of the consolidated deficit, while the
annual volume oftreasury bills alone has varied between 5 and 23 per cent of the
consolidated deficit. If quasi-fiscal operations are 'fiscalised', an increase in the
scale of bond issues is likely to be required.
The government has recently augmented the contribution of securities markets to
its financing, by enhancing its external bond issues. Following a long hiatus in
overseas sovereign bond issues after 1987, the government made a comeback in
overseas bond markets in 1993, with issues of around US$600 million (Rmb3.4
billion), and a huge increase in 1994, with issues of US$1.6 billilon (Rmb13.6
billion).24 If these are added to the measures of the relative size of government
bond issues and the budget deficit, the role of securities markets increases; to
around 38 per cent in 1993 (33 per cent from domestic bond issues, and another
5 per cent from overseas issues).
A second question concerning the macro-economic role of the securities market
is the extent to which securities issues have helped establish appropriate pricing
for government bond issues. That is, have government bond issues helped establish
benchmark rates for the pricing of new issues of debt securities? This issue is dealt
with in greater detail in Chapter 3. The broad conclusions are:
that the form of issue and design of debt securities so far have not been
conducive to the establishment of a well-defined yield curve and, to the extent that a yield curve exists, yields on the secondary market have not
been taken into account in the pricing of new issues of government securities.
In 1994, yields on the secondary market were well below interest rates offered on
new government securities issues. The implication i s that the government may
today be adopting an unnecessarily expensive form of financing its borrowing. In
the past, however, the government paid rates below those on the secondary market,
and was able to do so because ofthe largely administrative placement techniques
used. In the future, as the government moves away from administrative placement
and as the stock of outstanding debt issues increases, the question of the cost of borrowing for government debt wil l become an issue of increasing concern.
A third issue regarding the role of capital markets and macro-economic
management relates to whether the government can consider an increased use of
treasury bills as indirect instruments of monetary control, which would permit a
relaxation of reliance on the credit plan, and greater reliance on the control of
base money for implementing macro-economic objectives. The ability of the
government to conduct open market operations is also important for the use of
sterilisation as an instrument for regulating the impact of external capital inflows.
While these issues are of considerable importance, they are not covered in this
book, as they form the subject of detailed technical assistance from the IMF.
However, to the extent that financial institutions need to hold portfolios of (tradable)
government bonds to be able to participate in open market operations, it must be
pointed out that today such portfolio holdings are limited. Moreover, there is no
benchmark issue to help the pricing of such instruments, and the limited
development of the money market limits the liquidity available to financial
institutions to finance the holding of a sizeable portfolio of government treasury
bills.
Links to the real sector
To what extent have China's capital markets contributed to the investment needs
of the real sectors of the economy? Attempts to measure this contribution are
detailed in Appendix Table A1.6 and summarised in Table 1.1 below. The first
conclusion from the figure is that the contribution so far has clearly been
Looking at treasury bond issues alone, the volume of issues, relative to the volume
of investments, was 5 per cent in 1987, increasing to 9 per cent in 1989, and
fluctuating between 7 per cent and 9 per cent between 1990 and 1992. Adding
'investment bonds' (issued both by the treasury and by the erstwhile state investment
corporations) to this, the upper limit for both categories rises to 10 per cent over
the period 1987- 92.
Debt securities were also issued by state enterprises after 1986, and the outstanding
stock of enterprise bonds amounted to about Rmbl95 billion by the end of 1992.
The contribution of enterprise bonds to real sector investment shows a discernible upward trend between 1987 (just after they were first permitted), when their
contribution was only 1 per cent, rising steadily to 11 per cent of total state-
owned unit (SOU) investment by 1992. Adding all categories, the maximal possible
contribution of debt securities to investment finance grew from 8 per cent in
1987 to 21 per cent in 1992. After 1993, there was a clamp down on the issue of
new corporate debt, which would have led to a reduction in this percentage.
Table 1.1 Contribution of capital markets to real sector investment (Rmb billion)
Total investment in state
owned units 229.799 276.276 253.548 291.864 362.811 527.364 765.797
Treasury bonds issues 11.69 18.877 22.391 19.723 28.125 46.078 38.1 31
Investment bond issues 3 9 2.253 0.61 5 9.729 6.801 0
Enterprise bond issues 3 7.541 7.526 12.637 24.996 59.19 0
Equity issues 1 2.5 0.662 0.428 3.098 12.572 9.062
Source: State Planning Commission and State Council Securities Committee
Parallel to this issue is the question of the extent to which the equity market has
contributed to enterprise development. One concern here is the extent to which
these markets have helped enterprises raise finance, and the response here is, to
a very limited extent. New (domestic) issues of equities contributed only around
2 per cent to total SOU investment in 1992, and less than that in 1993 (Appendix
Table A1.7). The cumulative value of new equity issues has been around Rmb30
billion so far.26 About halfway through 1994, approved new issues of equities
were banned from going to market by the government.
Apart from the strictly financial contributions of capital markets to SOU investment,
the process of share issue and trade are sometimes considered to have other
beneficial effects for enterprises in a market economy; they are stated to lead to
improvements in managerial efficiency through shareholder appointment of a
board of directors who represent their views. Both enterprises and their managers
are said to be disciplined by stock market valuations of their firms, and threats of
mergers or take-over of inefficient firms.27 Certainly, listing on stock exchanges
usually requires improved standards of information disclosure accounting and
managerial practices, more in line with international norms, and provides
enterprises with greater public exposure as well as scrutiny.
The extent to which enterprises in China have benefited from these aspects of
securities markets so far is likely to be small. Firstly, enterprises list on the stock
exchange in China exclusively for the purpose of raising new capital, and the
extent to which real ownership rights can be exercised by the new shareholders i s
New share listings invariably take the form of initial public offerings
(IPOs), as opposed to selling existing shares, or selling new shares through
mechanisms such as private placement, which would be likely to lead to greater
concentrations of ownership. The tendency towards a high degree of ownership
dispersal i s compounded by the lottery system of share allocation hitherto adopted
for new share issue. Although the listing of enterprises in China undoubtedly
represents a form of gradual privatisation, largely through the dilution of the state's
share, there are no opportunities for new owners to become stakeholders, or
significantly affect management.29 Moreover the separation of 'state shares' from
other ordinary shares, and the non-transferability or tradability of state shares,
implies that control typically remains in the hands of the state.30
Chinese enterprises have also raised equity capital overseas, through the issue of
overseas shares, and the amounts raised through such issues are estimated to
have reached US$3.7 billion by the end of 1994; a significant amount compared
to amounts raised through domestic markets. The real significance of overseas
share issues however lies in the fact that overseas investors' requirements in terms
of accounting and disclosure are more rigorous than in the more speculative
domestic market, and these buyers have tended to place greater emphasis on the
underlying fundamentals of the enterprises. As such the disciplining effect of these
stock listings i s likely to be greater than in the domestic market, although domestic
investors too are exhibiting signs of 'maturing' in their decision-making, over time
(see Chapter 4).
Figure 1.8 Share of Bonds in China's Overseas Borrowing
I W ~ o t a l cornmittrnents Bands I 1 WTo Ia l mrnlttments Bonds 1 I Source: World Bank data. ~
Finally, Chinese enterprises have also approached the international bond markets
for resources. Although direct access of individual firms to these markets has
been allegedly relaxed, in practice, the bulk of foreign bond issues take place
through the 'windows'; large TICS, and certain banks, which have been allowed
access to the overseas bond markets by the SAEC3'
In terms of aggregate contributions to foreign resource inflows into China,
international securities issues still account for a small share of China's total external
debt (Figure 1.8). Details of the share of portfolio investment are given in Appendix
Table A1.7, and are discussed in detail in Chapter 5. The bulk of foreign capital
inflows into China have taken the form of foreign direct investment. Portfolio
equity only constituted 5.5 per cent of aggregate net resource flows to China in
1993, and bonds accounted for only 2.7 per cent of new borrowing commitments
in 1993.
To conclude, the key factor to bear in mind, regarding the contribution of capital
markets to resource inflows to the real sectors of the economy i s that, at least at
present, this contribution is controlled by the government, and embedded within
the mechanisms of the investment and credit plans. Quotas are determined for
the issue of domestic debt and equity securities, as well as for overseas bond
issues, by a combination of the SPC, PBC, and in the case of overseas issues, the
SAEC.32 Thus the extent to which capital markets contribute is largely determined
by the extent to which the government permits them to contribute, and the issuers
of securities are determined by the distribution of quotas for each of these heads
by the central and regional offices of these authorities.
Endnotes 1 Summary descriptions of the development of China's securities markets may be found in IMF
(1 991, 1994); International Securities Consultancy (1 994); Bei Duo Cuang, Koontz, Lu and
Xiangqian (1 992), and Bowles and White (1 992, 1993).
2 Indeed, China was unique, in the 1980s, in the issuing of shares in the absence of any legal
framework for shareholding companies, or securities. A description of the characteristics of
early securities issues in China is available in Bowles and White (1993).
3 The extent to which securities markets can provide support for the adoption of indirect instruments
of monetary control, although highly relevant, is however omitted from the scope of this book,
apart from an investigation of the extent to which the bond market can presently provide support
to this process through the establishment of benchmark issues which would assist the process of
pricing of government securities issues.
4 This occurred in early 1995, when bond trading seemingly exceeded trading in equities fourfold
(Appendix Table A1.3). However the escalation in bond trading was almost entirely in the bond
futures market, due to an incident of speculation on one specific security (see Chapter 3 for
details). Liquidity in the underlying spot market for bonds also rose as a consequence, but by a
much more limited extent.
5 Latest year for which comparable data are available (IFC Emerging Markets Data Base).
6 Another indication of the rapid growth of foreign investor interest in China's securities markets is
that at the beginning of 1994, foreign financial institutions from 15 countries had 298 representative
offices and 98 managing offices in China from a near zero base in 1990.
7 Details are in Chapter 4 and Appendix Table A4.1.
8 China today is estimated to have over 1500 brokers, dealers, and underwriters, 400 trust and
investment corporations, 40 finance companies, 52 mutual funds, 19 insurance companies, and
30 leasing companies.
9 The assets of securities institutions are not available as a separate category, but are partly subsumed
under the larger category of Trust and Investment Corporations. TICS includes many, but not all,
securities dealerships, and to this extent underestimate the result. But also, not all TIC business is
securities business, which would overestimate the result. Until 1993, data on insurance companies
was available separately. Moreover, in the present definition, Urban Credit Co-operatives are
grouped with banks as they are indeed deposit-taking institutions (from individuals and collectives,
although not from state enterprises), but thzy too participate in securities business. From 1994,
data supplied by the PBC are supposed to cover all non-monetary financial institutions (See
Appendix Table A1.4 for details of the numbers used). On the liabilities side, there is no separation
of government securities issues and securities issued by enterprises, because of the conceptual
difficulties in separating the bond issues by ownership in China.
10 The principal attempt to arrive at such estimates (until mid 19931, appeared in Montes-Negret,
1994.
11 Scott (1 994) summarises the key issues and their implications.
12 More detailed treatment, which elaborates alternative methodologies to these issues, and
summarises earlier research in this area, may be found in King and Levine (1 993, 1994), Levine
(1 994), and Demirguc Kunt and Levine (1 993).
13 Compared to the specialised banks, BOCOM management is relatively professional. Non-
performing assets are estimated to comprise only a small share of its total assets and provisioning
is applied to these.
14 From 1993, the government introduced a more flexible system of primary dealership, under which
the competitive bidding for terms was included, and primary dealers had certain additional market-
making responsibilities (see Chapter 3). The primary dealers belonged to a wider group, principally
specialist securities firms, rather than banks.
15 Administrative regulations issued by the PBC have not always been successfully enforced (see
Chapter 2, endnote 10).
16 Less obvious channels are available for resources to flow from banks to NBFls. One such channel
would be for banks to lend to an SOE which would then place an entrusted deposit with an NBFI,
with the instruction that the amount be lent for the ?on-priority project. Such arrangements
undoubtedly exist but are virtually impossible to detect.
17 As well as some enterprises. Securities companies, however, as a special category of NBFI, are
not allowed to borrow on the interbank market although they can lend surplus funds.
18 Further details on the interbank market are provided in World Bank (1995) and in Chapter 3.
Much of the operations of this market substitute for intra-bank operations elsewhere, due to the
problems with the payment system. Operations on the interbank market undertaken by bank
branches for liquidity management purposes are supplemented by short term PBC loans, and in
1993 were supplemented by the issue of PBC bills. In October 1994, the outstanding amount
loaned by PBC to the interbank market was estimated to be Rmb50 billion; roughly one third of
the total amount outstanding in the financial centres.
19 The new commercial bank law, however (1 July 1995), strongly prohibits new commercial banks
from investing in non-bank financial institutions. Separate implementing procedures are to be
prepared by the State Council on investments already made by existing commercial banks in
NBFls.
20 Supervision is sparse. In one case, a mutual fund operated by an NBFl was a major lender to a
project owned and operated by the manager of the fund.
21 To the extent that the credit plan is an effective tool of monetary control. The real problem with
financial disintermediation is that, at least until 1994, the PBC has stepped into supplement those
banks which have an unfulfilled credit quota, but an inadequate supply of loanable funds. This
form of PBC 'relending' is highly expansionary.
22 Demirguc-Kunt and Levine (1994).
23 See World Bank (1 995).
24 See Chapter 5. These included a Y30 billion Japanese bond with a maturity of 5 years and a
coupon rate of 5.375 per cent (October 1993); a dragon bond of US$300 million of 10 years
maturity and 6.1 25 per cent a year interest rate (October 1993); a global bond offering for US$l
billion, a maturity of 10 years and an interest rate of 6.5 per cent a year (February 1994); and a
Japanese bond offering of Y60 billion, split up into a 5-year Y30 billion issue at 4.4 per cent a year
and a Y30 billion offering for 10 years at 4.95 per cent a year.
25 There are problems of definition in arriving at a precise ratio, which are pointed out in the notes
to Appendix Table Al.6. Earlier, treasury bonds for investment expenditures were earmarked, but
this practice faded after 1987, particularly for 'key project construction', so that the separation of
the part of Treasury bond issues used for investment presented here is an upper limit.
26 Although market capitalisation (forA and B shares combined, in October 1994) greatly exceeded
this, at around Rmb600 billion (due to share price rises in the secondary market; see Chapter 4).
27 These potential benefits are controversial. Kumar (1993) provides one discussion of the debate.
Especially when ownership dispersal is high, an enterprises' shareholders may not be able to
effectively 'discipline' managerial performance.
28 Regulations today place restrictions on the acquisition of significant shareholdings of any single
individual in an enterprise (see Chapter 2).
29 Moreover, since dividends are paid mostly in the form of rights issues and the Government has
never chosen to exercise its rights, the capital market wil l gradually accelerate the dilution of the
state's share in enterprise ownership. The Government has not acknowledged that the present
process of erosion of the state's share deprives the Government of revenues from the effective sale
of public assets.
30 Enterprises are required under the Companies Law to issue new shares equal to at least 25 per
cent of existing share capital. Yet even this ratio implies that the residual 80 per cent (after share
issue) remains in the hands of the state.
31 There have been two cases where enterprises have directly issued (convertible) bonds overseas
(in Sweden and Switzerland). The authorisation for such issues was apparently granted at a local
level, and the appropriateness of this procedure is now being questioned.
32 A comprehensive discussion of the mechanism of China's credit plan is available in Montes-
Negret (1 994).
CHAPTER 2
Introduction
An understanding of the regulatory framework for China's capital markets i s an
essential prelude to the issues discussed in this book. The purpose of this chapter
is to describe the present regulatory framework, and evaluate its impact on capital
market performance. Key restrictions are identified and the extent to which they
may be justified at the present stage of market development i s evaluated. It must
be pointed out that the CSRC and other regulatory agencies are highly
knowledgeable and are aware of many of the matters raised here. It i s also
necessary to bear in mind that there i s an inherent trade-off in terms of the impact
of regulations on market participants. Sometimes high standards from the viewpoint
of one participant can be considered detrimental and unduly ;&strilctive practice
by another. Achieving the correct balance is the challenge facing a good regulator.
A first general finding i s that the provisions of existing regulations for domestic
securities are basically sound in terms of international comparisons, and fairly
well defined, especially for equities. While the provisions sometimes have unusual
features, and are sometimes in unorthodox places, these differences are generally
dictated by pragmatic considerations. The chief difficulties here appear to be the
substantial role and sometimes ad hoc intervention of the government, especially
in primary issues, and the difficulties of ensuring compliance and enforcement.
The absence of a national securities law makes the regulatory framework sometimes
confusing, and its passage would aid regulatory transparency.
Second, a major present issue i s the form of government oversight. In the present
regulatory approach to capital markets in China, this i s fragmented in three ways:
vertically, by the split between national and local regulation
horizontally, for example, the regulation of securities dealers i s split between
the PBC (licensing) and the CSRC (secondary market activities) and, functionally, since approvals for different types of security are split between
various government departments, and multiple approvals are required.
The distinction between national and regional regulators of securities, the multiple
institutions involved, and the CSRC's lack of regional offices have weakened its
authority, already limited by its lack of adequate staff.
Third, for equities, an official framework of secondary market regulation so far
has been geographically limited to the two areas of Shanghai and Shenzhen,
although the companies listed, brokers and investors are distributed throughout
the country. Only two stock exchanges are recognised, and dual listing i s not
permitted. The development of OTC and informal markets has not been co-
ordinated, leading to problems with the synthesis of the centres into a cohesive
national system. Moreover the electronic markets have been restricted to bonds
and C shares. There i s no real national market and opportunities to participate in
the development of the markets vary across the country. Given that the main role
of a securities market is to mobilise domestic capital, the lack of a'nationally
regulated market is a serious limitation.' Although the present arrangement may
be justifiable at an early stage on the grounds of experimentation, in the longer
run it will impede capitalisation. The split between national and regional regulation
for equities should be eliminated and any duplication removed. The regional
regulators should be branches of the central regulator.
Fourth, the present fragmentation of regulation particularly affects the bond market.
This could contribute to a situation where (like some other Asian markets) the
bond market is less well developed than theequities market, which will eventually
limit the financing options and financial structure of enterprises. Although the
present structure arose by historical circumstance, it should be reviewed. At this
stage of market development, a single regulator may be beneficial.
Our fifth point is that the regulation of dealers in securities, and particularly, the
role of the PBC in the licensing of intermediaries, in tandem with the role of the
CSRC in monitoring their operations, should be reviewed. In practice this appears
to be leading to a situation where limited de facto regulation is exercised.
A further point is that the links between securities dealers, non-bank financial
institutions, and the banking sector, although greatly clarified by the new
Commercial Banking Law for new financial institutions, have still to be spelled
out for existing institutions.
Finally, the CSRC needs to be considerably strengthened to exercise its present
mandate effectively.
Principles of Securities' Market Regulation: Relevance for China
The purpose of any regulatory scheme should be a framework in which business
can be honestly and at the same time profitably conducted. A sound regulatory
structure inspires confidence and is commercially beneficial for market participants.
Principles of regulation
The twin core principles of securities market regulators are investor protection
and the protection of the rights of shareholders. However, there i s also the concept
of caveat ernptor, ie, that the buyer should beware, and that the investor must
take some personal responsibility for his own decision to buy or sell. Probably
the best protection for all market participants is the availability of promptly
disseminated and accurate information about the listed enterprises and all trading
that takes place in their securities. Advances in electronic communication have
enabled markets to achieve high levels of transparency in recent years. In addition
all relevant laws, regulations and rules must be properly and promptly promulgated
and made available to those who need to understand them.
The regulator in a developing country has additional responsibilities: to assist in
market development. Regulators need to be involved in proactive as well as
preventative work and be able to work with practitioners to develop a high quality
market.
International standards
There is no one set of international standards for securities regulation and legislation
(as there is, for example, for the accounting profession). It i s possible to distill an
overall set of good standards, derived from forums such as IOSCO (International
Organisation of Securities Commissions), FlBV (F6d6ration Internationale des Bourses de Valeurs), and the Group of Thirty. IOSCO attempts to set standards in
areas such as capital adequacy of intermediaries, but they are not always successfuI
27
in encouraging implementation of their recommendations on a worldwide scale.
It i s difficult to get uniform standards in a line of business where regulatory arbitrage
can be commercially beneficial. National exchanges may wish to lower their
standards to attract particularly interesting overseas companies to list on their
exchanges. Equally important are certain accepted modern practices, which ensure
service to and protection of the investor and the overall minimisation of risk. The
principles of 'full, fair and timely disclosure', 'transparency' of dealing information
and 'minority protection' are all accepted as making a market attractive to investors.
The existence of efficient trading, settlement and clearing systems can also add to
a market's attractiveness.
Securities laws
These are less than a hundred years old; the oldest are those of the US, and the
newest in a major developed market are those of the UK, which had no law until
1986. Types of laws adopted depend on the nature of the underlying legal structure,
eg, whether there i s a framework of common law, the nature of the prevailing
companies law, etc. The necessity to take into account 'Chinese characteristics' is
indeed important. Developing markets can adapt what suits them from the
experience of overseas markets, based on the form of their overall regulatory
infrastructure. History has shaped the securities laws of different countries in
different ways. Economic, political and social realities have to be considered.
Regulation cannot be considered separately from these issues especially in a
developing market.
Regulation in a global environment
International and global markets increasingly do not lend themselves to regulation
in the conventional sense. This is not yet a problem for China but it should be
borne in mind for the future. Modern technology means that securities can be
traded and settled on electronic systems which have only a limited physical
presence in any one country. When such systems provide a global, screen-based
market, it is difficult to determine how and where they should be regulated.
Enforcement
The cornerstone to good regulation is consistent and thorough enforcement.
However, a new market regulator wil l not always have the capacity to follow up
every single misdemeanour. It i s necessary to set priorities. All forms of market manipulation are wrong but 'insider dealing' may not be the most detrimental to
28
the market on every occasion. The CSRC is in the process of introducing a
sophisticated stockwatch system which will be linked with Shanghai securities exchange and Shenzhen securities exchange. This wil l be a major benefit in
assisting enforcement. Both markets wil l have the same level of monitoring of
information available to them and in turn this wil l be available to the CSRC.
The Regulatory Framework
National securities legislation and regulation
China today has no national securities law.2 Its securities markets are governed
by a series of regulations, currently split between those that apply nationally and
those that are set at local level.3 Early securities regulations were promulgated in
1987 and were supplemented by a State Council circular and PBC circular in
1989. The first national regulations on securities issuing and trading (the Interim
Regulations on Share Issuing and Trading) were issued in May 1993 by the State
Council Securities Committee (SCSC). This set of more than 20 regulations forms
the framework within which the present regulators of securities markets, the SCSC
and China Securities Regulatory Commission (CSRC) operate. A draft national
securities law has been under preparation since 1993, and was put before the
People's Congress in October 1994, but has still to be e n a ~ t e d . ~ Meanwhile, a
major step forward for securities market regulation was the new national Company
Law, which came into effect on 1 July 1994. In the absence of a securities law, the
Company Lawcontains several provisions regarding the issuing, trading and listing
of 'public' securities which might more normally be included in the securities
law. The law does not replace or abrogate previous regulations and must therefore
be incorporated as a new layer into the existing legal framework.
National regulatory structure
Until 1992, all securities related matters were supervised by the Financial
Administration Department of the PBC. The PBC was also closely involved at the
regional level through its branch offices. Following the Shenzhen riots of August
1992, authorities decided to establish a new, national regulator for the developing
securities markets. Details were promulgated in Document No. 68 issued by the
State Council (1 7 December 1992). The new two tier structure has a first arm
which consists of the State Council Securities Policy Committee (SCSC). The SCSC
is responsible for macro policy issues relating to the securities markets. Such
matters include the approval for the establishment of new Stock Exchanges and
the approval of new securities legislation and regulations. It is also the body
responsible for setting the level of securities issues over a given period both for
bonds and shares at the national and provincial level, in conjunction with the
SPC.5
The second tier i s the executive arm of the SCSC, the China Securities Regulatory
Commission (CSRC).6 The CSRC has been established to operate as an independent legal entity. As such, it has taken over most of the functions previously performed
by the Financial-Administration Department of the PBC. The major functions of
the CSRC are officially:
to draft securities legislation and regulations
to supervise and administer the public issuance, listing and trading of securities
(examination of prospectuses, business activities, etc.) to supervise and administer securities firms, custodians and institutions for
settlement and delivery, mutual funds, and the professionals engaged in the
securities industry to set up qualification criteria and issue licenses for securities professionals
(such as accounting firms, asset valuers and legal firms engaged in securities
business) to supervise and monitor companies which issue securities (including the
acquisition and merger of public companies) to regulate companies which want to list on overseas exchanges and,
to supervise the operation of securities exchanges and automated quotation
systems.
The list of responsibilities i s substantial, and the present staff of the CSRC, at a
hundred and twenty persons, is not adequate to discharge them. Consequently the institution is severely stretched. Meanwhile, although most of the PBC's regulatory functions were transferred to these two new bodies from December 1992, the PBC remains responsible for the licensing of all financial institutions including securities intermediaries. The implication is that the role of licensing
intermediaries and their on-going supervision is split between two bodies.
The scope of the work of the CSRC is broadly similar to other national securities
regulators.' The one anomaly in China i s the role o f the PBC in licensing intermediaries. This occurred for historical reasons, since over 90 per cent of brokers originated as subsidiaries of banks.
Regional regulatory structure
Prior to November 1992, regional regulation was carried out by the provincial
governments, in conjunction with strong central regulation by the PBC through
its local branches and other government offices. Local securities regulatory bodies
were established in Shanghai and Shenzhen by the local municipal government,
namely the Shanghai Securities Commission and the Shenzhen Securities
Commission. The character and regulatory authority of these offices i s illustrated
by the example of Shanghai (Shenzhen is similar). In terms of its role as a regulator,
the main points of note are:
The Shanghai Securities Commission does not have authority in any area where
there is a national regulation. If, however, national regulations are silent on a
point, then municipal regulations including any from superseded regulations
can be enforced. In terms of links between the regional and national regulators, the Shanghai
Securities Commission still reports on a day to day basis to the Shanghai
Municipal Government and not the SCSC or CSRC.8 Yet it i s responsible to the
CSRC for the proper administration of the national regulations and i s required
to bring to the attention of the CSRC any observed breaches or problems within
the CSRC's jurisdiction. In terms of three-way links between the central and regional regulators and
the PBC, the position i s complex, especially with respect to securities dealers.
Although the PBC is responsible for the licensing of securities dealers, and
their on-going financial soundness, the Shanghai Securities Commission also
feels some responsibility for their business performance. At the same time, the
direct operation of the secondary market is overseen by the SCSCICSRC, and
if a broker i s in violation of the regulations, the CSRC is responsible for
investigation and penalties. In the most serious situations it can suspend a
broker from trading. On the other hand, it i s only the PBC that can revoke the
license of the broker and only the authorities of the exchange that can remove
the broker from the exchange floor.
The implication of the present regional and institutional division of responsibilities
i s that those who are actually in and near the exchanges and who know what i s
going on have no authority to investigate or penalise. The CSRC has the theoretical
power but no branches nor has it delegated any authority to the regions. Effectively,
the power is geographically separated from the action, and this can lead to
inefficiency and duplication. O n the other hand it avoids an over-familiar relationship developing between the regulator and the regulated.
3 1
The Shanghai Securities Commission
Some regulations on securities issued by the Shanghai municipal government.
have been superseded by national legislation. These regulations are administered
by the Shanghai Securities Commission. Regulations still in force (at the end of
1994) include:
Shanghai Measures for the Administration of Trading in Securities, 27 November
1990. Shanghai Measures for the Administration of Special Renminbi Shares (jointly
issued by the PBC and the Shanghai Municipal People's Government) 22
November 1991 (and Implementing Rules) - these are commonly known as
the B share regulations.
The Shanghai Securities Commission consists of 13 people, including
representatives from the following commissions and ministries:
the Vice Mayor of Shanghai
the Shanghai PBC
the Shanghai Planning Committee the deputy director of the Shanghai Commission on Restructuring
the Shanghai Bureau of the MOF
Municipal Auditing Bureau
Shanghai Foreign Investment Commission
Municipal Office of justice the Director of the Office of the Commission
Deputy Secretary General of the Municipal Government responsible for assets
and, Shanghai Branch of the State Asset Management Bureau.
The Shanghai Securities Commission operates through the Shanghai Securities
Administration Office which is headed by a director and has a staff of 22 people
split into five departments:
The companies division which regulates existing companies and the lPOs of
A shares. It is also responsible for overseeing the newly introduced coaching
period for new companies wanting to issue shares. The market department which is responsible for regulating the B share market
and the introduction of new financial instruments such as ADRs. It regulates B
share brokers, granting them the licence to trade, and keeps up a close liaison
with the Stock Exchange. The supervision department which looks into potential breaches of the
regulations and deals with disputes between clients and brokers. There are no
formal rules for the latter and the problems are usually solved by putting moral
pressure on the parties involved. An average of ten such complaints per month
are received, generally concerning the broker's failure to carry out a client's
instructions. The conflicts are normally solved. (This informal method of
solving disputes can be very effective in a small market and usually results in
speedier conclusion than if there are bureaucratic procedures.) The remaining two departments cover research, the handling of confidential
documents and general administration.
The office does not have any responsibility for the administration of company
law.
The reguhtion of bonds
The SCSC and CSRC are essentially responsible for the supervision of equity
markets, including equity option^.^ The regulation of debt securities i s less well
defined and more fragmented than the regulation of equities. The roles of various
bodies in this context are set out in Document No. 68, according to which:
The MOF is in charge of the issue of state treasury bonds.
The PBC is in charge of the approval of bonds issued by financial institutions
and the securities of investment funds. The SPC is in charge of the inspection and approval of state investment bonds
and bonds issued by state investment companies. The PBC and the SPC are together in charge of the approval of central enterprise
(corporate) bonds and, Provincial or municipal governments are in charge of the approval of regional
enterprise (corporate) bonds.
This division of responsibilities covers regulation only in the primary market, and
its fragmentation reflects the great variety of government debt issued in China
until 1993 (see Chapter 3). The PBC is responsible for bond trading activities only
to the extent that it approves securities trading centres. Monitoring bond trading
on a daily basis, to the extent that this occurs on the two officially recognised
exchanges, is within the realm of the CSRC, which i s meant to supervise the
activities of the exchanges. But monitoring the actual trading of bonds, especially
government bonds, has been a grey area. The PBC, while responsible for the
trading of government securities, has not had the capacity for regular monitoring,
and has tended to control by the issue of ad hoc regulations as problems manifest
themselves.1° Even at the official exchanges, the CSRC has hesitated to intervene,
as this could be regarded as an encroachment on the PBC. Outside the two official
exchanges, the CSRC does not have any rights of intervention. The government
was recently made aware of the lacunae by the government bond futures trading
debacle on the Shanghai Exchange in February 1995 (see Chapter 3), and it is
now drafting a Government Bond Law, which is expected to cover the supervision
of bond trading activities.
Securities market regulation in the US
Through a combination of competition ITS, these exchanges are l inked
and direction from the SEC, the US electronically so that a securities dealer
securities market has developed a can see on which exchange the best bid
national market framework. This or offer price for a particular security is
framework comprises three national available. The ITS system then directs the
markets; namely the New York Stock dealer's order to the exchange where he
Exchange (NYSE), the American Stock can get the best price at that moment in
Exchange (AMEX) and the OTC market time.
operated by the National Association of
Securities Dealers, called NASDAQ. The national trading market i s supported
by a national settlement system. A
The NYSE is America's largest exchange Depository Trust Company (DTC) and a
and acts as the Big (or Main) Board. AMEX National Securities Clearing Corporation
plays a more specialist role for medium (NSCC) have been set up by the NYSE,
size companies and equity options and AMEX and NASD (amongst others). Other
the NASDAQ market has specialised in exchanges like Chicago have their own
providing development capital for small depository companies but with links to
and innovative companies. In addition, the DTC. The DTC and NSCC provide
there are several regional exchanges such the mechanisms to clear trades made on
as Chicago (in the Mid-west) and the any of these exchanges and the DTC
Pacific (on the West coast). The SEC has immobilises securities and enables those
sought to ensure that there i s a national trades to be settled between participants
market framework through the by book-entry transfers, on a nationwide
lntermarket Trading System (ITS). Under basis.
Reguh tion of derivatives
Until February 1995, there was no specific legislation for financial derivatives in
China. At present, stock index futures, and products such as options and swaps,
are not permitted in China, and the principal form of financial 'derivative' securities
has been the futures contracts on treasury bonds, which were first offered on the
Shanghai Exchange at the end of 1992 (see Chapter 3). Following the incident of
runaway speculation on these securities on 23 February 1995, China rapidly
promulgated (1 March 1995, effective from 23 February 1995), new regulations
on derivatives trading." The new regulations, inter alia, provide:
that only those individuals approved by the CSRC and the Ministry of Finance
are eligible to trade that brokers cannot lend their seats on the exchange to smaller traders
daily price variation limits (set at Rmb0.5 in Shanghai and Rmbl .O in Shenzhen
limits on the number and volume of contracts for individuals, brokers, and
institutional investors
new margin deposit requirements, which increase as the settlement date
approaches, and the right of regulators to change margin deposit requirements12 daily markings of contracts to market, and
new disclosure requirements for brokers to their clients and to the regulators.
The nature of these provisions reflects international practice.
Regulations for overseas share issues
Special Regulations Relating to Shareholding Companies Issuing Shares and Listing
Abroad were issued by the State Council, as implementing regulations under the
new Companies Law on 19 August 1994. These regulations relate to foreign
share offerings and overseas listings by Chinese companies and are intended to
codify some of the practices and procedures which were developed to deal with
regulatory grey areas during the first H Share issues. Under these regulations,
shares which are issued to PRC investors and listed on a domestic exchange are
defined as 'domestic shares', while shares issued to non-PRC investors, and listed
overseas, are defined as 'foreign listed shares'. The regulations d~o not define B
shares, which are issued to non-PRC investors but listed only on domestic
exchanges.
The regulations require all issues of foreign listed shares to be approved by the
CSRC, to be issued in registered form, and denominated in Chinese currency,
although they are sold and purchased in foreign currencies.13 The regulations
acknowledge that depository receipts may be issued over Chinese shares and
these depository receipts are regarded as foreign listed shares. In many respects
the regulationsformalise arrangements already put in place by the H share issuing
companies. Thus the regulations empower the SCSC and CSRC to enter into
Memorandums of Understanding (MOUs) with overseas regulators, but MOUs
had already been signed with the Hong Kong and London Stock Exchanges, and
the US SEC. Similarly the regulations permit a company to maintain its register of
the holders of foreign listed shares outside China (on condition that a copy of the
register i s kept at the company's main office); a provision already agreed to for
Hong Kong listings. The regulations empower the SCSC to specify certain
mandatory provisions to be included in a company's articles of association if it i s
going to issue foreign listed shares. Again, these provisions will likely be similar
to the mandatory article provisions stipulated by the Stock Exchange of Hong
Kong for existing H Share issuers. In some respects the regulations represent a
modification of the Companies Law; notably, they permit a company to increase
its share capital and issue foreign listed shares at intervals of less than one year.
This facilitates the initial public offering of shares to foreigners as well as subsequent
issues of new shares to non-PRC investors. While they contain some provisions
which would not be found in most countries, these provisions may be permitted
in circumstances which may arise in China.14
Although the issue of the Company Law and related regulations has added some
confidence to overseas investors, there i s no doubt that the untried nature of the
laws, their ambiguous overlaps, the lack of a national securities law and the lack
of experience of Chinese companies in operating to international levels of
management, efficiency, governance and accounting, remain deterrents. The
absence of a national securities law and the periodic sensational incidents surrounding the market compound this effect. These factors are more likely to
affect foreign investor confidence than the substance of the regulations, which is
generally satisfactory.
Links to other regulations: The Company Law and securities markets.
Until the Company Law came into effect on 1 July 1994, China was unique in
having shareholding companies and a securities market operating without either
a companies law or a securities law. However, prior to this, there were national
regulations on shareholding, issued by SCRES, as well as regulations issued by
both the Shanghai and Shenzhen Municipal Governments, to cover the formation
of companies limited by shares both within their municipal jurisdictions and for
companies outside the municipality listed on their exchanges.
The main regulations issued in 1992 by SCRES were the Standard Opinion on
Companies Limited by Shares and the Standard Opinion on Limited Liability
Companies.15 The new Company Law of 1994 does not state that it replaces the
Standard Opinion (or previous regulations) and it must therefore be incorporated
into the existing legal framework of companies regulations. Effectively, two bodies
of law regarding companies are in existence today and no organisation i s in an
authoritative position to say which prevails. Over 90 per cent of listed companies
were formed under the Standard Opinion or previous municipal regulations.16 It
should also be noted that the national Company Law makes no mention of the
distinctions between A, B, C, H and N Shares and thus their only formal definition
remains in the Standard Opinion. To the extent that this envisages the removal of
such distinctions, which are increasingly uncommon in developing as well as
developed company legal structures, this absence i s appropriate. But if multiple
share categories persist, the present laws are contradictory.
In the absence of a national securities law, the Company Law has some provisions
which would usually be found in a securities law. Many of these provisions are
valuable and offer investor protection in the absence of a securities law. But some
others may be considered unduly restrictive.
Securities related provisions of the Company Law: some restrictions
Share issues A potentially restrictive clause of the Company Law i s that all share issues to the
public must be fully underwritten. This requirement may restrict the capital raising
efforts of companies. This is because underwriting depends not only on the viability
of the issue, but also on the size and availability of funds for underwriting. An
otherwise viable equity issue could be prevented from going to market because
of constraints originating from the nascent financial infrastructure in China. One
possible alternative solution to completely underwriting an issue, is to pre-place
a portion or all of the issue. Today the restriction on underwriting may have little impact because of the large role of the government in appointing underwriters
(see Chapter 3). If underwriting were truly competitive, this restriction would have
greater impact. A second restrictive clause with regard to share issues i s the
requirement that a company limited by shares may only make subsequent issues
of shares if it has been profitable for the previous three years and there has been
more than one year since the last share issue. This limits a company's ability to
raise fresh capital, and may be particularly limiting if it needs new capital injection for rescue or restructuring.
Share transfers The Company Law requires:
all share transfers to take place through a securities trading exchange. This
limits share trading to the Shanghai and Shenzhen Exchanges, and STAQS and
NETS. This implies that the transferor and transferee have to go through the
expense of a market transaction, eg, brokers' commissions. While this may reduce the possibilities of fraud, it could also be said to frustrate rights to pass
on ownership unimpeded. Elsewhere, special arrangements are made for
essentially non market (direct) transfers which reduce the cost burden.
that directors of a company may not transfer their own shares during their
term of office. This is one of the points that is in conflict with the Standard
Opinion, which permits directors to transfer their shares after three years. While
this reduces the channels for insider dealing and avoids the need for detailed
regulations on the disclosure of directors' dealings (which may be important
considerations in China today), it is not in line with normal international practice
and is restrictive. Prohibiting directors from dealing will discourage them from
having a financial interest in the company.
Share listing It is not usual to put minimum listing standards into a company law. In most
countries these are set by the Stock Exchange, subject to standards approved by
the relevant SEC. In China, this partly reflects the weak role of the exchanges in deciding upon listings (see Chapter 4). In the absence of a national securities law,
however, it may be acceptable for the present. International comparisons are given in Appendix Table A2.2.
Corporate bond issues The law requires all bond issues to be approved by the Securities Administration Department of the State Council which will grant or withhold approval within
limits prescribed by the State Council. Corporate bonds may be listed to facilitate transfers, although this is not essential (para. 170 of the Company Law). However,
where the bonds are to be listed is not clear. Bonds may be bearer or registered
bonds. Bond issues must be preceded by an Information Memorandum, and the
Company Law sets out provisions relating to its contents, and also relating to
app;oval documents which must be delivered to the Securities Administration
Department; and the form and contents of the bond certificates themselves. The
issuer i s also obliged to maintain a Register of Bondholders. Bonds may be issued
by all limited liability shareholding companies (with at least two shareholders
which are state-owned entities) or by wholly state owned companies (para. 159
of the Company Law). The Company Law provides that a company may only
issue bonds if it satisfies conditions on:
minimum net asset value
a maximum ratio of bonds issued to net assets
the ratio of distributable profits to interest payments the use of funds raised, which must be invested in industries which comply
with the policies of the state, and may not be used to cover losses or
non-productive expenditures the interest rate, which may not exceed the Iimit set by the State Council, and,
any other conditions which may be imposed by the State Council.
A company wil l not be permitted to issue bonds if:
on the last occasion when it issued bonds, the company failed to raise the full
amount required, or,
the company has defaulted in payment of principal or interest on bonds already
issued.
The State Council i s also empowered to set limits on the scale of all company
bond issues and the CSRC, as one of the organs of the State Council designated
for this purpose, may only approve bond issues within this overall Iimit. Acompany
can also issue convertible notes if it satisfies the conditions applicable to both a
bond issue and a public share issue. The Company Law does not envisage
companies issuing unlisted securities such as short-term floating rate notes issued
to a syndicate of banks. Some of these provisions are unusual (eg, the restrictions
on fund use or the interest rate, or on the success of the previous bond issue), and
also the provision that the state council is empowered to set limits on the scale of
company bond issues. They reflect the coexistence of central planning and the emerging market economy.
Links to other regulations: banking laws and securities laws
The role of the central bank, the PBC, in securities regulation i s at present defined in the securities legislation described above; primarily Document No. 68, and the
Interim Regulations. A key issue of importance for China i s the extent to which
specialised or commercial banks should be allowed to participate directly, or
through their subsidiaries, in securities markets. Links between banks or other
financial institutions, and securities dealerships have very recently been spelled
out in the new Commercial Bank Law, declared effective from 1 July1 995. For the
first time, the new law considerably clarifies in legal terms the degree of separation
between banks and non-bank financial institutions. While new commercial banks
are allowed to underwrite and trade government securities, they are not allowed
to engage in any operations related to other securities. Dealing in stocks is expressly
forbidden. Commercial banks are also forbidden to invest in trust and investment
businesses or real estate, and are also forbidden from indirectly investing in non-
bank financial institutions. Stiff penalties are detailed in case of contravention. However, the new law does not deal with existing investments of existing banks
in non-bank financial institutions. these are to be covered, according to the law,
by separate implementing procedures, to be prepared by the State Council. Given
that the large banks in China have a substantial or majority stake in many of the
most important and largest securities dealers, this i s an important remaining lacuna and it is hoped that this area too wil l soon be clarified.
In the context of China today, there are several advantages in keeping the securities
activities in separate subsidiaries:
the securities firm can more easily be regulated by the CSRC, without
jurisdictional conflicts with the PBC the securities firm can be required to meet the usual capital adequacy
requirements for brokers, with separate capital from the bank, and, the traditional deposit taking functions of banks can be protected from potential
losses in the securities business."
Other issues which affect the effectiveness of regulation
It is recognised today that market regulation depends not only on the legal
framework, but also on other forces which have a defacto regulatory role, notably, first, the press and media.18 There are few international standards for press reporting
and it is not normally the subject of special regulation. The press should educate
their journalists with reasonable standards in financial reporting. The Shanghai
Securities Exchange initially disseminated information through Friday meetings
with journalists. These have been replaced by daily nationwide information
dissemination which should improve the quality and timeliness of reporting. But
in November 1994, the Shanghai government announced restrictions on the
number of papers that could carry securities news. While the deliberate starting
of false rumours i s wrong, these new measures overlook the fact that education is
the key to moderating rumours in the first place.
A second key factor i s the education of the public. Investor awareness of the
fundamentals of the companies they invest in, and of the possible consequences
of speculation, must be raised. Speculation occurs in all markets, and should not
in itself be an issue of concern. The aim should be to increase investor awareness
so that they are in a position to judge if they wish. Investor awareness can take
many years to build up, but in the final analysis i s probably one of the most cost
effective forms of investor protection.lg
Third, credible enforcement i s required for any regulations to be effective. Rules
and laws that are not enforced lose their effectiveness. Widespread and continuous
lack of enforcement after a point can become legal defence for circumventing
legislation, by citing 'common market practice' (which has occurred in Hong
Kong). But the costs of regulation and enforcement must also be weighed, and an
appropriate trade-off has to be found for each market. The maximum use of
electronic surveillance mechanisms, which are currently being installed in the
CSRC, Shanghai Securities Exchange and the Shenzhen Securities Exchange, should
be made. A major problem is the lack of sufficient skilled regulatory staff, at the
centre or the regions.
Regulation of Securities Issue and Trading: An Evaluation
Selection of enterprises for securities issues
Access to the emerging capital markets in China is restricted in several ways:
The State Council, through the SPC, regulates the volume of securities issued
and their terms, by setting annual limits on the amount of shares that can be
issued. The State Council also sets limits on the amount of bond issues and
the maximum interest that can be paid on corporate bonds (see Company Law
above).IO Access to overseas listings i s restricted, and is subject to case-by-case approval.
The local government of the province in which a company i s located must
approve companies for public offering of equities of bonds (local SPC approval
is also required for bond issues). The SCRES and the CSRC must approve companies for public issue.21
The government can impose temporary bans on share issues to satisfy macro-
economic objectives.12
The quota assignment for securities, and the multiple layers of central and local
government approvals for listing (ie, approvals other than those required by the
exchanges) reflect the continuing existence of the planning framework within the
new market economy, and as such, reflect a policy choice. From a regulatory
standpoint, the most serious of the obstacles to listing is (5) above; that the
Government can stop agreed listings from going ahead to boost the market. This
amounts to unwarranted market manipulation of a major nature.
Having made a public issue and met the specified criteria, a company may apply
to the listing committee of an exchange for listing. Listing criteria are specified at
a national level under the Interim Securities Regulations and the Companies Law
(details are in Annex 2.3 and international comparisons are in Appendix Table
A2.3). Local criteria are also provided for at Shanghai and Shenzhen. The criteria
are broadly in line with international standards. According to the regulation, a
decision on the application must be made within 20 days and the CSRC must
then be notified of the decision. In practice, it is a merit regulation system and
once the necessary regulatory approval criteria have been met, the exchanges do
not exercise discretion in choosing their listings.
Trading
The integrity of the trading, settlement and clearing systems is essential to ensure that brokers and thus investors are fairly treated (ie, that the orders from one type
of broker are not given preference above those from another type of broker); to reduce the possibility of fraud and manipulation, and for the minimisation of
overall risk. 'The electronic systems in both exchanges are relatively sophisticated
(as well as STAQS and NETS) and are consequently much easier to monitor than
old floor based systems and enhance the opportunities for good market
transparency. The features of the system (eg, automatching, fair algorithm,
surveillance and monitoring systems, adequate back up systems) are as important
as the written rules. Details of how the trading systems operate are given in Annex
2.4. Details of clearance and settlement procedures are in Annex 4.1, which
shows that present procedures in China are, on the whole, adequate. With effect
from 1 January 1995, the CSRC abolished T+O settlement on the Shanghai
Exchange. The measure, which was announced several months in advance, helps
prevent speculation by abolishing day-trades. Problems in the trading system at
present do not appear to be on account of either the regulations, or the trading systems, but rather, due to difficulties in ensuring compliance with rules. There
have been allegations of brokers undertaking fixed-day trades without prior
permission, undertaking unauthorised deals on their own account, of exchange
members 'loaning' seats to others, and other transgressions.
Accounting and disclosure requirements
Under the new Companies Law,23 all listed companies must issue a financial
report every six months.24 The CSRC also has regulations on disclosure, which,
though not the same as regulations under the Companies Law, are of generally
good standard. The CSRC has also issued a set of implementing regulations on
the contents and form of annual reports. It is unusual for these to be set by a body
such as the CSRC, and this i s a reason why these annual report rules are not as
detailed as the standards that are set in other c o u n t r i e ~ . ~ ~
Detailed accounting standards are currently being formulated in China. As far as
possible the accounting standards should conform to those of the International
Accounting Standards Committee. Any deviations from the standards should be
clearly stated and explained in the notes to the accounts. Particularly if a company
has issued B shares or H shares to foreign investors it should prepare its accounts
in accordance with IAS for their benefit.
The difficulty again lies more in compliance than in the nature of the regulations.
For the year ending 1993, only 75 of the 183 listed mainland companies submitted
acceptable annual reports according to the CSRC. As at the end of July 1994, 14
companies had failed to submit a report at all and five submitted a copy of a
newspaper clipping of financial reports.
Part of the problem stems from the shortage of qualified accountants in China. It
is estimated that there are presently about 11,000 certified public accountants
(CPAs), but there is a need for 300,000. The Ministry of Finance has instituted
training courses run by foreigners to help rectify the problem, but this will take
time. Compounding the problem is the fact that companies all have the same
fiscal year ending, which serves to strain the limited resources further. The
possibility of bringing in overseas accountants is limited by the relatively high
costs involved. The CSRC has indicated their concern with the widespread problem
and has threatened to suspend trading in non-conforming companies' securities.
The lnterim Regulations on Share Issuing and Trading as well as the CSRC's
regulations provide for the disclosure of material events to shareholders and the
public. On the occurrence of a 'significant event', a listed company must
immediately submit all relevant documents to the stock exchange and the CSRC,
and shall issue a public notice setting out the facts.26 Again these regulations set
good standards. The extent to which companies have adhered to them is debatable.
Disclosure requirements under the Companies Law and the lnterim Regulations
provide that every offer of securities to the public to be supported by a prospectus.
In addition, the CSRC has issued implementing regulations on the information to
be included in a prospectus which are reasonably comprehensive in scope, called
the Detailed Implementing Rules on the Disclosure of Information by Companies
Making Public Offerings of Shares (for Trial Implementation).
All the above disclosure requirements are generally well framed. But in practice
their effectiveness will depend on the way in which they are implemented.
Investor protection: individual and institutional investors
China's lnterim Securities Regulations require that no individual may hold more
than 0.5 per cent of the issued ordinary shares of a listed ~ompany.~ ' Directors
and supervisors are required to notify the CSRC of their shareholdings, and any
changes therein, within ten working days. An institutional investor (legal person)
who holds, directly or indirectly, more than 5 per cent of a listed company's
issued ordinary shares must disclose hislher holdings to the company, the CSRC
and the exchange where the shares are listed within three working days. Any change of 2 per cent or more in such holding must be reported and announced in
the same way. These standards are sound. The CSRC publicises, to the extent to
which information i s supplied to it, reports on directors and substantial
shareholdings.
The role of a prospectus in the share issue process: China and other countries
Prospectuses have to serve two functions:
marketing, and, compliance with disclosure requ irements.
Regulatory regimes have differences in emphasis on these topics. In the US, the
compliance function takes precedence and so the document tends to be drafted in the first instance by lawyers. In UK or Hong Kong, marketing tends to be considered the prime purpose so that initial drafting is by merchant bankers. This derives primarily from the fact that in a UK/Hong Kong style public offer the securities are marketed to investors through the prospectus, whereas in a US
style offer the securities are usually marketed through a syndicate of brokers with networks of retail sales staff. In addition, the overall philosophy between regulatory regimes varies so there is not one overall international standard for the preparation of prospectuses although there are generally accepted good principles. At the moment China uses a UK/Hong Kong style public offering mechanism. The prospectus rules are set out clearly and are good by international standards but the excess of demand over supply means that issuers regard the full prospectus as merely a regulatory burden, ratherthan a marketing tool. This is likely to change once supply and demand are more equally balanced.
Insider dealing and market manipulation
Under the lnterim Securities Regulations, any director w h o holds more than 5 per
cent o f the voting rights o f a company and who, w i th in six months o f a purchase
o f company shares, sells shares (or w i th in six months o f a sale, purchases more
shares), and thereby makes a profit, must account for such profi t t o the company.
This is similar to the US law o n this issue.28 The lnterim Regulations also include
other standard restrictions against insider dealing (Annex 2.5 has details). The
issue regarding investor protection is to enforce disclosure o f interests and anti-
market malpractice measures.
Resolution of disputes and compensation schemes
The lnterim Regulations state that any dispute i n relation to the issue and trading
o f shares may be referred, b y agreement, to an arbitration institution for conciliation
and arbitration. In late October 1994 the CSRC announced that rules governing
disputes between brokers and exchanges and between brokers and brokers would
shortly be issued, pursuant to the promulgation of the Arbitration Law in August
1994. The arbitration approach is preferred because the courts are not familiar
with securities matters and legal action is likely to be very time consuming.
Procedures are thus being set up. At a municipal level, client complaints are
being dealt with by the local SEC.
There are no compensation schemes for investors in China at the moment. The
existence of compensation schemes i s held of paramount importance in the
securities regulatory schemes of some countries. However, they can be costly to
set up as eventually the investor is paying for his own protection and the rules
about who can be compensated for what have to be very clear cut. A decision
has to be taken as to whether investors alone can be compensated or whether
there will be some sort of mechanism for intermediaries as well. A guarantee
fund can be set up as part of a national clearing and settlement system. The other
side of the argument is that the existence of such a fund encourages slackness. At
present this is not a priority issue.
Corporate governance of the exchanges
The Interim Regulations contain provisions to stop the exchanges from operating in self-interest and there has been no reason to believe that the regulations are not
enforced.
To summarise, in the absence of a securities law, and in the absence of many
conventional aspects of a market structure, the interim Regulations, the parts of the Company Law which refer to securities, together with CSRC's implementing
rules and municipal regulations, form a regulatory structure that covers the large
part of securities regulation in a fairly standard framework, particularly with regard to secondary markets, despite the fragmentation, multiple sources, and sometimes overlap of regulation. The greater issues faced have been the large role of the
central and local government, especially in the primary issue process; the possibility
of ad hoc intervention by the government in the market; and the difficulties of
enforcement and ensuring compliance with the regulations.
Regulation of Participating Institutions
Brokers, dealers and underwriters: domestic securities
The key issues here are that while the CSRC supervises most brokers' secondary
market activities, the PBC licenses them in the first place. This separation is
unusual in international terms. It arose because first, the PBC was the original
regulator and second, most major securities dealerships were set up as bank
subsidiaries, so that the PBC would be in the best position to monitor their capital
adequacy. The situation is unusual. It would be acceptable provided that the PBC
takes a proactive role in ensuring on-going compliance by brokers but at present
it is not clear that it fulfils this role. The CSRC, however, also has problems in
regulating brokerage activities as it has no branch offices and is thus effectively
dependent on information provided by the exchanges and the local government.
Approval of securities dealers is undertaken at a local level, by the respective
branch offices of the PBC. Regulations governing securities dealers are also at the
local level. Details of present regulations are in Annex 2.6. Rules are more detailed
at Shenzhen relative to Shanghai, especially in terms of capital adequacy
requirements. Within this framework, the Shenzhen rules mainly require the
members to exercise self-regulation.
Securities dealers in the B share market
Domestic and foreign securities dealers may participate in the trading of B shares,
but the rules governing foreign dealers restrict their role, relative to domestic
dealers, and offer them fewer rights. In Shanghai, securities dealers engaged in B
share business must be approved by the PBC. Securities dealers in Shanghai who
are authorised to engage in B share business may only act as placement agents in
an issue of B shares and as an agent in the trading of B shares. Special authorisation
from the PBC must be obtained for the underwriting of B shares. Unless special
approval has been given, domestic securities dealers may not deal in B shares for
their own account.
An application by an overseas securities dealer for permission to act as agent
must be supported by a recommendation from a domestic securities dealer. The
paid-up capital of an overseas B share securities agent must be at least US$10
million and the agent must have carried on a securities business locally for more than five years, have a good business reputation and a sufficient number of special
securities staff. An overseas B share securities agent acting for a domestic securities
dealer must sign an agency agreement that sets out clearly the rights and liabilities
of both parties, detailed operational procedures, and any liabilities for breach of
contract. The agency agreement must be approved by the PBC. In terms of underwriting, an overseas financial institution may apply to the PBC to qualify as
a B share sub-underwriter. Overseas securities dealers have pointed out that the
inability to assume lead underwriter responsibilities i s restrictive, especially as
they would typically be expected to have a better knowledge of foreign investors
than local underwriters.
The Shanghai Exchange has created a new category of membership, with the
establishment of 32 special seats to deal in B shares. These special seats are
available to foreign brokers, but have to be held in the name of a Shanghai broker nominee at the same fee rates as for full local members. These special memberships
can send orders directly to their own traders on the trading floor of the Shanghai
Securities Exchange. The local broker is liable to settle all the trades of the special
foreign member and the commission is therefore shared between the two firms.
On the Shenzhen Stock Exchange, B share issues may only be handled by an
authorised securities dealer, approved by the Shenzhen PBC to handle B share
issues and to act as an agent to transfer B shares in Shenzhen. An authorised
securities dealer may also organise the underwriting of B shares by overseas
securities dealers approved by the Shenzhen PBC. Authorised securities dealers
may also enter into agency agreements with overseas securities dealers, whereby
the overseas dealer acts as the foreign agent of the authorised dealer to handle
matters relating to the buying and selling of B shares by investors. With the approval
of the Shenzhen branch of the SAEC, an authorised securities dealer may open B
share accounts with banks (including foreign banks) in Shenzhen. The accounts
are supervised by the Shenzhen branch of the SAEC. Unless specially approved
by the relevant authority, an authorised securities dealer may not buy or sell B shares on his own account, nor underwrite B share issues. Foreign securities
brokers (who can satisfy conditions on size, reputation, etc, and obtain PBC approval) can participate in the distribution of B shares. Approved overseas
securities institutions may also participate in the underwriting of B shares and act as comanager for a B share underwriting syndicate.
Since August 1993, the Shenzhen Securities Exchange has admitted 11 foreign
brokers directly to the exchange as special members. Although the seats are held
directly in the foreign broker's name, the brokers are not full members with voting
rights (which would require approval from Beijing). Each firm has paid a Rmbl
million (US$125,000) fee for the seat and a deposit of HK$500,000 (US$65,000)
by way of a letter of credit, bank guarantee or cash, to cover settlement defaults.
These members are not subject to any special capital requirements but must be a
member of an international Stock Exchange and be an authorised B share broker.
Other professionals
Under regulations issued by the CSRC, any lawyers, asset valuers and accountants
who are engaged in securities market business must be approved by the CSRC.
The regulations set down certain minimum standards and size requirements for
such approval. In general, professionals such as accountants, lawyers and asset
valuers are regulated by the standards of their own professional body which may
in turn be enshrined in the law of the country either directly, such as i s the case
with accountants in the US, or indirectly as in the UK. While the firms themselves
may specialise in, or have departments which specialise in, certain aspects of
securities business, it is not common for the securities regulatory body to impose
specific qualifications on the professional firm or require them to obtain a permit
for the purpose of dealing with matters relating to the securities industry.
However, in most countries, the professions of accountants, lawyers and asset
valuers are older than the securities industry and they tend to have professional
associations which have well established rules and standards going back in history
to before the establishment of the first securities regulatory bodies. Once recognised
as a qualified professional, most would regard themselves as equal as individuals
(even if in the size of firm they are patently not). In countries such as Hong Kong,
where it i s not possible for the exchanges or regulatory authorities to designate
experienced and approved individuals, difficulties have arisen. Thus, although
regulation in China is unusual, it may be appropriate in view of the limited number
of qualified and experienced professionals in these areas.
Credit rating agencies
China Chenxing Securities Rating Company Limited and Dagong International
Securities Rating Company Ltd. are the only two securities rating institutions
approved by the PBC. Some 20 or so rating institutions have been approved by
various local departments (at the provincial and municipal level) and around 80
or so institutions are said to offer rating services. However many of these do not
call themselves rating agencies at present, but rather, consulting firms, accountants,
etc. Due to the belief in implicit state guarantees on corporate bond issues, the
role of credit agencies is still u n d e v e l ~ p e d . ~ ~
Distribution of Oversight within the Government
A key concern in the regulatory structure for securities markets in China today is the fragmentation of oversight, both functionally, for different segments of the
securities markets, (and for different parts of the market for each security, ie, primary
and secondary markets), and regionally, between central and regional authorities.
The CSRC and SCSC are the principal central authorities. The PBC's role in
securities regulation is largely effected through its branch offices. Additionally,
the MOF has begun to assume a role in this area, and regional governments have
powerful bodies of securities legislation.
The CSRC
Prior to October 1992, the Financial Administration Department of the PBC was
the main regulator of securities in China. Day to day supervision was carried out
by branches of the PBC in Shanghai and Shenzhen in close liaison with municipal
governments which issued various decrees concerning company and securities
legislation. Following the Shenzhen riots in August 1992 over a new issue, the
decision was taken to establish a new, specific regulator for the developing
securities markets, with two arms, the SCSC and the CSRC.30 Details were
promulgated in Document No. 68 issued by the State Council on 17 December
1992. The SCSC and CSRC are responsible for the supervision of equity securities
markets, including equity options.
Some unusual aspects of the CSRC's present structure, which have diluted its
effectiveness and authority are:
It has no regional offices, and its regional authority thus depends on input
from autonomous securities' regulatory bodies for which it has no direct
responsibility. It has neither the licensing authority for exchanges nor for securities industry
intermediaries. It was established as a sub-ministerial level agency, and as such had limited
authority.
There have been instances when the CSRC has meted out penalties for transgressing
regulations, which offenders have refused to pay." In recognition of its inadequate
status, the standing of the CSRC was raised in early 1995, to an institution directly
under the state council. Whether the state council would wish to see a more
conventional concentration of power for securities matters located with the SCSC/
CSRC at this stage is a political issue.
The PBC
Although the PBC no longer has a major role in the supervision of equity markets,
it has retained responsibility forthe licensing of all financial institutions, including
securities exchanges, 'stock trading centres,' and securities dealers, under
Document No. 68, although it is required to report to the SCSC. However, this
requirement does not apply to securities firms which exclusively trade treasury
bonds since they are supervised by the MOF which has apparently said that the
PBC's approval is not necessary. This means that the role of licensing intermediaries
and the on-going supervision of dealers i s split between the PBC and the SCSC/
CSRC. The PBC remains responsible for all bond trading activities, including
financial futureson T Bills, and the supervision of mutual funds. Unlike theCSRC,
the PBC has a regional presence, through its branch offices.
Other central government agencies
Responsibility for the issue of different types of government securities i s primarily
under the Ministry of Finance, and has also been delegated to other state financial
institutions for a small part of the issue (see Chapter 3). Although the MOF has
not required the PBC to license dealers in government securities, it has recently
(under the new regulations of 23 February 1995) taken upon itself the authority,
together with the CSRC, to license dealers in bond futures.
Municipal governments
In the absence of a single strong central authority, municipalities have taken a
powerful role in the regulation of securities business within their own jurisdictions.
Document No. 68 provides that the Shanghai Securities Exchange and the
Shenzhen Securities Exchange are to be administered by their respective local
governments and supervised by the CSRC.
Comparisons with other countries
Most countries have a single principal securities regulator, who then comes under
the authority of MOF or Central Bank. The regulator is usually responsible for licensing and supervising securities intermediaries (Appendix Table A2.2 has
details). A key question here concerns the regulation of debt securities, which in
China, like many other Asian countries, have been generally underdeveloped,
compared to equities. The easiest way to ensure that inequalities do not develop
between China debt and equity markets i s to consolidate their governance under
one regulatory authority. Both markets should evolve in tandem. Anomalies in this regard are already apparent. In theory debt financing in China should be
more welcomed than equity. Not only is debt a cheaper source of financing, it does not dilute the ownership structure. To date, the amount of corporate debt
issued has been very small. While there are other problems that constrict the development of the debt market (see Chapter 3, and also high inflation and
relatively high pricelearnings ratios for equity securities), regulation can also distort
the issuing costs for debt and equity. Slight variations are to be expected, but
radical deviations can cause problems. If a situation evolves that i s radically
different from capital markets in market economies, PRC issuers would be at a
disadvantage in global markets and also would not be able to adequately implement modern corporate finance techniques. A sole regulator provides the
most pragmatic approach for the developing securities market in China.
The different levels of legislation create an environment where national regulations
may seem to conflict with regional rules, making interpretation difficult. In addition to inter-organisational fragmentation, there are also problems within regulatory agencies, notably the CSRC, which i s significantly understaffed and has lacked
adequate authority to impose its regulations, especially at a regional level. There is clear duplication between the CSRC and the municipal securities regulatory
authorities. The current division of regulatory responsibilities between the CSRC
and the PBC leads to instances where de facto there is little regulation (eg, in the
monitoring and regulation of the activities of securities dealers). This has also led
to problems of co-ordination. A recent example is the CSRC's market support
package announcement at the end of July 1994, which included provisions for a
line of credit for securities dealers. Although consulted prior to the announcement
of the package, the PBC maintained strong reservations about the credit line, due to its concern over aggregate credit. t h e premature announcement damaged the
credibility of the regulators.
The medium term: Government control versus self-regulation
Current self-regulatory framework in China
There are no laws underpinning the concept of self-regulation, other than Document No. 68 and the Interim Securities Regulations referenced above. Draft versions of the proposed securities industry legislation have discussed the concept
of a self-regulatory association with possibly mandatory membership for securities
firms, but whether the self-regulation of stock exchanges is also contemplated is
not known.
Various securities industry organisations in China (including the two formal
exchanges, STAQS, NETS, the SEEC and the Securities Association of China (SAC)) are today referred to as self-regulatory organisations but, in reality, none of them
completely fulfil such functions. In addition, it i s suggested that a new self- regulatory organisation i s being set up in Shenzhen, at the request of the Shenzhen Securities and Exchange Commission, to be known as the Shenzhen Association
of Securities Dealers. This organisation has not yet commenced operations. There is some discussion that a securities association self-regulatory organisation be
established in each province.
The two Stock Exchanges and the two trading systems regulate their marketplaces
in terms of listing and trading rules, but do not appear to have any conduct
regulations governing sales practices or other activities of their members. They do not perform regular inspections of their members to determine compliance
with the law and their own rules. They do not have adequate staff to do so. In fact, the CSRC has raised questions as to the commitment of the exchanges to
compliance by listed companies with continuing disclosure requirements. In this
connection, it is noted that the exchanges are very competitive and do not want
to lose listing to the other exchange. The CSRC also reports that the companies
themselves are not conscientious in complying with disclosure requirements, as
these represent a major departure from the practices they adhered to when they were state owned. Neither of the stock exchanges operates a market surveillance
system but an advanced electronic system is in the process of implementation.
STAQS does not operate such a system, and while NETS purports to, no details
are available. NETS has very few listings at this time and surveillance should not
be a problem. The SAC was established as a regulatory body but officials admit
that it has been slow to fulfil this role. Its primary function at this time is training
industry members. It has expressed that it intends to engage in member regulation
and to conduct a periodic examination programme in the future. It also asserts
that it plans to operate an arbitration programme.
New self-regulatory organisations Irrespective of the role SAC plays in the future of self-regulation in China's securities
industry, it would be a mistake to create any additional securities associations
with a view that they be self-regulatory organisations. The optimum situation and
the least costly to the industry would be that there be only one such organisation
nationwide. It may be that ultimately regional branches of the nationwide
organisation would be necessary. With only one organisation rather than a
multiplicity, not only would overall costs be lower, but uniformity of regulation
could more nearly be guaranteed. Self-regulation does not properly serve its intended purpose if regulation is more strict or more lax in one part of the country
than it i s in another.
The status of the informal trading centres in this respect is uncertain. While these
entities are considered neither exchanges nor self-regulatory organisations, they
must be considered when looking at the potential self-regulatory structure of the
securities industry in China. At some point their status will undoubtedly be clarified and it i s not inconceivable that they will be considered exchanges or some variation thereof. As such they will probably be considered self-regulatory organisations at
least regarding the operation of their marketplaces. At present, they cannot be
regulated by the CSRC. The CSRC has stated that their status is currently under review and action to legalise them may be taken in the future.
Self-regulation in securities markets
Self-regulation when applied to a Stock
Exchange implies that order w i l l be
maintained, according to a prescribed set
of rules, where standards are checked by
a regulatory authority, in parallel to a
system of peer regulation by which
members discipline other members as
necessary, for any transgressions. It has
been described as 'enlightened self-
interest' but the framework must also be
capable of protecting the public interest.
Self-regulation has the fo l lowing
advantages:
the operations of the market are
regulated by practitioners, ie, those
who are the most knowledgeable and
up to date on the matters being
regulated
flexibility and adaptability, so that the
system can keep up to date with
market conditions, and
cost effectiveness, relative to a
complete scheme of statutory
regulation, i s another claimed
advantage.
Its disadvantages are that:
it can allow conflicts of interest to
arise, such as when an exchange
owned by its members regulates these
members. Various self-regulatory
organisations are said to have been
'taken over' by the industry which
they regulate, and then used to
enforce anti-competitive rules
it requires a genuine commitment to
self-regulation which may not be
forthcoming in practice, even if in
theory the concept is welcomed.
Self-regulation may cease t o be
appropriate:
i n start up situations, where
participants are unfamiliar w i th
market operations
in situations where the government
may have to make major macro-
economic decisions which may be
outside the scope of normal market
operations
where there are multiple exchanges,
some or all based on international
electronic networks, unless
sophisticated arrangements for lead
regulation are already in place
where there might be major
dupl icat ion o f effort (eg i n the
regulation o f primary market
functions
where many international players are
involved, thus increasing the
opportunity for cross-border fraud.
Some exchanges confuse self-regulation
w i th an absence of regulation or
legislation, and when stating that they are
pursuing self-regulation, are really aiming
for the removal of legislation. There are
few markets running without any specific
securities legislation. Thus self-
regulation, although presently
+
widespread among securities exchanges,
and generally considered the best way
to operate among mature markets, is not
always the most appropriate and needs
strong statutory regulation to back it up.
Mature markets: the U K and the USA Self-regulatory schemes in developed
markets range from the US institutional
model where categories of market
participants are defined and the duties
which each type of participant must
undertake are specified, to the UK
functional model, where the activities in
need of supervision are identified and
regulation for each of these activities i s
specified. Self-regulatory status is granted
to exchanges and other industry bodies,
in the US notably to associations of
brokers, who are required to set rules
which they must then enforce on their
members. At the moment i t is widely
accepted that the SEC model in the US i s
less cumbersome than that in the UK.
Prior to the introduction of the 1986 Act,
London used to be a good example of
almost 'pure' self-regulation. There was
a long established system of self-
regulation which was rigorously applied
by practitioners to themselves. The codes
of honour and peer pressure were very
effective in exacting compliance with the
spirit as well as the letter of rules and
regulations. Since the 1986 UK Financial
Services Act was implemented, the
situation i s considered by many to have
deteriorated. With the advent of greater
formality in regulation worldwide there
has arisen a situation in which a regulated
person or organisation w i l l tend to
interpret the law to his own advantage,
leading to the imposition of new rules to
plug any gaps. There i s thus a continuous
cycle of regulation, reaction and re-
regulation.
The situation in Asia Self-regulation is part of the manifesto of
only a few exchanges and the concept i s
not particularly well developed in Asia.
No mention i s made of self-regulation in
most Asian securities laws. In Hong
Kong, the Hong Kong Stock Exchange
claims it i s a self-regulatory body but the
term 'self-regulatory organisation' is not
mentioned in the law. It is however one
of the Hong Kong Securities and Futures
Commission's objectives to encourage
self-regulation. In practice it has had to
lead the Hong Kong Exchange on many
aspects of regulation.
Endnotes
1 Although some Ashare issues in 1994 were also offered outside the region in which the company
i s based.
2 The legal framework for the financial system in China has generally taken the form of regulations, of which there are now more than 250. Legislation in China can be classified into regulations
promulgated by, in descending order of importance:
1 .The National People's Congress
2.The State Council and its ministries, and,
3. Provincial and municipal authorities.
As a rule, the National People's Congress enacts laws which are general in nature. Authorities at
a lower level in the hierarchy will, following the same principle, issue more specific rules and
regulations, which fit the context of the local environment. Provisions issued by the lower level
authorities are more specific in application and tend to have a more limited sphere of influence.
The interlocking rules and regulations, though opaque at first glance, are not haphazard. Appendix
Table A2.1 illustrates the structure of securities regulation in China.
Annex 2.1 lists current laws and regulations relevant to the securities markets, pointing out which
are of national and which are of regional/municipal scope.
Responsibility for drafting the national securities law has been with a State Council group. The
CSRC, although the proposed executor of this law, is able only to comment on the drafts produced
by this group. Divergence between legal views and the view of experienced market practitioners
is universal. Eventually, it is importantthatthe law should reflect market realities. The main areas
of the national securities law still under discussion include:
the relationship between the central and local government regulatory bodies
the role of self-regulation, and,
the scope for a national over-the-counter market for stocks that do not meet the listing
requirements of Shanghai securities exchange and Shenzhen securities exchange.
The SCSC consists of 14 representatives from relevant government departments, including the
Ministry of Finance (MOF), the State Planning Commission (SPC), the Ministry of Foreign Trade
and Economic Co-operation (MOFTEC) and the State Commission for Restructuring the Economic
System (SCRES). The Chairman of the SCSC is the Vice Premier for economic affairs (Zhu Rongji).
There is an interlocking arrangement of senior officials between the SCSC and the CSRC which
facilitates co-ordination. For example, the Chairman of the CSRC is also the first Deputy Director
of the SCSC. The Vice Chairman of the SCSC is common to the CSRC.
The split structure is similar to that recently introduced in Thailand. Regulation in places like the
United States and Hong Kong is operated through a single body, with executive commissioners,
but there is no overall balance of benefit in a unified approach. The two-tier approach, with its
inherent checks and balances may be preferable in a new market. Appendix Table A2.2 shows
the structure of regulatory bodies in other Asian countries.
Thus at present, the Shanghai Securities Commission is clearly not a branch of the CSRC. The
draft national securities law envisages regional presences of the national body and it would be
open to these municipal bodies to take on such responsibilities.
In addition, the CSRC is responsible for supervising commodities futures trading.
An example is the PBC's periodic regulations concerning the money market. An issue of concern
for some years has been the tendency of interbank loans to lengthen in maturity. Thus in 1986, the
PBC issued a regulation in which the term could be settled between the two parties. In 1987 the
PBC limited the term of loans to less than four months. In 1988, the PBC reiterated that borrowing
should be used only for short, rather than long term. In March 1990 the PBC limited the term to
generally one, and not exceeding four, months. In February 1992, the term was limited to one
month, and most recently, in June 1993, the loans were limited todaily transactions in principle,
not exceeding 7 days.
Financial derivatives are under the jurisdiction of CSRC (Futures Department), but bond market
trade surveillance is under the PBC. Overseas derivatives activities by Chinese entities are usually
confined to exchanges acceptable to the CSRC, such as the CBOE and clearing members of the
exchanges.
Variable margin deposits had been recommended for China's commodities futures markets in
World Bank (1 994).
Dividends and other distributions to non-PRC investors must be denominated and calculated in
local currency, but paid in a foreign currency. A company may provide in its articles for another
company to make these foreign currency payments on their behalf. This enables H share issuers
with foreign subsidiaries to utilise the foreign currency earnings of their subsidiaries to pay dividends,
rather than having to repatriate and convert the foreign currencies into and out of local currency,
For example, shareholders must indicate whether they wi l l attend, and a meeting cannot be held,
even if all shareholders attend, if they have not previously indicated as much. This is an unusual
requirement, contrary to conventional principles of company law which hold that shareholders
have an automatic right to participate in shareholders' meetings. Yet it is an example of a clause
with 'Chinese characteristics' - a fundamental principle subordinated to pragmatism. There could
be severe practical difficulties if the venue is too small.
The Standard Opinions governed companies limited by shares and limited liability companies
throughout China, excluding companies established under the authority of the Shenzhen
municipality which 'may continue to implement the Shenzhen Interim Provisions'. In terms of
legal status the Standard Opinion was equivalent to administrative measures promulgated by
ministry level entities. In addition, there are regional companies regulations which are still in
force; the first of which was the Shenzhen Company Law, followed by the Shanghai Company
Law. The Shenzhen regulations, for example, are applicable not only to companies limited by
shares established in Shenzhen but also to companies established outside Shenzhen with shares
listed on the Shenzhen securities exchange.
The law gives a grace period, unspecified, but understood by the CSRC to be from three to five
years, for companies formed under the standard opinion to comply with the new law.
The proper relationship between banking and securities broking is a contentious issue and the
trend today in many developed countries is towards 'universal banking'. However the US Glass-
Steagall Act still seeks to keep the traditional banking operations of deposit taking and loans
separate from all securities business, although there have been calls forthe removal of this restriction,
which has been seen as a competitive disadvantage in the international context. In Japan, which
was based on the US model, a recent change has allowed banks to set up securities brokers as
separate, wholly-owned subsidiaries. A detailed treatment of this subject is beyond the scope of
the present study.
Press education has been invaluable in a number of developing markets. Although scarcely of
comparable size, Sri Lanka adopted a policy years ago that responsible financial journalism was
one of the keys to their development and this campaign has been most successful.
In Hong Kong in the early 19705, following the early amah boom and bust, the Securities
Commission had a very successful 'Investigate before you Invest' campaign.
In 1993, the CSRC sought to ensure an even distribution of the national share issuing quota by
limiting each province to a maximum of two enterprises per year, but this was dropped in 1994,
since the restriction (August 1994) on issuing A shares.
Details of clearances for listing at the central and local levels are given in Annex 2.2.
22 The government's reaction to poor performance in the A share market has been highly
interventionist. O n 29 July 1994 the indices reached record lows of 328.85 on the Shanghai
securities exchange (record low for post-1 992) and 95.26 on the Shenzhen securities exchange,
after declining by more than 5 per cent per week for several weeks. O n the same day, the CSRC,
in consultation with the SPC, SCRES and the SETC, announced a series of measures intended to
boost the market:
a ban on all further issues of Ashares until further notice
the provision of a RmblO billion (US$1.15 billion) credit line to securities firms to encourage
trading
new regulations for foreign securities firms aimed to eventually allow them to buy Ashares,
and,
the eventual merger of A and B shares.
The proposals were not implemented. But meanwhile the market's reaction to the package was
both immediate and extraordinary. By 8 August 1994, the indices had risen to record highs of
729.52 on the Shanghai securities exchange (an increase of 122 per cent in one week), and
163.79 on the Shenzhen securities exchange.
23 Article 174 states that 'a company shall establish its financial and accounting system according to
the laws, administrative regulations and the regulations of the responsible finance department of
the State Council'. Article 175 states that at the end of each fiscal year the company shall prepare
a financial report which shall be examined and verified as provided by law.
24 The Company Law requires the financial report to include the balance sheet, profit and loss
statement, statement of financial changes, explanation of financial conditions, and profit distribution
statement. CSRC's requirements include: an interim report in the first six months of each financial
year and an audited annual report. The reports must comply with the accounting standards of
China and the relevant regulations of the CSRC.
25 In most countries, the detailed contents of annual reports are specified in a companies law (eg,
UK) or in relation to companies that issue shares to the public in a securities law (eg, USA) with
additional requirements imposed by the exchange where the company is listed. The accounting
standards are normally set out in the accounting law or by the professional accounting body of
the country and supplemented by detailed guidance on how to prepare annual (and other periodic)
reports for public companies.
26 Significant events include instances when:
the company enters into a material contract which may substantially affectthe assets, liabilities,
rights or results of the company
a substantial change in the business policy or operations of the company
the company makes a substantial investment or acquires a long-term investment involving a
large amount of money
the company incurs substantial debts
the company fails to repay a substantial debt
the company incurs substantial operating or non-operating losses
the company suffers a substantial loss of its assets
there is a change in the production and business environment of the company
newly-promulgated legislation, regulations, policies or rules, etc, substantially affect the
business of the company
there is a change of chairman, in over 30 per cent of the directors or in the general manager
a shareholder who holds over 5 per cent of the ordinary shares in issue increases or reduces
its holding by 2 per cent or more of the issued shares
the company becomes involved in major litigation, and,
the company goes into liquidation, or bankruptcy proceedings are commenced.
When reported news is misleading and affects the market price of the shares of a listed company,
the company must immediately issue a public clarification.
27 However, foreigners who hold B shares are not subject to this restriction.
28 However, the new Company Law states that the directors must declare their shareholdings to the
company and may not transfer such shares during their term of office. These provisions are in
conflict.
29 International rating agencies (eg, Standard and Poor's and Moody's) have been increasing activities
in Asia. Standard and Poor's rates China at a BBB- and feels that this rating wi l l continue until
China clarifies its political structure. S&P, which opened an office in Hong Kong in early 1995,
estimated that it would have rated 50 public Chinese and Hong Kong companies by the end of
1995. Moody's established an office in Hong Kong in mid 1994 and would be expected to assume
a similar pace of development.
30 During 1992, there was much debate as to whether the PBC, which would be a major player in
the capital markets, should also be the regulator of these markets. In particular, the State Commission
for Restructuring the Economic System (which has been responsible for the reform of state-owned
enterprises) is said to have lobbied hard for the creation of a separate regulator for securities
markets.
31 In early March, 1995, the Shandong Bohai group, a state-owned conglomerate, refused to pay a
Rmbl million fine imposed by the CSRC, after the company manipulated its own share price.
Shandong Bohai pushed up its share price on the Shanghai Stock Exchange in August 1994 by
102 per cent, and earned Rmb5.9 million through illegal trades. The company said it had already
paid Rmbl.6 million in fines to the Shandong provincial securities commission. The case also
illustrates thedifficulties of overlapping central and regional regulatory authorities. (Bloomberg, 9
March 1995).
ANNEX 2.1 CHINA: LAWS AND REGULATIONS RELATED TO SECURITIES ACTIVITIES'
Regulations of national scope
Accounting
( 1 ) Accounting Regulations for Selectedjoint Stock Limited Enterprises (1 January
1992)
(2) Accounting Standards for Enterprises (1 July 1993)
(3) Provisions on the Qualifications ofAccounting Firms and Certified Accounts
in Securities Business (23 February 1 993)
(4) General Financial Regulations for Enterprises (1 July 1993)
Companies
( 1 ) Companies Law (1 July 1994)
(2) Standard Opinion on Companies Limited by Shares (Promulgated on 15
May 1992)
(3) Addendum to the Standard Opinion on Companies Limited by Shares
Applicable to Companies to be Listed in Hong Kong (24 May 1 993)
(4) Measures for Trial Shareholding Enterprises (Promulgated on 1 5 May 1992)
(5) lnterim Provisions for the Administration of State-owned Assets in Trial
Shareholding Enterprises (27 July 1 992)
(6) Interim Provisions on the conduct of Business Relating to Trial Shareholding
Enterprises by Registered Accountants (1 7 September 1992)
(7) Special Regulations Relating to Shareholding Companies Issuing Shares and
Listing Abroad (made under the Companies Law) .
Securities regulations
( 1 ) Interim Regulations on Share Issuing and Trading (22 April 1993)
(2) lnterim Measures Governing Securities Exchanges (7 July 1 993)
(3) Provision on Qualification Confirmation for Asset Valuation Institutions
Engaging in Securities Business (20 March 1993)
(4) lnterim Provisions of the Ministry of justice and the China Securities
Regulatory Commission on the Qualification of Lawyers and Law Firms
Engaging in Securities Law Business (1 2 January 1993)
(5) Detailed Implementing Rules on the Disclosure of Information by Companies Making Public Offerings of Shares (for Trial Implementation) (1 0 July 1993)
(6) Rules ofcontents and Format of Information Disclosed by Cornpanies Issuing
Public Shares No. 1 : Contents and Format of Prospectus {Experimental)
(7) Rules of Contents and Format of Information Declared by Cornpanies Issuing
Public Shares No. 2: Contents and Format of Annual Report (Experimental)
(Promulgated 31 March 1994)
(8) Rules on Rights Issues for Listed Companies
Bankruptcy law
(1 ) Law of the People's Republic of China on Enterprise Bankruptcy (for trial
implementation) (enacted on 2 December 1986) (Only covers state-owned
enterprises)
Securities commission
(1 ) Notice From the State Council Regarding Further Strengthening of the Overall Administration of the Securities Market-Document No. 68 (Promulgated on
1 7 December 1 992)
(2) Code of Conduct for the Personnel of the China Securities Regulatory
Commission (24 July 1993)
Note: There are no national regulations on B share issues.
Regional/Municipal Regulations
Shanghai
Companies
(1 ) Shanghai Interim Provisions on Companies Limited by Shares (1 July 1992)
Securities regulations
(7) Shanghai Measures for the Administration of Trading in Securities (1
December 1990)
Stock exchange rules
(1 ) Shanghai Securities Exchange Trial Implementation Rules for Trading Market
Operations (26 November 1990)
B shares regulations (1 ) Shanghai Measures for the Administration of Special Renminbi Shares (22
November I 991 )
(2) Implementing Rules to the Shanghai Measures for the Administration of
Special Renminbi Shares (25 November 1991 )
(3) Shanghai Securities Exchange Supplementary Rules on Trading Market
Operations forspecial Renminbi Shares (Promulgated on 18 February 1992)
(4) Shanghai Renminbi B Share Provisional Operational Principles, including
Application Procedures for Special B Share Seats (May 1993).
Shenzhen
Accounting (1) Shenzhen Special Economic Zone Accounting Standards (Trial Basis) (1
January 1992).
Companies (1 ) lnterim Provisions of Shenzhen Municipality on Companies Limited by Shares
(1 7 March 1992)
(2) Shenzhen lnterim Measures for the Supervision and Administration of Listed
Companies (4 April 1 992)
(3) Regulations of Shenzhen Special Economic Zone Governing Companies
Limited by Shares (2 October 1 993)
Securities regulations (1 ) Shenzhen lnterim Measures for the Administration of the Issue and Trading
of Shares (1 5 June 1991)
(2) Shenzhen lnterim Provisions for the Administration of Securities Institutions
(25 June 1991 )
(3) Shenzhen lnterim Measures for the Administration of Internal Share
Instruments (26 February 1992)
(4) Operating Rules of the Shenzhen Stock Exchange (22 June 1991)
(5) Shenzhen Implementing Rules for the Centralised Custodianship
(Promulgated on 28 December 1991)
(6) Shenzhen lnterim Measures for the Administration of Special Renminbi Shares
(5 December 1 99 1 )
(7) Shenzhen Stock Exchange Operating Rules for the Trading and Clearing of B
Shares (31 January 1992)
(8) lnterim Regulations on B Share Crossed Transactions on the Shenzhen Stock
Exchange (1 0 October 1993)
Notes
1 Dates refer to effective date unless otherwise noted.
ANNEX 2.2 CENTRAL A N D LOCAL AUTHORITIES' APPROVALS REQUIRED FOR LISTING
Central Authorities: the CSRC
According to the new Companies Law and the Interim Securities Regulations
issued pursuant to Document 68 in all listings must be approved by the SCSC/
CSRC. Shareholding companies are selected after an exhaustive approval process
under which the entities must meet criteria for assets, management and profitability.
Among the documents required are:
an approval from SCRES
three years' audited accounts an asset statement audited by an approved accountant certifying the company's
net asset value, and, a statement as to the reasons for issuing shares.
The CSRC approval is then given pursuant to both the Company Law and the
Interim Regulations. The lnterim Securities Regulations include the following
provisions in relation to the issue of shares:
The issuer of securities must be a joint stock limited company which has been
established, or which has been approved to be established, which is entitled to
issue shares, and which complies with the following criteria:
it may only have one kind of ordinary share, all of which must carry the same
rights and obligations the value of the shareholdings subscribed by the promoters must not be less
than 35 per cent of the total number of shares to be issued by the company
the shares to be subscribed by the promoters must not be less than Rmb30
million (US$3.75 million), unless otherwise provided by the state the portion issued to the public must not be less than 25 per cent of the total
shares to be issued.
If the enterprise has recently been converted into a joint stock limited company, it
must also meet the following criteria:
at the end of the year prior to the issue, the proportion of net assets must not be
less than 30 per cent of the total assets, and the proportion of intangible assets
must not be higher than 20 per cent of the total assets it must have made a profit in each of the last three years.
Public share issues must be underwritten by a securities institution.
Article 84 of the Company Law requires that when the promoters of a company
offer shares to the public, an application for approval of the offer must be submitted
to the SCSC/CSRC with the prospectus and:
documents proving the establishment of the company
the company's articles of association
the operating budget the promoters' names, the number of shares subscribed by the promoters, the
type(s) of capital contribution and investment verification certificate names and addresses of the receiving bankers, and,
the names of the underwriters and relevant agreements
This multiple set of approvals is complicated. In practice it occupies a substantial
amount of regulatory time both at CSRC and Municipal level.
Listing In practice the CSRC state that approval for IPOs and listing are synonymous - a
company cannot have an IPO unless it has a listing. This is along the US merit
regulation lines.
Local Authority clearances for listing
Under Chapter 2 of the Shanghai Securities Regulations a company which wishes
to issue securities to the public in Shanghai must obtain the prior approval of the
SHSEC. At least 30 per cent of the company's shares must be subscribed by the
company's promoters.
Under the Shenzhen Securities Regulations a company must obtain the prior
approval of the SZSEC and the PBC (Shenzhen Branch). Article 1 5 of the Shenzhen
Securities Regulations states that a company must meet the following conditions
in order to apply for a public issue of its shares:
the establishment or restructuring of the company must have been approved
by the relevant administration departments of the state the production and operation of the company must meet the requirements of
the business and industrial policies of Shenzhen the financial status and business achievements must be good, and its net assets
must not be less than RmblO million (US$1.25 million) the ratio of net tangible assets to gross tangible assets one year prior to the
application must not be less than 25 per cent the promoters must purchase shares worth not less than Rmb5 million
(US$625,000) or 38 per cent of the total issued shares of the company stock offered to the public should not be less than 25 per cent of the total
issued shares of the company (the relevant authority can increase the ratio of
the public float according to circumstances) the company must have not less than 800 shareholders, and,
the applicant enterprise and its promoters must have had a clean legal record
for the previous three years.
ANNEX 2.3 CENTRAL AND LOCAL REGULATIONS: LISTING CRITERIA
National Regulations: Interim Securities Regulations and Companies Law
Under the Interim Securities Regulations a joint stock limited company applying for a listing must meet the following conditions:
its shares must have been issued to the public
the total amount of its share capital after the public issue must not be less than
Rmb50 million (US$6 million)
there may not be less than 1,000 individual shareholders each holding shares
of more than Rmb1,OOO face value, and the total face value of shares held by
individuals shall be not less than RmblO million (US$1.25 million) the company must have made a profit in each of the last three years (this
requirement does not apply to a newly-formed joint stock limited company),
and, any other conditions imposed by the SCSC.
The new Company Law also contains listing conditions which do not conflict
with, but are not identical to, the requirements laid down in the lnferim Securifies
Regulafions. The conditions require that the company:
has share capital of at least Rmb50 million (US$6 million)
is newly-formed under the new Companies Lawou has a three-year track record
has more than 1,000 shareholders who each hold shares with a nominal value
of over Rmb1,OOO has offered at least 25 per cent of its shares to the public (or at least 15 per cent
if the share capital of the company i s more than Rmb400 (US$46 million)),
and,
has not committed any serious violations in the last three years.
The CSRC is named in the Company Law as the authority to which a listing
application must be made and is given authority to suspend a listing if the company:
no longer has sufficient capital or distribution of shareholders makes no accounting disclosures, or makes false disclosures
commits a serious violation of the law, or,
suffers losses for three continuous years.
Regional listing conditions
For an enterprise to be listed on either the SHSE or the SZSE it must first be converted
into a joint stock company limited by shares.
Once converted into a joint stock company, the cornpany must meet the criteria set out below to be listed on the SHSE or the SZSE.
Basic conditions for listing on the SHSE
Under the rules of the SHSE, to be listed on the Main Board, a company must meet, inter alia, the following criteria:
it must be registered with the Shanghai Department for the Administration of
Industry and Commerce
its paid-up capital must be at least Rmb5 million (US$625,000) at least 25 per cent of the total issued share capital must be issued to the
public the company must have at least 500 registered shareholders
it must have been operating profitably for at least two consecutive years prior to the listing it must be sponsored by at least one member of the SHSE, and,
it must periodically announce its operating results in at least one newspaper
in public circulation.
To be eligible for a second section listing, a company must:
have a paid-up capital of not less than Rmbl million (US$125,000)
have at least 300 registered shareholders, and, be at least 10 per cent publicly held.
Listing B shares on the SHSE
A company applying to issue B shares on the SHSE must be a company limited by
shares, the establishment of which has been approved by the relevant authority.
All issues of B shares on the SHSE must be approved by the PBC.
An issuer of B shares must, when satisfying the requirements setout in the securities
regulations, meet the following conditions:
It must have obtained approval from the relevant authorities for its use of
foreign investment or for its conversion into a foreign-funded enterprise. Funds raised from its B share issue must be applied in accordance with PRC laws and
regulations relating to the administration of foreign investment. It must have a stable source of adequate foreign exchange income, and the
total amount of its annual foreign exchange income must be sufficient to pay
the annual dividends.
The proportion of B shares to the total number of shares, in a company which
has been restructured from a SOE, must not exceed the ceiling determined by
the relevant authority.
Basic conditions for listing on the SZSE
A company applying for listing on the SZSE must meet the conditions required by
the Shenzhen Securities Regulations for a public issue of shares (see above), as
well as the additional conditions set out in Article 37 of the Shenzhen Securities
Regulations.
The additional requirements set out in Article 37 of the Shenzhen Securities
Regulations are as follows:
the principal business of the company should have a three-year trading record,
and a continuous history of making profits the face value of the ordinary shares issued must not be less than Rmb20
million (US$2.5 million) the ratio of the net tangible assets to the gross tangible assets in the latest year
of the trading record must not be less than 38 per cent and there should be no
accumulated losses (there are specific requirements for special industries) the ratio of the profits after tax to the yearly paid-up capital for the first two
years of the trading record must not be less than 8 per cent and that of the most
recent year must not be less than 10 per cent, and, the shareholdings must be reasonably distributed. The number of registered
shareholders must not be less than 1,000. All the shareholders who individually
hold not more than 0.5 per cent of the total issued shares must together hold
not less than 25 per cent of the total paid-up capital.
Article 38 of the Shenzhen Securities Regulations further provides that a company
which has not yet made a public issue must have a three-year trading record, and
its shares may not be transferred or traded until six months after thle public issue.
If a company applies for a subsequent issue of shares, the Shenzhen Securities
Regulations state that the following conditions must be met:
its business achievements since the time of the previous issue must have been
sound, and its application of funds must have been of a better standard in
comparison with other companies in the same industry sector
not less than one year must have elapsed since its last share issue
the account of the further issue must not exceed the amount of its existing
issued shares (ie a maximum one for one rights issue)
its application of the funds previously raised must accord with the industrial
policies of Shenzhen, and, the issue must be beneficial to the healthy development of the Shenzhen
securities market.
The new National Regulations on Rights Issues will also apply.
Listing B shares on the SZSE
A company applying to issue B shares for listing on the SZSE must meet the
following conditions:
it must have obtained written documents issued by the relevant PRC authorities
approving its utilisation of foreign investment or its conversion into a
foreign-funded enterprise (funds raised from its B share issue must be applied
in accordance with PRC laws and regulations relating to the administration of
foreign investment) it must have a stable source of adequate foreign exchange income, and the
total amount of its annual foreign exchange income must be sufficient to pay
the annual dividends the proportion of B shares, including the sponsors' shares, to the total shares of
the company must not exceed the ceiling determined by the relevant authority,
and, the company must have been operating for at least three years. This condition
does not apply to those companies in the field of science and technology, or
in other special areas as approved by the relevant authority.
ANNEX 2.4 THE TRADING SYSTEMS
Despite the fact that both Shanghai Stock Exchange and Shenzhen Stock Exchange
retain floors, they both operate essentially floorless systems. The Shenzhen Stock
Exchange i s working towards eliminating the floor, so that brokers operate from
their offices. This is the most efficient method provided there are adequate
computer back up systems. The Shanghai Stock Exchange are increasing their
floors to eight in number. They believe that they can keep a better control of the
market by being able to physically watch what is going on, and they also prefer
the floor approach as it gives a market atmosphere. There are merits in both
approaches. The Shanghai Stock Exchange's approach is in line with modern
trends and appears advisable for the present.
Shanghai Stock Exchange trading system for A shares
The Shanghai Stock Exchange is open Monday to Friday and has two trading
sessions each day. Opening prices for Ashares are established during a preliminary
group trading session that takes place from 9 am to 9.25 am. Although trading i s computerised, the Shanghai Stock Exchange want to retain their trading floors so
that management and supervision i s easier and the atmosphere of a traditional
market is retained. At present, the Shanghai Stock Exchange has seven trading
floors and the eighth i s about to open. The main floor has 21 5 out of the total of
3,154 seats to accommodate 527 members.
Trading in securities in Shanghai is limited to members of the Shanghai Stock
Exchange. Only securities approved for trading by the Shanghai Branch of the
PBC may be traded on the Shanghai Stock Exchange or over-the-counter in
Shanghai. No futures or options trading in equity shares i s permitted, as all trades
must be spot transactions.
Before dealing on behalf of a client, a broker must open a stock account for the
client which i s registered with the Shanghai Stock Exchange. The investor i s
assigned an account number with the exchange and his shares are kept in the
Shanghai Stock Exchange. An investor may use any broker to buy and sell.
Brokers may not accept discretionary accounts. Trading i s conducted in board
lots of shares with a face value of Rmbl times 100 shares ( Rmbl00) and bonds
with a face value of Rmb1,OOO. Orders must be routed to the broker's dealer on
the floor in strict time sequence.
The trading rules of the Shanghai Stock Exchange provide for trading by open
outcry, auction bidding and computerised trading. Most trades are executed on
the Shanghai Stock Exchange's computerised trading system except in special
circumstances. Orders entered into the system are valid within the day. Orders are automatically matched on a strict time-price priority basis.
Prior approval from the Shanghai Stock Exchange is required before a broker can
execute a fixed-day trade.
Shenzhen Stock Exchange trading system for A shares
The Shenzhen Stock Exchange i s open for trading from Monday to Friday and has
two trading sessions each day. Trading on the Shenzhen Stock Exchange is fully
automated. Computerised orders are entered through terminals and are valid
within the day. The input of orders starts half an hour before the opening of the
centralised market. After the orders are accepted by the main computer, automatic
matching occurs, starting from the opening of the market. The matching of orders
i s on a price-time-order priority basis. Both centralised bidding and continuous
bidding are used. Centralised order matching is used for the opening and closing
of the market. Continuous order matching i s used when the opening price cannot
be generated from centralised order matching.
Once orders are transacted, a transaction slip is printed out on the relevant broker's
printer, which contains the broker's code, order number, type of order, securities
code, transaction quantity, transaction price, transaction amount, buy or sell order,
trading as an agent or trading on own account, and the transaction time.
Shares are traded in board lots with a face value of Rmb100 and bonds in lots
with a face value of Rmb1,OOO.
ANNEX 2.5 RESTRICTIONS AGAINST INSIDER DEAI-I NG
No institution or individual can carry out the following activities:
illegally obtain insider information, disclose insider information, sell or purchase
in accordance with such insider information or suggest to others to sell or
purchase such shares (insider dealing) carry out share trading in places other than the securities trading venues as are
authorised by the SCSCICSRC to carry out share trading (off market dealing) provide false or seriously misleading descriptions or omit to disclose significant
information in the process of the issuance and trading of shares
control the market prices of shares by conspiracy or by pooling together of
funds, or by rumours or other methods affecting the issuance and trading of
shares (price rigging)
conspire with others in creating false share prices
fail to transfer the ownership or actual control of the shares and thereby create
false sales and purchases
sell or offer to sell shares which it does not hold, disrupting the order of the
share market (short-selling)
through using official powers or other illegal methods, obtain or forcibly sell
or purchase shares, or assist others to sell or purchase shares
carry out the trading of options and futures on shares or share indices without
approval
not carry out the obligation to disclose and publish reports of relevant
documents and information in accordance with relevant regulations
make false business reports, financial accounts and other documents related
to the trading of shares, or amend or destroy the same without authority
participate in the illegal issuance and trading of shares and other related
activities.
All of these are fairly standard prohibitions.
ANNEX 2.6 REGULA-TION OF SECURITIES DEALERS
Shanghai
In Shanghai, the Rules Relating to the Supervision o f the Trading o f Securities i n
Shanghai Municipality, prohibit all people from engaging in securities business
without the approval of the Shanghai branch of the PBC. These rules were
promulgated by the Shanghai Municipal People's Government on 27 November
1990 and effective from 1 December1 990, (the Shanghai Securities Regulations).
Securities business i s defined as consisting of:
distribution and marketing of securities
buying and selling of securities for one's own account securities brokerage (ie agency work)
investment trust business involving securities
securities financing
registration, certification, settlement and payment of securities, or acting as a
central custodian, fiscal agent or registration agent of securities acting as a consultant on such matters as securities issuance and investment,
and,
other securities-related business.
To be approved as a securities dealer, the proposed dealer must:
meet the need to develop the securities business possess a complete set of articles of association and qualify as a legal person
have professional personnel capable of running a securities business, and,
have a paid-up capital that complies with the regulations, or, if it i s to engage
in securities business as a sideline, to have separately audited working capital.
When applying for approval to establish as a securities dealer, the following
documents must be submitted to the PBC:
an application report and a feasibility study on the establishment of the securities
dealer the dealer's articles of association
the name and resume of the main responsible person for the securities dealer,
and, any other documents which the PBC considers necessary to be submitted.
Shenzhen
In Shenzhen, the Shenzhen Interim Measures for the Administration of the Issue
and Trading ofshares (the Shenzhen Securities Regulations), promulgated by the
Shenzhen Municipal People's Government on 15 May 1991 and effective from
15 June 1991, regulate the licensing and activities of securities dealers, and the
establishment. Securities dealers must be approved by the Shenzhen Branch of the PBC (SZPBC) and may engage in securities. Securities dealers may only engage
in those forms of securities business and securities-related business for which
they have been approved by the PBC.
To apply for a securities business permit, a securities dealer i s required to submit
an application to the PBC containing the following particulars:
name and domicile
registered capital
the form of organisation business resumes of directors, supervisors and managers, and details of their
shareholdings in the share company the articles of association and the internal rules and regulations
details of the manner in which it wil l engage in securities business, and,
any other particulars required by the PBC for investor protection purposes.
They will also be required to:
have capital of more than Rmb50,OOO comply with the requirements stipulated by the PBC in respect of its organisation
and operating personnel agree to comply with the articles of association of the SZSE, and,
pay a membership fee to the SZSE of not less than Rmbl million.
Under the Shenzhen Interim Provisions for the Administration o f Securities Dealers,
promulgated on the 12 June 1991 and effective from 25 June 1991, authorisation
by the PBC is contingent upon the applicant:
having a paid-up capital of not less than Rmbl 0 million (with Rmb5 million
for each branch). (In addition, if the broker is authorised to deal on its own
account, it must maintain a capital of Rmb20 million)
having a minimum office size and facilities as required by the PBC
having a minimum of 30 staff with a set number of economics university
graduates, and, observing the following capital adequacy requirements:
the capital use for buying securities must not exceed 60 per cent of the
company's capital; the holdings of one type of stock must not exceed 20 per cent of the
company's issued capital; and, the holdings of all securities of one enterprise must not exceed five per
cent of the issued capital of that enterprise.
The PBC can close down any broker which breaches these capital requirements
or, following warnings by the PBC, fails to remedy a breach of any regulation. A
broker and its branches must submit daily reports of securities trading to the SZSE.
Brokers (except those engaging in securities business as only part of their business)
must submit a balance sheet and other information required by the PBC within
one month after the end of each fiscal year. Changes of members' details (such as
changes in the capital amount, the articles of association, the directors, the
supervisors, the managers, or details of operation) must be reported to the SZSE, together with any relevant documents, within three days.
Introduction
In parallel to the economic reforms which China embarked upon from 1979, the
first signs of a capital market began, with the issuance of government debt in the
early 1980s. Early government bond issues were essentially a revenue mobilisation
effort, for the financing of the newly emerging deficit, and bond issues bore a
strong structural resemblance to taxes. In some cases, payments for government
bonds were deducted through payroll deductions or compulsory withdrawals from
bank accounts. Bonds were distributed through administrative placement
mechanisms, and their acquisition was involuntary. Rather like budgetary line
items, bond issues were often targeted to specific investments, and earmarked by
use, such as construction bonds for key national projects. Alternatively they were
classified by the 'tax base' on which they were administered, and thus fiscal bonds
were bonds which 'taxed' the banking system, placed at banks which were then
prohibited from trading them. A bewildering variety of bonds thus emerged
(Appendix Table A1 .I).
The development of a market in bonds began spontaneously, through the
emergence of large numbers of multiple illegal curb markets in government paper,
often at the doors of the PBC bureau charged with the task of administrative
placement. Individuals would seek to sell their paper, at a discount, and use their
increased liquidity for more attractive investments, emerging elsewhere in the
economy. Such trade was gradually legalised by the government, which began to see the difficulties of placing paper on unattractive terms. Bond maturities
declined and coupon rates increased, relative to deposit rates, as issues were
gradually tailored to public preferences. The development of secondary markets
was greatly boosted from 1990, with the establishment of official stock exchanges,
which could list bonds, and the onset of regionally interlinked electronic trading
through the STAQS system. China began to experiment with the use of more
market-based distribution systems through underwriters and primary dealers, and
in 1994 began to issue scripless bills. Since last year, the development of the
bond market has achieved great prominence, as the government has accepted a
restriction on financing its deficit through central bank borrowings, and is now
obliged to turn to the bond markets for this purpose.
This chapter examines the functioning of China's bond market today, to see how
it could better be equipped to meet its new role. The first broad conclusion i s that
the Chinese bond market today i s a market in transition, and is confronting critical
conflicts between the requirements of efficiently functioning capital markets, and
features inherited from the former planning system:
the credit plan administratively determined interest rates, and,
the absence of market pricing of risk.
Bond issuance is still essentially regarded as an alternative revenue mobilising
system, and an extension of the budgetary process, in terms of financing options
under the Credit Plan. Coupon rates are set with regard to the administratively
determined deposit rate and do not reflect secondary market yields. Since the
default risk of enterprises is still relatively low, bond pricing has not adequately
reflected risk differentials. In these circumstances, the link between bond market
activity and underlying real sector developments, in terms of raising or pricing
capital, is constrained, and the bond market cannot act as an efficient allocation
mechanism for capital, or pricing mechanism for risk.
As a result, many of the market's features are contradictory. Secondary market in
bonds using relatively sophisticated trading technology, futures contracts and
repurchase agreements coexists with interest rate regulation in the primary market
and the money market; a system of underwriters and primary dealers has been
established, but these entities continue to use a retail distribution system that was
originally used for forced placements of bonds; there are many credit rating
agencies and government bonds are liquid enough to begin to provide an indicative
benchmark interest rate, but the quantity of enterprise bonds issued i s determined
by the credit plan and, interest rate regulation aside, the virtual absence of a hard
budget constraint on many state owned enterprises has blurred distinctions of
credit quality.
The second broad set of conclusions is that the primary process of bond issue in
China still retains many features which arose from its historic origins as an
obligatory tax mechanism. These features would require modification if bonds
are to function as a capital market instrument. In particular, the lack of effective
competition between underwriters, the large and infrequent nature of government
bill issues, instead of issues based on a pre-announced year-round schedule, the
targeting of the retail investor base rather than recognising and differentiating
between wholesale and retail investors, the system of coupon determination, based
on deposit rates rather than market yields, the lack of coupon payments and the
method of determination of redemption amounts, and the continued use of quasi-
administered placement (through bank distribution quotas, at above-market interest
rates), are points to be addressed to improve the efficiency of the primary issue
process.
In terms of the development of secondary markets, China has made considerable
progress since 1990. Yet, there are still improvements to be made. The third set
of conclusions is that the market needs to increase its liquidity and to achieve
greater price unity. Key factors in improving market liquidity are the primary issue
design features referred to above. In addition, present constraints on the operation
of the money market need to be addressed, to provide funding for bond portfolios
and a reliable short-term yield benchmark. Greater price unity across different
regions today requires the creation of a centralised depository (or existing
depositories will be required to agree on a common set of operating standards).
Fourth, to reduce speculative tendencies, the volume and quality of information
in the market should be increased. This applies particularly to enterprise and
financial bonds. This entails the improvement of disclosure requirements and the
standardisation of listing requirements. Another element of this concerns the
development of credit rating agencies. It also requires the development of a class
of informed institutional investors (see Chapter 6).
Finally, bond markets need an appropriate environment in terms of a regulatory
framework. Although this has already been dealt with in Chapter 2, it i s reiterated
here, as it is in the area of bond trading that the present regulatory framework still
requires fortification. Recently issued regulations on futures trading are a change
in the right direction and the proposed new Bond Law would be a major step
forward.
China's Domestic Bond Market Development: A Chronology
Phase 1: Bond issues resume, 1987: An illegal black market in treasury asapart of the State Credit Plan bills spread rapidly, spurred by rising
inflation and more attractive alternative 1981-84 After more than twenty years, investments. Black market discounts on
China resumed the issue of domestic
bonds. The issue was s laced bv forced treasury bills could be 50 per cent or
greater. allocation, via quotas assigned to state
enterprises, col lectives and local
governments, who subsequently placed Phase 2: Official development
the bonds with individuals. The bonds of secondary markets
were non-negotiable and had a ten year
maturity. Afifth of the issue was redeemed
by lottery each year, after the sixth year.
In 1984, the Ministry of Finance (MOF)
extended the abi l i ty to issue debt
securities to the People's Bank (PBC) and
the State Planning Committee (SPC). Over
the next few years a range of debt issues
developed, much of which was placed
involuntarily via administrative methods.
1985: The Ministry of Finance reduced
treasury bill maturity to five years and
abandoned the lottery system for
redemption. The use of treasury bills as
collateral was permitted.
1986: The People's Bank extended the
power to issue bonds to specialised banks
(f inancial bonds) and enterprises
(enterprise bonds), initially in five cities
only. These bonds could be sold to
individuals on a voluntary basis. In
August 1986, an experimental market for
enterprise bonds was established in
Shenyang, rapidly followed by markets
i n Shanghai and Shenzhen. These
measures led to an upsurge in non-
Government bond issues.
1988-9: The Ministry of Finance further
reduced the maturity of treasury bills, to
three years. From April 1988, the trade
of treasury bills was permitted, two years
after their issue. Over-the-counter
markets were permitted and by the end
of the year, all major cities had treasury
bill markets. However, only trade within
the locality was permitted. In the same
year, the tradability of securities was
extended to other major bonds, and also
to shares, commercial paper and
certificates of deposit. Meanwhile the
PBC permitted banks to issue short term
CDs to individuals (subject to PBC
approval, and an overall local quota). In
1989, the Ministry of Finance issued the
first floating rate bonds.
1990: Trade in treasury bi l ls was
permitted as soon as a new issue was
completed. Later in the year, the transfer
of bonds between cities was permitted
(October 1990). The PBC established a
Quotation Centre to provide market
volume and price data to dealers in
different regions. In November, STAQS
began, providing a satellite link with real
+
time prices to dealers in six cities. Bond
prices began to converge. In December
1990, the Shanghai Stock Exchange officially opened, and permitted the
listing and trading of bonds. t h e annual
volumeoftreasury bill tradingforthe year
was Rmb10.4 billion.
Phase 3: Voluntary placement of treasury bills; growth of secondary markets
1991: In April this year, the Ministry of Finance began experiments with the
voluntary placement of treasury bills. A
part of the years issue was undertaken by an underwriting syndicate which
placed the treasury bills with their clients
on a voluntary basis. The volume of
treasury b i l l trading for the year was
Rmb34 billion.
1992: The Wuhan Securities Exchange Centre was officially established in April, the nation's largest bond trading centre.
Later, the newly established official
equities market attracted funds away from
the bond market, and consequently,
trading volume slumped. Nevertheless, treasury bi l l trading for the year had
grown to Rmbl05 billion.
1993: At the beginning of the year, the yield at issue offered on treasury bills was
unattractive due to the booming stock and real estate markets. Placements via syndicated underwriting fell considerably short o f target, and the Ministry of Finance partially reverted to mandatory placement. The Ministry of Finance also
launched a new method of voluntary
placement, via a system of 19 primary
dealers. Unlike previous bonds which paid a lump sum at maturity, the five-year
treasury bill issued this year paid annual
interest. The PBC took a more active interest in the debt market, issuing short
term finance notes and lifting previous
restrictions on the holding of treasury bills
by banks and insurance companies. The
PBC also had a major ro le in the establishment this year of the NETS satellite trading system. Futures contracts
in bonds began, established at the
Shanghai Stock Exchange. The treasury
bi l l trading volume for the year was
Rmb83 billion.
1994: There was a dramatic rise in
volume of treasury bill issues this year, due to the government's decision to cease to fund any part of the budget deficit
through bor rowing f rom PBC. The Ministry of Finance issued treasury bills with a range of maturities from six months
to three years and experimented with the
first paperless (annual interest-paying) treasury bill issue, aimed for the first time
at wholesale investors. Government bond listing and trading on the Shenzhen
Securities Exchange began. The Ministry
of Finance decided to issue exclusively
treasury bills, moving away from the
placement of other treasury bonds, fiscal
bonds or special state issues. Bond trading in aggregate (including repos and futures, which escalated rapidly at the end of the year) has been estimated at Rmb3,OOO billion for 1994.
Sources: Bi (1993), Spencer (19941, IMF (1991, 7994), Zhang (1994), Bowles & White (1992),
SEEC (7995).
The Primary Market
Volume and composition of debt issues
Since 1984, the volume and variety of debt issue in China has grown rapidly.
Total debt issues increased from Rmb48.7 million in 1981 to Rmb65.6 million in
1985, and to Rmb113.3 billion in 1994. New issues in 1995 amounted to Rmb
125 billion. As illustrated in Figure 3.1, from 1981 to 1987 the majority of the
debt stock was in the form of government debt, particularly treasury bills, which
remain the largest single category of debt on issue. Government debt in China is
issued primarily by the Ministry of Finance (treasury bonds), and the part of this
which i s used for general budgetary purposes is referred to as treasury bills. State
financial institutions and state enterprises have also been authorised to issue debt
since the mid-1 980s. In 1992, treasury bills alone accounted for 33 per cent of
the outstanding issue, treasury bonds as a whole comprised 38.5 per cent, while
financial bonds and corporate bonds accounted for another 6.4 per cent and 43
per cent respectively (Appendix Table A1 . I ) . From 1994, there has been a
significant increase in the value of treasury bills issued, primarily due to
government's decision to cease to finance its deficit through borrowing from the
PBC. Government debt issues, at over Rmbl I 3 billion, increased threefold over
1993. Government issues in 1995 were higher still, at Rmbl25 billion. Enterprise
bond issues, meanwhile, were reduced.' Treasury bills are therefore estimated to
be a larger part of the total today.
Figure 3.1 China: composition of outstanding debt issues
Rmb 100 Per cent million
1 mob 3500
90% 3000 80%
Corporate 70%
2500
60% 50% 1500 40% Government 30% agency 1000 2040 10%
0%
$' 8 8 @a @ $' $' .$$ @+ & .@ $' Years Years
Source: Data provided by the State Council Securities Committee
Until 1992, the two major categories of debt in addition to treasury bills were
certificates of deposit and corporate debt. The growth in corporate debt (comprising
local enterprise bonds and short term enterprise bills) and financial bonds, issued
by banks, is illustrated in Figure 3.2. The growth in the supply of this non-
government paper reflected:
the increased liquidity of capital markets from 1990 and therefore the increased
likelihood of using debt issues as financing instruments increases in bond prices, due to increased liquidity, which further raised their
attractiveness for enterprises the desire of banks for funds to finance their own capital market activities, or
those of their TIC subsidiaries, and, the use of debt issues to tap local sources of f i n a n ~ e . ~
Debt issues by the government have not been homogenous. Other treasury issues
consisted principally of securities earmarked for specific budgetary purposes,
broadly following the compartmentalisation of fund flows under the credit plan,
rather than any significant difference in the issue terms.3 In some cases the
compartmentalisation was based on the target market to be 'taxed'with the bond
issue, rather than the end use.4 The coupon offered on a specific bond was not
always homogeneous, but varied with the purchaser, typically with a lower coupon
rate for enterprises, relative to individuals. The maturities offered have also varied
from year to year. Such differentiation was feasible largely because of administered
placement, combined with restrictions on tradability.
A consequence of the lack of homogeneity in bond issues has been that even after
trading has been permitted in many bond types, markets have remained thin, due
to segmentation. The government i s aware of some of the drawbacks of the large
variety of issues, and in recent years, there has been a trend towards reducing
their variety, and placing more emphasis on treasury bills. This trend should be
encouraged. Greater homogeneity in government debt issue wil l undoubtedly
assist liquidity in the secondary market. However, administered placement of
debt and focus on a retail investor base continue to have support and these factors
encourage the persistence of 'targeted' (and thus differentiated) bonds.
Figure 3.2 Outstanding debt composition disaggregated
Government bonds
Corporate debt Financial debt 900 900
800 800 State enterprise bonds
700 700 Investment fund bond
600 Inter-enterprise debt 600 Trust income securities S 500 - 500 - - .- - - 'li 400 'i 400 0 ,O 300 g 300 n n E 200 E 200 K a
100 100
0 0
Source: Data provided b y the State Council Securities Committee
Issue Method
Treasury bills
Methods used to issue government debt have evolved over the past decade,
reflecting attempts to move away from administered placement, towards more
market-based methods. The degree of success achieved so far, expressed in terms
of total debt issued, is still limited. Initially, all debt was placed administratively,
and on a mandatory basis. Quotas were assigned by the Ministry of Finance (not
markedly different from tax 'contracts') to financial departments of provincial and
local governments, and at the local level, quotas were distributed among
production units. These units in turn frequently 'levied' bonds on workers, as an
automatic deduction from wages.
Types of Debt Securities on Issue: A Summary
1 Government securities (treasury bonds)
Treasury bills These were first issued in 1981, by MOF
in association with financing the State
budget. Voluntary subscription is a recent
development. They are mainly in bearer
form although a scripless issue was made
in 1994. Treasury bills are traditionally
issued over an extended period in the first
half of the year at a predetermined
coupon and price. The issue is primarily
targeted at retail investors. Available
maturit ies have varied, general ly
downwards. In 1994, maturities ranged
from six months to five years. Bills on
issue are not homogeneous and formerly,
bills issued to enterprises carried a lower
coupon than issues to individuals.
Differences in issue methods have also
affected homogeneity. Treasury bills are
tradable. The three year bond of 1994 is
not tradable but early encashment, within
six months, i s permitted. Early
encashment (after three years) was also
permitted for the five year bond of 1993.
Fiscal bonds These were first issued in 1988. No new
issues have been made since 1994. They
were mandatorily assigned to banks and
other financial institutions to raise funds
for capital construction and to cover
budget deficits. The 1988 issue was not
redeemed on maturity in 1991 and i s
regarded by the MOF as a permanent
loan. Their maturity has been two to five
years. They were not tradable, but could
be pledged.
National construction bonds These were first issued in 1988, by MOF,
to the public, financial institutions and
enterprises, to provide funding for SOEs
and infrastructure. They have been
tradable and are income tax exempt, for
individuals only.
Key national construction bonds These were issued only between 1981
and 1987, t o fund major state
construction projects.
Special national bonds These were first issued in 1989 and were
merged with fiscal bonds in 1992. They
were issued by MOF to enterprises,
insurance companies and pension funds
by mandatory assignment. They were
created to make a distinction between
treasury bills issued to individuals and
those issued to institutions. They were not
tradable but were interest tax exempt.
Inflation-proof bonds These were first issued in 1989. Bonds
with an inflation adjustment were also
issued in 1992 (Three year and five year),
1994 and 1995.
National investment bonds These were first issued in 1991, by
provincia l governments, w i t h the
approval of the SPC, to fund regional development.
State investment corporation bonds
Key enterprise bonds Investment fund bonds These were first issued in 1987 by SOEs These are issued by provincial securities in petroleum, electricity and metals companies and TICS and are regulated industries, to client enterprises on a by PBC. mandatory basis. They were issued
through state investment corporations Corporate bonds and guaranteed by the state government.
They had a three to 15 year maturity and
could be pledged. These were first issued in 1984 initially to employees and clients. Some pay
Capital construction bonds interest i n kind, others pay annual
These were first issued in 1988 by the interest. More recently they have been
State Energy lnvestment Corporation, the issued to a wider public. Issued by SOEs
State Transport Investment Corporation under a quota administered by the local
and the State Transit Railway. PBC and SPC, they are used to finance
investment and have a two to five year
maturity. They are tradable, with a very Financial institution bonds defau risk due to social ised
Financial bonds These were first issued in 1985 by banks to individuals to provide liabilities on
which to base longer- term lending. They
were often project-specific and had a one to five year maturity. Unlike treasury bills
these often pay annual interest. 'They are
tradable.
Transferable high-value fixed deposit certificate These were first issued in 1988 by banks
to enterprises and individuals on the basis of a quota assigned by PBC. They have a maturity of 30 days to one year and are tradable.
ownership of enterprises.
Short term enterprise financing bills These are similar to local enterprise bonds
but used to finance working capital.
These have a three month to one year
maturity.
Inter-enterprise bonds These are issued by enterprises to their
employees to tackle short term liquidity
needs. Their issue is loosely regulated.
Housing construction bonds These are issued at the local level. There are no apparent regulations regarding their issue.
Trust income securities These were issued by provincial securities investment
companies and TI,-^, ~h~~ are regulated These have been issued at the local level.
by the PBC. There are no apparent regulations regarding their issue. +
PBC bonds
Financing bills
These were first issued in July 1993. The to redistribute bank excess reserves.
total issuewas Rmb20 billion, with three, Proceeds from their sales have been lent
six, and nine month maturities. They have to banks and NBFls in regions with a
been placed through interbank centres shortage of reserves.
Sources: Hong Kong Stock Exchange (19931, Bi (1993).
Limits to the government's ability to force bonds on workers became apparent
with the appearance of an illegal secondary market in bonds. As part of its attempts
to tailor bond issues to voluntarily held instruments, the Ministry of Finance adopted
an underwriting syndicate to launch a bond issue for the first time on an
experimental basis in 1991. The syndicate was entrusted with the issue of Rmb2.5
billion, out of a total of Rmb19.9 billion of the treasury bond quota issue for that
year. A private agency, the Securities Exchange Executive Council (SEEC), acted
as co-ordinator of the underwriting, which involved 58 financial institutions.=
-the underwriters received a commission of 0.1 5 per cent of the underwritten
amount and sold the bonds on a voluntary basis to c l ienk6 Underwriting was
used again in 1992, to distribute Rmb3.6 billion of treasury bills in combination
with the traditional administrative allocation for the balance (Rmb36.7 billion) of
the year's issue. Although this represented a larger absolute sum than the previous
year, it represented a smaller proportion of total issues (9.7 per cent, versus 12.5
per cent in 1991), reflecting the government's hesitation to adopt large-scale
change. The relative success of underwriting at the time can be partly attributed
to the relatively attractive (fixed) coupon offered on bond issues, compared to
other available forms of investments.
In the following year, 1993, underwriting failed to sell the desired quantity of
treasury bills, due to competition from the booming equity and property markets
and higher (unauthorised) returns on enterprise debt. The government reverted to
mandatory administrative allocation; localities which did not meet their quota
were severely discouraged from both issuing their own debt and from listing
companies from their region on the stock exchanges. The government nevertheless
made an effort to improve bond distribution and, accordingly, 19 financial
institutions were appointed as primary dealers. In return for underwriting a certain
volume of debt, primary dealers were entitled to receive privileges in kind, allowing
them priority in bringing equity offerings to market. The selection of primary dealers
was based upon guidelines which included capital adequacy and past
performance, in terms of the previous year's trading volume on the primary and
secondary market. In principle, primary dealers have an obligation to act as market
makers, but this function does not appear to have been exercised in practice.'
With some revival in the bond market in 1994,8 the government ventured to
experiment with four different methods of issue for treasury bills, representing a
compromise between those who desired more market-oriented issuing procedures
and those who doubted the effectiveness of the underwriting system in China.
Rmbl3 billion of six month and one year paperless treasury bills were issued
via underwriting agreements. The underwriters (many of whom were designated
primary dealers) were given a week to place the debt, after which it was listed
on the Shanghai Stock Exchange.
Rmb28 billion of two year bearer treasury bills were sold via local financial
departments, which applied for allocation^.^ The balance of the year's planned
issue then became available for distribution via other channels. The local
finance departments signed 'underwriting agreements' with financial institutions
at the local level, which then sold the securities to individuals and others.
Rmb2 billion of five year bearer treasury bills were placed directly with
institutions, but, 8 the largest part of the year's issue, Rmb70 billion, three years maturity, was
issued in the form of certificates, allocated by PBC to the headquarters of the
specialised banks which in turn allocated them to branches at various levels.
The branches then sold the treasury bills locally to individuals and others.
These certificates were redeemable at the bank of issue after six months,
although their listing and trading was not permitted. This issue was the outcome
of an intention to develop a purely retail debt instrument.1°
Of the four distribution channels used in 1994 the Rmb13.2 billion placed via
underwriting is the furthest removed from the old administered distribution
channels. Under this system, underwriters were supposed to compete for an
allocation of treasury bills, through a three part bid covering the amount to be
underwritten, the speed at which funds received from the sale of treasury bills
would be repatriated back to government and the underwriting fee. The institutions
involved in this part of the issue (mostly TICS) have more recent origins than the
specialised banks and the local finance departments, and the target market, for
the first time, i s wholesale (institutions) rather than retail (individuals). However,
this still accounted for only 11.7 per cent of the year's issue; even less than the
12.5 per cent placed by underwriting in 1991. The real difficulty i s that entirely
abandoning administrative placement systems i s difficult, within the framework
of the credit plan, since the fulfilment of 'placement' quotas could no longer be
assured. Another major difficulty with the transition i s the administered interest
rate, and consequently bond coupon rate, which effectively removes a major
plank of price competition for underwriters or primary dealers. Third, for reasons
discussed further below, institutional buyers are not at present accustomed to
government bond purchase. China is still a long way away from more sophisticated
bond issue techniques, such as auctions.
Enterprise bonds and short term bills
Approval to issue bonds is given to local state enterprises by the local State Planning
Council and the local PBC, within the quota allocated to the locality by the credit
plan. The aggregate volume of enterprise bond issues (permitted only to SOEs) i s
nominally supervised by the PBC head office. Central regulation of the quantity
of local bond issues has not always been successful and the issue quantity has
occasionally been larger than the aggregate quota, due to local governments'
interest in boosting investment. The PBC also regulates the aggregate volume of
issue of corporate bonds in response to liquidity conditions. On past occasions
when enterprise bond issues have appeared to threaten bank deposits, or the
banks' ability to meet lending quotas, the PBC has clamped down on enterprise
bond issues. The allocation of the quota between companies is based on a
combination of financial and (de facto) political criteria. While an acceptable
rating by a credit rating agency is required, the priorities of industrial policy are
given greater weight in practice.
Issue size, frequency and issue period
Another drawback of the primary issue process for government securities is that
treasury bills typically have been offered in a small number of issues, in the first
half of the year, rather than in several offerings spread over the year. Sales have
been made over a period which typically takes several months. The sale of paperless
treasury bills aimed at wholesale investors in 1994 was an innovation which permitted a much shorter issue period. Thus in 1994, the two paperless issues
took less than a week each (the six month paperless issue was placed between 25
January and 31 January, and the one year paperless issue was placed between 1
February and 3 February). But the two year bearer issue took two months to place
(1 April to 31 May) and the three year treasury bill certificate took longer still;
from 1 April to 30 July, or four months altogether. For the paperless issues, the
underwriters were required to sell the bills within a specified issue period, at the
end of which funds for bills sold, together with any unsold subscriptions, had to
be remitted to the Ministry of Finance. The issues were then declared tradable
with immediate effect. By contrast, for the two and three year treasury bills with
the long issue period, sales proceeds were remitted to the Ministry of Finance's
account at the PBC by each underwriter, according to the terms of their individual
underwriting agreements, rather than on a daily basis. The final payment occurred
after the close of the issue period. The retail investor base to which most issues
are targeted and the long distribution channels for this prolong the placement
time and reinforce the tendency towards large issues spread out over a few months.
The current practice has several undesirable implications. Firstly, in the absence
of regular maintenance of a sufficient volume of short term debt on issue, the
development of a liquid secondary market is not possible. Consequently a short
term market yield curve cannot develop. Moreover, the absence of a liquid short
term market presents problems for the use of indirect methods of monetary control.
Secondly, the absence of a regular supply of debt of any maturity to the market
implies that there is no 'current' issue to provide a 'benchmark', either long or
short term. Thirdly, since issues are made in the first half of the year, there is little
scope for synchronising the timing of the sales with the State's cash flow
requirements." This raises the cost of funds to the government.12 Fourthly,
investors cannot plan orderly acquisitions of new issues over the year in line with
their cash flows. A one-off issue period puts considerable strain on the liquidity
management and risk management capabilities of banks and institutions. In a
market economy such an issue pattern would limit the number of bidders and
cause a liquidity squeeze, both of which would operate to raise interest rates and
the government's cost of funds.
On account of these reasons, it would be more desirable for the government
(Ministry of Finance) to:
announce a schedule for the year's issue of longer term debt, based on the
government's term financing need, spread throughout the year, and in parallel, undertake regular issues of shorter term debt (one to twelve months maturity)
to meet short term liquidity needs.
In addition, the central bank (PBC) should issue short term paper as required,
to meet short term liquidity management needs.
Challenges for China in moving towards a debt management programme for a market economy
First, the pattern of the government's cash flows over the year would need to be determined with sufficient accuracy.
Second, the government should differentiate between retail and wholesale investors. Continued reliance on retail investors necessitates prolonged issue
periods due to the administrative burden of handling small sums of money. If the government continues to rely on a retail
investor base, it should design an 'on demand' savings certificate available throughout the year, adjusting interest
rates on this issue periodically according to, not only deposit rates, but also the government's desire to attract funds.
Third, to meet the estimated demand of the institutions which form the wholesale market, scripless treasury bil l issues
should be made according to a preannounced calendar at intervals throughout the year. A limited (but gradually increasing) amount can be sold on auction, with the rest distributed through average-price non-competitive
bids. As these institutions develop, increasing emphasis should be placed on
the wholesale market.
The development of a market in short term debt is dependent upon the development of a wholesale market.
Maturity
When the government first resumed debt issue in the early 1980s, the maturity of
government debt issues reflected exclusively, government needs. This was possible
due to the administered placement mechanism adopted. By the late 1980s the
authorities were forced to acknowledge investor discontent, expressed by the
emergence of secondary markets where government debt traded at large discounts.
In response, the government was obliged to progressively shorten maturities on
treasury bills from ten to five, and then to three years. The 1994 treasury bill issue
included six month and one year maturities for the first time, tailored to meet the
needs of banks and wholesale investors for the balancing of short-term assets and
liabilities. This demonstrates that whi le the market is still far from fully investor
responsive, the authorities are now more conscious of investor preferences and
the advantages of taking them into account when structuring an offering.
There i s still a need to widen the range of maturities offered to satisfy a wider
range of investor preferences. O n the shorter end, extending the range of short
term maturities to include 30 and 90 day paper and increasing the volume of
short-term offerings would assist financial institutions with liquidity management
and encourage the development of a short term yield curve. Financial institutions
in China are beginning to grow aware of the need for, and advantages of, liquidity management, especially as new options for investment develop. On the longer
end, in view of the central and local governments accelerating need for financing infrastructure investment, there would certainly be an interest on the part of these
authorities in the issue of long maturity bonds. However, from the perspective of
the investor, there is a lack of enthusiasm for debt of long maturity today due to a
number of reasons:
The lack of payment of coupons, and the long intervals to redemption.I3 High and uncertain rates of inflation, which make the real value of the
redemption amount difficult to predict, and usually (in the experience over the last few years) less attractive than the nominal value. Due to the low incidence of default on most forms of investment within the
framework of a planned economy, investor perception of, and allowances for, risks, are low. Consequently, the local markets focus on return rather than risk
adjusted return, and as such the security of a long term government bond which may be attractive elsewhere carries little premium in China today. Liquidity in the bond market is still low. If liquidity increased significantly,
investors would be more tempted to hold bonds of longer maturities.
The implication i s that even if the government were to issue bonds of longer
maturities today, it would find these difficult to sell, and would have to resort again to administrative placement.
The investor base for primary sales
Historically and currently the majortarget market of debt sales is individuals. This
stands in contrast to developed debt markets where the major target market of primary issues consists of wholesale investors such as banks, insurance companies
and mutual funds. Table 3.1 gives estimated figures for the division of government debt sales between individuals and enterprises. The data cover a range of different
government debt types including treasury bills, construction bonds and fiscal bonds.14
Table 3.1 Government debt purchases: households and non-households
Year Households Households Enterprises & Enterprises
institutions
(Rmb billion) (%) (Rmb billion) (%)
Source: Ministry of Finance and SEEC
The table shows that there i s no systematic trend reduction in the proportion of
debt issued to households, over time. Indeed, ratios for household purchases are
high in the 1990s. The Rmbl3 billion paperless issue in 1994 was the first attempt
to explicitly target wholesale buyers via voluntary treasury bill sales. Prior to 1993,
the PBC did not permit banks to hold Government securities except those issued
to them on a mandatory basis. Pension funds and insurance companies have also
been encouraged to hold treasury bills since late 1993.
The PBC has recently begun to encourage institutions to hold treasury bills as it is
examining its ability to control bank liquidity via secondary market treasury bill
transactions. The PBC's interest in open market operations stems from a recognition
that control of monetary and credit conditions via the credit plan is increasingly
impractical. But before secondary market treasury bill transactions can be used as
a policy tool, the relevant institutions must hold a stock of treasury bills and a
liquid secondary market needs to exist.
Issue price and coupon
Government bonds are issued at par and the majority carry a predetermined
coupon. There i s no auction process to determine the yield in the primary market.
Coupons are administratively set at a margin above deposit rates of comparable
maturity, without reference to the secondary market yield on issues of comparable
maturity. The lack of reference to secondary market yields, reflects the
administratively determined interest rate structure, and the role that debt issues
continue to play in the Credit Plan.
Most government issues of three years or more in maturity, since 1992, have had
a coupon related to the inflation rate; the 1992 three and five year bills; the 1994
three year issue of treasury bills in certificate form; and more recently, the issue of
Rmbl06 billion for 1 995.15 Only a limited number of scripless treasury bills have
paid an annual coupon; the five year 1993 issue and the scripless issue of 1994
are examples. Most bonds pay a redemption amount consisting of principal plus
accumulated simple interest estimated on the basis of the coupon at issue. The
authorities may see some advantage in paying the coupon in a lump at maturity
as it makes it more likely that treasury bills will trade on the secondary market at
a price above par. In a less sophisticated market this assists primary sales. Another
explanation may be that since most bonds are held by individuals in the form of
bearer certificates, there are no easy channels for coupon payment.
Table 3.2 compares coupon rates, comparable deposit rates and YTM at issue for
bond issues to 1993. The yield to maturity (YTM) at issue i s less than the coupon
rate. For example, a Rmb100 bond with a 13 per cent coupon rate and a two
year maturity would pay Rmb126 on maturity (before adding any inflation
adjustment). This is equivalent to a YTM on a semi-annual basis of only 11.9 per
cent (before adding any adjustment). If the inflation adjustment were known in
advance, its inclusion would widen the difference between the two yield
calculations. Table 3.3 compares these rates and in addition comparable secondary
market yields for the 1994 treasury bill issues. In 1994 both the two and three
year issues, aimed at retail investors, were issued at yields above those in the
secondary market. The fact that they were sold at above secondary market yields
indicates that there are potential benefits to the government from targeting
wholesale investors (who dominate secondary market trading) and from taking
account of secondary market rates. Had the two and three year issues been sold
at secondary market yields the cost saving would have been in the region of
Rmb3 billion per annum, not allowing for the inflation adjustment on the three
year issue. The most market responsive way to take account of market yields
would be to sell the bonds by auction.
Bond yield calculations: Current YieM and Yield to Maturity
Bonds in China have some unusual features in terms of interest payment as well as interest calculation, which reduce
the transparency of bond yields. Treasury bonds typically do not pay interest, but instead pay a lump sum at maturity. The lump sum payable at maturity i s estimated by adding accrued annual simple (rather than compound) interest over the total period, plus any inflation
adjustment.
Secondary market bond yield quotations in China are now available in some
publications, but these yields are quoted on a variation of a current yield basis. This follows from the way in which the coupon i s quoted in the primary market. This method i s not consistent w i th standard market practice and is deficient in that no account i s taken of the time
value of money.
Secondary yields in China are quoted using the formula:
s = maturity value, which in China includes
all interest payments as well as principle
p = market price
n = time left to maturity in years
The formula does not recognise that the further into the future a payment i s received, the less its value is today. For very short maturities (months) the formula will be adequate. The longer the time to maturity the less appropriate the formula becomes.
Bond yields are normally quoted on a yield to maturity (YTM) basis. The YTM
is the discount rate which equates current price with all future cash flows. The YTM formula is obtained from:
by solving for i, where
i = yield to maturity
p = market price
c = coupon
f = redemption value at maturity
n = number of periods to maturity
In this study, daily yields for each individual issue have been estimated using a yield-to-maturity formula, from primary data on daily trading prices,
maturity dates for each issue, and redemption value (in China this i s the p r i nc ipa l p lus interest w i thou t compounding), with coupon=O, and
additional assumptions on frequency of compounding; assumed to be semi- annual, (which i s the norm in most
market economies), and the basis of payment calculation (actua11365). N o
allowance i s made for the inflation adjustment, the full value of which i s
unknown until maturity. Daily yields
have not been homogenous across different securities, and the 'average y ie ld ' has been estimated as the average of daily yields on outstanding treasury bi l l issues, at a given point in time.
Table 3.2 Treasury bill coupon rate, deposit rates and inflation
Year Maturity Coupon
(years)
1981 10 8
1982 10 8
1983 10 8
1984 10 8
1985 5 9
1986 5 10
1987 5 10
1988 3 10
1989 3 14
1990 3 14
1991 3 10
1992(1) 5 10.5b
1992(2) 3 9.Sb
1993(1) 3 1 3.96b
1993(2) 5 15.86
Yield at issuea Comparable Inflation: retail
(%) deposit rate (%) price index ( O h )
6.84 2.4
7.92 1.9
7.92 1.5
7.92 2.8
8.28 8.8
9.36 6.0
8.3s 9.36 7.3
8.9 9.72 18.5
12.0 13.1 4 17.8
12.0 11.88 2.1
8.9 8.28 2.9
8.6b 9.00 5.4
8 . 9 8.28
1 2.0b 12.24 13.0
12.0 13.86
Notes: "'Yield at issue'here implies the yield reestimated on a YTM basis.
b F l ~ s the inflation adjustment at maturity.
Sources: Zhang (19941, IMF (19911, World Bank staff calculations
Table 3.3 Comparison of coupon and deposit rates, and secondary market yield"
(At time o f issue: 7 994 treasury bill issue) - - - - - - -
Issue Maturity Coupon at Yield at Comparable Comparable secondary Retail price
(years) issue (Oh) issue (Oh) deposit rate (%) market yield (%) index (%)
1994(1) 0.5 9.8 9.8 9 12.5 21.7
1994(2) 1 11.98 11.6 10.98 18.5
1994(3) 2 13.0 11.9 11.7 11 .O
1994(4) 3 1 3.96b 1 2.0b 12.24 9.6
Notes: "Yield at issue restates the coupon on a yield to maturity basis. Comparable secondary market yield is
representative of the yield (YTM basis) of a bond of similar maturity on the Shanghai Stock Exchange during
the primary issue period.
bThe 1994(4) issue is inflation indexed and is non-tradable. The rates here are rates before index
adjustment.
Source: Zhang 1994, Shanghai Stock Exchange, World Bank staff calculations
Prior to 1992 the coupon on debt sold by mandatory placement to institutions
was less than that on debt sold to individuals. This is illustrated in Table 3.4. All
treasury bills have carried the same coupon regard less of purchaser since 1 992.
Some enterprise and financial bonds pay an annual coupon while others pay on
maturity.16 The coupon on enterprise bonds i s restricted to no more than 40 per
cent above the deposit rate." In addition the Ministry of Finance has imposed
the restriction that the coupon should not exceed that on treasury bills in order to
reduce competitive pressure on treasury bill sales. However, the restriction has
been avoided by the use of fees and discounts. In practice corporate bond yields
are two to three percentage points greater than treasury bill yields at issue. The
more attractive rate offered on enterprise securities was one factor contributing to
the failure of the voluntary placement of treasury bills in 1993. Until recently,
enterprise bonds were particularly competitive with treasury bills as default was
not significant.18
Table 3.4 Comparison of coupon on treasury bills sales by purchaser: households, enterprises, and financial institutions
Year
- --
Households Enterprises
(treasury bills) (treasury bills)
Financial institutions
(fiscal bonds)
Note: "Rate on special state bonds given for enterprises
Source: IMF (7991)
Tradability
Another feature of bond design in China is that much of it has been non-tradable
by regulation. l g The tradability of government bonds i s affected by the evolving
nature of the debt issue process which has resulted in lack of homogeneity in the
outstanding stock of treasury bills. Even in recent years the treasury bill issue has
not been homogenous. The 1994 issue of Rmbl l3 billion was the largest issue to
date and represents 55 per cent of the treasury bills outstanding at the end of
1994. However, a breakdown of the 1994 issue shows that the bulk of it is not
tradable or is at least illiquid (Table 3.5). Trade in other issues, such as enterprise
bonds, is often hindered by lack of issue volume for individual issues (Figure 3.4).
Table 3.5 Tradability of 1994 treasury bill issues
Value (Rmb billion) Percentage Form of issue Form of placement Comments
Rmb13.2 billion 11.7 Paperless treasury Registered on the Trading low due to
bills Shanghai Stock Exchange insufficient issue volume
Rmb28 billion 24.7 Bearer treasury Issued via local Sold mainly to individuals
bills finance departments who largely buy and hold
Rmb70 billion 61.8 Certificate form Sold through Market listing not
specialised banks permitteda
Rmb2 billion 1.8 Certificate form Institutional placement Market listing not permitted
Note: "Even illicit trade is difficult as the certificate is from an individual bank, which carries the responsibility for
redeeming it, resulting in a diversity o f instruments. Large investors (Rmb2Om and above) have faced delays
in obtaining redemption.
Source: Ministry o f Finance
Bearer and scripless issues
The majority of debt securities are in bearer form. The exceptions to this norm are
the 1994 experimental treasury bill issue (Rmbl3 billion) and non-tradable debt
issued by mandatory placement to institutions. Bearer issues have contributed to
the lack of liquidity in the secondary market. While depositories exist to record
holdings in book entry form, lack of regularised registration procedures between
localities cause friction in inter-regional trade. The difficulty of aggregating retail
parcels has been exacerbated by the need to gather physical scrip.
Credit rating agencies
The development of credit rating agencies has been encouraged since 1 991. Rating
companies must be approved by the PBC before they can publish their ratings.
The PBCfs headquarters have approved only two agencies so far, although some
other agencies have been approved by PBC at a local level. In all, 82 credit rating
agencies have been approved, about 30 of which operate at a national level.
Not all the rating agencies call themselves credit rating agencies; some are
accounting firms and others are consultant firms. The ownership structure is also
diverse, reflecting the variety of entry points into the new industry. Some regional
rating companies are subsidiaries of the local PBC. Of the two credit rating
companies in Shanghai, one is a subsidiary of the Shanghai Academy of Social
Sciences and the other i s a subsidiary of the Shanghai University Institute of Finance
and Trade.
Rating agencies are used in the process of selecting the enterprises to be granted
permission to issue bonds. At present their role is of marginal importance to the
government and investors. In the debt issuing process rating agencies distinguish
the poorly performing companies from those with an acceptable performance.
However, among the acceptable companies the right to issue debt is not determined
solely, or even primarily, on the basis of the rating agencies'assessment. The local
PBC and SPC give weight to policy priorities. Investors do not place much weight
on the rating agencies' assessments because of a general excess supply of investible
funds and because enterprises rarely fail due to state ownership. As long as
socialised ownership creates soft budget constraints on enterprises, the risk
assessment role of rating agencies will be marginalised.
Secondary Markets in Debt Securities
The secondary market for China's debt securities has progressed rapidly, with the
initial legalisation of trade in 1988, followed by the legalisation of inter-regional
trading, the creation of the STAQS and the formal opening of the Shanghai Stock
Exchange in 1990. The market has improved immeasurably since, in terms of
increased I iquidity, greater geographic price unity and more sophisticated trading.
But in comparison to debt markets in other countries the market remains illiquid;
liquidity is not sufficient to meet the transaction needs of larger participants, and
uniform pricing and trading practices across different exchanges and trading
networks are still to be achieved. The concept of a benchmark issue has not
developed, and trading activity and pricing continue to be driven largely by the weight of liquidity available.
Listing standards
There are no unified standards for listing bond issues in China. Bond listing
standards are not as strict as those for equities. All treasury bill issues are eligible
for listing, the timing of listing being determined by the Ministry of Finance.
Financial and enterprise bonds are listed according to the requirements of the
local trading centre. The Shanghai Stock Exchange will list bonds provided the
issue amount is greater than Rmb100 million, the maturity is greater than two
years and the credit rating is A+ or higher.
Secondary market trading volumes and liquidify
The first aspect of secondary market efficiency examined here i s the extent to
which secondary markets have been able to achieve reasonable volumes of
turnover, ie, the degree of market liquidity. As shown in Figure 3.3, annual treasury
bill tradingvolume rose steeply from Rmb10.5 billion in 1990 to a peak of Rmbl05
billion in 1992. Although individuals hold the majority of bonds, institutions
account for the majority of trading. Trading volumes declined in 1993 because of
competition from high returns on equities and real estate. In July 1993, the PBC
tightened liquidity by increasing its control over the interbank market and reducing
the ability of provincial branches of the PBC to lend to other banks without approval
from headquarters. This restricted the diversion of credit to uses outside the credit
plan. In late 1993 the PBC permitted banks and insurance companies to purchase
treasury bills freely for the first time. The rise in secondary market trading in
Shanghai from 1994 (Figure 3.3) suggests that the reduction of the ability of banks
to lend in the interbank market, declining equity and real estate returns, and the
new ability of banks to buy treasury bills directly, have stimulated the secondary
bond market.
Figure 3.3 China: trading value of bonds --
Annual trading value: all China (1987-93) Trading value: Shanghai Stock Exchange (1991-94) 1 0 2 80 -- E Total
g 60 -- F
y c m m o - c u m m m m m m m m - , " " 5 . - N " 5 - N " 5 - c u " m &-&&-&-gciigggggggg Z ? " ? m m m m m m m m m m m m m m m
- - - r - - r - - r - - - - -
1 Source: Data provided by the PBC, the State Council's Securitites Committee, Almanac of China's Finance and
Banking and the Shanghai Stock Exchange -- A
The improvement in market liquidity since 1987 i s illustrated in Figure 3.4. Both
as a percentage of debt stock outstanding and as a percentage of GDP, China's
bond market liquidity rose markedly from negligible levels in 1987 to over 120
per cent of outstanding stock and almost 6 per cent of GDP, in 1992. The diagram
also illustrates the fall-off in 1993.
Figure 3.4 Ratios of trading volume of debt to debt stock and to GDP
Percentage of stock outstanding Percentage of nominal GDP Y 0 140 B ; 120 .. - - + - - Tbills *. g .. - -C --Local enterprise bonds ,, ',.. ; ;rA - ?
80 -- A F i n a n c f a l bonds
5 60 -. -Short term '8 2
2 1
0
1987 1988 1989 1990 1991 1992 1993 1987 1988 1989 1990 1991 1992 1993
L Source: Data provided by the State Council Securities Committee, World Bank
In addition to the cash (spot) market in bonds, China has bond futures markets,
and a market in repurchase agreements. Futures contracts based on treasury bills
trade mainly on the Shanghai (since 1993) and Shenzhen (since 1994) stock
exchanges.20 Contracts are marked to market daily. The contract calls for physical
delivery but the majority of contracts are closed out prior to settlement. Contracts
are designed to hedge interest rate fluctuations on the secondary bond market.
The PBC publishes an inflation subsidy each month which adjusts the interest
rates on individual deposit accounts and the adjustment for inflation payable on
most bonds of maturities of three or more years. Individuals have used the futures
contract to speculate against the amount of the inflation top-up and the expectation
of thetop-up has a large influence on futures trading2' The apparent large increase
in bond trading in early 1995 was virtually entirely driven by futures contracts,
which also enhanced the liquidity of the underlying spot market (Table 3.6).22
Table 3.6 China: spot and futures trading of bonds (Turnover, Rmb mill ion)
1-bond spot 1-bond repurchases 1-bond futures
January 1994
February 1994
March 1994
April 1994
May 1994
June 1994
July 1994
August 1994
September 1994
October 1994
November 1994
December 1994
January 1995
Source: Shanghai Securities Exchange: Monthly Market Statistics
Yet, relative to more mature bond markets, the degree of liquidity i s still poor.
Treasury bills, relative to other debt instruments, are the most liquid security, but
even for these securities, while a bid and offer price is always available, large
cash trades can take time to complete.23 Other debt issues are much less liquid.
Figure 3.5 compares the ratio of trading volume, as a percentage of GNP, with
more mature markets. Debt on issue as a percentage of GDP exceeded 13 per
cent in China, by 1992. But in the US and in Japan, debt stock as a percentage of
GDP is on a different plane; 90 to 120 per cent in the US, between 1987 and
1993, and 60 to 80 per cent in Japan over the same period.
Figure 3.5 Ratios of debt stock outstanding to GDP: China and other countries
(Percentage of G DP)
Per cent China 14 1 6 I
- a r n g g g ~ m m o - ~ r n m zz:zcmzzzzz:ZE m m m m m m
Per cent Other countries
40 USA
20 +Japan
1 Source: State Council Securities Committee, Salomon Brothers and lMF ~
Comparing the traded volume of debt to outstanding stock, the results are similar,
even if developing countries are included (Table 3.7).
Table 3.7 Ratio of bond trading value to stock outstanding
- -
Chinaa
Japanb
Koreac
Indonesia
----
Notes: "All types of debt on issue.
bJapan is reported on a net basis.
'Korea is reported on a gross basis.
Source: World Bank Asian Bond Market study, Salornon Bros
Causes of the lack of liquidity: ( I ) Primary market practices
A first group of causes of lack of liquidity stems from practices alluded to above,
in the primary market, and is itself a reflection of the uneasy coexistence of such
markets with controls on the financial sector (eg the credit plan, and controlled
interest rates), which are the legacy of planning. The impact of these primary
market characteristics on secondary market liquidity is discussed below. First, the
lack of homogeneity in the stock of debt reduces the amount of any one type of
debt which is available to trade. Second, the focus on retail investors as the primary
target market for debt issues reduces liquidity, because, while households hold
the majority of debt securities, they do not trade as much as ins t i t~ t ions .~~ Treasury
bills are sold in small parcels of Rmb100 to Rmb1,OOO to suit this market, and
securities firms have a major problem in accumulating sufficient bonds from
individuals to form a wholesale parcel. Third, the yield at issue i s not related to
secondary market yield. Due to linking the coupon to deposit rates, and issuing at
par, the YTM of a treasury bill at issue may be either above or below the secondary
market yield. If the issue yield i s below secondary market yields, the treasury bill
sells, as the coupon i s competitive by comparison with alternative returns on
deposits (for households) and loans (for banks). But an issue yield less than
secondary market yield inhibits secondary market trading as investors are reluctant
to sell at a loss.
Table 3.3 above compared the coupon rate, effective yield at issue, secondary
market yield and deposit rates for the 1994 treasury bill issues. In each case the
coupon was greater than deposit rates of comparable maturity. However the
effective yield at issue was less than the secondary market yield for certain issues;
(the six month and one year issues) and greater for others (the two and three year
issues). The six month issue sold well due to the demand for short term paper but
the one year issue only sold with difficulty. This is not surprising given that the
yield was nearly 700 basis points below the secondary market yield.
Fourth, the primary issue is not distributed over the year. t h e lack of a regular
issue calendar inhibits liquidity in two ways:
Without a regular issue programme, there cannot be a continual supply of
short dated money market paper (maturity under a year) from which a short-
end yield curve can develop. This inhibits money market development,
reducing the supporting role the money market plays to the bond market. There are no new issues to provide a 'trading' issue to act as a market
benchmark. Typically as debt issues age, an increasing proportion is held by
end-holder investment portfolios rather than trading portfolios.
Fifth, the limited range of maturities of primary issues also inhibits liquidity. The
market is dominated by issues of original maturity of three to five years. There i s
a lack of money market paper to provide institutions with liquid assets to match
their short term liabilities and an absence of long term paper. A greater variety of
maturities would stimulate trading by providing investors with the opportunity to
acquire assets of different maturities, ie, change the duration of their portfolios, as
their view of future risks changed. For example, an investor anticipating a rise in
inflation would want to sell longer dated debt and buy shorter maturities. With an
inadequate range of maturities available such transactions will occur less frequently.
The frequency of transactions for risk management purposes is also limited at
present by the low level of development of treasury risk management functions in
financial institutions.
Market participants are less likely to trade if they cannot easily agree on the price
of a security. The method of coupon payment in China makes it difficult to
accurately price treasury bills in the secondary market. The first cause of
uncertainty is the correct basis on which to quote bond yields; payment of
accumulated simple interest on maturity has led to bond prices being quoted on
a current yield basis rather than a yield to maturity basis. The second and more
important cause of uncertainty is the inflation subsidy. While inflation-like bonds
may be easier to place in the primary market in some circumstances, the future
payout on an inflation-adjusted bond will always be open to differing expectations,
which makes pricing it in the secondary market difficult. In a more developed
market, this would seriously inhibit trading. The speculative nature of the Chinese
market reduces the extent to which pricing difficulties inhibit trading in China,
and in fact increased trading volume over late 1 994 and early 1995. But this
short-lived burst of liquidity does not negate the generally less liquid nature of
indexed bonds.
Causes of the lack of liquidity: (2) Market infrastructure
The second group of causes concerns the supporting market infrastructure. First
of all, the money market does not function in a manner which assists bond market
liquidity. Normally, the money market plays an important role in assisting bond
market liquidity through the provision of funding for bond portfolios via either
loans or repurchase agreements. Repurchase agreements (repos) further assist
liquidity by enabling investors to quickly obtain funds without having to sell their
bonds.25 Trading in repos in 1994 is estimated to have reached Rmb314 billion
as described in Table 3.8. This amounted to an estimated ten per cent of bond
trading volume in 1994.
Table 3.8 Trading in repurchase agreements (1 994, Rrnb billion)
Trading centre Trading value
Wuhan Securities Trading Centre 160.0
STAQS 290.0
Shanghai Stock Exchange 63.0
Shenzhen Stock Exchange 1.3
Total 314.3
Source: SEEC
The more liquid the money market, the more certain bond owners can be that it
i s a stable funding source and the more they can rely on the short term yield curve
as representing the cost of carrying a bond inventory. The money market in China
fulfils this role to an extremely limited degree.26 The core deficiencies of the
money market, in terms of its potential support to the bond market are:
Its geographic segmentation, which implies that funds in the provinces are
unlikely to be available to finance bond transactions on one of the major
exchanges, limiting bond market unity.27
Its institutional segmentation. Regulations control the parties permitted to
transact and the maturities that can be offered.28 Moreover, bank sub-branches
manage their own liquidity on the basis of their allocated capital and credit.
The lack of centralised liquidity management also acts as a factor preventing
the development of a short term yield curve. Interest rate ceilings, on both loans and repos, preventing the development of
a short term yield curve, as there is no regular supply of short dated treasury
bills to provide a liquid low risk instrument to act as a short term benchmark. The treasury risk management capability of banks and other financial institutions
is very thin due to a lack of incentives to manage risk. Developing this capability
wil l be hindered by the cumbersome reserves methodology of the PBC.
The incentive and ability to manage liquidity risk and interest rate risk i s necessary
before a liquid money market can develop. Estimates of money market trading
volumes and assets of users are available in Appendix Tables A3.2 and A3.3.
Despite these difficulties, the PBCfs financing centres (the 'tangiblef component
of the interbank market), have fostered the achievement of nearly unified interbank
rates across China, by acting as a market benchmark. The PBC is aware of the
shortcomings in the functioning of the money market, and intends, in the medium
term, to create a nationally integrated market, to enable the introduction of open
market operation^.^^
A second institutional difficulty hampering the achievement of secondary market
liquidity concerns the lack of a common depository, which reduces inter-regional
trade. Since the bulk of debt issues are in bearer form and of small denominations,
depositories are vital to aggregate these into wholesale parcels that can be readily
traded. Although regional depositories appear to function well in China, there is
no central depository, or any mutual agreements between depositories, which
would enable them to recognise each other's depository receipts as good proof of
title. This inhibits inter-regional trading30
Secondary market pricing efficiency: price unity
The second major aspect of secondary market efficiency in China's bond markets
examined here is the question of a specific aspect of price efficiency - regional
price segmentation. The black markets prior to 1988 and the Government
sponsored markets which followed them were characterised by significant price
differences, especially between regions and between rural and urban areas, due
to the lack of information and the difficulty of transporting large amounts of physical
scrip and cash between markets. Local prices thus reflected local liquidity
conditions.
China's bond trading centres
China's bond markets consist of four principal markets (Wuhan, Shanghai, STAQS
and Shenzhen), and a number of lesser regional markets, whose size relative to
the principal markets i s gradually declining (Appendix Table A3.1). All the major
markets trade as exchanges. Electronic over-the-counter trade (ie, trade directly
between individual participants) has not yet developed except at STAQS. Each
market has satellite links which provide members across the country with real-
time quotation and ti.ansaction data. Order placement and confirmation is by
telephone or fax on the Shanghai Stock Exchange, at Wuhan, and on STAQS,
although the possibility of undertaking this through the satellite system is being
explored. Dealers in Shenzhen place orders via remote terminals. Shanghai also
has a unique system of record keeping and transacting using magnetic cards. The
cards are mainly used for individual's equity transactions but the scripless treasury
bills issued in 1994 can also be traded through this system. While repurchase
business at STAQS has grown, its physical bond trading has tended to shift to the
Shanghai Stock Exchange. The Shenzhen Stock Exchange (SZSE) has been active
in developing a bond market since late 1993. The Wuhan, Shanghai and Shenzhen
exchanges have an estimated common membership of 100-1 50 brokers. Many of
these brokers wil l also belong to STAQS. Members cover the whole of China.
The opening of STAQS and the Shanghai Stock Exchange in late 1990 provided
both a nationwide quotation system and an exchange with members from many
regions. These developments greatly assisted price convergence. Prices on the
Shanghai Stock Exchange began to act as a benchmark for regional markets. Figure
3.6 indicates the size of the arbitrage opportunities that existed in 1990. By the end of that year, there were signs of price convergence between the larger markets
(Shanghai and Wuhan), although looking at a spectrum of ten regional markets, including smaller markets, overall price convergence was slower. Regional price differences at the end of 1990 could exceed 700 basis points.
Figure 3.6 Regional bond yield differentials (7 990)
Basis points Highllow (1986 ByearTbill)
10 markets ~ncludlng Shanghai & Wuhan
Jan Feb March April May June July Aug Sept Oct Nov Dec I 1 Source: Based on data from Bi (7993) I
1
Price differences today are much smaller than those of the past. Prices on the
major centres of trading (Shanghai, Wuhan, Shenzhen and STAQS) are very close
to being unified. The barrier to unity in the major centres i s the lack of a unified
depository system. While quotation and execution of trading on the major markets
is technically sophisticated, settlement procedures are lagging in relative terms.
In the absence of a unified depository system, prices tend to be high in Shanghai,
which has the greatest liquidity and a well regarded depository. Prices are relatively
low in Wuhan, which has the least well regarded depository (Figure 3.7).
Figure 3.7 Yield differentials between treasury bills on principal markets: 1994 (Shanghai, Wuhan and Shenzhen)
7- ----- 7
Basis points Shanghai and Wuhan Shanghai & Shenzhen 500 7
-loo/ January 1994 September 1994 -100 f March April May June I
Source: Calculations based on data ~ rov ided by the Shanghai and Shenzhen exchanges and
Wuhan Trading Centre --
In early 1994, the Shanghai authorities grew concerned that depositories outside
its system were permitting short selling, by issuing depository receipts when the
scrip was not in fact registered. Consequently, in May 1994, the Shanghai Stock
Exchange ceased to recognise depository receipts from depositories outside its
own system. This increased market segmentation by preventing debt held outside
the Shanghai Stock Exchange's depository system from trading on the Shanghai
Stock Exchange. The effect of this event on yield differences is also shown in
Figure 3.7. Between January and September, the yield difference between Shanghai
and Wuhan widened from around 100 to around 500 basis points. A similar
increase in yield differences between Shanghai and Shenzhen appeared, after
May 1994.
The Shanghai Stock Exchange signed an agreement on depository procedures
with STAQS in October 1994 and now recognises their depository receipts. But
by the end of 1994, no agreement had been reached with Wuhan, or the Shenzhen
Stock Exchange. Problems associated with multiple depositories could be solved
if the existing networks agreed on a common code of practice, or alternatively by
the creation of a centralised depository. The Ministry of Finance has now embarked
upon the process of creating a centralised depository, for government securities
only. Ideally, depository practices for all classes of debt securities should be
standardised.
Lack of liquidity in provincial markets especially affects debt issues which do not
trade on the major markets, such as enterprise bonds and financial bonds, some
of which trade only on a regional market. Provincial markets are also less
technically developed and less informed than major markets. Consequently prices
on regional markets tend to be lower than prices in the main trading centres.
Benchmark issues, market pricing, and the yield curve
The third aspect of the functioning of secondary markets for debt securities which
i s analysed here, i s the extent to which bond market issues can provide a
benchmark rate, and help establish a yield curve. The concept of a benchmark
issue in relation to new debt issues i s not operative in China today, due to, first,
the administered setting of yields in the primary The operative benchmark
in China today is the interest rate on bank deposits, which i s administratively
determined. The second factor which undermines the role of a benchmark issue
i s that the pricing of credit risk is poorly determined, due to the lack of a hard
budget constraint on enterprises. It is hard to distinguish between the credit risk of
a government owned company, and the risk of the government. Considerably
greater interest rate flexibility, combined with enterprise reform which enables
credit risk to be credible, wil l be required before benchmark issues can play a
significant role in pricing debt.
Developing the role of benchmark issues in defining the secondary market yield
curve requires:
a greater range of maturities32
a more regular issue calendar so that fresh issues come to market throughout
the year, and, a greater focus on developing a wholesale market to enhance liquidity.
Due to the lack of a broad spectrum of maturities in the market, a yield curve has
been discernible only since late 1992. The changing shape and position of the
yield curve (YTM basis) is shown in Figure 3.8. Secondary market yields rose
from June 1992 to June 1993 and then progressively declined; first at the long end
of the curve (beyond one and a half years) and finally at the short end. The unusual
shape of the curve, rising at the long end, reflects the lower liquidity in the treasury
bill with the longest maturity. The lower liquidity itself suggests a preference for
short maturities, due to inflation.
Figure 3.8 China: secondary markef yield curve
0 C I I
6 months 1 year 1.5 2 year 2.5 3 year 3.5 4 year 4.5
Years
1 Source: Catulations based on data provided by the Shanghai Stock Exchange
Figure 3.9 China: bond yield, deposit rate and inflation
Average yield: YTM - 1 year deposit
- - - rate Average yield: simple Retail price index
/ Source: Calculations bared on data provided by the Shanghai Stock Exchange, PBC and the World Bank 1
The timing of the decline in yields, after June 1993, prima facie, i s difficult to
interpret, on two counts. First, the PBC acted to tighten access to funds by regulating the money market in June 1993. Deposit interest rates were increased at the
same time. Second, inflation began to rise more steeply from the end of 1993, yet
yields continued to decline. The trends in secondary market bond yields and
inflation are shown in Figure 3.9.
One interpretation of these contrary developments is that the money market
regulations of June 1993 resulted in a diversion of funds, away from the equity
market towards the bond market. Banks' lending to securities companies and
TICS via the money market was curtailed and this reduced liquidity t'o the equity
and real estate markets, which declined. In addition to this, banks themselves
were for the first time given clearance to invest directly in bonds. Bonds are a
relatively attractive investment for banks, compared to loans to favoured industries,
as they offer higher returns. This suggests that the market from mid-I 994 to mid-
1 995 has been dominated by actions based on regulatory change. A third influence
on bond prices which became more relevant in late 1994 was the high announced
level of the inflation subsidy and the speculative fever attached to anticipating i ts
final value on a specific bond; the three year bond maturing in June 1995. 33
Some evidence for the diversion of funds from equities to bonds i s shown in
Figure 3.1 0 which plots average yield and the Shanghai Stock Exchange A share index. The decline in equity prices i s accompanied by a fall in yields.
In conclusion, i t must be pointed out that many o f the problems faced b y the
bond market in China today are the problems faced by an economy in transition.
Yet, even among transitional economies, there may be interesting differences in
approach, and there are lessons to b e learned from the experience o f other
countries.
Figure 3.10 China: equity index and average bond yield
Index Per cent
' _ - 12 , ,
800 * , , * - - - > , - % , - - - - > . . 10 \ . > , . . , ' \ , \ .
600 " ' 8
, . \ ' I
400 200 Average yield
0
Source: Calculations based on data provided by the Shanghai Stock Exchange
Government bond markets in Russia and China: a comparison
Russia, another large country in transition developed due to high inflation.
between central planning and a market Virtually all debt issues are of three economy system, offers an interesting month maturities. By contrast, China contrast to China, in terms of bond market until 1994 had issued debt on two
development. There are str iking and three year maturities, and it was
differences in the evolution of the two only in 1994 that it issued bills of six
systems, and the problems which each month and one year maturities. The
country faces: short end of the market is relatively
undeveloped in China. The Russian bond market i s much There are very few non-government
smaller than in China. The volume of debt securities in Russia. Russian outstanding treasury bills amountsto firms can and do default on their
only 1.8 per cent of GDP. obligations. Russian banks are In terms of maturity, debt issues are likewise very aware of the credit risk
concentrated at the short end of the of clients and other banks, unlike market, and the medium and long Chinese banks.
ends of the market have not been -9
M o n e y markets i n Russia are
relatively free, with no interest rate
controls. There is no central credit
plan. The central bank has a discount
rate, changes in which triggers other
interest rate adjustments. Russia
issues its three month bills at regular
intervals, o f th ree weeks. T h e
implication of these factors is that
(unlike China) the short term yield
curve is relatively wel l defined.
Investors i n government bonds i n
Russia, un l i ke China, are mostly
wholesale, and most ly f i nanc ia l
institutions.
Un l i ke China, Russia faces major
d i f f i c u l t i e s i n t h e t r a d i n g o f
government bonds due to the lack o f
technology wh ich wou ld permit a
nationwide market. Virtually all trade
takes place at MICEX, the Moscow
Interbankcurrency Exchange, where
the shortage of screens restricts trade
to a virtual cartel of only 55 primary
dealers. Brokers cannot trade at the
exchanges, unlike China, which has
a large network of brokers, and screen
based trading at all its several major
bond trading centres. The primary
reason for this restriction is to preserve
the integrity o f the market against
fraud and default.
The problem of developing a national
market in Russia is more severe than
in China, due to the huge problems
of the payments system, which imply
that participants from regions outside
Moscow havedifficulty accessing the
market. This is i n contrast to the
intercity linkages o f the major trading
centres i n China, and the unifying
effects o f t h e e lect ron ic t rad ing
systems of STAQS and NETS.
Endnotes
1 This was due to the government's decision, in the latter half of 1993, to prevent a feared large-
scale diversion of funds out of the banking sector and towards capital markets, due to their relatively
attractive performance and higher returns in this year. The role of bank credit relative to enterprise
bond issue, in terms of their assigned quota under the credit plan, was therefore increased.
2 Capital market liquidity increased markedly following the legalisation of inter-regional trading in
October 1990 and the subsequent development of STAQS and the Shanghai Stoclc Exchange.
3 Thus National Construction Bonds were intended to finance infrastructure and state enterprise
investment in general, while Key National Construction Bonds were targeted tmoward priority
national projects. 4 For example, Fiscal Bonds were also intended to raise funds for capital construction projects, but
were issued exclusively, and on a mandatory basis, to banks and other financial institutions.
5 The SEEC at the time assumed the role of a co-ordinating association for the securities institutions
of China, in the absence of a national oversight body. Later that year the PBC and local finance
bureaus also organised an 'underwriting syndicate' for a further Rmb4 billion of treasury bonds.
Moreover, this underwriting by banks may have been closer to administrative placement, de facto.
6 The organisation of the underwriting syndicate however, seems to have precluded some of the
benefits of underwriting, such as permitting underwriters to offer bids for prices, commissions, or
terms, and as such was semi-administrative. Even the underwriting projections were fixed by the
Ministry of Finance.
7 Primary dealers in China's bond market are defined as follows: they are qualified to participate in
the national underwriting syndicate, they have the privilege of discussing issuance terms with the
Ministry of Finance, they wil l have the privilege of underwriting open market operations and
bond repurchase with the PBC, and they can set up investment funds in bonds. They also have
the duty of protecting the liquidity of secondary markets and can actively undergo bond trading
as commission agents, or on their own account. Underwriting is therefore just one of their functions.
8 Due to declining competition from equities and real estate, itself partly due to the government-
imposed delay in the issue of new equities and certain types of non-government debt, as well as
the clamp-down on real estate speculation.
9 One reason for the 'voluntary' application for quotas may have been the relatively attractive
coupon, and hence ease of placement, combined with a small commission or fee.
10 In 1995, Rmb 25 billion of the year's issues of Rmb 125 billion was placed by a group of financial
institutions, operating as primary dealers. This first tranche was issued on 1 March, 1995. These
three year bonds carried a coupon of 14.5 per cent with no inflation adjustment. They were
paperless, tradable, and in book entry form. Another Rrnb 105 billion of government bonds issued
at the same time, were placed though the five specialised banks for distribution on a retail basis
through their local branches. These bonds were not tradable, they were issued in certificate form,
and they did carry an inflation adjustment. The coupon rate before adjustment was 14 per cent.
This issue thus resembled the Rrnb 70 billion of certificates issued in 1994. Two further issues
were made later in the year, which were smaller in size; an issue of Rrnb 10 billion of one year
paper in July 1995, listed on the exchanges and in book entry form, and placed with financial
institutions, and finally, a small issue of Rrnb 2.6 billion in August 1995, placed for the first time
with financial funds, issued in certificate form, with a 5 year maturity and an inflation index.
11 The present arrangement appears to be based on historical practice associated with the plan
cycle. Another reason for lumpish issues may be a desire to avoid competition between different
securities.
12 The central government has a surplus in the first half of the year and a deficit in the second half
and so the Ministry of Finance, considering good debt management practice, would clearly prefer
a different sale pattern.
13 Payment of a semi-annual coupon may make the debt attractive to more sophisticated investors,
but secondary market trading prices suggest that the payment of an annual coupon on the five
year 1933 treasury bill did not give it enough appeal to overcome investor disli,ke of long maturities.
14 The data are based on initial placement. Reliable data on end holders of debt securities is not
available. The table wil l understate the proportion of debt sold to households in earlier years, as
enterprises passed on some of their debt to workers and may overstate the proportion held by
individuals in later years to the extent that:
undetwriters have retained treasury bills for their own portfoliosor have sold them to institutions
rather than individuals, and,
secondary market trading results in a net transfer to institutions.
15 The inflation adjustment is published on the 20th day of each month; adjusted according to the
inflation adjustments on the deposit rate, and a price index used by the PBC. In March 1995, the
adjustment amounted to 11.87 per cent. The PBC index differs from the index prepared by the
State Statistical Bureau; the former includes goods and services while the latter is based only on
goods. Moreover, the PBC index is not published. The formula used for the inflation adjustments
is as follows:
Adjustment = [(w, /w,,)-1)- r x n ] x 100 where
w, = the monthly price index, at time of maturity
wo = the monthly price index, at time of issue
r = annual interest rate
n = years to maturity
16 Bonds issued by provincial TICS did not have the approval of any government department. They
have a maturity of 5 to 20 yeqrs and are sold to both individuals and enterprises.
17 There are no specialised depositories for enterprise bonds. They are generally held in paper form.
18 In 1993 there was one prominent case of enterprise bond default; the Great Wall company incident.
The bonds had a coupon of 24 per cent, which the enterprise was later unable to honour.
19 Trade in Fiscal Bonds is not permitted, and Special State Bonds cannot be listed, and most of the
1994 and 1995 treasury bill issues are not tradable.
20 The first bond futures contract in China was put on the market on 26 December 1992. After a
year's experimentation and amendment to trading sales, it began real operation at the end of
1993.
21 Speculation on the inflation indexation of a treasury bond led to the recent tremendous increase
in futures trading on the Shanghai exchange, which as shown in Table 3.6 had rapidly outstripped
spot trading by January 1995. O n 23 February 1995, the volume of futures trading on the bond
market was nearly US$100 billion in a single day. Traders who had taken illicit short positions
defaulted, leading to widespread disorder and temporary market closure. The implications appear
to be that in China's present inflationary environment, index-linking, with a lack of transparency
in the redemption amount, may not be advisable, and also, that trading in derivatives requires
tighter regulation as well as supervision. Tighter regulations were drawn up rapidly after the
incident, with the publication of a 'Regulation on Bond Futures Trading', within days of the incident.
More details on international practice in terms of regulation of derivatives trading are available in
Chapter 5.
22 By the end of 1994, bond trading volumes on Shanghai were reported to be 300 times their 1993
levels.
23 Treasury bill holders can obtain short term liquidity against their portfolios via the growing market
in repurchase agreements.
24 In the early days of the market most trading was by individuals and, while individuals may still be
relatively more significant as clients of the provincial trading centres, on the major exchanges
where most turnover occurs it is institutions which dominate. For example, most of the bonds in
the depository of the Shanghai Central Clearing Corporation (a strong indicator of availability to
trade) belong to TICS, investment companies, banks and enterprises. Of the institutions, TICS are
reported to be the most active traders. Banks and insurance companies have become more active
from 1994 since previous restrictions on their holdings were removed after June 1993.
25 Trading in repos is conducted at the two major exchanges, Wuhan and STAQS. But trading
practices can range greatly due to the lack of uniform national conventions or rules. In Shanghai,
rep0 terms go from 7, 14 and 28 to 91 days, and bidding is on yield ratios. Wuhan has terms of
1, 2, 3, 6 and 9 months. O n STAQS, both terms and prices are negotiated between dealers.
26 A general description of the money market in China today (other than repurchase agreements) is
provided in a World Bank Country Economic Memorandum for China (Report No. 13399-CHA;
October 1994). Much of the market is used to conclude transactions that would occur intra-bank
in most market economies.
27 Internal transfers are complicated by the weak payments system and discouraged by the PBC's
branch-level reserve requirements. Afurther factor which geographically segments the interbank
market is intervention by local officials in reaction to the uneven rate of development across
China. Officials in some provinces try to place restrictions on the outflow of funds from their areas
towards others which may promise higher returns. The market is usually organised by provincial
branches of PBC which can further encourage transactions to remain within a particular area.
28 The interest rate ceiling is set with reference to deposit rates. In 1994, the ceiling (which also
applied to repos) was 1.098 (monthly rate) per cent. Loans to banks cannot exceed 40 days, and
to NBFls, 7 days. In practice, longer maturities are achieved through roll-overs, and the lending
ceiling has also been circumvented. Average maturity prior to 1994 is estimated, de facto, to
have exceeded a year, in the absence of administrative intervention (SEEC, 1995). The central
bank had repeatedly issued regulations to limit terms, usually to little avail (see Chapter 2).
29 The PBC is examining the use of open market operations as a mechanism for implementing
monetary policy. Two technical requirements for open market operations to work are that banks
hold a portfolio of treasury bills and thatthe interbank market is an efficient channel for distributing
system-wide liquidity.
30 By August 1995, the Shanghai Exchange had around 60 regional depositories and the Shenzhen
Exchange had its own, numerous separate depositories. The Government of China is aware of the
drawbacks of the present arrangement and is trying to establish a Depository Trust Corporation
with help from the Central Bank. The new instiiution wil l offer custodial and settlement services
to its members as well, and wi l l be affiliated to the present exchanges.
31 A benchmark issue is an issue which provides a reliable indicator of the market yield for a given
maturity due to good secondary market liquidity. Such an issue facilitates debt issuance by providing
an indicator against which to price new issues. Benchmark issues of different maturities help to
define the yield curve.
32 The volume of debt issued today is in principle sufficient.
33 Inflation peaked in October 1994 but remained high in early 1995. The government employed a
series of measures to curb credit growth and further raised interest rates (PBC lending to financial
institutions) in the first half of 1995. But bond trading volumes remained high and prices rose
further, therefore, yields probably fell during this period.
Introduction: Equity Markets and the Shareholding System
The development of a primary share market in China began informally in the
early 1980s. Initially, stocks in China differed from the concept of equity as
understood in a market economy in a number of ways. They usually carried a
fixed income with a fixed maturity and were issued to raise funds for specific
investment. In these respects, they bore a closer resemblance to bonds. The
exercise of shareholders' ownership rights and privileges was given low weight.
Stocks were initially issued largely to employees, rather than the public, sometimes
in lieu of bonus payments. Public stock issue began from 1984' and an informal
secondary market began shortly after, but did not really develop until 1988, when
the government first permitted the trade of state treasury bills. Share trade was
legalised with the formal recognition of the Shanghai and Shenzhen Stock
Exchanges in 1990 and 1991. Numerous informal stock trading centres were also
set up.
The concept of shareholding in China has now been formalised in the Company
Law. Shares are now issued in perpetuity, to a cross-section of investors, and
listed and traded on domestic and overseas exchanges. Yet, the issue and trading
of shares in China still has some special characteristics. Unlike many emerging
markets, government privatisation plans did not lead to the creation of, (unlike
Eastern Europe) or even significantly stimulate (unlike Indonesia, or many Latin
American countries) the development of China's equities markets. While the
development of a private shareholding system has necessarily involved a degree
of 'privatisation' in terms of dilution of the government's share in ownership, it is
not referred to as such. Some limited privatisation i s thus tolerated, but not, so far,
encouraged.' 'The sale of existing government shares to private shareholders is
still not permitted, and thus firms 'go to market' with new share issues. The primary
aim of listing i s therefore the raising of capital for investment. The proportion of
shares held by private investors is typically small (although the new Companies
Law requires at least 25 per cent of asset value for a new listing), and therefore
the extent to which shareholders can be expected to influence governance is
very limited. Using the stockmarket as a mechanism for merger or take-over threats
is rare.
In many respects, equity markets in China evolved spontaneously and more rapidly
than the government had foreseen, as enterprises sought new ways to raise capital.
This i s clearly illustrated in the description of China's share categories and their
evolution. Government recognition, and the drawing up of appropriate regulations
for the activities of the market, evolved expost facto. Officially, the Stock Exchanges
of Shanghai and Shenzhen have been authorised by the State Council to operate
strictly 'on an experimental basis', and equity markets are regarded as a controlled
experiment. The government has retained a high degree of control on the listing
of new enterprises, in terms of enterprise choice and the value of new stock issued,
as part of the credit plan. The government is now closely monitoring the
authorisation of new exchanges, and the overall degree and direction of growth
permitted to the fledgling market.
The rapid growth of the market, in terms of the number of listed shares, trading
value, and market capitalisation, has already been described in Chapter 1 (see
also Appendix Tables A4.1 -A4.5). The present chapter first details additional key
characteristics of these markets. It then analyses the efficiency of these markets,
focusing in turn on three key areas:
the primary issue process for new equity
the trading process or operation of secondary markets, and,
the issue of market segmentation, in the context of China's multiple share
categories for ordinary shares, and multiple exchanges.
The final section briefly examines some additional issues facing the efficient
development of these markets.
Principal types of shares in Chinese shareholding enterprises
China is relatively unique among emerging market economies in having a number
of different types of ordinary shares. There are five different types of ordinary
shares in China at the moment. They are set out in the Standard Opinion (see
Chapter 2 ) but are not described in the Company Law. A Chinese shareholding
enterprise can issue more than one type of share; and all enterprises which have
issued B shares or H shares (see below) also have A share issues. A shares, B
shares, H shares and N shares all enjoy the same rights and obligations (ie rank
par; passu) except that dividends on B, H and N shares are paid in foreign currencies.
A shares and domestic investors
In terms of size and level of activity, the A share market dominates China's equity
markets. These shares are equivalent to ordinary equity shares as generally accepted
in market economies. In China they are also known as individual or natural person
shares, to distinguish them from legal person or C shares (see below). A shares are
Rmb denominated and traded, and are the only class of domestic share that can be legally traded on the two major domestic exchanges . A shares may only be
bought and sold by individual or legal persons within China (but are distinguished
from legal person shares which individuals may not purchase). Employee shares
are also A shares. Because of the minority nature of A shares in enterprises'equity
structures, A shares give investors voting rights with little if any prospect of control.
Although overseas investors are not permitted to purchase A shares, it is generally
acknowledged that a small proportion of A shares are already in the hands of
foreign investors, probably Taiwanese, by investment through locally registered companies. The size of such investment is likely to be very small. It was such
clandestine entry into the domestic market by foreign investors which first prompted
the government to authorise legal investment by foreigners, in the form of B shares.
The possibility of permitting non-Chinese nationals to purchase A shares through specially authorised joint venture mutual funds was announced by the CSRC in
late July 1994, but no firm details were issued.
B shares and overseas investors in China's equities markets
B shares are ordinary shares bearing the same voting or ownership rights as A shares, denominated in Rmb but traded in either US dollars (in Shanghai) or Hong Kong dollars (in Shenzhen) and listed only on the SHSE or the SZSE. B shares may
only be subscribed by, and traded among, foreigners, and residents of Hong Kong,
Macau and Taiwan. The Chinese authorities are now proposing that B shares should be called domestically listed and foreign invested shares and that Chinese nationals with access to foreign currency should be allowed to purchase B shares
as well as A shares. In reality, Chinese nationals have already been acquiring B shares through overseas relatives and Hong Kong entities and therefore such
regulations would formalise and facilitate the current situation. The CSRC has
stated that it is intended to abolish B shares as a separate category when the yuan
becomes freely convertible.
H shares and the listing of Chinese companies in Hong Kong Some Chinese companies began to take stronger measures to access overseas
equity financing, by acquiring controlling interests in Hong-Kong listed companies.
Such 'back-door' listings of Chinese companies in Hong Kong (around 20 cases)
were frowned upon by the authorities. A variety of companies based in Hong
Kong are in fact controlled by mainland Chinese. These so-called 'red chips' or
China plays include high profile groups such as CITIC Pacific and Guangdong
Investment. Both these have blue-chip rank in the Hang Seng index.
Partly in response, to establish a legal avenue for overseas listing, a new category
of shares was officially created in July 1993 - H shares. H shares are listed on the
Hong Kong Stock Exchange and traded in Hong Kong dollars. H shares may only
be subscribed by, and traded among, foreigners and residents of Hong Kong,
Macau and Taiwan. Such shares are effectively a primary listing of a foreign
company on the Hong Kong exchange and are not unusual in principle. Their
novelty lies in the fact that special arrangements have been adopted and in practice
certain concessions have had to be made to accommodate the current lack of a
conventional legal infrastructure in the PRC.
N shares and listings in New York Similar to back-door listing on Hong Kong, back-door listings of Chinese
companies in New York began through overseas registered holding companies.
After some two or three such 'Bermuda listings' had occurred, the legal registration
and listing of Chinese enterprises on the New York Stock Exchange, using the form of American Depository Receipts (ADRs), was authorised (seechapter 5 for
details). The term 'N shares' should refer legally only to these ADRs, but the term
is sometimes used more broadly to include all China-related NYSE listings, and sometimes used more narrowly, to refer only to those New York ADRs which
have no corresponding issue of A or H shares; ie, they are uniquely traded in the
US.
C shares: legal person shares These are a category of shares not found in ordinary market economies. They
have been created in the PRC to designate holdings in SOEs by official bodies
such as state institutions, other SOEs and government departments. Individuals
are prohibited from holding C shares. But Chinese state institutions, enterprises
and departments having legal person status are entitled to purchase A shares as
well as C shares. C shares are traded over-the-counter on the hlETS and STAQS
systems and are generally very illiquid. The effect is that firms with a large
proportion of their capital structure in legal person shares are subject to higher
costs of capital than if they had more A or B shares. By October 1994, there were
only 17 C shares listed; ten on STAQS and seven on NETS, but it is estimated that
over 4,000 joint stock companies have issued C shares by way of private placement.
New listings of C shares have been banned since June 1993.
The official policy towards legal person shares has been under review. Many
companies would now like to convert their C shares into Aor B shares. However,
one of the over riding issues in this market has been official concern about allowing
the transfer of state assets into the public domain (ie conversion to A shares) and
perhaps more significantly foreign ownership (ie conversion to B shares, H shares
or N shares). Another apprehension about allowing the conversion of C shares is
that it could flood the usually sluggish securities market. At the same time, i t is
Dazhong Taxi The issue of the conversion of C shares
to B shares became topical in 1994 when
Dazhong Taxi company of Shanghai
expressed its intention to do so. Dazhong
proceeded to convert 10 million C shares
into 10 million B shares. C share holders
stood to benefit the most as the holding
of B shares afforded them the possibility
of capital appreciation (the trading
inactivity on the C share market
officials are still somewhat apprehensive
about approving conversions for all
companies. Authorities cite the fact that
the shares converted in Dazhong's case
represented a very small amount of the
overall shareholding structure of the
company (7.9%) implying the importance
of maintaining state control. Nonetheless,
Dazhong wi l l now have foreigners
holding 47.6% of the shares as compared
1 effectively ruled out this possibility) and with the 44.4% held by the state. This
it helped Dazhong to increase the foreign majority holding is a unique
liquidity of its B shares. However even situation among Chinese companies. though the conversion was approved,
argued that if C shares were allowed to be converted the proceeds from the
conversion could be used to purchase other classes of shares and thus add to
liquidity in the A and B markets.
Characteristics of China's Equity Markets
Turnover and market liquidity
A key issue to note is the contrast between activity levels on the A and B markets.
In contrast to the A share market, B markets are very thin, with low turnover
compared to A shares. On the Shanghai Exchange, A share turnover activity, in
terms of the daily number of shares traded, exceeded 1,250 million shares and
Rmbl0,OOO million on a number of occasions in 1994. The average daily trading
volume in the third quarter of 1994 was 577 million shares with a corresponding
daily average value of Rmb4,772 million. By contrast, B share turnover only rarely
exceeded 15 million shares and US$50 million The average daily trading volume
in the third quarter of 1994 was ten million shares with a daily value of Rmb44
million. The implication is that in the third quarter of 1994 activity in the A share
market, measured by the number of shares, has been approximately 55.7 times
greater, and measured by value 108 times greater than for B shares.
Similar patterns of activity are to be found in Shenzhen. For A shares, the volume
of trading often exceeded 700 million shares and Rmb5,000 million in 1994. The
Figure 4.1 Average daily trading value of shares
Rmb million A shares B shares
Rmb million 400,000 6,000 - 350,000 Shenzhen B
5,000 - shares 300,000
4,000 - Shanghai B 250,000
shares 200,000 3,000 -
150,000 2,000 - - -
100,000 - 50,000
0
Q1 0 2 Q3 Q4 Q1 Q2 0 3 Q4 0 1 Q2 Q3 0 1 Q2 Q3 0 4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
1992 1993 1994 1992 1993 1994
Source: Calculatio~is based on data from the Shanghai and Shenzhen exchanges
average daily trading volume for A shares in the third quarter of 1994 was 300
million with a value of Rmb2,028 million. The volume of trading in A shares on
Shenzhen has therefore been approximately one-half of that on the Shanghai
market, although there is enormous inter-day variability in volumes traded. For B
shares the volume of trading on the Shenzhen Exchange fell in 1994 from peak-
levels reached in 1993. In 1994 daily volume of trading peaked at around 2
million shares and RmblO million. This compares to peaks exceeding 15 million
shares and Rmb400 million on the Shanghai Exchange. The daily average volume
of trading in the third quarter of 1994 on the Shenzhen Exchange for B shares was
1.35 million shares and Rmb7.25 million.
A more meaningful measure of market liquidity i s the relative turnover rate or
turnover ratio on the two major exchanges, defined as average daily turnover
(value) divided by outstanding market capitalisation. Since B share market
capitalisation i s much smaller than A share markets, the turnover ratio is a more
relevant measure of market liquidity than absolute trading values. For Shanghai A shares the third quarter 1994 daily turnover rate was 4.72 per cent versus 4.5 per
cent for Shenzhen. For B shares, the Shanghai turnover rate was 0.4 per cent
versus 0.28 per cent for Shenzhen. Thus, A share markets have been much more
liquid than B share markets, with respectively Shanghai and Shenzhen A (B) markets
reflecting similar degrees of liquidity.
Table 4.1 Concentration ratios of member firms trading on the Shanghai Stock Exchange (January, 1995)
Rank Market share (%) T-bonds T-bond
Total A shares Funds T-bonds futures B-shares repurchases - - -
No. of firmsa 314 302 272 98 3 07 37 3 7
Rank of firms (Market share) Top 1 10.6 4.5 19.2 14.4 10.6 12.0 16.3 Top 5 23.0 15.2 32.3 51.2 23.0 45.1 49.6 Top 10 32.5 23.6 43.1 65.5 32.5 74.9 66.3 Top 20 44.2 35.3 54.3 77.1 44.3 95.7 00.6 Top 50 64.6 51.2 67.1 88.1 64.6
- - -
Note: "Only the top 320 firms, in terms of total trading volume, were included in the sample.
Source: Shanghai Stock Exchange: monthly market statistics, January, 1995
Concentration On both exchanges members can have more than one seat on the exchange. For
example, the Shanghai Exchange has around 3,800 seats but only 540 members.
Members from outside Shanghai are encouraged, and of the 541 members of the
Shanghai Exchange, close to 500 are located outside Shanghai, in 21 centres
linked to the trading floor by a communications satellite network and telephone
(Appendix Table A4.5). Despite the large number of members, trading i s highly
concentrated among a small number of members. As Table 4.1 shows, the top
ten members account for over 30 per cent of all trades placed on the Shanghai
E~change.~
Trading is also fairly concentrated in terms of individual shares (Table4.2). Looking
at five firm concentration ratios, the top five firms on the Shanghai Exchange
accounted for almost one quarter (23.4 per cent) of total trading value, and 29 per
cent of shares traded. Concentration was even higher on Shenzhen, with the top
five firms accounting for 36.9 per cent of trading value and 31.3 per cent of share
turnover. With the growth of the market, however, trading concentration declined
to half, or less than half, of these levels.
Table 4.2 Concentration of share trading on China's securities exchanges (Five firm concentration ratios: percentage share of top five firms)
Number of Concentration by Concentration by Concentration by
observations trading value trading volume trading volume
(Nos.) (Turnover value) (Shares traded) (Lots traded)
Shanghai Exchange
1993 83
1994 195
Shenzhen Exchange
1993 61
1994 138
Note: Since the data available extended till early September 7994, the observations for both years are based on
data for the first eight months of the year, to ensure comparability.
Source: Calculations based on data from the Shanghai and Shenzhen Stock Exchanges
Figure 4.2 Shanghai securities exchange
index (Index value as of 2711195) 3 7nn
Industrial Commercial Utilities Miscellaneous Real estate
1 Source: Shanghai Securities Exchange data
Sector
lndustrial
Commercial
Utilities
Miscellaneous
Real estate
Listings
120
35
13
24
12
Sectoral composition
Sixty per cent of the shares listed on the Shanghai Securities Exchange are industrial
companies. Commercial and miscellaneous companies account for another 30
per cent, while real estate and utilities enterprises each account for around 6 per
cent of the number of firms listed. Yet, real estate companies have more than
twice the turnover for listing of industrial or commercial firms (Appendix Table
A.7). A sectoral disaggregation of stock indices in January 1995 also shows that
the index for these enterprises was higher than for other sectors (Figure 4.2).
Clearance and settlement
Settlement of transactions on both exchanges is aided by the book-entry nature of
the share-depositories. As of 1 January 1995, A shares are settled at T+l on both
exchanges. This is quite a technical feat given that on the Shanghai market, shares
are registered at the individual level rather than at the broker-level (or nominee
level) as in Shenzhen. Prior to January 1995, shares were actually settled at T+O.
Currently, there are over 5.4 million separate shareholder accounts at the Shanghai
depository compared to a few hundred broker accounts in Shenzhen. By contrast
B shares are cleared at T+3 on both exchanges as a result of the need for payment
to be made in foreign currencies and transactions to be recorded with global or
regional custodians off-shore (eg, in Hong Kong). Currently, there are only 16,000 B shareholder accounts at the Shanghai depository, indicating the relatively
institutional and international nature of the B share market compared to the
predominantly retail and local A share market. Payment, clearance and settlement
issues are analysed in greater detail in Annex 4.1 .
Transaction costs Buying and selling shares on the exchanges i s subject to commissions, fees and
stamp duties. Commissions and stamp duties are paid by both buyer and seller.
Like many Asian exchanges such as Japan, trades are subject to fixed commission
charges. Estimating overall transaction costs i s complicated by the prevalence of
fees and other hidden charges by brokers but estimates suggest that total (two-
sided) transaction costs (including a 0.3 per cent stamp duty paid by both parties)
exceed 1.5 per cent on the Shanghai Exchange and 2.0 per cent on the Shenzhen
Exchange. It is illegal for brokers to sell shares to buyers on margin. In effect,
margin requirements are 100 per cent Margin-type loans have nonetheless been
extended by brokers to favoured customers.
Taxation and dividend payment
Trades on both major exchanges are generally free of either capital gains or dividend
taxation. While a 20 per cent capital gains tax exists as part of Chinese law it has
never been levied on equity transactions. Tradingfor short term gains i s encouraged
by this very generous tax regime. In addition, there are no taxes on dividends. A
remarkable feature of dividend payment in China is that cash dividends are rarely
paid. When paid, dividends have taken the form of new stock (typically stock
options). One reason cited for this is that enterprisesr cash flows from profits are
constrained, by a series of required allocations to special funds for staff welfare,
bonuses and enterprise expansion. The absence of meaningful dividends has
encouraged transactions based on capital gains seeking. This in turn has tended
to divorce stock prices from their fundamental values (the current and expected
future values of dividends) and has enhanced market volatility.
Secondary markets for equities in China
*the Shanghai and Shenzhen Exchanges (see also Chapter 2, and Appendix Tables
A4.1 and A4.2) The Shanghai Exchange was formally recognised on 19 December 1990, and the
Shenzhen Exchange on 3 July 1991. Apart from trading A and B shares, they also
trade debt securities (53 on Shanghai and 12 on Shenzhen), funds (12 and 8,
respectively) and warrants (one, on Shenzhen). Both exchanges exclusively trade
the shares listed on their own exchange. Companies from areas outside the
respective municipalities are permitted to list on the SHSE and SZSE. There is no
dual listing, and there are therefore effectively two official national systems. Both formal exchanges have members from every province ir, the PRC. The Shanghai
Exchange now has interlinked trading centres in 20 cities, and is also linked to
STAQS (Appendix Table A4.5). Trading centres outside Shanghai now account
for 29 per cent of stocks, and 15 per cent of bonds traded on the Shanghai Exchange
network. There is a substantial overlap in membership with approximately two
thirds of brokers being members of both exchanges. Non-Chinese members have
recently been admitted to both the SHSE and SZSE.
Electronic over-the-counter markets The Securities Trading Automated Quotations System (STAQS) was developed by
the Stock Exchange Executive Council (SEEC) and launched on 1 July 1992. It
has been described as a Chinese version of the National Association of Securities
Dealers Automated Quotation System (NASDAQ) adopted in the US. However,
STAQS is now based on four trading floors as earlier attempts to expand it as a
fu l l y electronic market were prevented by the lack of an adequate
telecommunications network.
The National Electronic Trading System (NETS) was established by the China
Securities Trading System Corporation Ltd (CSTS) on 28 April 1993. CSTS is owned
by the People's Bank of China (PBC), four other big banks, the People's Insurance
Company and three national securities companies. t h e system has been installed
in a number of cities using the PBC's VSAT satellite network to link up the trading
centres. CSTS has long term plans to extend the system into a national trading
system based on its satellite communications network.
STAQS and NETS trade bonds and SOE held C shares. They do not trade the A
and B shares of listed companies. Companies with C shares traded on STAQS or
NETS are not permitted to issue or trade A or B shares. The CSRC does not
regulate the STAQS or NETS systems, although i ts rules can affect them, as for
instance in June 1993 when the CSRC banned the listing of further C shares on
any markets. Since that date trading volumes on both systems have been mainly
concentrated in government debt. The number of shares and volumes traded on
these over-the-counter markets is small. STAQS lists ten C shares and had a peak
trading volume of Rmb40 million in August 1994. Daily trading volumes were
Rmb2-3 million per day in September 1994. hlETS lists seven C shares and has
lower trading volumes than STAQS.
Stock trading centres Informal Stock Trading Centres have been set up in most large cities and this
'unofficial' market is now believed to be large. At the end of 1994, there were 17
such centres (Appendix Table A4.6). Apart from government bonds, much of the
trading at these centres consists of locally formed closed end mutual funds. Tianjin,
one of the larger exchanges, lists nine such funds. The Stock Trading Centres have
an organisational structure, members, trading rules, trading sites and most other
attributes of an exchange. But they are not considered self-regulatory organisations,
nor have they been authorised by any agency of the government to operate as
'exchanges.' Each requires approval from the PBC to operate, and indeed many
have been set up jointly by, and enjoy the support of, the local government, and
local PBC office. However, the PBC has no regulatory authority beyond that and
neither does the CSRC. The CSRC's view is that if they took responsibility for
such markets it would incorrectly suggest they are officially recognised.
Future exchanges In early 1994, the two existing exchanges were not considered adequate to meet
demand, especially in Northern China. Authorities in other cities have been
lobbying to establish official exchanges. Hainan Island started an exchange which
was rapidly closed by the authorities because of its weak regulatory structure.
The current draft of the proposed National Securities Law suggests that additional
exchanges may be established. But in late 1994, authorities publicly stated that a
third exchange will not be established in the near future.
From 1997, of course, the Hong Kong Stock Exchange will be a Chinese exchange. A
working group has been established to investigate possible areas where the Hong Kong
Stock Exchange and the SZSE could cooperate. (Discussed further in Chapter 5).
The New Issue Process And Public Offerings
The first issue analysed in the present chapter concerns the listing process and the
efficiency of the primary market. Enterprises in China are listed on stock exchanges
primarily for the purpose of raising capital for investment, unlike many other state
enterprises in transitional economies, where enterprises 'go to market' for divestiture
or privatisation. All enterprises listing on stock exchanges in China have issued
new shares. Virtually all new issues have been first time offerings or initial public
offerings (IPOs). The present section examines the efficiency of both the pre-offer, or the initial selection mechanism, and the post offer, or the method by which the
listing is undertaken, once an enterprise has been selected for listing.
The pre-offer process
The aggregate value of new shares to be issued each year is a part of the national
investment and credit plan (as discussed in Chapter I), with the new share issue
quota for A shares determined jointly by the State Council Securities Committee
(SCSC), the State Planning Commission (SPC) and the central bank (PBOC).4 In
1993 the A share quota was Rmb5.5 billion of which Rmb2.8 billion had been
used by the end of 1993 (Appendix Table A4.8). A quota of Rmb5 billion was
announced for 1994, but in July 1994 the government announced a moratorium
on new 'A' share issues due to perceived instabilities in the stock market, leading
to an under-utilisation of the year's quota. As the table shows, the quota is allocated
by province as well as by 'independent-plan' municipalities. The criteria used for
allocation among provinces appear to reflect a balance between balanced regional
dispersion for distributional objectives, and a recognition of wide regional
differences in the production structure and enterprise base.
Within each regional quota, the local securities authorities invite enterprises to
request a listing, and make a selection based on criteria which combine good
performance, as well as sectoral development objective^.^ Local government
selection criteria take into account the profitability and performance criteria of
the exchanges. As a result, the real selection of enterprises for listing occurs at
this level. For example in 1 993, of around 1 00 firms which applied for A share
listing in Shanghai, approximately 30 were approved by the Shanghai Securities
Administration. Although these candidates are then required to seek the approval
of the CSRC and the exchanges themselves, approval at these successive levels i s
virtually automatic. While in principle any enterprise going public can list on
either exchange, this too is strongly influenced by local securities authorities.
€3 share quotas in 1993 were set at US$l00 million for each of the two exchanges
of Shanghai and Shenzhen. In 1994, a combined national quota of US$1 billion
was announced.' In addition to approval by local authorities, companies desiring
a €3 share listing also require the approval of the Ministry of Foreign Trade and
Economic Co-operation (MOFTEC). Overseas listing (for H shares or IN shares) i s
not subject to a quota but requires case by case approval, which has to be given by the SCSC, the SPC (in view of the annual overseas borrowing plan), the SRC
(for approval of state ownership dilution) and the SETC (for conformity with
industrial policy). Nine companies were authorised to issue H shares in Hong
Kong in 1993, and a further 22 companies were authorised for H share issues in
1994. In practice, constraints, in the form of the relatively low demand by foreign
investors for B and H shares, has limited the number of new B and H issues. For
example only 4 out of the 22 approved H share issues have been made in 1994.
The targets for new B shares also have little chance of being met.
The process described above of the selection of enterprises for listing differs
considerably from a more mature market economy, where the decision to list an
enterprise would usually be determined largely by the exchange where it seeks a
listing. The criteria adopted by the exchange would typically include size,
performance, and the extent to which compliance with the rules of the exchange
could be expected. The pre-offer process in China reflects the dilemmas of a
transitional economy where the planning mechanisms for credit and investment
are co-existing uneasily with new forms of markets. As a result, enterprises selected
for listing, though perhaps more successful than the average state enterprise, are
unlikely to be the same as the ones which would have been selected by the
market. While the establishment of independent review panels attempts to reduce
the arbitrariness of the selection process, it also leaves the system open to influence.
If the soundness of underlying performance is not the sole, or at least major
criterion, the result i s a distortion in the efficient allocation of resources.
Figure 4.3 China: a stylised /PO process: post-offer to the beginning of trading
4 6-8 weeks w
Sales proceeds from forms I T h e ~ o f a ~ ~ prospectus is Rmb are divided between the 1 state (65%) and the broker
or bank (35%)
1 Source: Interviews with exchanges and listed enterprises ~
The post-offer process
Once an issue is selected, a filing is made with the CSRC. Afiling fee of Rmb30,OOO
is paid by the enterprise and the CSRC undertakes a 'due diligence' type analysis
of the enterprise. Although approvals are meant to be made within 20 days (similar
to the US SEC) delays and refilings may stretch the filing period to two months or
even longer. In October 1994, the CSRC had approved all 190 of i t s 190 filings.
That is, the screening out of new applicants always occurs at the Municipal
Securities Administration level rather than the CSRC level.
After the offer (IPO) is announced, there are a number of further steps before it
starts trading. A stylised or representative example of the IPO underwriting process
in China i s shown in Figure 4.3. After the announcement, and publication of the
prospectus, underwriters are chosen, largely at the discretion of the local securities
authority, although the role of the local authority appears to have diminished
towards the latter part of the period examined. Prospective investors obtain
application forms from banks or brokers, at a small fee. In some cases, the fee
was subsequently divided between the brokers (who retained around one third)
and the state securities authorities. In other cases, brokers' fees were separately
determined. Only retail investors are legally eligible to buy the application forms
for a public offering8 Since the early lPOs were usually oversubscribed by a large
multiple, a lottery was then conducted to determine the final allocation of available
shares to investors.
New issues have tended to be made in 'lumps' or 'tranches' in which lotteries
typically determine both whether an investor is eligible to apply at all, and which
enterprise's shares he or she can buy. The histograms of new offering frequency
on the Shanghai Exchange show considerable bunching around July 1992 and
October 1993 (Figure 4.4).
Once the lottery has been completed, winning shareholders pay for their shares,
through cash or advance deposits at banks. Share ownership claims are then
allocated, and trading can begin on theexchanges. 'The stylised IPO underwriting new issue process has commonly taken as long as 1 1 / 2 months; not dissimilar
from the time taken for new issues in Hong Kong, Singapore, Taiwan and Thailand.
Figure 4.4 Initial offerings of Shanghai A and B shares
Number of new firms listed A shares
10 5 n
m m m s ! ? . . . r 7 m m v 7 7 7- $ 8 . . . . G z . s ? e ?- v 7 . 7 . 7 7 (D r m c o : a , - . .
$! ii3 g r e m
?-
Number of new firms listed
6 - - B shares
5 -- 4 -- - - 3 --
2 --
Source: Calculations based on data from the Shanghai and Shenzhen exchanges
The efficiency o f the new issue process
How efficient is the new issue process? One measure of the efficiency of lPOs i s to see how realistic the pricing levels achieved by the process are. The efficiency
of new equity issue pricing, (ie, pricing at levels close to what the market would
be willing to pay) is crucial for any emerging market ec~nomy .~ First, an ill-designed
new issue mechanism that results in significant underpricing, (ie, a public offer
price well below the stock market's valuation of each new issue), implies in China
that there is a large differential between the (administered) offer price and the
market price, determined after trading begins. This limits the efficiency of the
resource allocative function of these new markets. Second, if new issues are on
average (or consistently) underpriced this raises false and unrealistic expectations
among investors. Such expectations lead to herd-like behaviour, speculative
bubbles and excessive price volatility. Third, to the extent that bank credit is used
to fund the purchase of new issues, it can distort the allocation of credit as well as
the money supply. Although in China, margin credit and bank credit for the purpose
of stock purchases are prohibited, there appear to be many indirect channels
through which credit and loans have been used to finance new issue purchaselo.
Fourth, this results in a wealth transfer from the general public (represented by the
state, as the initial sole owner of the enterprises) to a select group of private
individuals. Finally, the cost of capital to the firm is increased.
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The questions investigated here are:
How large has underpricing been in the Chinese equity markets vis 2 vis other
emerging market countries? Do we see diffe~ences in underpricing among A and B shares, in view of the
fact that B shares are purchased by supposedly more diversified and
sophisticated foreign investors? Is underpricing evident only on the opening of trading? In particular, does
underpricing decline as the issue gets seasoned in the aftermarket? As equity markets have matured, and local participants have become, more
experienced, has the absolute degree of underpricing declined? What has been the underpricing experience of new issues by Chinese
enterprises in Hong Kong (H-shares) or in New York (N-shares)? Specifically,
has the relative degree of underpricing been less and if so why?
The key findings to the analysis are summarised below (details are available in
Annex 4.2).
A shares First, examining the capital gains to those investors able to obtain application
forms and win allocations at the lottery (rrl ), the average returns, or average degree
of underpricing of A shares, is an extraordinary 732 per cent. That is, the opening
price on trading has been more than seven times higher than the offer price (Table
4.3).
Second, the risk-adjusted returns for those investors who bought at the open of
trading and sold at the close on the first day (rr2) were on average quite small (1.9
per cent). This suggests that, at least on average over the entire period examined,
brokers and dealers who legally abided by restrictions prohibiting them from
acquiring IPOfs in the lottery would have largely been precluded from enjoying
the massive wealth transfers from the issuing enterprises (or the state) to investors.
The very large returns to those who obtained forms in advance and the small
returns to those who waited till trading began would suggest that there were huge
incentives to brokers and dealers to circumvent the regulations and acquire shares
before trading began. These large initial gains declined markedly towards the
end of the period examined (see Annex 4.2).
Third, the returns to holding shares for longer periods of time were examined. If
the price of a new issue at open of trading represents an overreaction or speculative
bubble rather than the true economic or fundamental price, then we should witness
a significant decline in the stock's return in the aftermarket. An analysis of the
data showed relatively small declines. The return to a buyer of the average IPO on offer who holds it for 60 days (rr6) was 667 per cent, or not significantly lower
than the gains to selling at the opening of trade. Thus, the undervaluation of share
prices at offer i s real, and not a speculative phenomenon.
B shares An analysis of the underpricing results for B shares shows that the absolute degree
of underpricing for B shares has been less than that for A shares, but i s still
extraordinarily large by international standards.
On the first day's open, the average B share exhibited a return of 281 per cent
over its offer price (rrl). Moreover, as with the A shares, returns to the 'honest
broker'on day one are at least relatively low (85 per cent), and in addition, after-
market seasoning made little difference to these returns with (market) risk-adjusted
returns of 192 per cent over the offer price after two months (rr6).
A diagram of risk-adjusted returns to investors who are able to 'win the lottery' (ie,
r r l ) i s presented in Figure 4.5. Mean returns for A and B shares are slhown on the
x axis and relative expected frequencies on the y axis. Mean returns to both are
positive, to A are higher than to B, and in both cases, especially for A shares, are
widely dispersed."
Figure 4.5 Risk-adjusted returns to IPOs at Shanghai (Offer to opening price)
0% _ o c p a y c y o c u q m m o - 2 z z 2 : 3 a % : %
Mean returns
Source: Calculations based on data from the Shanghai and Shenzhen exchanges
Maturity effect (Annex 4.2, Tables 1 a and 1 b).
The above analysis i s based on average returns over the entire period since listing
and trading began on the Shanghai Stock Exchange. An important policy question
is whether the absolute degree of underpricing has declined as the market has
matured. If a market is maturing, and underwriters and enterprises learn to price
new issues more accurately, we should expect to see the absolute degree of
underpricing decline over time. Returns to new issues are therefore analysed
separately for each year, from 1991 to 1994. For A shares, returns to lPOs offered
in 1991 and 1992 were on average higher than those offered in 1993 and 1994.
Average returns from offer to opening (rrl ) declined from 1,246 per cent for the
52 A shares brought to the market in 1992 to 239 per cent for the 50 lPOs of
1993, and further to 128 per cent for the 8 lPOs of 1994. Similarly, for B shares
the degree of underpricing was considerably higher in 1992 (6 IPOs; 1,033 per
centj versus those brought to the market in 1993 (1 2 new issues; 14 per cent) and
1994 (5 new issues; 17 per cent). Indeed, the underpricing performance of the 17
B share issues in 1992-3 i s not very dissimilar from that experienced on many
mature equity markets.
H shares and N shares
The results of the analysis of 11 'H' share issues by Chinese companies in 1993
and 1994 up to October 1994 shows underpricing is a relatively modest problem
in this more mature market1*. Concentrating on the degree of underpricing between
the offer date and the first day's open price (rrl), these lPOs were on average
underpriced by 26.7 per cent (or 16.1 per cent, if one outlying observation is
removed from the ample).'^ This degree of underpricing is not very different
from that observed for B shares brought to the market in Shanghai in 1993 and
1994.
For N-share lPOs on New York, the offer price is usually set (less than) one day
before trading starts, and share allocations are at the sole discretion of the
underwriters. Data were available for only two N shares. For China Tire, the
degree of underpricing is estimated at 5.14 per cent, and for Brilliance China
Automotive Holdings, underpricing amounted to 25 per cent, or 15 per cent on a
weighted average basis. This degree of underpricing i s again broadly consistent
with that found in Hong Kong for H shares and more recently Shanghai B shares.
The results show clearly that by any international benchmark or holding interval
one finds that the degree of underpricing of A shares has been excessive. It is
particularly striking in view of the limited alternative investment opportunities
available in China, and has certainly implied a loss of potential investible funds
for the enterprises 'going to market.'
Comparisons with other countries
China is not alone in having its new issues underpriced (on average). Table 4.4
shows world-wide evidence of underpricing, defined as the percentage amount
by which the price on the first day of issue (usually the opening price) exceeds the
public offer price. More importantly, the evidence shows that underpricing is
relatively high in Asian countries such as Hong Kong (1 8 per cent), Singapore (27
per cent), Taiwan (45 per cent) and Thailand (58 per cent). Yet, as the table also
demonstrates, the average degree of underpricing in China over the entire period
examined far exceeded that observed in other markets. The problem remains
today although markedly less severe.
Table 4.4 /PO underpricing worldwide
Elapsed time Discretionary allocation Non-discretionary allocation
(days) Country Underpricing (%) Country Underpricing (%)
2 8
or longer
US (firm commitment)
Belgium
UK (placing)
Canada
Germany
Japan (post-1 April 1989)
Japan (pre-1 April 1989)
Australia
Brazil
Korea (post-June 1988)
Switzerland
France
Netherlands (tender)
Portugal (auctions)
UK (offer by tender)
Belgium (tender)
UK (offer for sale)
Hong Kong
Singapore
Taiwan
China
Shanghai A shares
Shanghai B shares
Note: Elapsed time refers to the typical time period from the ?etting of the offer price to the issue date.
Source: Loughran, Ritter and Rydqvist (1994)
Given that significant underpricing remains a problem in the A share market,
while B shares seem to increasingly exhibit international characteristics regarding
the degree of underpricing, what policy reforms to the new issue process might
be considered to improve the proceeds raised by enterprises and the allocation of
new issue gains among investors? In addressing this question it needs to be
recognised that underpricing will always be a feature of an emerging market in
which considerable information imperfections and political uncertainties exist.
INevertheless, the degree of underpricing observed in Thailand (around 60 per
cent) might be viewed as a not unreasonable short-term benchmark for Chinese
IPOs, compared to A share average underpricing of 128 per cent, even in 1994,
on the Shanghai Exchange.
Causes of inefficiencies in the /PO process
Recommendations for measures to strengthen the IPO process in China first require
an understanding of the factors leading to underpricing. First, as the table indicates,
underpricing in other countries has been associated with a relatively long elapsed
time lag between the public offer and issue date (exceeding one month). A second
factor i s a relatively high degree of investor uncertainty regarding the true quality
of the firm going public, due to weakness in disclosure and auditing standards.
Third, as also indicated in Table 4.4, the allocation mechanism adopted for the
new share issue affects the degree of underpricing. Non-discretionary allocation
of shares, by mechanisms such as a lottery, exacerbate the tendency to underprice.
Afourth reason is that the underwriting procedures and process significantly affect
the efficiency of pricing for new offerings.
Elapsed time lags
Because a long time period (usually one to one and a half months) has existed
between the announcement of an offering and the lottery, and because new issues
have been bunched, this has created classic conditions for information leakages and herding behaviour, ie, classic conditions for large-scale oversubscriptions
and underpricing. Long lags make it easier for investors to observe the subscription
demand of other investors (eg, news stories of queues or riots for application
forms). It i s interesting to note that two countries with relatively low degrees of
underpricing are the US and France, which have a very low 'institutional lag'
between the announcement of an offering and its actual offer. Efforts should clearly
be made to reduce such institutional lags.
The lottery system and non-discretionary share allocation
Two problems with the [PO process have clearly been the lottery system and the
associated clustering of new issues. The combined impact of these two has been that investors do not even know which enterprises' shares they may acquire, making
it impossible to undertake investment decisions based on fundamentals. The
demand for equity i s thus necessarily driven by speculation. While limited
availability of information due to poor disclosure is certainly true, under this system
investors would be precluded from using such information even if it were available. A first step would therefore be to avoid the bunching of IPOs. Second, authorities should then ensure that each new offer is backed by widely-available and reliable
information about the fundamentals of the enterprise.
It has sometimes been suggested that the lottery system may provide revenues to
local authorities (through the price charged for the form), and that this revenue
will necessarily increase with the degree of oversubscription. Moreover, the system,
sometimes adopted in the past, of sharing such revenues between the state securities
office and participating banks or brokers who distributed the forms, tended to reduce the incentive of all agents other than the enterprise to raise the offer price,
as the demand for application forms was reduced. While it is difficult to assess
how widespread such revenue-sharing arrangements are today, one
recommendation which emerges is that charging a price or fee for application
should be discouraged.14
The underwriting process
Another factor concerning the underwriting process is the relative monopoly enjoyed by local underwriters. The selection of the underwriter is often guided by the local authorities approving an enterprise for listing. Regional authorities tend
to choose two to three local underwriters to syndicate an offering. By comparison in some countries (such as the US) syndicates compete to become the new issue
underwriters. Competition among underwriters has the potential of raising the
offer price received by the issuer in a firm commitment underwriting mechanism,
because in order to win the underwriting contract the underwriters are willing to take more risk. Local underwriters may be relatively inexperienced. Preferring to
err on the side of caution, and ensure that the subscription i s a 'success', in terms of high demand, it has been suggested that local authorities and underwriters
tend to advocate low prices. Encouraging more competition in the underwriting
process i s recommended. It i s recognised that if this process is pushed too far
there i s the risk of overpricing and bankruptcies . . among the least experienced
local underwriters. To protect against this, appropriate criteria for permitting
participation in the underwriting process should be developed.
In addition, foreign underwriters might be allowed to become members in A share
underwriting syndicates. Foreign underwriters are already allowed to participate
in B share underwriting, and this overseas experience may account for the lower
degree of underpricing on the B share market. In most cases B share offers have
taken the form of private equity placements rather than initial public offerings, in
which the overseas distributional networks of foreign securities firms such as
Sassoon, JP Morgan etc have played a crucial role. It i s recognised that a potential
problem with foreign securities firms playing active roles in A share underwriting
syndicates i s the current restrictions on their overseas customers holding domestic
A shares. The extent to which this i s advisable i s revisited in Section D below. It
is also recognised that large-scale participation by foreign underwriters may
discourage the development of the 'infant' domestic financial services sector.
Cautious and limited collaborations with overseas underwriters could be launched
in an initial phase.
The present 'firm commitment' underwriting mechanism usually adopted in China
also needs to be revisited. This mechanism creates incentives for underwriters to
set the price low, to ensure the placing of the whole issue with outside investors.
As a result the costs (or benefits foregone) of underpricing are borne by the issuer
(the enterprise) rather than the underwriter.15
In the US, the underwriter has completediscretion in allocating shares to investors
(underwriting by the 'bookbuilding' method). Primary buyers of new issues tend
to be largely wholesale buyers such as institutional fund managers. Such discretion
would clearly be inadvisable in the current nascent stage of Chinese equity markets where there are already profound concerns about the social fairness of the current
lottery system. Indeed, it would probably enhance the tendency of underwriters1
brokers to favour certain customers at the expense of the small retail investor.
While this system of underwriting has reduced the US institutional lag (to around
one day), China may prefer to consider the French system of allocation; the
discriminating price auction. This is similar to the system used in many government
bond markets. France has the lowest average degree of underpricing (4 per cent),
and also enjoys an institutional lag of less than a day.
At the end of 1994 there were two experiments with this type of auction in China,
one on the Shanghai Exchange and one on the Shenzhen Exchange from March
to April 1994. In the Shanghai auction the underwriters set a minimum reserve
price and investors bid for the shares using the exchange's screen technology.
Shares were allocated in descending order of price bid with the whole process
being completed in a few hours. It is recommended that the municipal securities
authorities, exchanges and CSRC continue to encourage experimentation with
the auction process.
Credit availability
A parallel set of policy reforms could be aimed at further monitoring the leakage
of credit to retail investors seeking to invest in new issues. Legally, banks cannot
provide credit for stock purchase nor can brokers (implying an implicit 100 per
cent margin requirement for stock purchase). However, reportedly there have
been many indirect ways in which bank loans have been channelled into stock
purchase and in which brokers have provided credit to favoured customers. While
the problem is said to be less severe in primary than in secondary markets, it i s
recognised that these indirect channels are very hard to monitor and control, and
require an examination of the 'firewalls' between the banking system and the
non-bank securities firms, investment companies and trust and investment
corporations that participate in the securities markets.
As China's financial markets mature and interest rates elsewhere in the economy
grow more flexible, the appetite of Chinese investors for A shares as the 'only'
investment that promises a possible return above inflation i s likely to decline. In
addition, as retail investors learn by experience and become increasingly
sophisticated they wi l l no longer chase every issue that comes to the market. Both
these issues are likely to have a secular effect in reducing the degree of underpricing
of A shares. As the analysis above of the IPO return data for 1993 and 1994
showed, such a process has already begun.
Stock Price Volatility and Returns to Investors
The second issue examined i s the efficiency of trading on China's equity markets,
and specifically, the low levels of returns to investors, and the efficiency of the
pricing mechanism, and the high degree of variability of these returns, as evidenced
by their volatility. An empirical examination of the behaviour of prices and returns
on the Shanghai and Shenzhen A and B markets shows that, due to the different
investment clienteles in the A and B markets (small local retail investors for A
shares and foreign institutional and wealthy investors for B shares), there are
significant differences in the return and volatility characteristics of the two share
categories.
First, looking at returns to investors, the results are summarised in Table 4.5. The
table shows that:
Returns (risk-adjusted) have, on average, been very low, on both share categories
and on both exchanges.16 Returns on A shares are similar on the two exchanges (assuming a one-week
holding period). There i s a significant difference between returns to B shares and returns to A
shares. Returns on B shares at both exchanges have been relatively poor. B share (one-week) returns are 0.0 on Shenzhen and negative on Shanghai. For longer periods, returns on Shanghai A shares improve, but returns on
Shenzhen A shares deteriorate further. Risk-adjusted returns on H shares in Hong Kong are higher than on B shares in
China.
Table 4.5 Trading on China's equify markets: returns and volafilify
Shanghai Shenzhen Hong Kong
A shares B shares A shares B shares
Returns
One week returns
Mean returns
Std deviation
Risk-adjusted returns
Ten week risk-adjusted returns
Twenty week risk-adjusted returns
Autocorrelation of returns
One-week lagged auto
corr. coefficient
Autocorrelation of volatilities
First order squared returns
0.1 7
sig. at 95 %
0.01 4
not sig.
0.27
sig. at 95%
-0.036
not sig.
0.38
sig. at 99%
significant
0.026
sig. at 95 %
significant
0.28
sig. at 95 %
not sig.
Source: Calculations based on data from the Shanghai and Shenzhen Exchanges
142
One measure regarding the efficiency of these markets concerns the degree to
which these returns are autocorrelated over time. In a highly efficient equity market
news is immediately impounded into stock prices. Since news arrives at random
intervals (and can be good or bad) we would expect to observe a low degree of
correlation between successive index returns." In less efficient markets, where
trading is thin and news and information are dispersed among investors relatively
slowly, we might expect to see some degree of autocorrelation among returns
over time. The results show:
The markets are poor in terms of pricing efficiency, measured in these terms.
The performance of the A share market in Shenzhen is much poorer in this
respect than Shanghai. O n Shanghai the implied efficiency of the B share market i s much poorer than
the A share markets, but in Shenzhen this appears not to be the case. These problems appear to be present in the Hong Kong traded China shares as
well.
Figure 4.6 China: Shanghai and Shenzhen share indices and volume of trade
Shanghai A shares Daily turnover Shenzhen A shares Daily turnover
(No of shares) Index (No of shares) (billion) Daily furnover (billion)
la00 . r 1.80 400 - r non
Shanghai B shares ( ~ ~ ~ f ~ ~ ~ ; Shenzhen B shares Daily turnover
Index
[BlnllDl.dY)
(No of shares) (billion) r00D)
9 Daily turnover I Daily turnover
Index r 35 T I T 25,000
1 Source: Calculations based on data from the Shanghai and Shenzhen exchanges.
Next, looking at market behaviour in terms of volatility, the problem of extreme
price volatility, which the Shanghai and Shenzhen markets have exhibited since
opening, is illustrated in Figure 4.6. For example, the Shanghai A share index
more than doubled in a single day, from 61 7 on 20 May1 992, to 1266, on 21
May. By 17 November 1992 the Shanghai A share index had fallen back to one
third of this level, to 393. More recently, this index was trading at the 400 level in
July 1994 but by September 1994 it had risen above 900.18
More detailed analysis of the behaviour of the markets in this regard shows:
A share markets in both Shanghai and Shenzhen have exhibited far greater
volatility than B share market.19 The absolute sizes of volatility 'jumpsfin the Shenzhen A market have generally
been less than those in the Shanghai A market. Both these points are illustrated
by an examination of the standard deviations of share prices on both exchanges
(Figure 4.7). Volatility patterns in Shenzhen, in both the A and the B share markets, like the
behaviour of returns, suggest that markets are thin and inefficient, and that
information i s dispersed slowly to i n v e s t ~ r s . ~ ~ Particularly large daily jumps in volatility have been noted on a few specific
dates.
While excessive volatility appears to be a common feature of equity markets in
their formative stages, persistent and high levels of volatility can discourage a
Figure 4.7 Shanghai and Shenzhen: share price variance (Ten-week standard deviations)
Standard Deviation Shanghai Standard
Deviation Shenzhen
Source: Calcubtionr bared on data from the Shanghai and Shenzhen exchanger ~
market's growth. In particular, more risk-averse investors are likely to seek
alternative outlets for their saving^.^' The important questions to address, from a
policy perspective, are: what factors give rise to the poor efficiency and high
volatility of equity trading in the case of China, and, what action can regulators
take to bring volatility under control?
First, through identifying the causes of volatility, it i s clear that, as pointed out in
China, a basic factor has been the short-term horizons and speculative behaviour
of poorly informed retail investors who place little apparent value on underlying
economic fundamentals of enterprises (such as dividends) in determining firm
equity values. But this short-term behaviour itself is encouraged by a number of
other factors, such as:
the IPO process, (as discussed in the previous section), including limited
disclosure and the 'lottery process' associated with the bunching together of
I POs. The tendency of wealthy investors and brokers to engage in front-running
behaviour that is nothing less than overt market manipulation, itself the outcome
of relatively limited supervision of intermediaries in the securities markets.22 The absence of an enforced capital gains tax, which would encourage
shareholding for longer periods of time, also encourages short term speculation. The typical non-payment of cash dividends implies that the only way of realising
cash gains is by capital gains rather than by the dividend income flow. The absence of large, stable institutional investors is certainly a factor, but as
pointed out above, not a sufficient explanation for market behaviour.
In addition to these factors, a major contributant to market volatility has been the
succession of regulatory 'events' generated by the government. As illustrated
above, there have been specific instances of very big jumps in A share price
volatility; notably, in the data above, May 1992, December 1993 and July 1994.
The May 1992 and July 1994 jumps are clearly attributable to government policy.
The first jump followed the removal of the 5 per cent daily price change limits for
individual stocks on 20 May 1992 which led to a one-day doubling of the Shanghai A share index. The July 1994 jump reflects the 'market support' policies announced
at the time by the CSRC which included:
a moratorium on new A share issues (to raise prices by restricting supply)
easier credit availability for brokers in Shanghai through a special line of credit,
and,
stimulating the establishment of mutual funds, though the establishment of
new funds and possible foreign participation in this industry.
The market support measures of July 1994 contributed to the near tripling of
Shanghai A share index values in the following two to three months. The Shenzhen
A market also showed a significant (but less dramatic) reaction to the July 1994
announcements. Most recently, the market had a dramatic negative reaction to
the government's announcement banning same-day settlement, on 1 January 1995,
followed by a sharp market reversal in February, with another announcement,
requiring the payment of cash dividends.
It i s ironical that many of these announcements were made with the intention of
'improving' market functioning, and reducing volatility. But in practice, polices
such as the sudden lifting of individual share price ceilings in May 1992 and the
July 1994 moratorium on new A share issues (plus other market support actions)
appear to have actually enhanced volatility. This suggests that the Chinese
government and CSRC must adopt a longer term perspective of the types of
regulatory policies that would suppress rather than encouragevolatility, by inducing
investors to taking a long-term view, linking their investment decisions more closely
to underlying asset values of the enterprises in which they invest.
A first measure to be considered is the reintroduction of daily price limits. t h e
success of this measure in the past is illustrated above, where it occurs that pre-
May 1992 A share volatility levels appear to have been significantly below post-
May 1992 volatility levels. Korea kept individual price limits on stocks for over
20 years, whereas they were removed in less than two years in China. The
advantages of price limits is that they suppress volatility and allow investors the
time to revise their expectations about any given news item. It thus prevents
excessive over-reaction among relatively unsophisticated investors and limits the
profit incentives of those who float such rumours. O n the other hand, it must be remembered that price limits wi l l interfere with genuine price adjustments and
potentially create (considerable) autocorrelations or trends in daily price
movements. A possible approach would be to set price limits with higher
boundaries than those established in the pre-May 1992 period, to inhibit abnormal
daily volatility. For example, normal daily volatility over the December 1990 to
September 1994 period was 6.3 per cent (weekly standard deviation divided by
K) on the Shanghai A share exchange; thus individual share price change limits could be set at that level or above.
Second, appropriately structured taxes on capital gains can discourage speculation.
In developed economies, where taxes are relatively easy to collect, a two-tier
short versus long-term capital gains tax could be applied, imposing a higher tax-
rate on short-term (under one year) capital gains versus long-term (over one year)
capital gains. This type of tax structure existed in the US until 1986. However, in
view of the potential difficulties of tax collection in China, such a tax might require
~impli f icat ion.~~ A more transparent tax might be imposed, Iinked to share turnover.
Since ownership claims are computerised as book-entry items on both exchanges,
it should be possible to monitor transaction behaviour of individual investors and
traders through their accounts at depositories. A transactions tax inversely Iinked
to the time a stock was held (speed of turnover) would penalise those investors
who take a short rather than long-term view. A flat turnover tax (such as recently
implemented in Israel) would probably not create sufficient incentives to deter
gains trading. However, arguably, the information systems needed to accurately
track and historically record the buy and sell orders of individual investors are not
in place in China nor wil l they be for some time.
Third, the CSRC, the PBC and the exchanges must take a more pro-active stand
on insider trading and front-running. The failure to prosecute all but a handful of
cases has encouraged the most egregious types of manipulative behaviour. The
effective introduction of the NYSEfs 'Stock Watch'system in Shanghai wil l provide
a tool for monitoring the market and identifying offenders. However, monitoring
i s not enough without enforceable penalties.
The above policies are largely short term. Afourth, more secular policy to reduce
volatility, i s to create a market environment in which investors are encouraged to
take a long-term view. This may be achieved by at least three different routes.
Cash dividend paying by firms must be en~ouraged .~~ Currently, dividends
appear to be very much a residual after a firm i s required to make allocations
from profits to various /poolsf including investment, bonus and staff welfare.
To make dividends more prominent, enterprises must be given more discretion
on dividend payments (especially cash rather than stock dividends) and
dividend announcements should be made at least annually. Foreign securities firms such as Merrill Lynch and Morgan Stanley should be
allowed to trade A shares (as well as B shares). Such firms with their relatively
sophisticated analytical tools and advice would be likely to add some degree
of stability to the A share market at least in the long-run.
The development of longer-term private pension and mutual funds should be
encouraged (discussed in greater detail in Chapter 6). Such funds with their
long-term horizons would counter balance the largely small retail-oriented
investor equity markets that currently exist. Given appropriate income tax
incentives, small investors may well choose, in the longer term, to invest in
the equity market through mutual and pension fund vehicles rather than through
di rect share purchase. As discussed i n Chapters 5, just such an
institutionalisation of the equity market has occurred in the most developed
equity markets, such as the New York Stock Exchange and the London Stock
Exchange.
Market Integration: Current and Potential
The third key policy issue confronting the development of China's equity markets
concerns market segmentation, both across different exchanges (geographical
segmentation), and different share categories (segmentation by investor type).
Today, cross-listing of shares at the two official Exchanges of Shanghai and
Shenzhen is not permitted. The listing of enterprises at the other exchange-style
trading centres (Appendix Table A4.9) is not recognised under national law. The
multiple share categories in China which have already been described, separate
shares according to whether their holders are resident or non-resident, individual
or institutional, and whether the shares in question are traded in domestic or
overseas exchanges.25 Geographical segmentation in China arose due to the fact
that 'exchanges' were established independently at different locations, in the
absence, initially, of a uniform national framework. Today while many core
elements of a national framework are being put in place by the centre, the extent
to which all individual regulations should be subsumed under a single national
law i s a serious issue. Segmentation by domestic and overseas investors has
arisen because of fears, which have legitimate precedent, of the possibly
destabilising impact of volatile capital inflows and outflows.
-the question today i s whether the need for this type of segmentation still exists. The costs of market segmentation are a decrease in liquidity, and a likely decline
in the pricing efficiency of the markets due to thinness of trading; reduction of
access to available investor bases; and likely illegal transactions with 'leakages'
arising due to the possibility of arbitrage across markets. Moreover, the government i s aware of the potential advantages of a 'National Stock Market' and has been
debating the possibility of allowing one of the present exchanges, such as Shanghai,
to develop into such a national market. In this context, this section will first
examine the extent to which market segmentation has existed, and its effects, and
then discuss policy options for market integration, or the emergenc~e of a national
market, in the future. On domestic exchanges, the emphasis i s on the largest
categories of traded shares; Aand B shares, in the two largest Exchanges; Shanghai
and Shenzhen.
In the first section of this chapter, the significant differences in the liquidity of the
A and B share markets were discussed. A second measure of the market integration
across exchanges and share categories i s to measure the correlation of share
movements. Results show that:
A type share index movements are closely integrated across exchanges as are
B index movements, however, the integration between A and B share index movements is
B and H share indices are highly correlated, indicating that international
investors tend to look at similar economic factors in making investment and
pricing decisions about these two share classes. The slightly higher correlation
of B and H for Shenzhen may reflect the fact that both are tracled in terms of
Hong Kong dollars (Shanghai B stocks are quoted in US dollars).
The low degree of correlation between A and B share indices and returns i s not
surprising since these share classes have different investor clienteles with different
investment and risk preferences. B share investors can more easily diversify risk
internationally. They also have greater concerns about Chinese sovereign and
political risks, such as expropriation, and they are exposed to foreign exchange
risk as well as liquidity risk, given the relative thinness of trading in the B share market.
Although A and B shares only weakly move together over time, both classes have
potentially the same dividend and voting rights. An important question which
follows is, are their prices similar, and if not, which price is usually higher? That
is, for Chinese enterprises issuing both A and B shares, what i s the price premium
or discount between A and B shares? This i s the third measure of market integration
examined here. In most emerging markets, foreign-owned shares have normally
traded at a premium to domestically-owned shares2' Spreads between the price
premiums and discounts between individual enterprise A and B shares on the
Shanghai and Shenzhen Exchanges are shown in Figure 4.8. As can be seen, on
average Chinese B shares trade at a considerable discount to A shares. In fact, the
daily average discount of B shares relative to A shares over the period analysed
was 21 3 per cent. Furthermore spreads have been lower in Shenzhen than
Shanghai, by approximately half.
What can explain the reason for the discount on Chinese B shares while foreign
held shares in other Asian emerging markets tend to trade at a premium? First of
all there i s the high differential in liquidity. Foreign-owned and domestic-owned
shares can be traded back and forth among investors in Thailand, Singapore and
Korea, while China is relatively unique in having two distinct classes of shares,
and B shares have a relatively low capitalisation compared to A shares. A second
reason is that foreign investors require higher risk premiums to hold Chinese shares, due to economic uncertainties and political risk.28
Figure 4.8 Spreads between Shanghai and Shenzhen A and B shares (Discounts of B shares to A shares)
% Discount of B shares to A shares Shanghai
- 0
450 - /D Discount of 400 -- 350 -- 300 -.
I % Discount of B shares to A shares Shenzhen
250 - -% Discount of B shares to A shares
50 --
n Q2 Q3 Q4 Q1 Q2 Q3 93 93 93 94 94 94
Source: Calculations based on data from the Shanghai and Shenzhen exchanges
The analysis of premiums and discounts can be similarly calculated between A,
B, H and N shares, in cases where a given firm issues or trades shares both
domestically and internationally. Figure 4.9 shows the discounts on Hong Kong
H shares relative to A shares issued by the same enterprise. For six matched H
and A stocks, all H shares stood at discounts to their respective A shares. The daily
average discount was 47.6 per cent.
Figure 4.9 also illustrates price differentials for a New York listed enterprise,
Shanghai Petrochemicals, relative to both its domestic and Hong Kong market
price. For the H shares, the daily discount averaged only 0.2 per cent. For the A
shares, the daily discount averaged 1 5.3 per cent. Indeed, while the discount
started high, it has fallen over time and for a short while was negative (ie, the A
share traded at a discount). As wi l l be discussed in Chapter 5, this enterprise
presents a special case in some respects, and i s considered to have a good
performance relative to other New York listings. Since even in this case, the New
York listing traded at a discount, it reinforces the finding that shares held by
overseas investors trade at a discount to domestically held shares.
Figure 4.9 Discounts on shares listed in overseas exchange
% Discount of H shares to A shares % Discount of Shanghai Petrochemicals
200- 120- ADR to A shares
100.. - 0 /. Discount of ADRs to A shares
- %Discount of 60 .. ...... % Discount of shares to A shares 40 .. ADRs to H shares
-50 - 1993 1994
Source: Calculations based on data from the Shanghai and Shenzhen Exchanges and the New York Stock Exchange ~ What are the policy implications of these findings? First, the data on the correlation
of returns shows that Shanghai A and Shenzhen A stock price indices and returns
have tended to move together over time, and thus, they appear to respond to
common news and economic factors. This raises the question of the potential for
a fully national market for enterprises' shares. At the moment A shares listed in
Shanghai are heavily associated with enterprises located in the Shanghai 'region' while Shenzhen and Guangdong enterprises are heavily represented on the
Shenzhen Exchange. These are thus largely regional exchanges, reacting to some
common factors and news. To create a more national market for shares the
government and regulatory authorities should encourage cross-listing of A shares
on the two major Exchanges.
Such cross-listings would potentially benefit investors and enterprises by creating
a deeper and more liquid market for shares as well as giving an enterprise a
national identity or brand label. Of course, the risk to each exchange i s that the
other exchange will attract the bulk of the volume of shares traded, marginalising
the exchange that fails to compete effectively. Discussions suggest that today,
this i s perceived to be a danger at the Shenzhen Exchange, although exploratory
discussions on the possibility have already begun. An alternative way for a national
market to develop would be by direct government intervention, that is, through
the government directing new issues and trading volumes to one particular
exchange, and restricting trade at other exchanges. Arguably, cross-listing
competition among exchanges would be likely to produce a slower path to a full
national market, but such a process is potentially more beneficial, to both investors
and enterprises, if the exchanges compete for business and national market share
though lowering fees and commissions, and improving the efficiency of their
trading services. Furthermore, some enterprises, due to the nature of their business,
may only serve a regional area. Such enterprises then have the option of listing
on a local exchange, possibly at a lower fee or with less onerous listing
requirements.
The question which follows is, what are the current barriers to the cross-listing of
A, or B, shares on the Shanghai and Shenzhen Exchanges? There are barriers of
varying degrees of severity, at least four levels. The first set of barriers are at the
issuer level. Here the problem is the regional equity quota allocation system.
Since local municipal authorities determine share allocations, and since they have
an interest and commitment to building up the business of local stock exchanges, they have a strong interest in getting those enterprises that receive a new issue
quota to list on the local exchange. This effect can only be ameliorated, eventually,
by eliminating the national quota system. That is, a reduction in the power of the
municipal securities authorities may be a necessary step in moving towards a
national stock market.
The second set of barriers are at the investor level. Today, shares on the Shanghai
market are registered in the individual shareholder's name while those on the
Shenzhen market are registered at the broker (nominee) level. Thus a system would
need to be arranged whereby investors on one exchange could open accounts at
depositories on the other exchange. This would allow them to trade and settle
any given share on both exchanges, inhibiting price discrepancies and arbitrage
possibilities. For example, Shanghai investors could open accounts with Shenzhen
brokers (who settle on their behalf), while Shenzhen brokers could open direct
accounts at the Shanghai depository. Interviews with depository officials suggested
that at the technical level, the ability to undertake this exists already.
The third set of barriers exist at the member or broker level. Membership of an
exchange gives a broker quasi-monopoly power (with other members) over trade
in shares on that exchange. Indeed, franchise value is created by making
membership as restrictive as possible. By giving access to a broker from a competing
exchange (membership, or seats) the franchise value of existing brokers wil l fall.
In China today, this difficulty may be eroding, as many large brokerage houses
(an estimated 80 per cent in August 1995) already have cross-membership at the
two exchanges. But one can expect to see opposition to cross-member access on
exchanges by small local broker members.
The fourth barrier is technological. For an effective national market to develop,
screen and other information technologies would need to be available to give
investors speedy access to price and volume information on the same share in
both markets. Not only would such information have to be available it would
have to be widely available across a large set of investors (both wholesale and
retail) at relatively low cost. The failure to develop the technology to make
information widely available could result in considerable inefficiencies, with the
same stock trading at widely different prices on the two major exchanges. Given
the current quality of Chinese equity information technology it may be a number
of years before a fully 'price' integrated national market becomes feasible for all
but the very largest sized A share issues.
Other Issues: Enterprise Debt Securities
In addition to equities, Chinese enterprises are permitted to issue debt securities.
But China's corporate bond market has failed to develop. Some of the factors inhibiting the development of this market are briefly discussed here. In theory,
corporate bonds or enterprise bonds potentially give significant advantages over
equity to both investors and enterprises. Yet few bonds have been issued and even fewer are traded. The over-the-counter bond markets at Wuhan and Tianjin
trade almost exclusively government bonds and investment trusts. Relatively few
corporate bonds are actively traded on the Shanghai, Shenzhen, NETS or STAQS
Exchanges. In the third quarter of 1994, trading in enterprise bonds on the Shanghai
Exchange amounted to Rmb1.46 million (US$200,000 or 56 transactions) while
trading in financial bonds (issued by financial institutions) amounted to RmbO.616
million (US$80,000, or 15 transactions). In Shenzhen no enterprise bonds at all
were traded in the third quarter of 1994.
Why is this the case? On the issuer side is the fact that Chinese enterprises have
long relied on bank credit for leverage. The close links developed between 'main'
bank lenders and associated enterprises has discouraged a switch to corporate
bond debt. In addition, in many countries of the world the interest on corporate
debt is tax deductible (as an expense) against enterprise profits or net income
while dividends are not. In China, by contrast, bond interest paid by an enterprise
provides no such tax shelter.
On the investor side the advantage of corporate bond debt is that it gives the
holders (in theory) priority in bankruptcy over equity holders. That is, corporate
debt i s a senior claim on an enterprise's assets in most developed capital market
systems. In China, bankruptcy laws have yet to be fully developed and bankruptcy,
particularly with claimant losses, is virtually unknown, even though it i s estimated
that as many as 100,000 Chinese enterprises are technically bankrupt.
Moreover, there is a technical difficulty limiting the national growth of a bond
market. This is the fact that coupons would have to be physically paid to and
collected by an investor locally from an enterprise in the absence of a national
distribution system for coupon interest. Such a system would require centralised
book-entry records of owners and ownership changes on corporate bonds.29
For these reasons it i s likely to be a number of years before a significant corporate debt securities market emerges. Nevertheless, it is worth recognising that even in
highly developed countries, such as the US, with the largest corporate bond market
in the world, less than 0.2 per cent of corporate bonds are traded on the New
York Stock Exchange. When corporate bonds are traded, they are traded among
major dealers, (such as Salomon Brothers and Morgan Stanley) on an over-the-
counter screen-based system. Thus, we might expect that in the future any growth
in trading is likely to take place in the form of OTC trading among institutional
holders of these bonds rather than among retail investors on the two major Stock
Exchanges.
Endnotes
1 'In July 1984, China's first securitised corporation, the Beijing Tianqiao Department Stores Ltd.,
was registered in Beijing. The company, formed by merging two state-owned department stores
and a wholesale store, openly issued Rmb3 million worth of shares to domestic institutions as
well as individuals. The fixed assets of the original stores, which had belonged to the central
government, became the government's share of the investment in the new company (51 per cent),
while the rest of the shareholding was split among state-owned banks (26 per cent), other firms
(1 9 per cent) and private investors (4 per cent).'Hu Yebi China's Capital Market, Chinese University
Press, Hong Kong.
2 In a speech on 28 October 1994, Premier Li Peng appeared to suggest a more open acceptance
of privatisation in the future, stating that by the year 2000, one third of all state-owned companies
would be privatised or would otherwise face the prospect of bankruptcy.
3 Compared to the two major exchanges, STAQS has 388 members (1 50 seated at the exchange).
NETS has 60 members connected to four micro-computers by a satellite dish, with no trading
floor.
4 Quotas for new share issues have been low compared to quotas for bond issues and these are
both low compared to the proportion of investment financed through bank loans. The relatively
small size of the annual new equity quota reflects also the cautious and experimental approach
adopted towards the development of the stock market in China. See Chapter 1, and also a World
Bank study on Public Investment (Report No. 4CHAER058, November 1995).
5 The Shanghai Securities Exchange Commission (1 994) first classified its applicants by sector, then
appointed an 'expert team' for investigating each sector's applicants and assigning them a rank,
and finally chose the top few performers per sector in accordance with state priorities. In 1993,
infrastructure enterprises especially in electricity and water supply were deemed to be priority. In
1994, the persistence of fixed prices in these sectors led local authorities to hesitate to select
them.
6 As a result, Shanghai has tended to attract mostly large industrial companies while Shenzhen lists
smaller, export-oriented companies.
7 The aim was to encourage B share listings from outside the province. In mid 1994, of the 22 B
shares listed at Shenzhen, only one was from a company outside Shenzhen.
8 However, discussions of the huge capital gains that have been evident on the first day of trading
suggest that brokers may have unfairly directed these forms to favoured customers and/or put in
illegal (disguised) bids themselves.
9 The Shenzhen riots of August 1992 were the consequence of an inefficient new issue process,
which resulted in oversubscription by a multiple exceeding 600 times.
10 For example, evidence from Hong Kong and Singapore has shown money supply increases of 30
per cent or more around the time of major new issues.
11 The coefficient of variation, expressed as a percentage, is slightly higher for A shares (66 per cent)
versus B shares (61 per cent). Note that in the diagram (Figure 4.5), a normal distribution of
returns around the mean has been assumed.
12 A 12th issue, Shanghai Hai Xin Shipping Co. Ltd., was listed on 11 November 1994 and a 13th,
Zhenhai Refining and Chem~cals, on 2 December1 994. Data on these were not available for the
analysis.
13 Risk- adjusted for returns on the market, this time using the Hang Seng index (HSI) as the market
benchmark. The outlying stock is the Kunming Machine Tool Company, which was underpriced
on a raw return basis by 136 per cent and on a risk-adjusted basis by 128 per cent.
14 To the extent that fees are charged to cover processing costs, these can instead be charged to
winners of the lottery afterwards, or to other costs recoverable from new or existing shareholders.
15 In the 'firm offer' method of underwriting, the underwriter guarantees a certain price to the issuing
enterprise. Alternative underwriting systems include the 'best effort' method, in which the
underwriter agrees to sell as many shares as possible, for a fee or commission, and the 'auction'
method, underwhich a minimum price is set, and the underwriter agrees to buy acertain percentage
of residual shares, if necessary, at the reserve price.
16 For ten week holding periods the mean weekly risk-adjusted returns on Shanghai A shares were
0.325 and for the 20 week holding period 0.284.
17 That is, stock returns should follow a random walk over time.
18 Early indications are that the introduction of the T+l settlement system in January 1995 has
helped reduce volatility.
19 A detailed description of the estimation undertaken is given in Annex 4.2.
20 In other words, volatility is significantly autocorrelated over time, in the Shenzhen market, as
Table 4.5 shows.
21 Excessivevolatility, where 10 per cent daily rises and falls in the market index areseen as 'normal,'
has been common in other Asian equity markets at similar stages of develolment. For example,
Hong Kong went through a period of considerable volatility in the early 197(1:, while the Korean
and Taiwanese markets also exhibited considerable volatility in the 1960s and 1970s.
22 'Front-running' refers to market manipulation by brokerswho float rumours that are likely to sway
the market, when they may be in a position to take advantage of such market movements. A
classic case was a week in October when rumours about the health of Deng Xiaoping resulted in
a fall of 40 per cent in the Shanghai A share index on one day, followed by a jump of 36 per cent
in two hours the next day when the rumour was denied. By buying and selling in front of such
news leaks large investors and brokers can make huge potential gains at the expense of small
retail investors.
23 It is also recognised that policies towards capital gains on share trade cannot be imposed in
isolation, and must be in line with tax policies towards capital gains elsewhere in the economy.
24 Policies introduced in 1995 to only permit stock dividends if cash dividends have been paid,
allow stock dividends to be paid only once in twelve months, and only up to one-third of total
dividend payment, are a move in the right direction.
25 See Chapter 1 and Chapter 4 Part A.
26 Details are in Annex 4.2.
27 A paper Bailey and Jagtiani (1 994) found that the premiums paid for shares by foreign investors
were of the order of zero per cent to 30 per cent over the prices paid by domestic investors.
28 Bailey (1 994) found some evidence of foreign investors demanding relatively high risk premiums
on certain Chinese B shares.
29 See Chapter 3. This is one reason why Chinese bonds are typically non-interest bearing.
ANNEX 4.1 CLEARANCE, SETTLEMENT AND DEPOSITORY SYSTEMS
Introduction
An efficient clearance, settlement and depository system (CSD) allows investors to maximise their asset allocation opportunities and enhance the liquidity of their
asset portfolios. CSD services effect transfer of ownership to the securities buyer
and payment to the securities seller. An efficient system does so promptly at low
cost, with a minimum degree of uncertainty that the transaction will be concluded
on the precise terms agreed to in the trade. The efficiency of clearance and
settlement services determines a significant part of the cost to the investor of
buying or selling a security.
Issues relating to CSD cannot be divorced from the national payment system.
This is because while CSD services may be provided by an exchange, or its direct
agent, the payments system will reflect the nature and the functioning of the banking
system. The mirror image of every securities transaction will be some payment by the buyer. An inefficient payment system can therefore be as much a barrier to
an efficiently functioning securities infrastructure as a poorly designed CSD system.
Clearance involves the determination of what each counter-party owes and is
due to receive in a trade. This trade determination may or may not involve netting
of trades among participants (bilateral netting) or with the CSD organisation itself
(multilateral netting). Settlement is the actual transfer of securities from the seller
to the buyer. Settlement can take anywhere from T+O (same day) on some
exchanges to as long as a month on others (T+20). Payment is the cash side of the
securities transaction and may involve check payments or wire-transfers on a
national automated payment system. Depository services are the wide set of
services relating to the registration and recording of ownership rights for financial
claims. When securities are placed in a (central) depository they are said to be immobilised. When these securities are also held in book-entry form, rather than
paper form (ie. are scripless), they are said to have been dematerialised. Some depositories also provide ancillary services such as corporate dividend processing and information announcement of corporate events(such as mergers).
The next section looks at the CSD structure of the four main equity markets in China: Shanghai, Shenzhen, NETS and STAQS. The following section analyses
the efficiency of these systems and their risk implications in the context of the
Group of Thirty's benchmarks for CSD efficiency. The CSD features of China's markets are compared with those found in other countries. The final section looks
at other CSD issues-especially those relating to government bonds issued in
China and the prospects for a nationally integrated CSD system.
CSD features of the four Chinese exchanges
The essential features of the current Chinese equity market CSD infrastructures
are summarised in Annex 4.1 Table 1.
Annex 4.1 Table 1 China: Comparison of clearing and settlement procedures in the exchange and trading systems
Administration
Securities Cash
Settlement period Delivery and Clearing agency payment type
Record Settlement Securities safekeeping Cash Funds custody account date date transfer
Primary Secondary market market
SHSE Direct Indirect T+O T+ 1 Not Exchange Exchange ICBC Conventional
access access Netting simultaneous
settlement
SZSE Indirect Indirect Same as T+l Not Exchange Local ICBC Conventional
access access above simultaneous registrar
STAQS Indirect Indirect Same as T+l Not STAQS Member ICBC Conventional
access access above simultaneous securities Ind.
firm Bank
NETS Indirect Indirect T+l T+l simultaneous STAQS ember PBOC Electronic
access access securities
firm
Notes: SHSE - Shanghai Securities Exchange
SZSE - Shenzhen Stock Exchange
STAQS - Securities Trading Automatic Quotation System
NETS - National Electronic Trading Systems
ICBC - Industrial and Commercial Bank of China
PBOC - People's Bank of China
Direct Access means investors can open the account with the exchange while lndirect Access means
accounts are opened through brokers.
While securities on each of these exchanges have been immobilised and
dematerialised (ie are in book-entry form) the registration of ownership or securities
custody shows some important differences. The Shanghai Securities Central
Clearance and Registration Corporation (SSCCRC) that provides the CSD services
for the Shanghai market, allows for beneficial ownership of shares at the individual
level. Thus, as of October 1994, the SSCCRC had to keep records on the ownership
claims of some 5.4 million shareholders. By contrast, on the other exchanges
registration is in the form of omnibus broker (nominee) accounts. The Shenzhen
Securities Clearing Company Ltd. centrally administers accounts at the member
or broker level (around loo), while individual accounts/records are kept at 30
regional sub-depositories. That is, Shenzhen exhibits central clearance with local
registration or a so-called 'dual' system.
In addition to securities accounts, traders also need to establish centralised cash
accounts which the appropriate CSD can access to ensure settlement of trades.
These accounts have been established at ICBC (Shenzhen and Shanghai), ClTlC
(STAQS), and the PBC (NETS). These accounts are established at the broker level,
with individuals in turn keeping accounts at their major broker(s). A recent
development has been the use of magnetic cards by individual investors on the
Shanghai Exchange. These cards work in a similar fashion to debit cards, in that
individual investors can use bank automated teller machines (ATMs) to pay directly
for trades. This has replaced indirect access by direct access for some 1.5 million
cardholders. Shanghai is thus moving toward direct access for the individual
investor at both the securities and cash account levels. These ATMs are currently
limited in number and location (20 ATMs, mostly in Shanghai) and the future
growth of direct access will be linked to the development of a nationwide network
of ATMs, and will also depend on whether there i s any movement towards a
national securities exchange.
Settlement i s very different between A (local resident) shares ancl B (overseas
investor) shares. All four exchanges use a form of 'automated matching'of trades
(which in turn i s very similar to the market micro-structures in other Asian countries
such as Korea and Hong Kong). Investors contract with brokers to enter buy or
sell orders for a given quantity of shares at a pre-set (limit) price. The exchange's
centralised computer system then automatically searches for a match. As a result
the Chinese exchanges can be viewed as order-driven rather than quote-driven
markets. If an order i s not matched, it wil l stay in the central order system until
the investor cancels the order or until the end of the trading session. If an order i s
matched, the computer checks that the investor (broker) actually has sufficient
shares in hislher account before confirmation.
Settlement for domestic (A) shares, on the major exchanges, takes place first among
brokers (members) and then between the broker and his investor clients. The
first, or primary, level of settlement (among brokers) takes place at the end of the
trading day (at T+O). On the major exchanges the trades in any given share are
netted among members and the exchange's CSD (multi-lateral netting). Secondary
settlement, between the broker and his investor client, and the legal transfer of
share ownership takes place the next day (T+I).
O n both the major exchanges, the settlement of B shares takes place at T+3 and is
a more cumbersome process. There are two reasons for this:
the institutional and international nature of the investor clientele, and,
trades are conducted (and payment effected) in foreign currencies (HK$ in
Shenzhen and US$ in Shanghai).
Moreover, the settlement system itself differs across the major exchanges.
O n the Shanghai Exchange, notification of net trading positions among brokers
are made at the end of the day (at T+O) as for Ashares. However, foreign custodians
acting on behalf of the overseas investors in B shares must also confirm the trade
and settlement details. This may include contacting their investor clients directly
and seeking to resolve any mismatched trades. This is normally completed by the
afternoon of T+2. Because payment i s in US dollars through Citibank in New
York, full settlement does not occur until T+3. By contrast B shares are not settled
through the domestic CSD (the Shenzhen Registry Co.) on the Shenzhen Exchange.
Instead all clearance and settlement details are handled by three foreign 'clearing'
banks; Citibank, Standard and Chartered and the Hong Kong and Shanghai Banking
Corporation. That is, the Shenzhen Exchange sends trading data to these clearing
banks who effect clearance and settlement in Hong Kong dollars among their
clients by T+3.
Settlement involves the transfer of legal title to a security from one investor to
another. If a seller transfers a security without simultaneously receiving payment
at the exact moment title is transferred, then one or other party is subject to a
credit risk, or at the very least, has extended a short-term loan at no interest.
Because settlement occurs through the exchange's CSD while payment occurs
through transferring accounts in the banking system, it is very rare for an exchange
to achieve exact simultaneous delivery versus payment (DvP). In fact payment
normally occurs on the two major exchanges on the same day as securities are
settled (T+I), however there is invariably a time-lag between the settlement and
payment parts of the transaction. In many cases payment is delayed to T+2,
especially between investors and member brokers.
The closest to DvP is achieved on NETS, partly owned by the China Securities
Trading Systems Co. a joint venture that i s in turn partly owned (1 2.5%) by the
PBC. Because of its close links with the PBC, NETS utilises the same satellite
system as the PBC as well as its national wire transfer payment network (the
National Electronic Payment System (NEPS)). This potentially allows it to get close
to DvP. As wil l be discussed in the next section, only the United States Federal
Reserve Bank's (Fed) federal fund and securities wire-networks achieve full real
time DvP simultaneity. This has been aided by the Fed's book-entry system for
bonds. It might be noted that the MOF in China only began experimenting with
book-entry government bonds in 1994. Prior to this, bonds were not dematerialised,
ie, they were issued in paper form and immobilised at exchange depositories
such as those at Shanghai, Shenzhen, Beijing, Wuhan and Tianjin.
The efficiency of China's current CSD infrastructures
In analysing the efficiency (and risks) of the Chinese CSD infrastructure, a
comparison with the benchmarks for CSD efficiency and risk control established
by the Group of Thirty (1989) is useful. This will allow us to identify areas in
which Chinese CSDs are ahead of other equity markets (both developed and
emerging) and areas in which they are lagging behind and/or exhibiting potentially
worrisome risk exposures.
The Group of Thirty had nine principal recommendations. These are discussed
below.
The first two recommendations were for institutional comparison of trades
(reporting and checking) by T+1. All four markets have achieved these goals for
domestic shares (A and C shares). Indeed, three achieve institutional comparison
on the same day of trade (T+O).
The third recommendation is for a centralised securities depository to be
established. China is ahead of many countries (including the US) in both
immobilising and dematerialising equities. The one feature of the current Chinese
depository system that raises concern i s that each exchange tends to have its own
depository. Not only are clearance, registration and settlement rules different but
important economies of scope and scale are lost. This potentially wastes resources
and limits market growth and liquidity. By comparison the US has multiple
exchanges but only one major depository, the Depository Trust Corporation (DTC).
As was discussed in Chapter 4, the technological barriers are currently large but
not insurmountable. It is recommended that the government and the CSRC play a
proactive role in integrating the four exchanges and linking their depositories. A
first step would be to rationalise the share ownership and registration rules across
exchanges. A second step would be to encourage members on one exchange to
open depository accounts on other exchanges (this has already happened in the
case of brokers who are currently members of both the Shanghai and Shenzhen
Exchanges). The danger of a single centralised national depository is that it possesses
considerable monopoly power which may be reflected in high fees and charges.
For example the US DTC has been accused of hampering technological innovation
and i s one of the main reasons for the delay in the US moving from T+5 to T+3 for
equities trade settlement.
The fourth recommendation was for buy or sell orders for any security on any
given day to be multi-laterally netted among the brokers at the end of the day.
Such netting reduces broker exposures and the potential size of settlement risk
exposures, eg, 'cherry-picking' good (winning) trades and defaulting on the
settlement of bad (losing) trades. On the major Chinese exchanges, netting occurs
at the end of the day. Interestingly, equities netting occurs in Japan and Thailand
but not in Korea or Singapore.' Here, as well, the Chinese markets appear to
satisfy the Group of Thirty benchmark.
The fifth recommendation concerns achieving simultaneity in delivery versus
payment (DvP). Most Asian exchanges, including China, Hong Kong, Korea and
Singapore achieve DvP on the same day but lack exact simultaneity. As noted
above lack of simultaneity i s equivalent to the securities seller 'lending' the
securities free of interest to the buyer if securities are delivered before payment. If
payment is made before securities delivery the buyer is extending an interest free
loan to the securities seller. In an extreme case, lack of simultaneity can create
incentives for one or other side of a transaction to default on settlement obligations.
Only the US government bond market has managed to achieve full real time DvP
simultaneity as a result of the Federal Reserve's book-entry securities system and
the Fed funds and securities wire-transfer networks. Specifically, in the US, debits
and credits to securities and money accounts in the Federal Reserve's book-entry
system for US government securities are final (irrevocable and unconditional) as
soon as they are posted; both the securities and the funds transfer systems are
gross real-time systems. In contrast, at private depositories in the United States,
both the securities and fund transfers in these systems are provisional. Participants
receive final payment in the form of a claim on the Federal Reserve on a settlement
bank. Payment typically must be made by the end of the day. Securities transfers
in the system become final only when all participants in a net debit position have
completed final payment.= Thus, the potential for China achieving full DvP
simultaneity for equities in the near future i s problematic, although the government
bond market may have greater potential (this wil l be discussed further in the next
section).
The sixth Group of Thirty recommendation concerned time to settlement. The
immediate goal was for countries to achieve settlement by T+5 after a trade, with
T+3 being viewed as the longer-term benchmark. The time to settlement i s
enormously important in controlling the credit risk related to settlement. In general,
the longer the period between a trade and its settlement, the greater the incentives
for one or other side of the trade to default on their settlement obligations. This i s
because buying an equity today with settlement sometime in the future is equivalent
to a forward contract. As spot prices move away from the contracted price at the
time of trade, one or other side of the contract has an incentive to default. Moreover,
the greater the volatility of stock prices the greater wil l be the default incentives.
Given the high volatility of Chinese stock prices (see Chapter 4) it i s crucial that
the settlement period i s kept as short as possible. Thus the current T+1 settlement
for A shares i s well within the Group of Thirty guidelines and is well ahead of
many developed countries (eg the US settling at T+5) and emerging market
countries (eg, Thailand settling at T+3 and Singapore at T+4).
On the other hand B shares settle at T+3, which exactly meets the Group of Thirty
benchmark. th is wi l l only likely be reduced if and when Chin~a moves to full
convertibility and foreign custodians and clearing banks can accelerate payments
to meet a shorter settlement period. Shortening the settlement period itself might
require a rationalisation of the whole regional custodian system for B share trades,
which can be very cumbersome. Recent proposals to set up a regional 'Asiaclear'
for settling trades in Asian equities may be a step in the right direction3 although
the payment, political and technological barriers are likely to deter its development
for some time especially as a fully fledged 'Asiaclear'would require China and
other Asian countries to abandon their local and national CSDS.~
Apparently because of their short settlement period (T+1) settlement risk has not
been a major problem on the Chinese exchanges. Moreover, all exchanges have
member-funded guarantee schemes to cover defaults. Such funds are crucial
because failure to settle by one participant can result - in extreme cases - in the
failure of other participants to settle as well. This is a situation of systemic or
contagion risk. Because such events are rare it i s hard to know how robust these
guarantee schemes are likely to be to systemic shocks. Nevertheless, it should be
noted that since settlement i s effected through limited liability private sector
corporations, eg, the Shenzhen Securities Registry Co, with limited access to bank
credit and limited guarantee funds, this risk cannot be ignored. Chinese CSDs
would find it hard to cover defaults in major shock conditions without implicit
or explicit back-up support from the government. Such back-up guarantees have
advantages in reducing systemic risk exposure, but also have potentially high
costs for the government and its budget deficit. Government guarantees (whether
explicit or implicit) to CSDs also raise important social welfare issues as to whether
society should subsidise private CSD systems.
The seventh recommendation concerned achieving payment for securities in same
day funds. In general where payment for securities is made by settling through
deposit accounts held at a settlement bank, as on the Shanghai, Shenzhen and
STAQS exchanges, same day payment is not always possible. This is because
payment transfer delays from a broker's local bank into the broker's account at
the settlement bank may inhibit payments being effected on a timely basis. Indeed, one of the reasons for Shanghai moving from T+O to T+1 in 1995 is because the
bank check clearing system for deposits is less efficient than the securities netting
settlement system. To achieve better payment performance brokers' may need to
gain access to either the national payments system (such as INEPS), or to establish
a private wire-transfer system between the brokers' local banks and the settlement
bank (such as ICBC). Direct access to NEPS would confer bank-like status on
brokers.
The eighth recommendation concerned the use of standardised international
numbering or coding systems for securities, such as the International Securities
Identification Numbers (ISINS) of the International Securities Organisation (ISO).
This international coding system aids cross-border trades of international investors
and thus the liquidity of B-type shares. Both the Shanghai and Shenzhen Exchanges
have adopted internationally recognisable coding systems.
The ninth recommendation concerns securities lending. Often trades fail to settle
on the settlement day because the seller's securities account is short of the required
number of securities on that day. To prevent 'fails' some countries allow for a
system of organised securities lending among brokers/investors. Securities lending
enhances market liquidity and investor portfolio flexibility, but at the same time it
creates an increased ability for investors to take short positions. For the securities
lender, additional returns can be earned over and above normal portfolio returns.
No organised securities lending system currently exists for Chinese equity markets.
However, an organised repurchase agreement (repo) market exists for bonds on a
number of exchanges such as Wuhan. The absence of securities lending for equities
is partly because of regulatory concerns regarding the destabilising effects of
enhanced short-selling opportunities (short-selling i s officially prohibited on the
Chinese equity markets). Given the high volatility of Chinese equity prices, the
benefits of enhanced securities lending are probably outweighed by the costs, at
this moment in time. Indeed, of the Asian emerging markets, only Singapore has
relatively few restrictions on equities securities lending.
Overall, the major Chinese exchanges have come a long way towards meeting
the Group of Thirty recommendations. The two areas of greatest weakness appear
to be the absence of a single (national) securities depository for equities and the
fact that the payments system lags behind the securities settlement system in terms
of efficiency.
Other CSD issues
As China liberalises and reforms its financial markets and instruments of monetary
policy it has been proposed that it place greater reliance on open market operations
(OMOs). OMOs require an ability of the Central Bank to buy and sell government
securities at short notice (eg holding an auction to sell to (or buy from) dealers
some pre-determined quantity of bonds).
Currently OMOs are hampered in China by the fact that bonds are not
dematerialised. Moreover, they are immobilised at different depositories with
different standards on registration and transfer. A proposal has been made by the
CSTS, the owner of NETS, to establish a government bonds book entry system
(GBBS). The advantages of a centralised book-entry system for bonds, apart from
making O M 0 easier, include enhanced market liquidity and investor safety. In
addition it allows the Central Bank to better monitor the demand conditions for
new issues of bonds.
The key question is, who should operate and who should own such a system? In
many developed countries, such as the US, the book-entry system for government
bonds i s operated by the Central Bank alongside a fund wire-transfer system. The
advantages of a 'nationalised' or government-run wire-transfer system is that the
credit risk relating to transactions is eliminated for the private buyers and sellers of bonds. In particular, the Federal Reserve guarantees all transactions made on
both the Fed's bond and fund wire-transfer systems. While CSTS has access to
the Central Bank's satellite communications system and its wire-transfer system,
and i s partially-owned by the PBC, it is still a limited liability company. As such
its creditability and status must be less than the PBC or a bond CSD directly
established by the government. This makes any guarantees regarding settlement
and DvP contingent, in part, on the creditstanding of the CSD itself. As noted
earlier CSDs are not banks and, in general, they have limited access to funds
should material settlement or payment failures occur. This suggests two policy possibilities: either the PBC directly guarantees all transactions on a CSTS operated
GBBS, or else it moves towards establishing a fully nationalised, government-
owned and operated bond book-entry system, and connecting it to its NEPS wire-
transfer system along the same lines as the system operated by the Federal Reserve.
Notes 1 Harrison (1 994). 2 Clearance and Settlement in US Securities markets, Federal Reserve Board of
Governors Staff Study, March 1992, page 10. 3 Giddy, Saunders and Walter'l 992. 4 Asian Finance ,1990
ANNEX 4.2 TECHNICAL NOTE ON THE ANALYSIS OF EQUITY MARKETS
The underpricing of initial public offerings
IPO data: A shares and B shares
The analysis uses all data on new issues of A and B shares on the Shanghai Stock
Exchange, from the start of trade to 13 September 1994, as well as all available
data on new issues of H shares and N shares, until the end of 1994.
There have been at least three previous studies of underpricing of stocks on the
two major Chinese equity markets (Fung and Ho (1 994), Chen (1 993) and Shyy
and Ho (1 993)). These studies have been based on very small samples and very
limited time periods. The present study utilises all available new issue data, over
the entire time period since trading began, as long as the required data were
available for price changes over six time intervals, defined as:
T+1 price on offer date to opening price on first day of listing
T+2 opening price on first day of listing, to closing price on first day of listing
T+3 closing price on first day of listing to closing price on trading day T+20
T+4 closing price on trading day T+20 to closing price on trading day T+40
T+5 closing price on trading day T+40 to closing price on trading day T+60
T+6 price on offer date to closing price on trading day T+60
For A shares, 11 4 met these criteria; for 'B' shares the number was 23.
In addition Shanghai 'A' market index and '6' market index prices were collected
for periods that matched the offering and trading dates for lPOs denoted above.
These indices allowed 'raw' returns on lPOs to be adjusted for market return
movements over similar periods, ie., to calculate market risk-adjusted returns on
lPOs by taking the difference between raw returns and market returns.
Table 4.3 in Chapter 4 provides data on the risk-adjusted returns for different
holding periods different share categories, and over different sample periods.
-the mean, standard deviation, minimum and maximum degrees of underpricing
of risk-adjusted returns for both A and B shares are given, for the IPO holding
time intervals T+l to T+6. This table calculates average risk-adjusted returns for
the IPO holding periods, for the entire sample period.
Annex 4.2 Table l a China's equity markets: underpricing of new share issues
Risk-adjusted returns on Initial Public Offerings: Shanghai A shares 7 992 to 1994 - - - - - - - - - -
1992 1993 1994
Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max.
Dev. Dev. Dev
Rrl : Offer date to
opening price on T1 52 12.46 14.34 0.94 58.74 50 2.40 2.22 0.37 12.79 8 1.28 1.12 0.45 . 3.08
Rr2: Opening to closing
price on T1 52 0.02 0.11 -0.20 0.35 50 0.02 0.14 -0.20 0.40 8 -0.06 0.11 -0.17 0.14
-4
OI CO Rr3: Closing price
TI to T20 52 -0.07 0.36 -1.45 1.17 50 -0.01 0.22 -0.29 0.79 8 -0.08 0.09 -0.24 0.05
Rr4: Closing price on
T20 to T40 52 0.21 0.99 -0.38 5.65 50 -0.01 0.13 -0.25 0.35 8 0.1 7 0.31 -0.16 0.71
Rr5: Closing price on
T40 to T60 52 -0.04 0.24 -1.20 0.36 50 -0.01 0.11 -0.33 0.48 8 0.06 0.10 -0.06 0.20
Rr6: Offer to T60 52 10.72 17.73 0.13 76.40 50 1.85 1.98 0.12 12.45 8 0.94 0.56 0.11 1.73
The risk-adjusted returns rr3, rr4 and rr5 show, respectively, the aftermarket or
seasoned return performance of lPOs for the period from close of trade on first
day to close of trade on day T+20 (rr3), close of trade on day T+20 to close of
trade on day T+40 (rr4) and close of trade on day T+40 to close of trade on day
T+60 (rr5). There are only relatively small declines in the stock's return in the
aftermarket. Similar calculations were undertaken for B shares.
The extent to which the market 'matured' is captured in Tables I a and 1 b, where
analogous calculations have been undertaken for new issues of A and B shares,
grouped by year of issue.
IPO data: H shares and N shares Raw (ri) and (market) risk-adjusted (rr,) returns are estimated on the 11 H share
issues by Chinese companies in 1993 and 1994 up to October 1994. In this case
too, both raw and risk-adjusted returns were estimated, and the market risk
estimates were calculated on the Hong Kong Hang Seng index.
There have been only two 'China'shares on the New York Stock Exchange where
data is available from the Bloomberg screen; China Tire Holdings Ltd and Brilliance
China Automotive Holdings Ltd, and the analysis is based on these companies
(which are actually 'Bermuda' companies). Since the offer price on the NYSE is
usually set (less than) one-day before trading starts on the NYSE, the 'offer to
open' raw and risk-adjusted returns (rri) are isomorphic.
Trading of equities and market volatility
Returns: raw and risk-adjusted The analysis of return performance first calculates raw returns on the A and B share indices, for both Shanghai and Shenzhen. Returns are estimated for one
week holding periods (r,) from the market's opening in December 1990 to the
middle of September 1994. Next, risk return trade-offs ('ratios') are estimated by
dividing mean weekly returns by the standard deviation of weekly returns on the
market index (:,/oA) over the whole sample period.
Risk adjusted returns were also computed using two assumed holding periods -
10 weeks and 20 weeks. Although 10 weeks and 20 weeks are somewhat arbitrary
they give an indication of the type of risk-adjusted returns a well diversified investor
who bought and held equities for relatively longer horizons might generate. Results
are presented in Table 4.5 in Chapter 4.
Annex 4.2 Table 1b China's equity markets: underpricing of new share issues Risk-adjusted returns on Initial Public Offerings: Shanghai B shares 7 992 to 7 994
Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max.
Dev. Dev. Dev.
Rrl : Ofier date to opening
price on TI 6 10.33 1.39 9.35 13.1 12 0.15 0.13 0.01 0.39 5 0.17 0.22 0.00 0.55
Rr2: Opening to closing
price on TI 6 -0.01 0.08 -0.12 0.12 12 0.17 0.17 -0.05 0.44 5 0.00 0.04 -0.04 0.05
Rr3: Closing price
TI to T20 6 0.00 0.04 -0.04 0.07 12 0.00 0.15 -0.30 0.25 5 -0.07 0.09 -0.19 0.05
Rr4: Closing price on
T20 to T40 6 0.11 0.08 -0.04 0.19 12 0.07 0.07 -0.04 0.18 5 0.00 0.08 -0.11 0.08
Rr5: Closing price on
T40 to T60 6 -0.16 0.35 -0.86 0.1 12 0.05 0.13 -0.1'1 0.28 5 0.08 0.04 0.03 0.13
Rr6: Offer to T60 6 6.31 3.22 0.10 9.5 12 0.48 0.34 0.04 1.23 5 0.15 0.28 -0.20 0.57
Returns: autocorrelation Autocorrelations of weekly returns were estimated for the Shanghai A and B markets. The lags potentially allow for autocorrelations of up to lag 48 for A
shares and up to 33 lags for B shares (Figure 1). Although the one, two and three
week lagged autocorrelations with the current week's return were estimated, only
the first lag's autocorrelation coefficient i s statistically significant at the 95O/0
confidence level.
Annex 4.2 Figure 1 Autocorrelation of Shanghai and Shenzhen weekly index returns
1 Autocorrelation coefficient Shanghai
Autocorrelation coefficient
Week
Shenzhen
I Week
Source: Calculations based on data provided by the Shanghai and Shenzhen exchanger
Overall, there is evidence of trends in returns in both the Shanghai A and B share
markets. Given the greater relative thinness and low trading volume of the B share market, price movements tend to persist in that market longer than in the
more liquid A share market.
Shenzhen A share autocorrelations show a much stronger first order autocorrelation
than for B shares. Specifically, the first order A share autocorrelation is 0.38 versus
0.026 for B shares. This first order A share autocorrelation coefficient i s statistically
significant at the 99% level. This evidence may well reflect the greater relative
thinness of the Shenzhen A market to the Shanghai A market.
Real returns, stock prices, and inflation
A final test undertaken on returns seeks to examine the degree to which stock
prices reflected fundamental economic values. It has long been argued that stock
returns should provide a good hedge against inflation since, unlike fixed coupon
bonds, an enterprise's nominal cash flows wil l tend to move in line with inflation
as would its nominal profits and potentially dividends. This has usually been
tested by examining the empirical relationship between stock returns and the one
period lagged inflation rate (see, for example, Bodie (1 976) and Jaffe and Mandel ker
(1 976)). If the lagged inflation rate is a good proxy for next period's expected
inflation rate such a test is also equivalent to testing whether the Fisher equation
holds for stocks ie., there is a one to one positive relationship between stock
returns and expected inflation rates such that stock returns fully reflect expected
inflation rates.
Chinese inflation rates were collected monthly for the period December 1991 to
February 1994. Chinese inflation rates are based on moving annual periods eg.,
January 1993 to January 1994, February 1993 to February 1994, etc. Matched
returns were calculated for A and B shares over the same sample period. For the
Fisher equation to hold, the slope coefficient of the regression of the lagged inflation
rate on returns should be positive. However, for Shanghai A shares the relationship
was found to be -0.36, indicating that the returns on A shares have actually been
negatively correlated with inflation. Moreover this relationship is highly significant
(at the 99% confidence level). For Shenzhen A shares, measured over the April
1992 to February 1994 period, the relationship was also significantly negative (-
0.28). For B shares, the regression coefficient was close to zero (.00122) for
Shanghai and statistically insignificant at meaningful levels. That is, B share returns
on the Shanghai Exchange appear to have moved independently of inflation.
Moreover the results for Shenzhen also produced a coefficient insignificantly
different from zero (0.04).
These results suggest that Chinese investors seeking to hedge their savings against
inflation might have been better off investing in government bonds whose coupons
have been (partially) indexed to inflation in recent years. In addition, they suggest
that foreign investors have not been impounding a (risk) premium for inflation
into their required returns on B shares.
Volatility The analysis of 10 week standard deviations for Shanghai and Shenzhen A and B
shares is presented in the text (Figure 4.6).
Autocorrelation of volatility An examination of the degree to which volatility (like returns) is autocorrelated
over time i s also undertaken. The question is, does Chinese stock market volatility
exhibit some type of autoregressive conditional heteroscedasticity or (ARCH)
behaviour or i s i t largely random on a week by week basis. Weekly volatility is
characterised, following Lo and Mackinlay (1 988), Brock (1 994) and others, by
looking at the autocorrelations among weekly squared returns. The autocorrelations
from lags 1 to 48 for A shares, and from lags 1 to 33 for B shares, on the Shanghai
market were estimated (Annex 4.2 Figure 1). As with returns, Shanghai B share
volatilities show stronger autocorrelations than A shares. The first, second and
third order autocorrelations for A(B) shares are respectively 0.01 4 (-.036), -0.007
(-.080) and -0.0099(-.0806) none of which are statistically significant at meaningful
levels. Thus, it appears that both A and B Shanghai share volatilities tend to have
been largely random on a week-to-week basis. In particular, there is no evidence
of an ARCH type process.
In contrast to the Shanghai market, A share volatilities (squared returns) on
Shenzhen show significant autocorrelations at the one and four-week lag level,
while B share volatilities show some evidence of a significant autocorrelation at
the one-week lag level. Thus B, and especially A shares, on the Shenzhen market
appear to show some ARCH-type properties, ie., volatility itself has not been
random over time.
Returns and volatility behaviour of H shares The comparative analysis of return and volatility performance of H shares traded
in Hong Kong is based on the new Hang Seng Chinese Enterprise Index, overthe
period from July 1993 to October 1994.
Returns Returns on H shares in Hong Kong are higher than on B shares in China. Details
are given in the text (Table 4.5).
Volatility The ten week standard deviation of H shares has varied between a low of 0.03
and a high of 0.09. The level of volatility and the volatility pattern is quite similar
to that for Shanghai B shares and Shenzhen B shares over the same period.
Autocorrelations These were estimated from lag one to 15 for weekly H share returns and return
volatility - returns squared. Like Shanghai B shares, H share returns have a strong
first order autocorrelation (0.281). Also like Shanghai B shares, H share volatilities
tended be uncorrelated over time, ie, volatility appears to have followed a random
walk on a week by week basis.
Market in fegration
Correlation of indices and returns across the major markets The contemporaneous correlation matrix among indices (levels) using all available
daily observations up until 14 September 1994 i s shown in Table 2 (first table
below). As can be seen, the indices on similar classes of share tend to co-move
together across exchanges. The high daily correlation of Shanghai Aand Shenzhen
A share indices, indicates strong sensitivity to common factors and news. By
comparison the correlation of Shanghai Aand B shares has been low, and Shenzhen
A and B relatively low. B and H share indices are highly correlated. Table 3 (second
table below) recalculates the correlation matrix using weekly returns rather than
daily index levels. Although the size of the correlations are lower, the results
generally support those found for daily index movements.
Annex 4.2 Table 2 Contemporaneous daily correlations among A, B and H share index levels (All available data December 1990 to September 1994)
Shanghai Shanghai Shenzhen Shenzhen Hong Kong
A shares B shares A shares B shares H shares
Shanghai A 0.1 57 0.91 9 0.388 0.399
Shanghai B 0.051 0.746 0.859
Shenzhen A 0.472 0.342
Shenzhen B 0.862
Hong Kong H
Annex 4.2 Table 3 Weekly correlations among A, B and H share returns (All available data December 1990 to September 1994)
Shanghai Shanghai Shenzhen Shenzhen Hong Kong
A shares B shares A shares B shares H shares
Shanghai A 0.41 08 0.475 0.151 0.207
Shanghai B 0.31 7 0.324 0.527
Shenzhen A 0.256 0.315
Shenzhen B 0.208
Hong Kong H
Price premiums and discounts between A and B shares
Stock price data are adjusted for all A and B share stock splits. Comparisons of
prices quoted in Rmb, HK$ and US$ were undertaken using daily, end-of-day
exchange rates. Calculation results are discussed in Chapter 4.
A and B spreads are described in terms of the B share discount, defined as [(pa-p,)/
p,]. The A and H discount i s measured by [(pa-pJ/p,J, or the daily A share price
(in Rmb) minus the daily H share price (converted into Rmb, using each end of
day HK$/Rmb exchange rate). A positive spread indicates that H shares stand at
a discount to A shares. H share discounts were estimated over the period 27
August 1993 to 13 September 1994. Given the very limited number of H shares
in total, however, and the even more limited number that can be matched with
corresponding issues of Aor B shares, the evidence must be viewed as preliminary.
Data on N shares are scarce because of the Chinese ADRs listed in the US. Two,
(Shanghai Chlor-Alkali SP and Shanghai Erfang Co. Ltd) have no published or on-
screen daily price data, as these are privately traded. Another two (Shandong
Huaneng Electric and Huaneng International Power) have no domestic A or B shares (see Chapter 5).
One Shanghai Petrochemical NY ADR is equal to 100 Hong Kong H shares of this
enterprise. In this case the enterprise issued its H shares on the same day as the
ADR (26 July 1993). This enterprise also issued Ashares later, on 11 August 1993.
Using 100 H and 100 A shares as equivalent to 1 ADR, average spreads are
calculated between the A and the ADR share prices of the enterprise, and between
its H share and ADR prices, in the period until 13 September 1994.
CHAPTER 5
Like other emerging markets, China's securities markets are rapidly developing
international links, both as China seeks to augment domestic savings from
international resources, and as increasing volumes of private investment flows
from overseas seek higher returns in emerging markets. While the augmentation
of domestic savings by the resources of international investors i s valuable, it also
raises questions about the impact such flows may have on the domestic economy,
and thus, how to provide for a stable and orderly increase in international
participation. China today faces the need to formulate strategies for the opening
up of its capital market to foreign participation in terms of appropriate vehicles
and instruments, and appropriate terms and conditions.
The present chapter first examines the issue of the 'safe' internationalisation of
China's securities markets, and (especially in view of the Mexican crisis of late
1994), the extent to which China i s vulnerable to domestic destabilisation through
international participation in its securities market. The next section examines
equities markets, in terms of international participation in Chinese domestic
securities exchanges (B shares) and also, the trading of Chinese securities in
overseas exchanges (H shares, N shares and depository receipts). The third section
examines debt securities, in terms of the possibilities for overseas participation in
China's domestic debt securities, and also, the terms which China is able to obtain
for its overseas debt issues. Alternative debt instruments (syndicated loans versus
securitised debt) are considered. Finally, the desirability of introducing new
derivative instruments i s briefly reviewed.
The key conclusions of this chapter are first, that China today is not vulnerable to
a destabilising domestic backlash, if flows of portfolio investment to China were
to be sustained. Indeed, China needs to achieve a better balance of its foreign
resource inflows between direct and portfolio investment. Second, in terms of
foreign equity investment, greater efficiency could be achieved in the design of
China's overseas equity issues, which will be required for sustained and increasing
foreign interest. Today the novelty value of Chinese shares has begun to wane
and greater emphasis on strengthening fundamentals is necessary. A major difficulty
faced by overseas investors in China equities has been the limited liquidity in the
thin and segmented markets for overseas shares, especially in the B share market
but also elsewhere, for example shares listed exclusively on the New York Stock
Exchange. Almost all China shares held by overseas investors trade at a discount
to domestic shares. If China were to remove its present distinctions between share
categories, this problem would be alleviated, and other efficiency gains would
also ensue. While uncontrolled foreign equity inflows are undesirable, many
optional safeguards are available. Meanwhile, another option open to China is to
increase liquidity through dual listings, and the recently popular GDR or multiple
depository receipts mechanism provides a useful vehicle for this. China can explore
the more complex options available under such programmes as 'side-by-side'
ADRs, or gradual increases in ADR levels. Third, on the issue of taxes on portfolio
investment, this is today a lesser fiscal issue than achieving a level playing field
between FDI and portfolio investment, and reducing preferential incentives for
the former while introducing double taxation treaties for the latter i s desirable.
Fourth, China's domestic fixed income securities market is today closed to foreign
participation. For the time being, strengthening the domestic market should be
the first priority. In the medium term, however, a gradual opening up to foreign
investors can be adopted, using a sequenced approach. The fifth conclusion i s that China, like other countries, has greatly increased its presence in the
international bond market, and to date enjoys favourable terms, relative to most
other emerging market economies. China could try to further expand the maturity
of its bond issues, in view of domestic needs. Streamlined domestic procedures
for issuing international bonds would benefit from greater flexibility. The sixth
point is that China has also been able to increase the volume of international
syndicated loans it receives, in this case contrary to global experience. Again,
the terms so far have been favourable, and initial-launch spreads were steady
through to the end of 1994, though maturity appears to be on the decline.
Secondary market prices show some weakness. Creative extensions to longer
maturity may be possible. The next conclusion i s that there are some indications
that terms of commercial bank credit to China may grow less favourable if the
borrowers credit ratings and guarantee status are not clarified. In overall terms,
broadening of overseas funding options should be the strategy for the Chinese
authorities to pursue. Finally, China's participation in international derivative
markets is inevitable, and the key consideration in increased participation is that
it should be orderly and regulated.
The Scope for Safe Participation in International Securities Markets
China has been very successful in attracting large private foreign resource inflows
in recent years. Total private flows (on a net basis) jumped to $36 billion in 1993,
up from $5 billion in 1990, and are estimated to have reached $40 billion in
1994. The increase in private resource inflows to China parallels a global trend
of rapidly increasing private resource inflows to emerging market economies. Yet,
the composition of external investment flows to China is strikingly different from
comparator countries. While the international experience suggests that foreign
portfolio equity investment has been increasing the most rapidly, resource inflows
to China have been increasingly skewed towards foreign direct investment (FDI),
which accounted for more than two thirds of the total net private investment
flows to the country in 1993.
Figure 5.1 Private capital flows to China
US$ million
50.000 r
I 0 + 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Year
1 Source: World Bank
Foreign direct investment
The contrast to other major emerging markets, even in absolute terms, is clear
from Figure 5.2, which shows China's enormous share of developing country
FDI, but its small relative share in terms of securitised flows, such as equities or
bonds.
Figure 5.2 China and other emerging markets: Participation in international capital flows
Portfolio equity Bonds
Mexico Mexico
Indonesia Chile
0 2 4 6 8 10 12 14 16 - 1 0 1 2 3 4 5 6 7 8 9
US$ billion (1993) US$ billion (1993)
Foreign direct investment
China
~ e p i b l c of Korea
I Source: WorldBank
0 5 10 15 20 25 30
US$ billion (1993)
Relative to portfolio flows, FDI flows tend to be more stable and long term. A key
factor in the Mexican crisis in late 1994 was the predominance of foreign
investment in short-maturity government securities linked to the US dollar; the
tesobonos. Bondholders in domestic government securities markets tend to be a
more volatile group of investors than holders of equities, and this i s compounded if the securities held are short term. Moreover, even in the case of portfolio flows,
China's segregated share categories, with foreign investment on domestic markets
limited to the relatively small B share market and with H shares tradable only
outside the country, a 'withdrawal' from China can only mean a decline in share
price among foreign investors with no dollar pull-out from China. As Figure 5.3 supports, China, on account of both the composition and maturity of foreign
capital inflows, does not appear to be vulnerable to the potential contagion effect
of the Mexico crisis.'
It i s acknowledged that today there are instances where the distinction between
portfolio investment and direct investment grows blurred. One example is the
emergence of so called 'direct investment funds.' This investment vehicle takes
the form of closed-end funds (like portfolio equity investment), but i s used to
participate in FDI projects (eg, take a minor stake in a new joint venture investment).
This new development is attributable to:
international investorsf efforts to take equity positions in Chinese firms, in the
face of limited supply of B shares in the local markets and international equity
issues pricing inefficiency of public offering, and,
tax incentives for FDI.
A second example i s offered by overseas investors who undertake FDI in Chinese
enterprises today which they hope are likely to be listed some years later, thus
providing an opportunity for a one-time gain from share price increases at the
time of the IPO; the so called 'pre-emptive FDIf strategy. Nevertheless, these
investments also have stable and long time horizons, and therefore today share
these characteristics with FDI. O n balance, to the extent that a position can be
taken without a sensitivity analysis of macro-economic consequences, China is,
rather, in a position to cautiously increase participation in world securitised flows.*
Figure 5.3 China and Mexico inflows
~ China (US$146 billion) Mexico (US$81 million) I I
7%
Other private flows
Source: World Bank
One question which may be raised here i s why it i s at all desirable for China to
seek to diversify its foreign capital inflows, in view of the relative stability and the
concomitant (nonfinancial) benefits of FDI. First, the heavily concentrated nature
of private capital inflows in FDI (compared with portfolio equity flows) i s a source
of concern. The FDI boom has been fuelled, at least in part, by preferential
treatments (eg, tax incentives), which could distort investment decisions and
resource allocation in the long run, and are also costly to the government. Another
reason for high FDI levels has been the low availability of equities and limited
development of the capital market. Secondly, it i s known that at least a part of
China's FDI takes the form of 'round-tripping,' to benefit from tax incentives.
Thirdly, FDI often generates substantial reflows of remitted profits, making the
cost of capital on the part of the host economy quite high.3 Striking a better balance between FDI and portfolio equity investment in local capital markets
should serve the national interest in the long run. Ashort-term policy measure for
the Government would be to eliminate preferential tax treatments for future FDI.
International Participation in China's Equity Issues
Foreign investment in domestic share markets: B shares
As described in Chapter 4, foreign portfolio investment in Chinese equities was
initially made possible through direct purchase of B shares listed at Shanghai and
Shenzhen Stock Exchanges (Appendix Table A5.1). By the end of November 1994,
the 28 B shares listed on Shanghai and 23 listed on Shenzhen had raised a total of
US$1.3 billion equivalent, through new share issues of an average size of US$25
mil lion each. Chinese securities regulators authorised different classes of shares
for local listing and sales to foreign investors, primarily to accommodate limits on
foreign ownership and Rmb ~onvert ibi l i ty.~
As documented in Chapter 4, the segmented market structure has yielded a
divergent performance between A and B shares, where B shares typically sell at
a large discount to A shares. The performance of China's B shares contrasts with
the experience of other countries, where stock markets that have Iiberalised foreign
investment rules (for example, Argentina, Brazil, Colombia, and Pakistan) have
subsequently experienced huge price increases, although followed by significant
market corrections. In Chile, Mexico, and the Philippines, price-to-earnings ratios
have risen continuously for several years after the market opening. The current
system of separation of A and B shares presents problems, of which the first is
price distortion across markets. Second, the possibilities for arbitrage lead to
illegitimate transactions, such as A share investments by non-residents; reducing
market transparency. Third, share segmentation curtails liquidity and reduces
efficiency. Fourth, the learning benefits of permitting more experienced and less
speculative share market participants are also lost.
These disadvantages would be removed by the synchronisation through merger
of the A and 8 share markets. Two arguments are generally offered against this.
The first i s the limited convertibility today of the Rmb. It should be pointed out
that this need not be a necessary condition, provided foreign exchange i s freely
available for transactions relating to equity investment. Countries such as Korea
permitted foreign investment in domestic equities before full convertibility, although
the commitment to full convertibility had already been adopted. The second factor
i s the concern that the merger of A and B shares could leave China vulnerable to
the problems of excessive inflows, which could crowd out domestic participation,
or excessive outflows, which could destabilise the domestic market. A range of
alternative safeguards may be adopted, as the experience of other countries shows:
Ceilings may be imposed on foreign investment, at the enterprise, sectoral,
and individual levels. For example, in Korea, foreign investors can own up to
12 per cent (recently increased from the previous ten) of the shares of most
listed companies, but an individual investor can only hold three per cent.
Lower ceilings are set for sensitive sectors such as power generation, or iron
and steel. In Indonesia, foreigners can hold up to 49 per cent of shares. Participation can be restricted to known and approved large investors. In some
cases, non-resident participation can be permitted only through approved
mutual funds or trust funds or country funds, with pre-approved credentials
(Korea, Taiwan, India). Selective secondary equity market transactions with a destabilising potential
can be restricted. For example, foreigners can be restricted from buying or
selling at the margin (Korea) or short selling (India). In Taiwan, foreigners are allowed to sell one day after purchase; earlier, they were allowed sales only after taking delivery.
Restrictions on voting rights or board membership have also been adopted by some countries (Appendix 85.1).
In ferna fional financial flows fo developing countries
The pattern of international financial f lows t o developing countries has changed fundamentally in the 1990s. First, the volume of private capital flows now far exceeds official flows. From less than one third of resource flows till the late 1980s, private flows today account for three quarters of resource flows to the developing wor ld . Second, the composition of private flows i s strikingly different from official flows.
Equity, rather than debt flows, dominate. Equity investment accounted for two thirds of private capital flows in 1993. Securitised, non-bank flows such as bond issues are replacing bank loans. In FDI, growth has been strong and sustained, facilitated by structural and secular developments such as the increasing global integration of production. Recipients are now mainly private instead of predominantly sovereign. Private-to-private flows now represent roughly 70 per cent of net flows to developing countries. Recipients are mainly middle-income countries. China and India are two notable large low-income exceptions.
The causes of these changes are largely structural. Major contributing factors have been:
low real interest rates (particularly in key source countries - the United States and Japan), leading to improved developing country creditworthiness, macro-economic policy changes w i th in developing countries, including trade liberalisation, fiscal consolidation, privatisation, and deregulation,
structural changes in global financial markets, inc lud ing increased financial integration of developing countries, growing international diversification of investment funds, and easier access by developing countries to industrial country capital markets, especially for FDI, deregulation of the private sector, the growth o f regionalism in trade and investment, disintermediation from the banking system since the onset of the debt crisis, and lower costs i n transportation and communication.
In terms of strategies and instruments, 40 per cent of long-term bond financing received by developing country borrowers went to three Latin American countries - Argentina, Brazil, and Mexico (1 989-93). Over 50 per cent of portfolio equity flows (including international equity issues such as ADRs and direct foreign investment in developing country stock markets) went to three countries - Mexico, Korea, and Brazil. And over 50 per cent of total FDI flows went to five developing countries -Argentina, China, Hungary, Malaysia, and Mexico over the same period. China, with FDI inflows of US$27 bi l l ion in 1993, became the second largest recipient of FDI in the world, after the United States, and was the leading recipient of aggregate external financing among developing countries, accounting for 20 per cent of net flows to all developing countries.
Available borrowing strategies reflect a combination of factors includingcountry creditworthiness, past creditor exposure, country regulations and institutions, and country/corporate funding strategies
between debt and equity. Between 1991 and 1993, Chile, China, Indonesia, Korea, and Thailand were able to access a wide range of private sources of long- term finance. For both China and Korea, only about 15 per cent of new debt acquired was short-term. Argentina, Brazil, and Mexico converted foreign loans to bonds through debt reduction operations, or to equity, through debt-for- equity swaps. About two thirds of new borrowing by Mexico was short-term, which was a critical factor contributing to the country's recent financial crisis. About half of new debt flows to Argentina (and Malaysia and Thailand) have been short-term.
Portfolio equity investment flows to developing countries
Portfolio equity investment flows, either in the form of direct purchase by foreign investors in host country's local stock markets, or investment in equities traded outside the country of issuer, often through closed or open-ended investments, have been the fastest growing component of private capital flows in the 1990s. From a mere US$3.5 b i l l i on i n 1989, port fo l io equi ty investment in developing countries has increased more than thirteen times to
US$47 billion in 1993, and i s estimated to have reached US$40 billion in 1994, with roughly US$20 billion through direct purchases by foreigners in the emerging stock markets, and international equity offerings.
Prior t o 1990 the bu lk o f foreign port fo l io investment i n d'eveloping country equities took place through closed-end country funds. A number of developing countries have recently l iberal ised the i r domest ic equ i ty markets for direct foreign investment, and subsequently experienced large investment inflows. For example, since its market opening in 1992, Korea has received about US$10 bi l l ion of net investment up until the end of 1994. Studies (Jun, 1994) show that the impact of market opening has been largely beneficial. Improved market performance contributes to lowering cost of equity capital, although foreign portfolio investment was often followed by increased volatility in host country stock markets. Estimates for Korea showed that US$1 bi l l ion of foreign portfolio investment inflows improved the rate of return by 20 per cent, with on l y marginal ly increased market volatility and inconsequential macro- economic disturbances.
I . . Trends In prlvate flow to developing countries Major recipients of private captial flow, 1989-93 1 US$ billion US$ billion 1
250
200
150
100 I
50 On#c#al loans 20
0
1986 1988 1990 1992 1994'
'Pro~ected
Such restrictions on equity purchase and equity market participation differ from
foreign exchange controls, on the repatriation of capital or dividends. In certain
circumstances, holding period limitations may be imposed on capital gains
repatriation (Chile, Taiwan), or ceilings may be stipulated above which case by
case approval for capital gains repatriation may be required (Thailand). Examples
are given in Appendix 85.2.
Special protection is sometimes given to domestih 'financial institutions, for
example, ceilings on the foreign acquisitions of domestic banks' shares (Thailand
and Indonesia: 49 per cent; Argentina: 30 per cent without special government
approval). In some cases, special measures may also be taken to encourage the
development of local non-bank financial institutions, such as securities firms or
brokerage houses. Thus, Brazil requires the domestic comanagement of foreign
investment funds, and Argentina requires investment to be undertaken through
authorised domestic stock brokers.
Thus a range of safeguards exist, applied in varying degrees in other countries.
China must take care not to impose too many 'safeguards,' which could make
entry unduly restrictive. An appropriate balance has to be found, to ensure safe
participation in a manner which is beneficial to the domestic market's development.
Tax treatment of foreign equity investment
A question frequently raised by Chinese authorities concerns the desirability of
imposing taxes on dividends and capital gains on overseas investors. At present
no such taxes are imposed. It is true that these are applied in a number of other
emerging markets (Appendix B5.3 has examples of tax policy of emerging markets
with regard to portfolio investment). Yet at present, China's chief concern should
be to level the playing field between taxes (and tax incentives) for FDI and foreign
portfolio investment. At the same time, China would benefit from some form of a
capital gains tax, at least on A shares, as this would discourage speculative
investment (see Chapter 4). China has a difficult path to tread in this realm, as it
i s recognised that the imposition of dividend or capital gains taxation may
discourage liquidity and further reduce the attractiveness of portfolio flows relative
to FDl.5 On balance, it is suggested that although a tax on dividends may be an
unnecessary discouragement, a form of capital gains tax could be beneficial.
Overseas listing of Chinese equities: H and N shares; depository receipts6
Access of foreign investors to Chinese equities expanded considerably with the
introduction of H shares (Appendix TableA5.2).7Averaging around US350 million
each, these are considerably higher than the averageof US$25 million for B shares, and thus more significant, as a vehicle for raising capital overseas. Nine of the
most internationally well-known Chinese enterprises (including Tsingtao Brewery,
Shanghai Petrochemical, and Maanshan Steel) were listed on the Stock Exchange of Hong Kong in the form of H shares by the end of 1994 representing a cumulative
total of US$3 billion. By the end of 1994,15 of the total of 31 approved companies
had already established a listing on Hong Kong.'
Chinese companies began to go further afield for capital, to the New York market,
as early as 1992. Before the regulatory authorities had developed policies for raising capital and listing shares overseas, three joint venture companies established
Bermuda-based subsidiaries to issue and sell shares in US public offerings. Meanwhile, encouraged by the success of early H share issues, the authorities
permitted selected Chinese companies to officially approach the US market. The first officially recognised and authorised Chinese company listing on New York was the Shanghai Petrochemical Company, in July 1993, for US$170 million. It
was decided that the listings in New York would take the form of depository
receipts, based on underlying Chinese Rmb shares, rather than being listed as US
shares.
By the end of 1994, eight Chinese companies had established Level Ill or Rule
144A ADRs. Six of these were companies that already had H share listings. Shanghai Petrochemicals, the first, had a dual listing of an H share offering in Hong Kong and a registered public offering under a Level Ill ADR, traded on the
New York Stock Exchange. The remaining five used privately placed Rule 144A ADRs, not tradable on NYSE or INASDAQ.' Further such ADRs (Level Ill or 144A)
are expected from companies approved but not yet listed in Hor~g Kong, and
some of the H share companies already listed are likely to establish 'side-by-side' Level 1 or I1 ADR programmes to supplement the liquidity of the HKSE listings.1°
Another two companies, Shandong Power and Huaneng Power, launched ADRs which had no corresponding H share listings; the so-called 'N share"ADRs. There
have been no simultaneous offerings of B shares and ADRs so far, but four B share
companies have subsequently set up Level I ADR programmes to stimulateoverseas
Characteristics of Depository Receipts
A Depository Receipt (DR) is a negotiable certificate evidencing ownership of a fixed number of shares, or fractions of a share, in a foreign corporation, based on a ratio set by the issuing company. The underlying shares remain on deposit in the issuer's home market. DRs are quoted and traded in the currency of the country in which they trade and are governed by the trading and settlement procedures of that market.
American Depository Receipts (ADRs) are the oldest form of DR. ADRs were developed to address concerns of US investors who were interested in investing abroad but were reluctant to purchase foreign stocks. ADRs eliminate many of the disadvantages of holding non-US securities because they are quoted in US dollars and pay dividends in US dollars, thus helping investors avoid currency conversion cost and risk. They trade on major US exchanges in accordance with US clearing and settlement conventions. There are several types of ADRs:
Unrestricted ADRs (sponsored Level I, I I and Ill): Publicly traded; US SEC Registered Sponsored Level I ADRs: These require minimal SEC procedures, and can only trade in the over-the-counter (OTC) markets. A Level I programme cannot be used to raise capital in the United States. After one or two years of Level I trading, or when an outstanding ADR reaches 5%, companies typically upgrade their ADRs to Levels II or Ill.
.Level I I and I l l ADRs: These ADR programmes permit listing on an exchange or on NASDAQ, and require compliance with 5EC registration and exchange requirements. Disclosure requirements are lower for Level II, but
in this case new capital cannot be raised. Level Il l, with rigorous disclosure, allows capital raising and provides access to the broadest US investor base and the most liquid US securities market.
Restricted ADRs: Privately traded; Exempt from US SEC Registration Rule 144A ADRs (RADRs): these are DRs pursuant to Rule 144A, which was adopted by the SEC in April, 1990. This is a 'safe harbour' rule which allows companies to offer unregistered securities to large institutional investors known as Qualified Institutional Buyers (QIBs) who can resell these to other QIBs, but not to US retail or public investors for at least two years.
Global Depository Receipts (GDRs): An offering of DRs that i s available in two or more markets outside the issuer's home country.
Combinations and offshoots 'Side-by-sider ADR programmes: With this programme, first introduced in 1991, a company establishes a publicly traded Level one programme as well as a privately placed RADR or GDR for the same class of stock. This structure allows issuing companies to combine the benefits of a publicly traded programme with a RADR or GDR programme's usefulness as a capital- raising tool.
American Depository Debentures (ADDS): This represents debt rather than equity. Since 1993, ADDS were offered in conjunction with rights issues, which are convertible into ordinary shares or ADRs.
Source: Bank of New York; World Bank
demand for their shares. By the end of November 1994, the total overseas capital
raised over 1991 to 1994 by Chinese companies amounted to US$ 3.73 billion
equivalent of which US$1.35 billion was through B shares (36 per cent); US$
1.13 billion through H shares which had already been listed (30 per cent) and
US$ 1.25 billion (33.5 per cent) through ADRs or GDRs."
Table 5.1 Chinese companies with A DR and GDR programmes (December 1994) (and other China stocks traded on New York)
Listing Where Amount
date listed raised
(US$)
Offer
price
(US$)
12/30/94 AlDR type
Price
(US$) - - -
H shares
Shanghai Petrochem 7/93 NY/SE/QI/H K
Maanshan 11/93 Portal
Yizheng 3/93 Portal
Harbin Power 11 /94 Portal/HK
Shanghai Hai Xing 11/94 Portal
Qingling Motorsa 6/94 H WQIIPortal
N shares
Shandong Power 6/94 NYSE
Huaneng Power 8/94 NYSE
B shares
Erfangji 12/93 OTC
Chlor-Alkali 3/93 OTC
Shenzhen SEZ 8/94 OTC
Tire & Rubber 12/93 OTC
Other China-related stocks (Bermuda shares)
Brilliance China 10/92 NYSE
EK-Chor 6/93 NYSE
China Tire 7/93 NYSE
$28 7/8 Level Ill
n.a. Rule 144A
n.a. Rule 144A
n.a. Rule 144A
n.a. Rule 144A
n.a. Rule 144A
$9 5/8 L.evel Ill
$14 3/4 Level Ill
1.evel I
Level I
Level I
Level I
Notes : NYSE: New York Stock Exchange
QI: SEAQ International
HK: tfong Kong
"Chinese ADR.
Sources: Bank o f New York; World Bank
International equity issuance can be beneficial to both issuing companies (and
countries) and foreign investors. From the issuer's viewpoint, it expands the investor
base, which can lead to a higher stock price and a lower cost of capital. It also
provides new markets for raising funds, and enhances visibility of the issuing
company and its products in international markets. From the investor's perspective,
an international share listing allows share trading and dividend payments in
convertible currencies; provides international diversification to institutional
investors, which are often prevented by their charters from investing in foreign
currencies (since ADRs, for example, are treated as domestic securities in the
United States); allows convenient and dependable settlement and custodian
services (especially in cases of cross-border settlements with dual listings), and
meets standard disclosure requirements.
A potential drawback of heavy dependence on offshore investment, however, is
that a concentration of trading in domestic equities abroad could slow the
development of local capital markets. Nevertheless, studies have shown that an
international share-listing programme (even for small numbers of issues) can
produce an economy-wide benefit for the home country.12 This arises from the
'spillover'effect on the pricing of domestically traded securities.
The Performance of China's Overseas Equity Listings
Although H shares had higher average returns and lower volatility than B shares,
H shares, like B shares, typically traded at discounts to their A share counterparts.
Compared with H shares in the first wave of issues, those in the second batch
experienced more difficult market conditions. For example, Luoyang Glass saw
prices drop sharply on post-issue trading of its HK$660 million shares, and the
issue by Shanghai Haixing Shipping was postponed because of weak demand.
An H share offering by Tianjin Bohai Chemical Industry, the last of the first batch
of H share issues, was subscribed only 1.003 times, the lowest level for any H
share offering. Although this is partly due to exogenous factors, the recent
experience underscores the importance of solid and stable performance in the
home markets.
In terms of shares listed and traded at New York, the early 'Bermuda shares',
while successful at raising capital, have performed poorly in secondary trading,
with share prices falling, on average, by 38 per cent by the end of 1994. The two
N share Level Ill ADRs were also trading at a discount, of 29 per cent. By contrast,
the one dual H share Level Ill ADR, Shanghai Petrochemicals, sold at a premium
of 42 per cent. The poor performance of the N share ADRs has been attributed to
the lack of dual liquidity with a regional Chinese market (such as Hong Kong)
where investors have access to company information." The five 144A ADRs
have yet to establish 'side-by-side' programmes with Level I or II ADRs, which
would help liquidity and enable US investors to buy unrestricted ADRs of the
same underlying share class (for example, H shares), thus countering any flowbacks
of shares to the underlying (H share) market.
Other options for overseas listing of China's equities
New opportunities for international equity offering are appearing. From 1 January
1995, the Tokyo Stock Exchange (TSE) introduced reforms to its restrictive listing
system, aimed at attracting listings by companies from Asian emerging markets,
especially China. The liberalisation measures include:
reduction of the existing minimum requirements for shareholders' equity from
100 billion yen to 10 billion yen acceptance of an application for listing from companies that are not listed in
their home countries abolition of the required minimum time period for incorporation before listing
relaxation of the requirements for dividend payments, minimum number of
shareholders, and financial disclosure, and, reduction in initial listing costs and listing appraisal charges.
Most of these deregulation measures are angled towards privatised companies,
particularly Chinese infrastructure ventures with no track record as corporate
entities.
The Singapore Stock Exchange also offers promise, in view of strong local
investment interest in China. At present, no Chinese companies have been officially
floated in Singapore, but there i s one back-door listing, Cosco Investment, and
one fund, Hoare Govett's China North Fund. London Exchange too is stepping up
its efforts at attracting emerging market issuers. To this end a special depository
receipt programme was set up in August 1994 to provide a less demanding means
of raising capital than a traditional listing on SEAQ International (the exchange's
computer-traded systems for international equities).14 A key concern with listing
in new exchanges wil l be the degree to which liquidity can be expected (as in the
case of the US China ADRs with no cross-listing). Cross-listing programmes may
therefore be a good route to begin. Several companies are believed to be
considering simultaneous offering of Singapore Depository Receipt programmes
and B shares. Another general issue concerns the timing of new share issues, and
the 'bunching' that Chinese companies have had to conform to, due to 'batch'
government approvals. Greater flexibility in timing would permit better prices
wherever the new issues are made.
China investment funds
Closed-end national index funds (or country funds) targeted at emerging capital
markets shares have expanded considerably since the mid-1 980s. The value of
such indirect investment vehicles, aside from the mobilisation of external resources,
i s that they also promote pricing efficiency in the originating stock markets.15
Since the introduction in 1992 of the first country fund targeted exclusively at
Chinese stocks - the China Fund listed on the Stock Exchange of Hong Kong - a
total of 18 China country funds had been launched by end November 1993,
attracting some US$3.0 billion of foreign investment.
Like most other closed-end funds, these China funds have traded mostly at a
discount to net asset value, with discounts ranging from zero to about 20 per cent
over the last few years. Although some China funds initially commanded a
premium, boosted by rarity value, the trend has been increasing discounts. The
rising trend in discounts could be attributed to the fall-off in rarity value, with the
rising supply of Chinese equities, but also, to sluggish performance in the home
markets in Shanghai and Shenzhen since late 1993.
Moreover, as Figure 5.4 indicates, the relative performance of China's closed-end
funds, initially superior to other emerging markets, deteriorated. This i s confirmed
by an analysis based on a selected group of China funds, which had average
annual returns of 9.4 per cent in the third quarter of 1 994.16 This was considerably lower than many other funds, especially those for Latin American countries, but
fared better than the large emerging Asian economies of India (6.5 per cent) and
Indonesia (5.7 per cent) during the same period. The deteriorating performance
of China funds, like many China equities listed on overseas exchanges, which
have traded at discounts to their offer price, re-emphasise the importance of first
strengthening the domestic market. China shares are no longer a novelty on the
overseas market today, and their attractiveness to overseas investors wil l depend
on the performance and intrinsic value of the companies listed.
Table 5.2 China closed-end counfry funds: discounfs/premiums (per cent difference from net asset value to share price)
China - equity funds % Discount/Premium
5/31/92 11/30/92 5/31/93 11/30/93 5/31/94 11/30/94
BOC China Fund Ltd.
CH China Investments Ltd.
China & Eastern Inv Co.
China Fund (HKSE)
China Fund Inc.
China Invest & Develop Fd
China Investment Company
China Investment Trust
Equity Fund of China
Fleming Chinese Inv Trust
HSBC China Fund Ltd.
Jardine Fleming China Inc
Jardine Fleming China Ltd
Lloyd George China
Shanghai Fund (Cayman)
Shanghai Growth Inv. Ltd.
Templeton China World Fd
Templeton Dragon Fund Inc
Source: World Bank
Figure 5.4 Country funds - average discount
I +China --Emerging global +India +South Korea 1
Source: Lipper Analytical Services; World Bank
Opening of Fixed-Income Securities Markets
One of the most notable recent developments in the cross-border flows to
developing countries is the growing portfolio investment in local currency-
denominated fixed income securities. High real interest rates in some developing
countries, often the outcome of external credit constraints or tight monetary
policies, have attracted international investors seeking high return alternatives in
the emerging domestic debt markets. Latin American countries such as Mexico
and Argentina have had high foreign participation in these markets.17
Among emerging Asian markets, Korea, with more than US$100 billion equivalent
of local currency bonds outstanding at the end of 1993, has the largest fixed
income market, but until recently it had been closed to foreigners. In July 1994
Korea partially opened its bond market, to foreign investment in convertible bonds
of small and medium-size companies listed on the Korean Stock Exchange. Other
Asian markets are relatively open to foreign investors but have much smaller
fixed income securities markets.18
The nature and potential impact of cross-border flows differs between equities
and fixed income securities. On the one hand, bond investment raise no sensitive
issues of foreign control of domestic industry (an argument raised against the
complete opening of stock markets). But on the other hand, foreign investment in
fixed income securities tends to be volatile, reflecting the global (as well as host)
market situation, and thus undermining the stability of domestic markets and
effectiveness of monetary control. In the long term, despite the macro-economic
management issues (particularly in monetary control) raised by portfolio inflows,
foreign participation in local currency fixed income securities can contribute to
the deepening of domestic financial markets and to the reduction in the cost of
capital in the recipient economies. For instance, bond yields have declined by
some 300 basis points in Malaysia and the Philippines since foreign portfolio
investment took off in early 1993. But effective mechanisms for monetary control
should be in place first to afford protection.
Compared with other emerging Asian market economies, China's fixed income
securities markets are fairly large. Primary money and bond markets reached Rmb300 billion or US$25 billion equivalent at the beginning of 1994. Unlike
stock markets, money and bond markets in China remain closed to foreign
investment. In view of the large and growing needs of China's real sector, global
participation in its financial markets is an important question. But the benefits of
increased foreign investment must not be outweighed by the costs of reduced
stability and autonomy.
As discussed in Chapter 3, China's fixed income securities markets today require
further strengthening in a number of areas. Given the current weak infrastructure
in money and bond markets, it would not be advisable to proceed with direct
foreign investment in Rmb denominated fixed income securities within the medium
term. The financial crisis in Mexico in late 1994 also underscores the importance
of an adequate policy framework, in tandem with the liberalisation of short-term
capital flows. China must first strengthen its domestic securities markets, dealing
with the issues raised in Chapter 3, including the lack of a market-based benchmark,
due to irregular government bond issues, administered or below-market rates;
illiquid secondary trading, itself partly due to instrument design, interest rate
controls, and the absence of institutional investors; and regionally s.egmented
bond markets, due to the absence of a central depository or mutual recognition
of certificates of ownership.
The first steps are therefore to develop money market instruments to conduct
efficient policy actions, such as sterilisation, to deal with large inflows of foreign
capital. In parallel, domestic bond markets should be strengthened, and domestic
bond instruments expanded, to longer maturities, more sophisticated structures
(such as convertibles), and more non-government issuers. As a long-term objective,
China may fo l low a gradual and sequential approach to bond market
internationalisation, such as the approach adopted by Japan (1 970s) and Korea
(1 990s). Partial and/or indirect opening would be a prudent first step. Specific
types of instruments (convertibles, non-guaranteed), maturity ranges (longer end),
and eligible sectors could be considered, with additional safety features such as
restrictions on resale or holding period conditions during initial phases, to mitigate
any adverse impact on the market and economy. A closed-end fund for total
currency bonds during initial phases is another possibility for the early phase of
market opening.
China's Access to Overseas Securities Markets
International financing activities by developing country borrowers are being
increasingly dominated by securitised arrangements, such as bonds, as opposed
to loans. This reflects in part the increase in securitisation in global capital markets.
Developing countries raised US$53 bil l ion (gross) through bond issues in
international capital markets in 1993, more than twice the amount raised in 1992.
Low interest rates, particularly dollar rates, and improved creditworthiness in many
developing country borrowers contributed to that surge.lg
Overseas bond issues
China's access to international capital markets has expanded substantially in recent
years, emulating the global trend. The annual volume of new overseas bond issues
has grown remarkably fast, expanding from less than US$200 million a year, on
average, over 1989-91, to over US$2 billion per year for 1992-94. In 1994 overseas
bond issues reached US$3.5 billion, an all time high. In terms of currencies,
China's overseas bond issues have been concentrated in two currencies, the
Japanese yen and the US dollar. Currency denomination of new bond issues has
recently shifted away from the yen, which was the dominant currency before
1992, to the US dollar, due to the combined effects of the strengthening yen and
relatively low dollar interest rates. In terms of rate structure, recent historically
low interest rates in major markets led to a concentration of new issues in fixed
rates (70 per cent). The average maturity of new bond issues has increased every
year since 1991. In 1994, new US dollar bonds had an average maturity of 9.3
years, compared to 5 years in 1 992.20 Yen bonds in 1994 averaged close to seven
years, compared to around five years in 1992 and 1993. Although growing, these
maturities have not yet achieved the levels desirable for long gestation infrastructure
projects.
Figure 5.5 International bond issues by Chinese borrowers: currency, type and maturity
US$ million equivalent Years to maturity
Source: Eurornoney Bondware; World Bank (IEC)
Interest spreads on new issues, on average, have had some downward trend since
1989 until late 1994. While lower interest rates in the early 1990s partly reflect
declining global interest rates, it is interesting that the relative spread on new
issues for China, compared to other emerging markets, is low. In 1994 China
enjoyed lower spreads than lndia or Thailand, (although not as good as Korea),
and also countries outside the region, such as Hungary and Mexico (before its
~r is is ) .~ ' The favourable terms enjoyed by China until recently reflect in large part
its good macro-economic per f~rmance.~~ Following the Mexico crisis, developing
countries as a whole witnessed some decline in their terms. In the case of China,
there was some deterioration in secondary market prices on bonds.23
Table 5.3 Average spread on floating rate medium and long-term bond issues (Basis points)
China Hungary lndia Korea
Mexico
Thailand
Source: World Bank, lEC
Chinese overseas bond issues
Chinese bond issuers have diversified their currencies and markets. Aside from
the new entries to Yankee bond markets and continued Samurai issues, China
entered the Dragon bond (Hong Kong dollar denominated) market for the first
time in October 1993, with a $300 million ten year issue. China's first Dragon
was also the first sovereign issue in this market and the first with a maturity of ten
years. With Moody's rating of A3, it was also the lowest investment grade in this
market. After a six year hiatus, China returned to the Eurobond market in September
1993 with a five year Rmb30 billion issue to finance infrastructure projects.
In early February 1994 China launched a $1 billion ten year global bond issue;
the largest global dollar bond issue by a developing country so far. It was China's second Yankee bond issue, following CITIC's pioneering ten year issue in 1993.
Despite the slack market, due to recent US rate hikes, China's first global issue was well received. The benchmark Chinese offering was priced to yield 85 basis points over the comparable US Treasuries.
There have been five international sovereign bond issues up until the end of
1 994:
DM30 million issue in October 1987, which was fully repaid in October 1992
Rmb30 billion five year Euro-yen issue in September 1993, carrying 5.375 per
cent coupon; $300 million ten year Dragon issue in August 1993, with 6.125 per cent
coupon; $1 billion ten year global issue in February 1994, with 6.5 per cent coupon;
and Rmb6O billion Samurai issue in July 1994, in two tranches (Rmb30 billion,
five year maturity, and 4.4 per cent coupon, and another of Rmb30 billion,
ten year maturity, and a 4.95 per cent coupon).
Within the total borrowing approved in 1994 ($1.5 billion), the choice of specific
markets is based on the combined considerations of, relative prevailing rates,
listing costs, issue and listing processes (for example, the Euromarket i s usually
considered to have a simpler listing process), general market recognition and reception (Asian markets are relatively favourable to China), diversification and
market liquidity. International bond issues by the state government are conducted
and managed by the MOF.
Chinese borrowers remain relatively inactive in convertible bonds and bonds with derivative elements. Only three issues have been launched: China Textile
Machinery's $23 million equivalent of SFR-denominated five year convertible
bond, in November 1993, and two separate seven year US dollar bond issues,
with a 'put'option, by Shandong Industrial Trust & Investment in July 1994 ($1 30 million) and September.1994 ($1 50 million).
China's credit rating enjoys an above-investment grade by all major rating agencies.
The country's sovereign rating was upgraded to A3 by Moody's in September 1993, thanks to the agency's assessment of its strong potential to attract foreign
investment, low external debt burden, and likely 'soft-landing' for a successful
transition to a more advanced market economy.24 This was followed by a similar
upgrade for three major financial institutions; Bank of China, CITIC, and People's Construction Bank (Appendix Table A5.4).
Looking at the domestic organisation of overseas bond issues, these, like other
securities issued, still form a part of the annual credit plan, and specifically, part
of the foreign borrowing quota. The allocation is carried out in consultation with
the People's Bank of China. Priority is usually given to the central government-
and 'pre-approved' SPC projects; unallocated portions are then distributed to
provincial borrowers, and other Chinese entities. Approvals are also required by
the State Administration of Exchange Control for medium to long-term issues. The
SAEC imposes stricter controls on bond issues, relative to commercial loans and
short-term debt. Convertible securities are regulated by both the SHEC and the
CSRC.
China's international bond issues have been carried out by certain financial
institutions comprising selected banks and those trust and investment corporations
authorised to engage in international operations. By 1993, around ten such
institutions had been authorised, referred to as the 'ten windows.' The 'windows'
act essentially as intermediaries, who on-lend to domestic end-users (although a
portion of their borrowing i s for their own use). Among the 'windows,'ClTlC and
the Bank of China (BOC) have been the most active. In the late 1980s, these were
the only two institutions issuing debt. Gradually, the government's authorisation
of additional bond issuers has reduced their share, which in 1994 accounted for
29.7 per cent of all Chinese external bond issues (or 55.6 per cent of non-
government bond issues).
These domestic procedures raise certain issues. First, it i s difficult to ensure that
proceeds from foreign bond issues eventually go to the projects with the highest
returns. Allocation of the 'residual' quota among provinces suggests, rather, that
distribution criteria and bargaining elements could be introduced. On-lending'
terms for overseas loans to eventual domestic borrowers do not appear to be
clearly defined and may not be governed by creditworthiness considerations alone.
Second, the merits of 'window-based' overseas borrowing requires careful thought.
While this approach may accrue benefits to China, mainly in the form of cost
savings due to the higher credit standing of some windows in the international
capital markets, the system also has disadvantages. Some windows have weak
balance sheets leading to cost ineffectiveness, and market absorption could also
be an issue. Exclusive emphasis on the windows can encourage back-door financing activities, such as inducing offshore borrowing by Chinese enterprises
through their foreign subsidiaries. Greater direct access by non-windows to overseas funding should therefore be encouraged for more efficient resource
mobilisation and allocation. Since 1993, the authorities have been considering a
more pragmatic approach, which allows domestic enterprises direct access to
overseas bond markets. Yet as Appendix Table A5.6 indicates, this plan has not
been actively implemented. Direct bond issues by manufacturing enterprises have
been rare, and bond issues linked to specific infrastructure projects are unknown,25
although increased flexibility has been afforded to some institutions (including
CITIC) in the execution of individual borrowing programmes within the quota. A
limited role has also been conceded to internal credit rating agencies in assessing
the financial adequacy of borrowing entities. Increased direct market access would
be advisable, with international creditworthiness being the principal criterion for
selection.
Role of credit rating for developing country bond issues
Developing countries' desire to gain access to overseas funds has fuelled formal
rating activity by international rating agencies. The assignment of investment
grade credit ratings to developing countries by international rating agencies such
as Moody's and S&Pfs has allowed these countries to raise resources from industrial
country institutional investors (including pension funds and insurance companies).
Stipulated portfolio allocation guidelines by the trustee of institutional investors
often do not permit investment of asset portfolios in less-than-investment-grade
securities.
The proliferation of developing country bond issues was supported by the more
active participation of rating agencies. In addition to the two above-mentioned
agencies, these include Fitch, Duff and Phelps in the United States; Japan Bond
Research Institute (JBRI), Japan Credit Rating Agency Limited r:JCR), and Nippon
Investor Service (NIS) in Japan; and IBCA, the only cross-border rating agency
that i s based in Europe and specialises in the rating of financial institutions.
An increasing number of non-sovereign developing country borrowers are also
being rated, as established issuers diversify funding sources and access a wider
investor base and as new borrowers enter the market. As emerging-market issuers
shift from the Eurobond market (where formal rating i s not required) to other
international bond markets, demand for ratings i s rising. For example, issuers
entering the Samurai market have all been required to obtain ratings (from Japanese
rating agencies). Ratings are not formally required in the Yankee bond market,
but because a credit rating provides investors with a standardised benchmark for
evaluating bond issues, several developing country borrowers in this market have
acquired ratings. In the primary issue market 18 per cent of total bond issues by
developing country borrowers were rated by Moody's and S&Pfs in 1993, compared
with 15 per cent in 1992, and this shift toward rated issues i s continuing. As the
first among the international rating agencies, Moody's opened its Hong Kong
office during the summer of 1994.
Figure 5.6 China: international syndicated loans
US$ million
7000
6000
5000
4000
3000
2000
1000
0 1990 1992 1992 1993 1994 (end July)
Source: Eurornoney Loanware
Yen
FFR
[3 Lit
Syndicated loans
Syndicated loans to Chinese borrowers rose in tandem with new international
bond issues, reaching US$7.3 billion (equivalent) in 1993, compared with less
than US$3 billion in 1991. The firming trend was sustained during the first half of
1994, exceeding US$4 billion through to the end of July. The continued buoyancy
in international commercial banking flows to China is noteworthy because the
global trend has been the slowing of new bank loans. Most commercial banks in
major industrial countries have becomeextremely selective, at least during 1993,
in extending new credits in the aftermath of the debt crisis of the early 1980s;
their capital adequacy ratio has been under pressure and profit margins squeezed.
This certainly bodes well with China's track record (ie, no history of loan
rescheduling) and impressive macro-economic performance and thus market
creditworthiness.
China's new commercial bank credits have been arranged largely in US dollars,
unlike new bond issues which have been more diversified between dollar and
yen. Also in contrast with international bond issues, the average maturity of
syndicated loans for Chinese borrowers has been progressively shortened during
the 1990s: from 8.4 years in 1990 to 5.5 years in 1994. This partly reflects some
international banks (especially Japanese) concerns over large Chinese exposures
built up during the period.
International syndicated loans to China are increasingly linked to project financing
largely in support of infrastructure projects, and this trend will be likely to intensify
in the coming years. While estimates vary considerably, infrastructure financing
cost for China could amount to hundreds of billions of dollars by the end of the
decade. The Three Gorges project for the world's largest hydro dam i s a good
example, which alone would cost US$24 billion, with as much as 80 per cent of
the total cost to be financed by foreign resources. Greater activities in limited
recourse project financing such as build-operate-transfer (BOT) schemes are
anticipated to be the main vehicle to mobilise funds from commercial banks,
which are less willing to engage in long-term financing.26 Malaysia i s one of the
countries more actively implementing BOT schemes by making them a major
component of its privatisation programmes. Earlier in 1994, IFC helped launch
Peregrine's planned US$1 billion Asian Infrastructure Fund with Chinese projects
being the main focus, emulating the AIG-sponsored Asian Infrastructure Fund.
Efforts to structure infrastructurefinancings for China have been going on widely:
JP Morgan recently arranged an innovative US$80 million syndicated loan deal
for a coal-fired plant providing 15-year debt, with the last five-year maturities
guaranteed by the World Bank.
Figure 5.7 China: maturities and spreads on international syndicated loans
Years Basis points
6 ................................... -Am-+-
-. 100
.. .I.. ., :. - .-
Source: Eumrnoney Loanware and World Bank Staff estimates ~ -&China - -C - -Hungary - -+ - -All currencies -US$ - - -A - - HK$ - - -A - - India S Korea
The State Development Bank (SDB), one of the three newly established policy
banks (the others are the Export Import Bank of China and Agricultural
Development Bank), has been designated with managing two-thirds of China's
infrastructure financing needs. The SDB is therefore expected to play a major
role in developing an environment conducive to foreign investment. While the
SDB funding will come primarily from the issuance of domestic bonds, the first
SDB mandate that involves a foreign currency component i s the US$350 million
Qinshan nuclear power plant in Zhejiang Province, based largely on OECD export
credits.
In summary, the large volume of syndicated loans extended to Chinese borrowers
in recent years reflects good credit perceived by risk-conscious international
commercial banks, adding to the greater diversification of China's external funding
source. And there i s nothing inherently wrong with this form of financing to the
extent that the fund is used productively and i s well managed. In view of a
growing need for longer-term financing, overseas financing must be structured
adequately to meet this changing need (eg, extending maturities with IF1
guarantees). Mexico's recent problems highlight the need for a prudent macro-
level asset-liability management. Viewed from this perspective, more active bond
issues, vis-2-vis bank loans, should be considered.
Trading in Derivative Instruments on l nternational Markets
The trend towards global financial integration has been accompanied by an
explosive growth i s the use of derivative financial products. These financial
instruments can be used for risk management, for lowering the cost of capital, or
for spe~u la t i on .~~ Developing country involvement in derivatives has so far been
modest due to a combination of several factors: regulatory barriers, small and
unsophisticated financial markets, and little demand for risk management tools in
the presence of implicit government guarantees. Yet this market has been witnessing
rapid growth, in unison with the growing integration of developing country financial markets into the global market.
International trade in derivatives of financial securities
While the development of markets in financial derivatives is a vital part of any
well-functioning capital market, due to the need for effective risk-management
tools, the development of derivatives also gives rise to systemic risk issues. This
sometimes prompts regulatory authorities to clamp down on domestic derivatives
activity, but the typical consequence i s that these markets move off-shore to
circumvent legislation. The appropriate approach therefore is not to restrict their
emergence, but to create appropriate guidelines for the prudential regulation of
derivatives activity.
The prevention of systemic risk i s of concern to financial authorities, and also of
concern to market participants. One complicating factor is the typically huge
size of the OTC market worldwide, which makes supervision and controls difficult
because of the off-exchange and bespoke nature of the contracts. International
guidelines have evolved to deal with the issue of systemic risk. Since derivatives
activity of banks i s off-balance sheet, the imposition of the 1988 Basle capital
adequacy requirement to account for off-balance sheet positions of banks has
been an important step in this direction. Capital has to be set aside to cover credit
risks from the risk-adjusted asset positions of banks as they relate to their derivatives
exposure. The contracts are marked to market (ie, periodically revalued at current
market prices) to determine credit exposures of each bank. Disclosure requirements
are also an important element of the evolving regulatory framework, so that market
participants realise, and hence limit, their exposures. There is also an effort towards
legal recognition of netting procedures to establish exposures between
counterparties. (Bilateral netting reduces the replacement value of the positions
between two parties to their net, rather than gross, obligations).
At the level of participating firms, regulators suggest imposing strong internal risk
control procedures. The recent well-publicised cases of trading losses related to
derivatives (such as Codelco, the Chilean copper company, Metallgesellschaft,
Proctor and Gamble, Barings) all involved to a lesser or greater extent the lack of
proper internal risk control programmes. The management of any firm engaging
in derivatives has to enforce limits on aggregate positions, aggregate credit risk
and capital at risk. 'this would imply restrictions on the level of autonomy given
to the desk traders and the appropriate supervisory infrastructure for the
management to effectively monitor the activity of the trading desk.
China's involvement today in the domestic trading of derivatives of financial
securities consists mainly of Treasury bond futures, traded on the Shanghai
Securities Exchange. The enormous burst of activity in the trading of futures in
government treasury bills in February 1995 is detailed in Chapter 3. The
government is aware of the need to better regulate derivatives activities; and new
regulations on futures trading were published in the same month (see Chapter 2
for details). The need for tightened regulations i s particularly acute in view of the
plans in 1994 to widen financial futures. The Shanghai Securities Excha~ge
planned to start trading financial options, for which government approval had
been given.28 There are no equity-linked futures (eg, stock index) or foreign
exchange futures in China. Foreign investors are currently prohibited from trading
commodities and financial derivatives in China.
In the international arena, since several large loss-making incidents by Chinese
enterprises through overseas derivatives dealings in 1994, financial operations in
international derivatives markets grew more tightly controlled. Financial derivatives
are under the jurisdiction of CSRC (Futures Department). Overseas derivatives
activities by Chinese entities are usually confined to exchanges acceptable to the
CSRC, such as the CBOE (Chicago Board Options Exchange) and clearing members
of the exchanges. Large financial institutions are considering the use of overseas
derivatives to hedge risks associated with international bond issues. An expansion
of involvement in these areas is inevitable, in view of the deepening domestic
financial market, and the increasing international integration of China's securities
markets, and the government should, with appropriate precautions, encourage its
development for risk-management capacity (hedging) rather than speculative
trading.
For China, therefore, the appropriate policy stance is one which encourages the
development of derivatives markets, but with appropriate risk control procedures
in place. This includes compliance with capital adequacy standards, disclosure
rules and the recognition of netting procedures. It also requires the adoption by
participants of the principles for prudential internal risk reduction programmes,
such as limits on positions, credit exposures and capital at risk. Finally, it requires
a sound internal risk supervision system which would monitor trading activity in
derivatives by these firms. In terms of sequence, however, the development and
strengthening of underlying (cash) securities markets should be given first priority.
Endnotes
1 Moreover, from a macro-economic standpoint, the positions are very different. China has a healthy
external payments situation, no significant exchange rate distortions, and a current account surplus
in 1994. Even when the current account has been in deficit, deficits have rarely exceeded 2 per
cent of CDP.
An analysis of the range of macro-economic consequences of foreign capital inflows is omitted
here.
Recent US Department of Commerce studies (Survey o f Current Business, various issues) suggest
that rate of return on FDI in East Asia (including China) has been consistently large at over 25 per
cent, more than double the worldwide returns on FDI.
According to sources in China, the introduction of B shares was virtually necessitated by the
pressure of demand for Chinese shares from overseas Chinese, and especially, Hong Kong Chinese.
The introduction of B shares provided a first safeguard against means of seeking illegitimate
investment in the local market.
The lack of double-taxation treaties with most source countries further curtails the interest of
foreign portfolio investors in China's equities.
Data for this section were obtained from the World Bank, and from the Bank of New York, which
has been particularly active in launching Chinese ADR programmes.
Again, legalisation followed the fact, as backdoor listings on Hong Kong through local subsidiaries,
the so called 'red chip'shares, had already begun to occur.
A second batch of 22 companies had been approved for listing in 1995, but a series of delays
reduced the total number of new listings in 1995 to only five, with a total value of US$60 million.
However, the pace resumed in 1996, and in the first six months of the year, around US$450
billion had been raised on the Hong Kong market through ten H share issues by six Chinese
companies.
One of these, Qingling Motors Company, launched a CDR programme for the first time as a
Chinese issuer (July 1994).
A step already taken by over 60 major and many medium sized companies listed at Hong Kong.
These figures are approximate. For ADRs and CDRs, details of capital raised through the private
placement 144AADRs are not all available. For H shares, where data are from the World Bank
data base, details are not provided for all 15 companies.
For example, Eun, Claessens, and Jun (1 993). It is shown here that to the extent that internationally
traded securities' prices are correlated with those of domestically traded securities (which is the
case with Chinese shares, although the degree of correlation is not very high), the firms represented
by the latter could 'ride free' and benefit in terms of higher securities prices and lower cost of
capital.
New York specialist firms have complained that trading is too thin to even fix an opening price,
and they must wait for matching buy and sell orders, which may take several hours.
SEAQ accounts for 60 per cent of all share trading outside home markets, with over 470 companies
quoted.
Diwan, Errunza and Serbert (1993).
Appendix Table A5. 3. A group of 13 'best performing' funds, for China . This was most noticeable in Mexico, where foreign investors held more than US$23 billion in
Mexican government securities (one-third of the entire market) by the end of the first half of 1994
(a rapid build-up from US$1.8 billion in 1990). Most holdings by foreigners were in short-term
government paper (cetes), dollar-linked securities (tesobonos), or in the medium-term, floating
rate Mexican government bonds (ajustobonos). Foreigners have also been active in Argentina's
fixed income markets, traditionally favouring bonex (dollar-denominated government debt),
although peso-denominated bocones were popular in 1993 because they could be used to buy
shares in the newly privatised companies. Brazil's bond market is large, but restrictions on foreign
participation have constrained foreign investment.
18 Malaysia's market had outstanding ringgit bonds of about US$27 billion equivalent in 1993, and
Thailand had about US$6 billion equivalent of baht-denominated bonds, but with little secondary
market activity. Some market sources report US$5 billion of new inflows into the fixed income
market in Malaysia and US$1.5 billion in Thailand in 1993.
19 Almost half the total went to issuers in Latin America, with the remainder going in almost equal
proportions to borrowers from Europe and East Asia. The bulk of the borrowing has been in the
Euromarkets, mainly the Eurodollar market.
20 Looking at major new issues, dollar bond maturities stretched from seven years in November
1992, for the People's Construction Bank of China, to ten years in July 1993, for a ClTlC Yankee
issue, and to 20 years in March 1994, for the Bank of China.
21 An adequate set of comparable data for each year and country, in terms of currency of issue and
maturity does not exist, and the table is therefore based on a specific bond type, the floating rate
bond, for medium and long bonds.
22 A recent study suggests that the price of developing country new bond issues is strongly affected
by macro-economic performance (Jun and Mahajan; 1994). Four determinants of bond risk premia
are statistically significant in this study: reservesldebt ratio (-); variance of reserves (+); inflation
rates (+); and real CDP growth rates (-).
23 Since China's overseas bond issues are not traded on the exchanges, but are traded largely over
the counter between major international investors, the measurement of the true deterioration in
these terms is difficult.
24 At this time, Moody's rated Argentina, Brazil and Mexico, as well as Venezuela, Turkey, Pakistan
and Hungary, below investment grade. Chile, Colombia, India and Indonesia were investment
grade but below China. However, three Asian emerging economies enjoyed higher ratings; Korea
(Al), Malaysia and Thailand (A2). (Appendix Table A5.5)
25 Although Chinese authorities claim that a substantial part of the proceeds from overseas bond
issues are used for domestic infrastructure projects, it is difficult to assess the extent to which this
occurs (since each bond issue effectively 'bundles' a number of loans to infrastructure projects),
or its effective cost to the final borrower.
26 Limited recourse project financing refers to independent project financing where the balance
sheet of the sponsor is not exposed (or only exposed in a limited way) to the project's risk.
27 Derivatives enable the underlying financial instrument (from which they 'derive' their value) to be
stripped of various dimensions of risk, which are then packaged and marketed as new instruments.
Derivatives can be broadly classified as forward-based (eg, futures, forward rate agreements,
swaps) and options-based (eg, options, caps, floors, collars).
28 The Shenzhen Stock Exchange expressed an interest in a currency futures exchange. There has
been a currency swap market which has received some recent setbacks, and traders had expressed
interest in establishing a currency futures market, which has, so far, been resisted by the authorities.
CHAPTER 6
Institutional Investors and Securities Markets
As the, previous chapters illustrated, China's securities markets are characterised
by relatively low liquidity and high volatility. The behaviour of investors tends to
be speculative and oriented towards short-term returns. Among the factors which
give rise to such characteristics is the investor profile, which is biased towards
small retail investors. The absence of professional investors in China is notable
even relative to other emerging market economies. Increased participation by
institutional investors such as insurance companies, pension funds, and mutual
funds, would stabilise the market. The focus of the present chapter is an analysis
of the reasons for the limited participation of institutional investors in China, and
suggestions for how such participation could be increased. '
A first difficulty concerning the participation of institutions for contractual savings
in the securities market in China, is that such participation has been limited by
restrictive regulations. Appendix B1 discusses investment patterns oi contractual
savings institutions in other countries: developed and developing. In China, such
institutions have been obliged to invest their resources in a combination of
government securities and bank deposits, which have often paid low or sometimes
negative rates of returns. Aware of the consequences of such restrictions, the
government is considering the gradual lifting of these constraints, with appropriate
safeguards against speculative investments that may lead to large-scale losses for
individual savers. Yet China's contractual savings institutions today also face a
second serious handicap; the problem of low relative levels of contractual savings,
of only three per cent of GDP. This i s an apparent anomaly in a country with a
notably high savings rate. While it is true that China is a low-income country, contractual savings as a proportion of GDP in China are much lower than other
developing East Asian countries, such as Korea (1 8 per cent), Malaysia (48 per
cent) or Singapore (78 per cent). A primary reason is that under the system of
central planning, the state assumed the functions of providing pensions, housing
and social security primarily through state enterprises. Services such as domestic
How do institutional investors benefit securities markets?
Contractual savings institutions such as life insurance companies and pension funds can:
mob i l i se long- term f i nanc ia l resources. Their investments can increase the demand for long-term bonds and equities. Mutual funds mob i l i se re la t ive ly short - term funds, but they pool the resources of many smal ler investors. Institutional investors can increase the e f fec t ive demand for marketable securities. They can prov ide professional investment and management services, and thus higher long terms returns to their clients. As professional investors, their managers may exert pressure for better standards for accounting and aud i t ing as we l l . as for more meaningful and timely disclosure of information to investors. They may also encourage improved brokerage and trading arrangements and help establish more efficient and rel iable clearing and settlement facilities. lnstitutional investors may further encourage financial innovation and efficiency. In sum, insti tut ional investors may stimulate the
modernisation of securities markets. In some countries, insti tut ional investors have played an important part in faci l i tat ing privatisation programmes. They can also: help ownership dispersal, and stimulate greater corporate efficiency by monitoring the performance of the companies in which they invest. lnstitutional investors wi th large shares in individual companies can exert contro l over corporate management.
These beneficial effects wi l l materialise only if institutional investors face the right types of incentives. For instance, their impact on market liquidity wi l l depend o n whether i ns t i t u t i ona l managers are encouraged to trade ac t ive ly or t o acqu i re long- term strategic holdings. Their impact on corporate performance wi l l depend on their abi l i ty to col lect information about corporate performance and then analyse the prospects of individual companies and sectors. Their contribution to ownership dispersion w i l l depend on the extent to which laws encourage c lose ly -he ld companies to accept a d i lu t ion of control.
insurance were not permitted. W i th the transition towards a market economy,
China today has t o face the problem o f h o w t o bui ld u p such institutions. The
emphasis of the present chapter is therefore o n the second and more structural
problem o f bui ld ing u p efficient vehicles for contractual savings. This chapter
discusses the current situation and future potential and options facing the principal
types o f contractual savers and potential institutional investors i n China; the
insurance industry, the pension system, housing funds and mutual funds.
The growth of contractual savings in different countries
High income countries with relatively
low social pensions: (USA, UK, Canada,
Australia, New Zealand, as well as some
European countries, such as Denmark,
the Netherlands and Switzerlandl
These countries rely mostly on funded
occupational schemes for supple-
mentary pensions.
They have experienced a rapid
growth of contractual savings.
Institutional investors play a dominant
part in these countries' capital mar-
kets.
High income countries with relatively
high social pensions (France, Germany,
Italy, Austria). These countries are char-
acterised by:
Relatively underdeveloped occupa-
tional pension schemes.
Lower contractual savings.
Limited role of institutional investors.
Large accumulated long-term finan-
cial resources.
Relatively large contractual savings.
Developing countries with partially
funded pension schemes: (Brazil, Indo-
nesia, the Philippines, lordan and Turkey)
These countries have partially funded
private or public pension schemes,
and the size of their assets in relation
to total financial assets i s not very
large.
Developing countries with Pay As You
Go pension schemes: (Most Latin Ameri-
can, Eastern European and Central Asian
countries)
In contrast, these countries have pay-
as-you-go pension systems that make
little or no contribution to the accu-
mulation of financial savings.
Developing countries with funded pen- Source: World Bank
sion schemes: (Singapore, Malaysia,
Egypt, Cyprus, Chile and Zimbabwe)
The principal conclusions of this chapter, regarding the different segments of
China's contractual savings are first, that the insurance industry is growing rapidly
but is still dominated by the People's Insurance Company of China (PICC). It is still structurally biased towards non-life insurance, which provides relatively shorter-term funds for investment, compared to life insurance. While both the life
and non-life business appear relatively well managed, the restrictions on
investment, and lack of profitable financial investment opportunities, in the face
of the relatively high inflation rate, lower the real financial performance of PICC.
Yet, the insurance industry i s better poised today to potentially contribute investible
funds to China's capital markets in the medium term than pension funds. These
may take time to emerge as a reform of the current unfunded pension system and
reduction of its high contribution rates may first have to be undertaken. Such a
reform programme is unlikely to be implemented in the short run. While the
The three segments of institutional investors: pension funds, life insurance and mutual funds I
Size of life insurance Size of mutual pension funds and pension funds
Growth of pension funds (% GDP):
Singapore (1 976-86) 28% to 73% Malaysia 11980.87) 18% to 41% Chile (1981-90) 1% to26%
Total assets of life insurance companies and pension funds
(1 990, % GDP)
UK 97% USA 75% Singapore 78 % Malaysia 48% Chile 30% Korea 18%
Net assets of mutual funds (% GDP, 1993)
France USA 1 UK lapan 11% Korea 21% India 12% Mexico 5%
Factors behind the growth of contractual savings:
coverage
contribution rates
(wage growth
returns to investment.
eg Chile: mandatory personal pension plan introduced in 1981 high returns in the 1980s, averaging 13% per year.
USA, UK (1 980s): Large rise in stock market prices.
Switzerland, Netherlands: Expansion to near universal coverage of working
population by funded pension schemes.
The slower relative growth of mutual funds is due to their voluntary nature. Pension
fund participation, even if not mandated by the government, is usually compulsory at
thecompany level. Growth in mutual funds has been stimulated by the development
of money market funds, bond funds, and recently, in developed countries, by low
deposit interest rates.
Source: World Bank
difficulties of China's pension system are sometimes attributed to its enterprise-
based nature, the real drawbacks of the system lie with the complete reliance on
pay-as-you-go schemes. Today pension funds have negligible accumulated
balances to invest in capital markets, and the building up ofthese balances through
pension reform must occur before their serious participation in capital markets
can begin. Meanwhile, other contractual savings funds are beginning to take
shape but are still very small. Housing funds are effectively still forced saving
schemes with very low real returns and with little incentive to attract investors'
funds. Prospects for mutual funds have been constricted by the lack of an
appropriate supervisory framework, and ad hoc changes in the regulations they
face, reflecting the government's concerns about their possible effect on diversion
of bank deposits. Strengthening the macro-economic environment is a requirement
for encouraging their growth. Measures to strengthen the development of the
contractual savings industries are discussed in each section.
The Insurance Industry in China
Prior to 1979, the insurance industry in China was limited to only a small volume
of foreign insurance, mainly marine cargo and aviation insurance. All types of
domestic insurance, including life insurance in particular, had been banned since
1959. A first observation on the development of the industry is that insurance
business has experienced phenomenal growth since 1979, driven by the radical
transformation of the Chinese economy (Figure 6.1). In 1993, total annual
premiums are estimated to have doubled, and life premiums trebled.
Figure 6.1 China: insurance premium growth (1 986 - 1992)
--r i n n
1 Source: Niu ( 1 994) I
Yet, the second key observation is that relative to other countries, including
countries in Asia, the industry i s still poorly developed (Figure 6.2). These countries
illustrate that apart from income levels, the development of the insurance sector
is also related to factors such the regulation of the industry, especially to permit
competition, including foreign entry. Countries which have allowed market forces
to play a greater role in their domestic markets and have encouraged greater
integration with international markets through freer retention policies and freer
entry of foreign companies have experienced high growth of their insurance
markets (Appendix Table A6.3).
Figure 6.2 China: infernafional comparison of insurance premiums (1992)
Asia
Korea
Japan
Taiwan
Malaysia
Singapore
Philippines
Thailand
China
0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0
South Africa
Zimbabwe
Kenya
Morocco
I % GDP Latin America
1 Source: Sigma,
Africa
Brazil 1 Panama
Chile
Venezuela
Uruguay
Colombia
Argentina
Mexico
0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
% GDP
ce in 1992, Swiss Reinsurance Company, March 7994
% GDP I
Although there are signs of new competition in the insurance industry, it i s
dominated by the state-owned People's Insurance Company of China (PICC) which in 1992 held over 90 per cent of the market.2 There are a total of 24 companies in China but most of these are regional and are partly owned by PICC. Most were
regional branches of PlCC that were transformed into separate subsidiaries with partial ownership by local interests, notably banks, during the 1980s. Two
independent domestic companies also exist, which are evolving toward competing
and innovative nationwide insurers. China Pacific lnsurance Company (CPIC),
which has its headquarters in Shanghai, i s owned by the Bank of Communications,
and the Ping An lnsurance Company (PAIC) of Shenzhen i s jointly owned by a
group of banks from Shenzhen and Hong Kong and the Chinese Merchants Group
in Shen~hen.~ With the opening up of domestic insurance and the growth of
competition, PlCC modernised its operations in the 1980s, introducing new
products, computerising its data processing and improving overall efficiency.
The number of household property insurance policies increased from 30,000 in
1 980 to 1 30 mill ion in 1 993, while life insurance contracts, covering three classes
(pension insurance, industrial life insurance, and personal accident insurance)
grew from 300,000 in 1 982 to 300 million in 1 993. Motor insurance also registered
a large increase, growing from less than 8,000 vehicles insured in 1980 to 20
million in 1993. More specialised lines of business also grew at very high rates.
For instance, marine hull insurance reached 11 0,000 ships in 1993 from less than
300 in 1980 and aviation insurance reached 7,400 aircraft in 1993 from just 13 in
1986. Signs of competition are emerging in certain regions (eg, Shanghai) and
sectors (aviation insurance) by the aggressive marketing strategies of new
companies. So far, the new companies, primarily established by banks, have still
to acquire the professional skills which would permit them to seriously compete
with PICC.4 In 1993 foreign insurance companies were selectively allowed to
enter the market and American International Assurance (AIA) Ltd., a fully-owned
subsidiary of American lnsurance Group (AIG), was given a license to operate in
Shanghai. AIA can sell non-life insurance to foreign companies and joint ventures
and life insurance to individual Chinese, and i s reported to be expanding rapidly.
Tokyo Marine and Fire has also received a full authorisation license, while more
licenses are expected to be granted to foreign or joint venture companies with
permission to operate nationwide. Meanwhile, Chinese companies are also
developing links to international market^.^
As in most developing countries, the insurance industry in China is strongly tilted d
toward non-life business (Figure 6.3), although the rapid growth of life insurance
enabled it to account for 30 per cent of the total in 1992. The rapid growth of life
insurance i s partly explained by rising income levels, but primarily by the growth
of group life insurance, for workers in joint ventures, foreign and private companies,
and small rural co-operatives, which are not covered by the social pension system
but are required to be covered by group policies arranged through insurance
companies (Figure 6.4).
Figure 6.3 China: comparison of the life and non-life structure of insurance with selected countries
r 1 I Africa Latin America I
100% ro 100% .? 90% .- 5 90% E 80% E 80% g 70% g 70% = 60% 3 60% 5 50% 5 50%
40% 2 30%
.tj 40%
2 20% = 30%
" 10% $ 20%
2 0% 9 10%
5 .s 3 X 0 0%
0 a, 0 - m 0 m m -
G 5 .- .-
0 Y .o .- N .- X E 2 6 F 5 - 6 5 m
Ki S P
a East Asia
1 Source: Sigma, Swiss Reinsurance Company, March 1994
Figure 6.4 China: insurance premiums by line (1 992)
1 Source: 1992 PlCC Annual Report
The financial performance o f China's insurance industry
An evaluation of the financial performance of China's insurance industry (based
on the results reported by PlCC for 1993), shows that non-life insurance in China
has relatively high loss ratios, unusually low commission ratios, and modest
expense ratios, even compared to typical developing count r ie~ .~ Its profits are
modest, ranging from a five per cent loss for motor vehicles to 15 per cent for
marine and general insurance (Table 6.1).
Table 6.1 China: underwriting performance of the People's Insurance Company of China
(1 992/93)
Fire Motor vehicle Marine & general Total non-life Life
1992 1993 1992 1993 1992 1993 1992 1993 1992 1993
Operating results
(Rmb billion)
A. Premiums
B. Investment
income
C. Claims
0. Addition to
reserves
E. Surrenders
F. Commissions
G. Expenses
H. Taxes
I. Profit
Ratios
(pcr cent o f premiums)
Loss ratio (C/A) 59 59 66 69 48 52 57 60 24 28
Pay-back ratio
[(C+D+E)/Al 6 1 65 75 84 58 63 65 71 107 107 Commissions (F/A) 5 4 2 4 8 4 5 4 3 3
Expenses (G/A) 11 11 13 12 12 12 12 12 8 7
Combined ratio 77 80 90 100 78 79 82 87 118 117
Taxes 5 6 5 5 6 6 5 6
Investment income 1 18 17
Profit 18 14 5 -5 16 15 13 7 - Source: PlCC annual report 7992
PlCCs financial management of life insurance is relatively good. The PICCfs
reported loss ratio for life insurance amounted to 28 per cent, but including
additions to reserves and policy surrenders, the pay-back ratio amounted to 107 per cent. PICC also reports an investment income equal to 17 per cent of life
premiums. This is used to cover commissions, which amount to only three per
cent of premiums and expenses of seven per cent of premiums and the rest is
credited to policyholders in the form of life funds. These loss and expense ratios
compare very favourably with those of other developing countries (Figure 6.5)
whilst the commission and expenses ratios are low by the standards of most
developing countries.
This assessment, however, masks a rather poor overall financial performance in
life insurance, due to low returns on investment income. With Rmb20.3 billion
as the estimated value of funds available for investment throughout the year, the
investment income of only Rmb 1.6 billion implies a rate of return of only 7.9 per
cent. This is a negative rate of return as inflation during 1992 exceeded 13 per
cent. It reflects the low nominal returns obtained on the assets of PICC.
Adding its life and non-life business, overall financial performance i s weak due to
low returns on investments. PICC had total assets of Rmb59 billion in 1993, but
of these only Rmb39 billion were income earning (Appendix Table A6.6). IUearly
70 per cent of income earning assets (Rmb22 billion) were placed in cash or bank
deposits, while the remainder was mostly invested in government bonds. The
mid-year value of income earning assets was Rmb35.5 billion and the total investment income for the year was Rmb3.3 billion, implying a nominal rate of
return of 9.3 per cent. The low overall financial returns are a result of the investment
rules imposed on PICC, combined with relatively high rates of inflation. The non-
availability of financial instruments with positive real returns is forcing insurance
companies to emphasise the family protection aspect of their policies and to
downplay potential investment returns. Within this financial environment, PICC maintains good control of its financial affairs. At less than three per cent of annual
premiums, premiums receivable stand at a very low level by comparison with most developing countries where they often reach or exceed 30 per cent of annual
premiums. PICC also has a strong solvency margin, amounting to 26 per cent of premiums and 51 per cent of claims.
INSTITUTIONAL INVESTORS
Figure 6.5 China: comparisons of the performance of the insurance industry in selected countries
Non-life insurance: loss ratios and expense ratios
Life insurance: payback ratios and expense ratios
~ Source: Munsalem e ta / ( 1 993) and World Bank Staff Estimates
As i s clear from the accounts of PICC, insurance companies build up substantial
reserves. The reserves of life and annuities policies are of a long-term nature and
are available for investment in government, corporate and mortgage bonds as
well as in corporate equities and real estate. In the case of PICC, however, the life
reserves have been mostly invested in bank deposits and treasury bonds. Even
non-life business, which covers relatively short-term risks, can accumulate
substantial reserves. Since loss claims facing non-life insurance companies often
suffer from processing delays, non-life insurance companies in OECD countries,
especially in Anglo-American countries, also tend to place a high proportion of
their reserves in equities, which are expected to provide a better hedge against
inflation than bonds, while being more liquid than real estate. In China, the non-
life reserves of PICC have necessarily been mostly placed in cash and bankdeposits
yielding an even lower rate of return than life reserves.
Regulatory reform of the insurance industry and future prospects
Until 1995, the insurance industry was regulated by the Interim Regulations
Governing lnsurance Enterprises issued in March 1985. These allowed for the
demonopolisation of insurance activity and the authorisation of new domestic
companies as well as subsidiaries or branches of foreign companies. In October
1991 the drafting of China's first Insurance Law began, and China's lnsurance
Law was finally adopted on 30 June 1995, and effective as of 1 October 1995.
Measures of insurance efficiency
Efficiency in the insurance industry i s
difficult to measure because, like all other
types of financial services, there is no easy
definition of the output of the sector.
Various measures are used for
comparative purposes.
Non-life Insurance. In non-life business,
underwriting performance is measured by
four basic ratios: the loss ratio, the
expense ratio, the combined ratio and the
operating ratio.
The loss ratio measures claims paid
(and provisions for losses incurred but
not settled) as a proportion of retained
premiums, ie., gross premiums
received less premiums ceded to
reinsurers. It shows the percentage of
premiums that are paid back to the
insured; a h igh ratio normal ly
indicates an efficient and competitive
industry. Differences in reserving
policies and manipulation of reserves
for tax and other purposes reduce the
usefulness of the loss ratio.
The expense ratio is computed as
general expenses and net com-
missions paid (ie., commissions paid
to agents less commissions received
from reinsurers) as a proportion of
gross premiums. It provides a measure
of the acquisition costs of insurance
business. A high expense ratio would
suggest low operating efficiency in
marketing and product innovation
and in processing claims as well as
an uncompetitive distribution system.
The combined ratio, which is often
used as a measure of the underwriting
profitability of insurance companies,
is the sum of the loss and expense
ratios.
The operating ratios, which also takes
account of the investment income
earned on loss reserves. It is obtained
by deducting investment income as
a ratio of retained premiumsfrom the
combined ratio.
Traditionally, non- l i fe insurance
companies aimed to operate wi th a
combined ratio of 95% and earn a 5%
profit on their premiums without taking
account of investment income. With an
average ratio of premiums over equity of
3, this resulted in a satisfactory return on
equity of 15%. But high inflation and high
nominal rates of investment returns as
well as a growing level of reserves in
relation to premiums forced insurance
companies to take account of investment
income on reserves and to engage in what
has become known as cash f l o w
underwriting
When investment income i s high as a
proport ion of premiums, insurance
companies may lower premiums in
relation to expected losses and the
combined ratio may exceed loo%, giving
rise to an underwriting loss. This is made up from the investment income earned on reserves. This explains the use of the operating ratio.
International comparisons of non-life
insurance results are complicated by differences in accounting conventions, market structure, business mix, inflation rates, and data coverage. Differences in business or product mix are particularly important because both acquisition costs and loss claims vary significantly across different lines. In most countries, automobile insurance operates with very high combined ratios, because premiums tend to be regulated, whileexpenses and losses are high. In contrast, the fire contract is almost everywhere associated with low loss ratios, due to cross-
subsidisation by regulation.
Life Insurance. In life insurance, the concept of the loss ratio has less meaning, as it would include only claims paid due to death or maturity of contract. For a
growing industry, the loss ratiso would be quite low because a substantial part of premiums is placed in reserves to cover the long-term liabilities inherent in life policies. If benefits and dividends paid to policyholders and additions to technical reserves are treated as representing the premiums paid back to policyholders in the long run, then this pay-back ratio could be a better measure of efficiency for life insurance business than the loss ratio.
Source: World Bank
The new insurance law is a good start i n implementing an internationally
acceptable standard of insurance regulation, with management accountability, a
strong focus on contract law, emphasising a balance in protecting the rights of the
insured and the insurer, and a strong emphasis on defining the role of the regulator.
O n the other hand, i t vests considerable authority in the supervisory body and its
capacities. For example, until the passage of the new law, insurance premiums
were subject to a controlled tariff but with a wide range of variation of 30 per cent
above or below the approved premiums. The new law states that all basic insurance
premium rates shall be formulated by the supervisory body whi le other rates shall
be filed with the supervisory body. This may reduce the discretion permitted to
insurance companies to determine premia. In terms of capital market development,
the law is cautious; more so than its previous draft versions. t h e application of
funds are limited to bank deposits, government bonds, and other forms of fund
application specified by the State Council. Investment in enterprises (presumably
including the holding of equity shares) is explicitly precluded. If the law is to be
successfully implemented in China today, a considerable amount of training of
actuaries and other insurance specialists including specialists at the supervisory
authority, i s required.
Future prospects On the whole, the prospects for the insurance industry are bright. Continuing
high economic growth i s likely to stimulate the demand for non-life insurance,
while the high rate of saving and the need to cope with the ageing population
will stimulate the demand for life insurance. On the supply side, the ongoing
regulatory reform, the modernisation of the operations of PICC, the creation of
new domestic companies and the entry of foreign insurers are all pointing to
higher efficiency and an expansion of the insurance habit among Chinese firms
and households. The government could also undertake supplementary measures
to stimulate the growth of the insurance industry and enable it to achieve its
potential and contribute to the development of ttfe socialist market economy,
including: completion of the passage of the implementing regulations for the new
insurance law; providing for the training of regulators and insurance examiners;
establishing an effective new supervisory authority;
increasing the contestability of the insurance market by encouraging new
domestic companies; authorising more foreign and joint venture insurance companies to stimulate
competition; improving accounting and information disclosure standards to facilitate the
solvency monitoring of the industry and protect the interests of policyholders;
and taking measures to strengthen links with international insurance and financial
markets, especially by opening up the reinsurance market to foreign companies.
In the medium term, China should consider undertaking revisions to the recent insurance law to provide more flexibility to insurance companies in terms of
(a) setting premia and (b) determining their own investments, while encouraging
them to invest prudently and profitably, to permit them to contribute to the
further development of the capital market and the real economy.
China's draft insurance law
Coverage: The new law consists of 152
articles in eight sections. It focuses
primarily on the contractual relationships
between insurer and insured and the
supervision of the insurance industry. It
does not cover social insurance and
employee welfare benefits or some
specialised forms of insurance
Authorisation criteria: Two types of
domestic insurance companies may be
established: a shareholding company
with limited liability, or a wholly state-
owned enterprise. lnsurance companies
can engage in life or non-life insurance
only. The minimum capital for creating
insurance companies is Rmb 200
million. Twenty per cent of the capital
must be deposited as guarantee with the
Financial Supervision Authority.
Prudential norms and solvency
requirements: lnsurance companies are
required to maintain an unearned
premium of 5 0 per cent, as well as IBNR
(incurred-but-not-reported) and RBU
(reported-but-unpaid) claim reserves, and
to make contributions towards an
accumulated fund reserve. To avoid
concentration of risks, no individual risk
can exceed 10 per cent of net assets. ' lnsurance companies are also required
to maintain a solvency margin. Retained
1 premiums cannot exceed four times net
assets.
Investment rules: With regard to the
investment of accumulated funds, the
law is conservative. The application of
funds is limited to bank deposits and
government bonds. lnvestment income
wil l therefore be limited, combined with
the solvency tests, lack of profitability
could restrict growth, and paradoxically
encourage foreign insurers to provide
needed capital.
Premium and product controls: Basic
premia are to be set by the Financial
Supervision Authority. Other premia must
be submitted to this Authority for record.
The law also requires insurers to cede at
least 20 per cent of each contract to a
reinsurance company. The law also
provides for the creation of a fund to
cover catastrophic risks and a guarantee
fund to cover the liabilities of insolvent
companies.
Supervision: The law provides for an
industrywide Financial Supervision
Regulatory Authority, under the State
Council, with considerable powers of
surveillance, on-site inspection, and
intervention and sanctioning. This could
be within the Peoples Bank of China, as
at present, or could be an independent
body. It wil l be responsible for issuing all
detailed regulations.
The Pension System
Currenf sfrucfure
Chinese pension funds are even less developed than the insurance s e c t ~ r . ~ A major reason why pension funds have grown so slowly in China i s the prevalence
of unfunded pension schemes. Second, the population coverage of the current
schemes i s very small and excludes the large rural population of China. With the
urban population representing 30 per cent of the total population and a coverage
ratio of urban workers of about 60 per cent, the overall coverage of the pension
system is probably only about 18 per cent of the economically active population.
The current system also suffers from a very uneven burden among enterprises and
provinces, reflecting large differences in demographic structures and dependency
ratios. A further problem confronting the system is the rapid ageing of the
population, which makes future pension reform of critical importance. But the
system also has three mitigating factors that enhance the potential for reform: the
current low level of pension spending (which makes pension reform and the
transition to a new system easier and less costly); the high rate of economic growth;
and the very high rate of household saving.
The enterprise-based character of China's pension system has often been held to
be a factor responsible for its inadequacy. But this feature is far from unique to
China and is found in many high and low income countries. Enterprise or
company-based schemes suffer from portability, vesting, funding and labour
mobility problems in all countries. What i s uniquetochina and its current pension
problems is a combination of three additional features: the absence of a social
safety net or public pillar covering all workers; the complete reliance on 'pay-as-
you-go' rather than even partially funded pension financing systems; and the
economic problems of many state-owned enterprises.
To assess the efficiency of the present system, we first look at the national efficiency
ratios for pension schemes. The general finding i s that while costs are relatively
low, so i s coverage, and the volume of contributions in terms of pension funds
available for investment is very low. Thus, in 1993, the overall system dependency
ratio was 23 per cent, which is not much higher than the demographic dependency
ratio, of 18 per cent.9 The average replacement ratio is 65 per cent.I0 Though
lower than the targeted rate of 70 per cent to 80 per cent, it is quite high in view
of prevailing inflation." Table 6.2 shows the required contribution rate for break
even in China (1 5 per cent) and the implied share of covered wages in GDP (only
10 per cent). A comparison with other countries shows that the cost of pensions
in China is currently quite low, both because of the low dependency ratio and
because of the low share of covered wages in CDP.
Table 6.2 China and other countries: basic equation of social pension system (%)
Average System Required Labour IPensions
replacement dependency contribution income YO rate ratio rate share CDP
- -
China (1993) 65 2 3 15 1 0 1.5
Hungary (1 992) 49 59 2 9 37 10.6
Czech Republic (1 992) 49 49 24 42 10.2
Poland (1 992) 74 49 3 6 4 1 14.8
Russia (1 992) 3 4 46 16 29 4.6
Note: Administration costs and investment income are not taken into account.
Source: Vittas and Michelitsch (1 994)
Annual contributions are low, amounting to only Rmb50 billion, or around 1.5
per cent of CDP. In Eastern Europe, pensions correspond to 10 per cent or more of
CDP. Annual pension expenditures are around Rmb45 billion, leaving a very
small investible surplus per year, of only Rmb5 billion. By 1993, the total
accumulated capital amounted to Rmb27 billion, of which Rmb7 billion was
invested in specially issued non-marketable treasury bonds and the rest mostly in
bank deposits. The rate of return has been well below the rate of inflation in
recent years and has eroded the real value of accumulated balances.
Uneven burden of pension funds: Shanghai, Beijing and the railways indust ry
Provinces such as Shanghai, Beijing and Tianjin, with many loss-making enterprises
and aged labour forces, bear a greater burden from pensions than new cities like
Shenzhen, which have profitable firms and young labour forces. The difficulty of
transferring pension and other employee benefits is impeding the restructuring
and downsizing of state enterprises. To cope with this problem, a programme of
'socialising social security' has been under implementation since 1986. This
involves the 'pooling' of the social responsibilities of enterprises, either along
geographical lines, or on a sectoral basis. A limited number of industrial sectors pool enterprises on a national scale: electricity, water, power engineering, railways,
airlines and transportation, post and telecommunications, banking, coal mining,
petroleum and natural gas, and construction. All other enterprises are pooled
either at a province or city level. Under this programme, enterprises continue to
be primarily responsible for collecting contributions and paying pensions but
those with deficits receive transfers from those with surplus funds through provincial
agencies. However, as the pools are not connected across provincial or industrial
lines, pools with heavier burdens are forced to increase their contribution rates.
As the illustrations from three cities and one industry show, there is currently
considerable variation in contribution rates across different regions or industries,
while benefits are still not transferable across different pools.
In Shanghai, the system dependency ratio, at nearly 35 per cent, is 50 per cent
higher than the national average.12 The replacement rate of 57 per cent is below
the national average, of 65 per cent, and even further below the promised
replacement rate of 70 to 80 per cent.13 Contribution rates, of 54 per cent of
aggregate benefits, or 28.5 per cent for pensions alone, are very high by
international standards, especially for a country with the level of income of China
and pension reform should aim to lower contribution rates. Maintaining current
pension payments requires a lower (20 per cent) contribution rate for break even.
A small surplus has thus accumulated, amounting to Rmb 450 million in 1993,
and projected to reach Rmbl.2 billion by the end of 1994. The management of
these funds i s relatively innovative; as they are entrusted to the Pudong
Development Bank (PDB), which invests the funds in local firms and projects.
The returns of the PDB are higher than those obtainable on bank deposits and
treasury bonds, and the permission to allow a diversification of investments away
from an exclusive reliance on these i s broadly speaking to be welcomed. Yet, in
the present instance, a note of caution should also be interjected, as the PDB is
effectively under the aegis of the Shanghai Municipal government, and funds
invested are thus prone to be utilised for municipal government priority investments. Some investments of such new financial institutions may also be highly risky and speculative, with large reliance on real estate investments (in the
recent past). Safeguarding the savings of pensioners must not be forgotten. The
eventual aim should be to permit pension funds to invest in a diversified portfolio
of publicly traded securities.
1 China: pooled pension funds
Shanghai municipality Number of active workers: 4.9m Number of retired workers 1.7m Dependency ratio: 35.0% Average monthly pension 265Rmb
Average monthly wage 465Rmb Replacement rate 57% Pension contribution rates: 28.5% Employees: 25.5% Employees: 3.0% (New employees rate: 8.0% Break-even contributions 20.0% Other employer contributions: Medical 1 5 .O% Unempt. insurance 0.5% Housing costs 5 .O% Other employee contributions Housing costs 5.0% Total benefit contribution 54% (Employers 46%)
(Employees 8%) 0 Individual accounts:
1. Actual (full employers cont: 3 '10)
2. Notional (half employers cont: 13%)
Accumulations (end 1993): Rmb 450m Projected accum. (end 1994): Rmb 1.2b
Railways industry Active workers (1 993) Retired workers (1993) Dependency ratio Average monthly wage Average monthly pension Replacement rate Breakeven contribution (per cent of payroll) of which, employee contribution
Employees: Employees: (New employees rate: Break-even contributions
3.4m 900,000
26.5% Rm b 400 Rrnb 320
80% 2 1 O/O
2% 25.5%
3 .oO/a
8.0% 20.0%
Beijing Municipality Number of enterprises in pool 10,000 Number of active workers 2 m Number of retirees 740,000 Dependency ratio: 3 7%
Effective contribution rates (Oh payroll)
State enterprises 19% Foreign cos and joint ventures 17% Collectives 27% Contract workers 17%
Coverage Pensions Living allowance for staple foods Health insurance
(Foreign and JV cos.) Average monthly pension (similar to Shanghai)
Average replacement rate 60% Additional savings plans (Beijing municipality)
Employer contributions 2% Employee contributions 5 % individual accounts: (less experimentation than Shanghai)
Tianjin municipality Average monthly wage Rmb 310 (Including benefits) Average monthly pension Rmb 260 Replacement rate 84% Dependency ratio 33% Required breakeven contribution 28%
Actual average contribution 26%
SOE employers 20% SOE employees 4% Foreign enterprises and JVs 30% (of which medical 18%
pensions 1 8% employee 4%)
Accumulated reserves (end 1993) Rmb 340m
Reserves as total spending on pensions (1 993) 3 3 '10
Another innovation was recently introduced by Shanghai in the management of
retirement funds (early 1993). The retirement and medical insurance contributions
of foreign companies and joint ventures, hitherto paid to PICC, wi l l now be made
to the Retirement Insurance Management Centre of the Shanghai Municipality.14
These can then be placed in PICC, AIA, or other competitive domestic or foreign
insurance companies. Such investments may be safer than deposits with financial
institutions such as Trust and Investment companies which have large exposures
in securities markets.
The situation in Beijing is not very different from that of Shanghai, although
experimentation with individual accounts i s less advanced. The average monthly
pension and average replacement rates are similar, and the pension system should
be running a small surplus. But many loss-making companies are unable to pay
their contributions and thus the system suffers from a small deficit. Meanwhile
the Beijing Municipality has introduced additional savings plans, involving a two
per cent contribution from employers and five per cent from employees.
In Tianjin, the level of both wages and pensions i s lower than in the other two
municipalities, but the average replacement rate i s much higher at 84 per cent.
Average contributions are about 26 per cent, compared to a break-even
contribution rate of 28 per cent, leaving a small deficit for the system. The
accumulated reserves of the fund for the Tianjin Municipality amounted to only
Rmb 340 million, which corresponded to just over one third of the total spending
on pensions in 1993. The situation in terms of funding i s thus worse than Beijing
or Shanghai.
The railways industry i s one of the sectors where pooling is based on industrial
rather than geographical lines. The system dependency ratio of 26.5 per cent is
lower than that of Beijing or Shanghai, but higher than the national average. The
current average replacement rate of 80 per cent implies a required contribution
rate for break even at just over 21 per cent of payroll. Of this, two per cent was
contributed by workers and the rest by the employer. The railways industry is
currently restructuring. Some units have high dependency ratios, are unable to
make adequate contributions and rely on transfers from surplus units for meeting
their pension obligations.
Reform options and policy recommendation15 The Chinese authorities at the Ministry o f Finance, Ministry o f Labour and the
State Commission for Restructuring Economic Systems are fu l ly aware o f the
problems facing the pension system from its uneven burden and the rapid ageing
o f the population, and are considering a range o f reform options. The reform that
appears to command widest support involves the creation o f a dual public-pi l lar
structure, w i th the opt ion o f additional pillars t o be provided by company schemes
o r personal pension plans.16
Pension reform policy options: funded and unfunded pillars
Many options are available. For instance,
the unfunded pillar could be financed
from payroll taxes or from general tax
revenue, although given the low coverage
of the formal pension system the latter
approach would not be advisable. The
benefit from the unfunded pillar could be
a f lat pension paid to a l l workers
irrespective of their career earnings and
years of contributions, or it could follow
the structure of the Swiss public pillar and
divide the publ ic pension into two
components; one based on years of
service and the other on career earnings
with a clear ceiling on the public pension.
Similarly, the funded pillar could be
based on centralised management by a
public agency analogous to the Central
Provident Fund in Singapore or it could
be operated by competit ive fund
management companies as in Chile or
by employers as in Switzerland. The
funded pi l lar could also cover the
housing accounts that have been
established in many provinces, as well
as saving for other uses such as education
and medical care. Care should also be
taken to ensure that the resources
accumulated in the funded pillar are
invested prudently and wisely, with the
objective of maximising the returns for
their members subject to a reasonably
low degree of risk.
Over time the funded pi l lar would
become a major source of institutional
funds and wou ld complement the
operations of the insurance companies
in modernising the capital markets.
Initially, its investments would be tilted
toward marketable government bonds
and other lower risk instruments, but later
on as the equity market gets better
organised and accounting standards and
information disclosure considerably
improve, a growing proportion of funds
could be invested in corporate equities.
A t that stage, a move away from
centralised management would be
advisable, both in order to ensure a
compet i t ive and eff icient fund
management industry, and in order to
avoid undue state influence in corporate
affairs.
The drawback of the present proposal is that the two public pillars would not be
funded and would require a rising contribution rate to break even.17 While the
practical difficulties of mobilising resources for funded pension schemes are
recognised, it must be seriously considered that a largely unfunded pension system
would be difficult to sustain in the long run, given the projected rapid ageing of
the Chinese population. Given the low cost of current pensions, China today has
a golden opportunity to introduce a fully funded, fully vested and fully portable
second pillar that would be based on individual capitalisation accounts
supplementing a first, unfunded pub1 ic pillar, in a two-pillar or multi- pillar system.
Combined with a gradual raising of the normal retirement age, such a system
would not only be sustainable in the very long run but would then be able to
generate long-term funds that would be available for investment.16 A combined
unfunded/funded structure would also in the long run reduce contribution rates
and thus lower the burden on labour costs.
An unreformed pension system will face major pressures in the future. Projections
carried out by Chinese researchers show that the system dependency ratio may
exceed 50 per cent and the required contribution rate may reach over 30 per cent
by the year 2050 if no reforms are carried out (Table 6.3). A reform of the system,
based on the forms suggested above, suitably adapted to any special features in
China, and offering adequate but affordable and therefore sustainable benefits
should be undertaken as soon as practically possible. The benefits from an effective
and sound reform and from the creation of a new multi-pillar structure will be
very large not only for the pension system itself but also for the labour and capital
markets and thus for the national economy.
Table 6.3 China projected basic equation of social pension system (Without major reform) (Percentages)
- -- -
Year Average System Required Labour Pensions
replacement rate dependency ratio contribution rate income share % of CDP
2020 63 3 5 22.1 18 4.0
2050 63t 5 3 33.4 22 7.3
- - -
Note: Administration costs and investment income are not taken into account.
Source: Pension projections and simulations prepared by the 710 Agency. Research institute affiliated to China's
Aerospace Ministry
Housing Funds
Since 1992, most municipal authorities have established compulsory individual
housing savings schemes where both employers and employees are required to
contribute, generally five per cent from each party for a total ten per cent of
wages. These funds are intended for housing purchase. They are operated by
banks under terms and conditions considerably influenced by municipal
authorities. The accounts purport to help workers accumulate the required
downpayment for purchasing a home. However, the rates of interest paid on
these accounts are very low and have been highly negative in real terms since
their inception. The housing accounts are effectively forced saving schemes subject
to heavy taxation. A large number of accounts appear to have been established,
but in some cases they represent little more than payroll entries, maintained at
the enterprises concerned, rather than individual and separate bank account^.'^
In the Shanghai Municipality, 4.6 million such 'accounts' had been opened by
the end of 1993 and the balances accumulated on these accounts reached about
Rmb 5 billion by end 1994. These funds are placed with the PCBC rather than the
Pudong Development Bank. The rate of interest offered in these accounts has
been set at the interbank, yearly fixed deposit rate, which amounted in mid-I 994
to close to 11 per cent per year.
The business of housing accounts is dominated by the PCBC, with ICBC taking a
growing, but still small, share. The choice of bank is made by the employer. The
rate of interest paid is largely determined by the municipal authorities, subject to
PBC administered guidelines. Accumulated funds in housing accounts are used
by banks for loans to municipalities for land development and to enterprises and
housing developers as well as for loans back to employees to enable them to buy
their houses. The money saved on housing accounts can be withdrawn on
retirement or when it accumulates 30 per cent of the value of the house. On rare
occasions, a 15-year bank loan can be obtained, at generally negative interest
rates. Under current terms, the average worker needs to save for around nine
years to accumulate 30 per cent of the value of a standard house. With the negative interest rate earned on housing accounts, this period is likely to increase to the point where the likelihood of housing purchase grows low.
Housing funds may have some potential to contribute to institutional investment
funds, but only if accounts at banks are genuine in character, and if their operation
was streamlined and their rate of return raised to a reasonably positive level in
real terms. At present, however, realistic levels of contributions to contractual
savings are low. To the extent that funds accumulate, they are used by municipal
authorities for low-return financing schemes, reinforcing low returns to savers. In
future, if genuine housing accounts are created, they could be linked wi th
individual accountsfor retirement, which have already been introduced in several
provinces. Administrative problems of opening individual accounts for millions
of workers can be overcome, if the implementing institutions make considerable
progress in computerising their operations.
Mutual Funds
Mutual funds, the third pillar of contractual savings, can play a very important
part in the development of Chinese capital markets. It already comprises many
providers, is potentially highly competitive, is free from the legacy of non-
performing loans and bad investments that afflict the banking sector, and shows a
high degree of financial sophistication. Mutual funds facilitate pooling to benefit
from economies of scale, risk diversification and professional management. They
can provide an attractive vehicle for financial saving, especially for less wealthy
investors. *O
Mutual funds come in three main varieties:
money market mutual funds, which invest in short-term financial instruments, such as treasury bills, commercial paper and large bank certificates of deposit and thus compete directly with short-term bank deposits
bond funds, which compete with long-term bank deposits and life insurance policies, and, equity funds, which compete with investments in other real assets, such as land and housing.
Mutual funds have the potential to offer a better combination of return, liquidity and risk than alternative instruments if
well managed and regulated.
Banks and other financial institutions were permitted to set up mutual funds for
equity and bond investments in 1991 as it was appreciated that they could become
a big factor in reducing the high volatility of the Chinese stock markets and could
also help individual investors participate more easily to invest in corporate bonds
and equities. Following this authorisation, 50 funds had been set up by mid-
1993, raising nearly Rmb5 billion. In September 1993, the PBC imposed a
temporary freeze on all new authorisations as it was concerned that their apparent
high success rate and rapid growth could divert large funds from the banking
sector.
Most are closed-end funds that invest either in bonds or in equities. Very few
have been established as open-ended funds. In the absence of national regulations,
the various stock exchanges have issued provisional rules for the operations of
mutual funds. Under these rules, funds are defined as trust-type businesses in
which specialised investment management companies invest in securities or other
assets after collecting funds from the public. Closed-end funds may be traded
both over the counter and through stock exchanges, while shares or units in open-
end funds may be redeemed by the manager at any time. The parties involved in
a fund, ie., the manager, the trustee and the investors, have a contractual
relationship through a contract that sets out the rights and duties of the respective
parties and defines the method of calculating the net asset value of the fund.
Limitations have been imposed on the managers and trustees in order to contain
conflicts of interest and minimise the occurrence of related-party transactions
and self-dealing. For instance, the manager and the trustee may not own more
than 10 per cent of the shares of any listed company, nor act as manager or
director of a listed company. Neither the trustee nor the manager may engage in
the distribution of securities or act as guarantor for loans. In addition, no more
than 10 per cent of the fund's assets may be invested in a single company, while
a reserve for trading losses must also be set up. The trustee must be approved by
the PBC and either belong to a state-owned financial institution or have capital
(net assets) of at least of Rmbl00 million. The trustee'sduties include the clearance
and transfer of transacted securities, protection of the rights of fund investors, and
supervision of the manager. The fund manager must also be an approved institution
with a minimum capital of at least Rmb20 million and appropriate qualifications
and skills. One third of its employees must be graduates in economic disciplines
with two years' experience in securities markets. The manager's duties include
managing the fund, redeeming shares, commissioning securities brokers to handle
fund's investments (with a limit of not more than 25 per cent to any one broker), and reporting to the trustee and investors.
Potential role and benefit
The high potential of the mutual fund industry has been held back by:
the absence of a supportive legislative and regulatory framework
concerns of the monetary authorities that growth of the mutual fund industry
may divert resources away from the banking sector, with potentially adverse
effects for the financing of loss-making state-owned enterprises erratic macro-economic performance with a significant rate of inflation.*'
On the other hand, their growth has been stimulated by the controlled rates of
interest on bank deposits, frequently set at negative real levels.
The future prospects for mutual funds would be improved by a clearer definition
of their regulatory framework. They would also benefit from the restructuring of
the pension system and the setting up of a fully funded pillar as well as by the
future growth of life insurance and annuity business, which will itself be linked to
the reform of the pension system. Pension funds and insurance companies are
major investors in mutual funds in several high income countries. This has been
associated with the growth of variable (or unit-linked) insurance and annuity
policies and with the pursuit of specialised investment vehicles by both insurance
companies and pension funds.
Endnotes
1 A glossary on technical terms for institutional investors may be found in Annex 6.1.
2 Because of the creation of many regional companies in which PlCC has a controlling stake, the
share of insurance business attributable to PlCC seems to have fallen to around 60 per cent in
1993 (Rmb31 billion out of a total of Rmb54 billion for the market as a whole). But PlCC may still
effectively control 90 per cent of the market.
3 There is also an agricultural insurance company in Xinjiang province and the China Reinsurance
Company, an independent subsidiary of PlCC responsible for reinsurance both within China and
in foreign markets.
4 PlCC officials have been able to acquire considerable knowledge and expertise over the years, in
large part through their regular contacts with the Hong Kong and international reinsurance markets.
5 Such as Ming An (a PlCC subsidiary), China Re (Hong Kong), (a subsidiary of the PRC China
Reinsurance Company), Guandong Asia Insurance Company, and Bank of China Group Insurance
(Hong Kong), China lnsurance Co (a PlCC subsidiary) in London, the Chinese American Insurance
Company (CAIC - a joint subsidiary of PlCC and AIC) in New York and Ping An lnsurance (USA)
in Delaware. Interests from China are reported to control 35 per cent of the insurance capacity of
the large Hong Kong market.
6 Additions to reserves absorbed between two and ten per cent of premiums. PlCC does not report
any investment income for its non-life business.
7 Many training programmes are under way, through close co-operation with overseas professional
bodies such as the US Society of Actuaries and the UK Institute of Actuaries.
8 The comments made here are preliminary. Two further World Bank studies on this issue were
completed in 1996; a study on Pension Reform by the World Bank Beijing Office, and a study on
State Enterprise Reform.
9 The system dependency ratio is derived from the ratio of retired workers receiving pensions (1 9
million), toactivecontributing workers (83 million). In many developingcountries in Latin America
and Eastern Europe, there is a much greater gap between the system and demographic dependency
ratios.
10 Estimated as the ratio of the average pension (Rmb2,400 per year) to the average wage (Rmb3,650
per year).
11 Pensions are not fully indexed to inflation but are adjusted on an ad hoc basis.
12 The system dependency ratio is likely to grow, and the Shanghai Municipality expects it to peak at
50 per cent in the year 2020. It does not anticipate any need for a further increase in contribution
rates. However, estimates suggest that there is no reason why the system dependency ratio wil l
not go higher than 50 per cent.
13 This is partly because pension payments were not indexed until 1993 although adjustments were
made on an ad hoc basis. The indexing of pensions and the expected growth of real wages
however imply that the average replacement rate wil l continue to be low.
14 Workers will be required to contribute 3 percentto their individual accounts, while both employers
and employees wil l also be required to contribute 5 per cent of wages to housing accounts. These
contributions are subject to ceilings that are set at twice the average level of wages in Shanghai for
the pension contributions and equal to the average wage for the housing accounts.
15 For a comprehensive worldwide review of pension reform issues, see World Bank (1 994). See
also Davis (1 993), Diamond and Valdes-Prieto (1 9941, Queissar (1 991 ), Vittas (1 993a) and (1 993b),
Vittas and Skully (1 991), Vittas and lglesias (1 992), and Vittas and Michelitsch (1 994).
16 The first public pillar would pay a flat benefit to all full career workers equal to 25 per cent of the
average economy-wide wage and a second public pillar would pay earnings-related pensions at
an accrual rate of one per cent for every year of service (after the fifth year) up to a maximum 35
per cent of average indexed lifetime earnings. This would give a total replacement rate for a full
career average-wage worker of 60 per cent. These two pillars would be unified national schemes
covering all urban wage-earners. Rural workers would be covered by a mutual assistance and
co-operation system.
17 To keep the contribution rate from reaching too high a level, an extension of the normal retirement
age is contemplated, although such a move would be complicated by the growing need to provide
employment opportunities to younger workers and to workers who might be displaced by the
restructuring of state and collectively owned enterprises. Currently the normal retirement age is
50 years for women and 60 years for men. These may be raised gradually to equality first and
then to 65 years.
18 Such long-term funds could be valuable sources of finance for infrastructure; managers of such
funds could provide demand for longer maturity bonds.
19 Two other sources of funds that are far less important are city or provincial funds initiated by
municipal authorities and funded from real estate taxes and the proceeds of land sales to developers
and enterprise funds which are funded from rent income, sale proceeds, and sometimes a profit
allocation.
20 A description of mutual funds in Hong Kong may be found in Annex 6.2.
21 International experience shows that, faced with high inflation and instability, wealthy investors
find ways to engage in capital flight and invest in overseas markets, while less wealthy investors
respond by investing in real assets, such as land and housing, or by increasing their consumption
and lowering their rate of saving.
ANNEX 6.1 GLOSSARY O N CONTRACTUAL SAVINGS INSTITUTIONS
Benefits
Commission
Controlled tariff
Expense ratio Fire insurance
Group insurance
Actuary A professional expert who calculates insurance
premiums, reserves and dividends.
Bancassurance A regulatory framework in which banks and
insurance companies are allowed to operate in each
other's field and to combine their operations to
lower marketing cost.
A payment provided for under an annuity, pension
plan or insurance policy.
A fee paid to agents in compensation for selling
insurance.
A schedule of premium rates set by a governmental
body or an insurance association.
Ratio of expenses incurred to premiums written. An insurance which covers damages caused by fire
to real property.
A form of life insurance in which a master policy is issued to an employerto cover all employees in the
plan.
Household property An insurance which covers damages to insurance household goods.
Industrial life insurance A life insurance issued in small amounts, usually
under US$1000, with premiums collected door to door on a weekly or monthly basis.
Life fund
Life insurance
Loss claim
Loss ratio
Marine insurance
Motor (vehicle) insurance
Operating ratio
Pension
Personal accident
Insurance
Personal pension plan
Policyholder
Premium
Reinsurance
Reserve
(Technical reserve)
Retention ratio
Social pension
Solvency margin
An account representing the stake of policyholders
of a life insurance which is to be distributed later in
the form of benefit, cash surrender or dividends.
A contract which provides a certain sum of money
to a designated party upon the insured's death.
Demand for payment for a damage suffered from
an event covered by an insurance policy.
Ratio of claims incurred to premiums written.
An insurance covering property damage due to sea
perils.
An insurance which covers losses associated with
a car accident. It consists of two broad classes;
physical damage insurance which reimburses
automobile owner for damages to own vehicle and
liability insurance which provides payment to third
parties who are injured by a negligent policyholder.
Ratio of losses and expenses incurred to premiums
written.
A contract which provides retirement income.
An insurance covering medical costs due to an
accident; purchased on individual basis.
A private contract of providing retirement income:
purchased on an individual basis.
The owner of an insurance policy.
The consideration paid for a contract of insurance.
The shifting of risk by a primary insurer (known as
the ceding company) to another insurer ( known as
the reinsurer).
A fund set aside to meet claims that are expected to
arise in the future.
Ratio of retained premium (after subtracting the
premium ceded to a reinsurer) to the whole
premium. A government sponsored plan which provides
income after retirement.
A minimum level of net worth to be maintained by
an insurance company to secure financial stability
of the business. The level depends on the size and
the type of risks underwritten by each insurer.
ANNEX 6.2 INSTITUTIONAL INVESTORS I N H O N G KONG
Hong Kong has a highly developed financial system and well established institutional investors. Considerable expertise has been accumulated in operating
insurance companies, in creating pension schemes, and in fund management.
Such expertise draws on the presence of a large number of financial groups with
high international reputations. Its availability in Hong Kong could make a very
significant contribution to the development of Chinese institutional investors and
capital markets. Such contribution could take the form of new operations and
joint ventures in different regions of China or it could involve the provision of
training and other technical services, such as marketing, system design, and fund
management.
Insurance companies
The insurance industry of Hong Kong comprises 228 companies (September 1994),
of which 40 specialise in long-term business (life insurance) and 169 in general
insurance, while 19 companies are composites. One hundred and three companies
are registered in Hong Kong, although most of them are owned by foreign interests.
Of the remaining companies, 29 are from the UK, 17 from other EU countries, 21
from the US, eight from Japan, seven from Switzerland and four from China. The
split of business, based on gross premiums in 1992, was 52 per cent in general or
non-life insurance and 48 per cent in long-term or life insurance.
The Hong Kong insurance market i s governed by regulations that emphasise
solvency monitoring and prudential norms. The regulations lay down minimum
capital and solvency margin requirements as well as 'fit and proper'standards for
insurer directors and controllers. For general insurance, a 20 per cent solvency
margin in relation to net premiums is required, while for life business the EU
approach that relates solvency margins to technical reserves and liabilities to
policy holders is likely to be adopted. The Insurance Authority also has powers of investigation and intervention.
Companies are required to appoint an auditor and to submit annual audited accounts, while long-term insurers must also appoint an actuary. General
insurance, but not life, companies are required to maintain assets in Hong Kong
of not less than 80 per cent of their liabilities and solvency margins arising from their general business in Hong Kong. The motivation for this requirement is to
protect legally assets pertaining to local companies in cases of insolvency.
Insurance intermediaries are subject to self-regulation arrangements administered
by the Hong Kong Federation of Insurers in the case of insurance agents and the
Hong Kong Confederation of Insurance Brokers in the case of brokers. The
insurance industry employs a total of 50,000 people, including agen.ts and brokers.
There is also a strong actuarial society with over 250 members, 70 of which are
qualified fellows of US, UK or Australian societies.
Total gross premiums in general insurance amounted in 1992 to HK$14.2 billion
or about 1.85 per cent of GDP. Property damage accounted for 28 per cent of the
business, 26 per cent for motor insurance, 14 per cent for general liability and ten
per cent for accident and health. About six per cent of the business represents
premiums for active reinsurance, ie., inward reinsurance business accepted from
other primary insurers. Passive reinsurance varied from 80 per cent in the case of
ships to 50 per cent in the case of property damage to only 15 per cent in the case
of accidents and health insurance. Over all lines, the retention ratio stood at 64
per cent. The total net premiums (after subtracting premiums ceded to reinsurers)
amounted to HK$9.1 billion and the net earned premiums (ie., after deduction of
the provision for unearned premiums) to HK$8.4 billion.
The loss ratio, based on net claims incurred as a proportion of net earned premiums,
amounted to 55 per cent. Among the big lines, property damage had a loss ratio
of 41 per cent and motor vehicle business of 58 per cent. Some of the smaller
lines, like aviation and ships, had much higher loss ratios. Management expenses
amounted to 15 per cent of net earned premiums and net commissions payable
to 30 per cent, resulting in a very small underwriting loss. Technical reserves for
non-life business stood at HK$7.8 billion, corresponding to only about one per
cent of GDP or 86 per cent of net premiums.
Long-term business covers life insurance and retirement schemes. Total premiums
amounted to HK$13.0 billion or 1.7 per cent of GDP. Individual life business
accounted for 63 per cent of total premiums and retirement schemes for 30 per
cent. More than 60 per cent of individual life business i s in the form of participating
with profits policies, with the remainder in non-participating policies. Unit linked
business represents only a small part of total business.
Reserves of long-term business, representing the net liability to policyholders, amounted to HK$32.1 billion or 4.2 per cent of GDP. Thus, despite the presence
of a large number of companies, life insurance business has not accumulated
large financial resources, probably because of the existence of occupational
pension schemes. No information i s available on the investment allocation of
reserves, though Hong Kong companies are expected to follow the 'prudent man'
rule and are not subject to any specific guidelines regarding their investment
policies.
Hong Kong has two insurance guarantee funds that cover compulsory business,
relating to motor insurance and workers compensation. The Motor Insurers Bureau,
set up in 1980 and covering all car insurance companies operating in Hong Kong,
operates two schemes. One i s funded by a 0.5 per cent surcharge on motor
insurance premiums and covers against uninsured or untraced drivers, while the
other i s funded by a 2.5 per cent levy on premiums and protects claimants against
the insolvency of insurers. The Employees' Compensation Assistance Scheme
was established in 1991. It is financed through a two per cent levy on work
accident insurance premiums and protects workers who are otherwise uncovered
(failure of employer to arrange insurance policy or insurer insolvency). It also
covers employers against insurer insolvency.
Pension funds
Hong Kong has a large number of occupational pension funds. There are over
15,000 such schemes, covering over 30 per cent of the local workforce. Ninety
per cent of the schemes are set up as defined contribution plans where benefits
depend on the contributions made by employers and employees and investment
income. Ten per cent of schemes are organised as defined benefit plans where the
benefit i s based on final salary and years of service. However, defined benefit
schemes cover more than half the labour force. There i s also a civil service scheme
that covers 5 per cent of the labour force.
Defined contribution schemes typically involve a ten per cent contribution rate, split equally between employers and employees. Defined benefit schemes are
non-contributory and they typically offer 1.5 per cent of final salary for every year
of service. Most schemes make lump sum payments on retirement or termination.
Although there is no standard age for retirement, most workers retire at 65. The
civil service scheme pays a monthly pension, but otherwise very few schemes
pay benefits in the form of periodic pension payments. It i s claimed that this i s
because there is littledemand for annuities while lump sum benefits are not subject
to tax.
Employees leaving before retirement have a right to their vested accrued benefits,
subject to a vesting scale. For defined benefit schemes, the typical vesting scale
i s 0.25 per cent per year of service, rising by an additional 0.25 per cent for every
three years of service, until it reaches 1.25 per cent which is the typical accrual
factor until retirement, when it rises to 1.5 per cent. In defined contribution
schemes terminating employees are entitled to their own contributions plus a
rising share of the employer's contributions. The typical vesting scale i s zero for
less than three years and then jumps to 30 per cent after three years of service,
rising subsequently by ten per cent for every additional year of service. Employer
contributions up to 15 per cent of payroll are tax deductible (and not included as
part of employees' salaries for income tax purposes) and lump sum benefits are
not subject to tax, but employee contributions are not tax deductible. Investment
income is not subject to tax but pensions, when they are paid, are taxed.
There are no data on the total size of pension funds because until recently no
registration was required other than for tax purposes. A new law requires
registration with the Registrar of Occupational Retirement Schemes from December
1995. Estimates by research institutes and consulting firms put the total assets at
between HK$100-120 billion and growing fast. This corresponds to between 13
per cent and 16 per cent of GDP. Surveys conducted by consulting firms show
that the typical pension fund places 77 per cent of assets in equities, 17 per cent
in bonds and 6 per cent in cash. Hong Kong equities represent 28 per cent of the
total portfolio, US equities 11 per cent and other equities 38 per cent. All in all,
foreign assets account for 57 per cent of total assets, of which 20 per cent are in
US instruments and 37 per cent in others. The average rate of return over the five
years ending in 1993 for the typical pension fund amounted to 16.9 per cent.
This exceeded the growth rate of salaries of 13.4 per cent and the rate of inflation
of 10.1 per cent over the same period.
There are a few detailed investment rules, and these aim to safeguard the interests
of members. Thus, pension funds assets are subject to a ten per cent limit for
investments in securities of the sponsoring employer, while no investments are
allowed in unlisted equities or in equities listed in non-recognised exchanges
(this limit i s likely to be relaxed to permit such investments up to 15 per cent of
total assets). Otherwise, pension fund assets must be separated from those of the
sponsoring employer and cannot be mortgaged or leveraged. Pension schemes
must be audited and subject to regular actuarial review and funding
recommendation (if based on defined benefit plans), while adequate information
on benefits and the financial standing of the pension scheme must be disclosed to
its members on a regular basis.
The Hong Kong authorities have considered two major changes in the pension
system over the past few years. First, a consultative paper was prepared
recommending the adoption of a community-wide retirement protection system.
This would have made mandatory the provision of employment-related pensions
with minimum benefits stipulated by law and based on defined contribution
schemes with individual capitalisation accounts. The aim of the scheme was to
expand coverage to the large number of workers who were not covered by the
existing occupational retirement schemes. The proposed system would have
followed the precedents set by Switzerland and Australia. The committee that
prepared this study rejected the alternatives of having either a centralised national
provident fund or a totally decentralised non-employment-linked Chilean pension
system. The committee expected an increase in coverage with better retirement
protection for all covered workers but without any large macro-effects since the
proposed contribution rate of ten per cent was rather low compared to the 28 per
cent rate of saving of Hong Kong households.
However, the recommendation of this consultative paper was not adopted by the
authorities, mainly on the grounds that the protection benefits of the system would
take too long to be felt by the currently uncovered workforce. Instead, a proposal
was put forward to introduce a 'pay-as-you-go' public pillar. Currently, Hong
Kong pays an old age allowance that consists of two parts: a non-means tested
payment of HK$510 to people over 70 and a lower means-tested allowance of
HK$450 to people aged between 65 and 69. But elderly people who are in
financial need can apply for assistance under the Comprehensive Social Security
Assistance Scheme. A single elderly person will receive HK$1,510 per month
plus other supplements and benefits, such as reimbursement of rent, free medical
treatment and a special diet allowance.
The proposed pay-as-you-go pillar would pay a pension of HK$2,300 to all
residents who were 65 years or older. This pension would equal about 30 per
cent of the average wage, but as it would be linked to prices, its relation to the
average wage would decline over time (assuming rising real wages). Acontribution
rate of three per cent, equally divided between employers and employees, was
envisaged, while the government was to make an initial contribution of HK$10
billion to cover the cost of the first generation of beneficiaries. The scheme came
under strong attack because it assumed very high rates of real wage growth and
implied very low real rates of return on younger participants. The need for a pay-
as-you-go scheme paying a universal benefit was also questioned, especially for
a society with a generally high rate of saving. The proposed public pillar seems
unlikely to be adopted.
Mutual funds
In 1993 there were over 900 mutual funds in Hong Kong with total net assets
amounting to HK$200 billion. Mutual funds are both closed-end and open-ended
funds. The former may be listed on the Hong Kong Stock Exchange, although
most trading i s done over the counter with minimal trading on the exchange. The
latter are operated by fund management groups, who stand ready to redeem
individual units or shares at any time. Hong Kong has a large presence of foreign
banks, fund managers, stockbrokers, securities dealers, and investment advisers.
Many of them engage in business with non-residents, especially high net worth
individuals from the Asian region, making Hong Kong Asia's largest offshore fund
management centre. In all, there are over 900 securities dealers as well as stock
exchange members and over 500 investment advisers. Most of these are registered
with the Securities and Futures Commission, though some are exempt from
registration because they deal exclusively either with non-residents or with
professional investors.
The vast majority of mutual funds are established in foreign jurisdictions. Only
about 80 mutual funds are local ones, authorised by the Securities and Futures
Commission. Mutual funds authorised in a number of recognised jurisdictions,
such as Luxembourg, the UK, Jersey, Guernsey, the Republic of Ireland, and the
Isle of Man can operate in Hong Kong without obtaining local authorisation.
Such mutual funds may be sold in Hong Kong but are not allowed to be advertised
or actively marketed to the public. They must comply with local regulations
regarding fees, reporting and public announcements in Hong Kong, and their
management companies must obtain approval from the local regulators.
Local mutual funds must comply with the Hong Kong Code on Unit Trusts and
Mutual Funds. The code was first issued in 1 978 and was revised in 1991 . It provides that offer documents must be printed in both Chinese and English, and
that the fund must be subject to the jurisdiction of Hong Kong. It applies investmen?
rules that include limits of no more than ten per cent of net assets invested in one
company's securities, no more than 15 per cent in unquoted securities, no more
than 15 per cent in warrants and options not held for hedging purposes, and no
more than 20 per cent in physical commodities.
The trustee of a mutual fund must be a licensed bank or trust subsidiary, a trust
company, or an overseas bank or trust company acceptable to the SFC. The
minimum capital of trustees must be HK$IO million, although lower requirements
are imposed on subsidiaries of large financial institutions. The trustee acts as
custodian for the securities of the mutual fund and has significant responsibility
for supervising their management, ensuring that prices are properly calculated
and other rules are complied with. The trustee must be independent of the
management company and i s required to report annually to investors on the
conduct of the management company.
Managers of mutual funds must comply with local regulations as well as with a
code of conduct issued by the Hong Kong Investment Funds Association. The
code requires members of the Association to preserve client confidentiality, give
priority to the interests of investors, and avoid the issuance of misleading advertising
material.
CHAPTER 7
As the preceding chapters show, China's capital market is still evolving, and at a
rapid pace, with frequent dramatic new developments. Is it possible, in the context
of such trends, to draw any longer term and more enduring conclusions about
this market? The answer i s yes. Many features of the present market are symptoms
of a common thread of underlying causes. Most of these causes are embedded in
policy decisions and options, and as such, lend themselves to actions which can
certainly improve market functioning. The emphasis here is therefore on
recommendations that are appropriate regardless of day-to-day events on the
market.
The preceding chapters have summarised the conclusions and recommendations
appropriate for improving the functioning of each segment of the market. The
purpose of the present chapter is not to reiterate these, but to synthesise findings
across all segments of China's securities markets and point out underlying links
between problems observed in individual market segments. The following section
draws together the ten most important broad areas of concern raised by this study,
and the final section provides priorities for action.
Capital market development in China is still embedded within the framework of
an economy in transition, where many of the features of the former planning
system remain. Specifically, capital market expansion and development i s
contained within the framework of the aggregate credit plan, and state investment
plans. Capital markets are therefore viewed primarily as a route, and one among
alternative routes, for raising funds for investment. The extent to which capital
markets grow, either in terms of debt issues or stocks, is determined essentially by
the credit plan, ratherthan by agents issuing securities. In addition to the continued
existence of the aggregate credit and investment plans, the economy still retains
other basic pillars of a non-market regime; the regulation of interest rates, a banking
system which lends largely on the basis of the credit plan and i s unaccustomed to
the management of interest rate risks, liquidity risks, or asset liability management,
and the widespread state ownership of enterprises which de facto face limited
financial risks, as they can access credit, provided this i s allocated within the
credit plan.
-In a mature market economy, while capital markets are indeed intended to mobilise
resources, this is only one of their aims. Price discovery, risk management and
efficient resource allocation are key capital marketfunctions. Resource mobilisation
can also be undertaken by other means, such as bank deposits. The value added
of well-functioning capital markets lies in their ability to act not as primary vehicles
of resource mobilisation, but in the channelling of large volumes of savings, at
short notice, and in a flexible fashion, between alternative uses. The first finding
of this book i s that, as capital market growth and development i s embedded in an
environment which still retains many elements of a non-market economy, and
indeed, the extent to which capital markets develop depends on the role assigned
to them under the credit plan, capital markets in China today are unable to realise
their fundamental functions of increasing the efficiency of resource allocation,
aiding the pricing of risks and returns, and providing a vehicle for risk management.
The approach to capital market development in China has been cautious and
experimental. The problem with this approach i s that eventually its internal
contradictions wil l distort capital market development.
Second, these problems today most acutely affect primary markets. In secondary
markets, transactions are sophisticated, with screen-based, satellite-linked trading
systems, continuous order matching and the capacity for T+O settlement. The
form of the markets is advanced, compared to other developing countries and
even relative to the standards of advanced economies. But the closer one gets to
primary markets, the more apparent are the conflicts due to controls imposed
under the remnants of the former system, and the less efficient the securitiesmarkets
are. Apart from controlling the volume of issues and selecting the issuer, the
government today also regulates coupon rates on debt securities, in tandem with
its controls on deposit and lending rates. It can also intervene, through local
government security offices, in the pricing of initial offerings of equities, and sets
margins on coupon rates on corporate bonds, relative to government securities
coupon rates. The government i s in a position to also change the relative rates of
return on different securities, for example by boosting returns to equity through
announcement effects, if i t i s felt that the equity market i s in need of support, or
by raising coupon rates on bonds, when large new government securities issues
are due to be made. And reform in primary markets will be difficult without parallel
reforms in other basic features of China's transitional economy.
Third, controls on the growth of China's securities markets under the credit plan
imply that the extent to which they are able to support the investment requirements
of the real sector i s also predicated upon the limits imposed under the credit plan.
As such, whether China's capital markets will lend support to the financing of
infrastructure investment, or to the raising of equity capital for enterprises, depends
today on whether these investments are approved under the credit plan, and
whether capital markets are the chosen vehicle for the financing of these
investments. In the case of bonds, the problems of illiquidity of the bond market
additionally make investors reluctant to hold instruments of long maturity, and
this effect i s compounded by the relatively high levels of inflation China has
experienced in recent years. In terms of equities, new issues are again rationed
under quotas embedded in the credit plan. Outstanding (and non-negotiable)
state owned shares remain the dominant stock in most enterprises, and as such,
secondary benefits of participation in equities markets, such as exposure to
shareholder scrutiny, are not being significantly realised. Moreover, the formulation
of an appropriate balance between debt and equity, essential for the
implementation of modern corporate finance techniques in a market economy, i s
difficult to realise with the aid of China's capital markets today.
Fourth, the contribution of capital markets to the financing of the government's
deficit, and their potential aid to macro-economic management is not being realised
to the extent desirable. The government's targeting of retail investors, and extensive
use until recently of administrative placement techniques when voluntary purchase
i s not forthcoming, has its limitations, which the government realised after the
mid-I 980s, when it was obliged to shorten maturities and permit the development
of secondary markets, to prevent the illicit sales of bonds at heavy discounts.
Another solution, sought more recently, has been the raising of coupon rates on
government issues. Coupon rates on government securities have been set with
reference to, and at a relative premium to, deposit rates of comparable maturities,
rather than with reference to secondary market yields (and problems in the money
market compound the difficulties of such pricing, due to an ill defined yield
curve). The difficulty with this strategy i s that it could prove very expensive in the
long run, as the stock of outstanding debt cumulates. For example, secondary
market yields are shown to have been low in the latter half of 1994 (around 8 per
cent), but the government had issued its new debt for the year in the first half of
1994, at rates varying between 10 and 14 per cent. The implication is that the
government may be adopting an unduly expensive financing strategy. With
increased reliance on government debt issues to finance the deficit due to
restrictions imposed since 1994 on treasury borrowing from the central bank, the
problem will become more important over time. A fortiori, should the invisible
(quasi-fiscal) deficit currently covered through PBC lending to the financial system
be transferred to the visible budget, costs of government borrowing will be an
increasingly serious issue.
The high volatility and highly speculative nature of China's capital markets has
drawn much attention, and much of the blame has been laid at the door of the
inexperienced retail investors in the market.' A fifth basic conclusion of this
report is that there are many other inbuilt mechanisms in the market which
contribute to instability, some of which stem from the primary issue process. These
are at least as important as investors' inexperience. Limited disclosure, which
could permit decisions to be based more on underlying fundamentals, i s a pervasive
problem. In the equity and corporate bond markets, this refers to corporate
fundamentals; in government bond markets it refers to features such as the inflation
indexing of most long (three to five year) issues to an unpublished index (with the
resulting extreme speculatign documented in Chapter 3). Other market features
have also encouraged speculation; for example, the 'lottery system' assignment,
of bunched IPOs, in the equities market, (described in Chapter 4); and the limited
role allowed to competitive forces (for example the circumscribed role of
underwriters and primary dealers, both in the equities and bond markets).The
design of securities (with non-payment of cash dividends on equities and non-
payment of period interest on bonds) have also implied that purchasers tend to
seek capital gains from securities rather than investment incomes. Finally,
government announcement effects and sudden changes in interest rate differentials
themselves lead to increased volatility.
The sixth broad conclusion is that the market distortions of today are also due to
the limited participation of wholesale and institutional purchasers of securities.
This refers not only to the limited development of contractual savings institutions
(see Chapter 6) but also, to the limited (voluntary) participation by large financial
--- -- _/. '*->.-^-I I.. mi-- ----- , . - - , --
institutions such as banks in the wholesale market for government securities (see
Chapter 3). The causes lie deep in the evolution of the financial system. Insurance
was banned at the outset of reform in 1979, and has since been largely the
monopoly of a single institution. Yet its accumulations are growing faster today
than pension funds or social security systems, which have suffered primarily from
largely unfunded pension schemes. The growth of significant funds here for
investments in securities could take time. Meanwhile, participation in wholesale
securities markets by financial institutions has not developed because of their
limited active liquidity management; itself partly the outcome of branch-level
liquidity management and difficulties in intra-bank transactions. Neither has the
design of securities issues by the government, with typically Iimited transferability
and administrative placement, facilitated the participation by financial institutions.
A seventh broad area of concern is regional market segmentation. The regional
participation of China's provinces in the emerging securities market is still Iimited.
The primary market for equities is still regionally distributed by quota. This returns
to the issue of the difficulties of reconciling the credit and investment plans and
the growth of capital markets. From the point of view of market growth, it can
limit the access of enterprises, especially enterprises in regions which do not
have recognised trading centres, and are relatively unknown at a national level,
to the market. The regional primary market for bonds i s also driven by a
combination of quotas (for corporate bond issues) and administrative placement
(for government securities). In terms of secondary markets, restrictions against
the cross-listings of equities impedes the growth of a national market, although
the inter-linkages of satellite centres of the Shanghai Exchange permit dealers in
many regions to access its quotations. From a regulatory point of view, the principal
central regulator has no regional offices at trading sites and moreover no authority
whatever in informal trading centres. Secondary market integration in the bond
markets has been facilitated by the growth of the automated electronic quotation
systems; STAQS and NETS, which have greatly helped reduce regional price
differentials. However the national integration of the debt market is impeded by
the multiple independent depositories, and the lack of mutual recognition of bond
certificates issued by different centres.
The eighth major issue also concerns market segmentation - by investor type.
Although this problem has been virtually eliminated in debt securities (where
formerly the coupons payable to individual and enterprise investors differed for
the same security), it is a major problem in the equities market. China is virtually
unique in having different categories of investors for the same class of ordinary
share. Among domestic securities, the persistence of non-traded state shares, and
thinly traded C (legal person) shares, reduces market liquidity (acutely, in the case
of C shares). Looking at foreign investors, the distinction between A and B share
classes, as well as other shares, has led to wide price differentials and a consequent
inducement to illegally benefit from arbitrage (see Chapter 4). China is also unique
in that shares held by overseas investors have traded consistently at a discount to
domestic shares. One reason i s that the small B share markets are highly illiquid,
and as a consequence, overseas investment in this market is being discouraged.
Ninth, looking at China's participation in international securities markets, the
report shows that despite the alarm caused by the recent Mexico crisis, China
faces no dangers of macro-economic destabilisation due to foreign portfolio
investment inflows. Indeed, in China today, the mix of foreign resource flows
may be too heavily skewed towards foreign direct investment, which may be
unnecessarily expensive in the medium term, especially in view of the preferential
tax treatment currently enjoyed by FDI investors. China can cautiously encourage
an increase in foreign portfolio capital inflows and should curtail the preferential
treatment accorded to FDI. The problem may lie in the opposite direction.
International investors' early eagerness to buy any Chinese securities due to their
novelty value has passed. Foreign investment in China is increasingly being driven
by fundamentals, and in this context the problems in the B share market are of
concern. Meanwhile, China's present strategy of broadening its access to a variety
of overseas markets is an appropriate one.
Another issue concerns China's access to international securities markets. While
the high international ratings enjoyed by China until the end of 1994 are
commendable, China is likely to face deteriorating terms in the future, on two
counts: the general reduction in international enthusiasm for emerging markets
following the Mexico crisis and the rise in developed country and especially US interest rates, and also, persistent symptoms of macro-economic imbalance,
particularly concerning inflation, in China. Chinese overseas bond issues have
begun to trade at a discount in secondary markets.
Finally, on the subject of securities market regulation, the government correctly
points out that regulation per se is not the issue. Details of many securities
regulations, particular1 y concerning equities, are basically in accordance with
international principles. Rather, the problem here primarily concerns government
oversight, both functional and institutional. At present, oversight is splintered in
both these senses, and also regionally scattered between municipal and central
authorities. One consequence of this i s that some areas of regulation tend to 'fall
between the cracks' and certain segments of the market have little de facto
regulation; notably, securities dealers and institutional participants in securities
markets. The regulation of corporate bonds (trading, rather than issues) is another
grey area.
All the above issues suggest that there i s a need for intervention, and the adoption
of revised policies, if future development of China's capital markets is to proceed
in a healthy direction.
Suggested Policy Changes
First of all, the government has to determine whether it is prepared to launch
upon reforms on a broad front, in terms of those features of the economic system
that impede capital markets from performing efficiently: financial sector reforms
which allow a greater role for the interest rate as a pricing mechanism; a reduced
role to credit and investment plans for capital allocation, the transformation of
banks into entities which lend on the basis of risk evaluations and creditworthiness
of clients rather than their credit plan quotas, and reforms of state enterprise which
permit them to face a real environment of risks and returns; ie, a 'binding budget
constraint'. Such major decisions can perhaps not be taken solely on the basis of
the future development of capital markets alone, but it is necessary to recognise
that these affect and apply to all segments of the financial system.
The question which follows is, how, in the context of capital market development,
are such changes to be implemented? It i s recognised atthe outset that abandoning
the credit plan in the absence of indirect instruments of monetary control, or the
simultaneous decontrol of all interest rates, wil l lead at least initially to chaotic
conditions, and the more germane question therefore is, what are the next
incremental steps that can be taken towards realising these objectives? While
questions of time-phasing of overall reform are beyond the scope of this book,
three broad suggestions are proposed here, before interest rate deregulation, and
reduced reliance on the credit plan, are embarked upon.*
The government must better co-ordinate its monetary and fiscal policy. If the
government intends to exercise monetary control through debt sales, it needs
to be certain, in a deregulated environment, that the volume of debt sold wil l
not cause interest rates to rise to levels which damage both the real economy
and the developing capital market. So far, this has not been a problem, but as
the volume of treasury debt outstanding escalates, it wi l l be an increasingly
important concern. In parallel, the government must establish better knowledge
of its cash flow requirements, so that debt issues can be better co-ordinated
with its spending requirements.
In terms of the banking sector, the speedy implementation of the separation of
'policy' and commercial lending is required, so that banks grow more aware
of the need for risk management. In parallel, banks must begin to acquire the
capacity to manage interest rate risk, and also attend to the current mismatch
between their assets and liabilities.
Interest rate deregulation could begin in the areas which most affect primary
markets; short-term rates and money market rates. Liberalising interest rates in
these areas would help establish a better defined short-term yield curve and
thus help the pricing of new short and medium-term government securities
issues.
Second turning to securities markets themselves, the most important area for
attention, where the greatest problems lie, i s the primary market. Any remaining
administrative placement of bonds should be curtailed, and all bond issues should
be tradable. In the bond market, the government must:
Clearly distinguish between wholesale and retail investors, and increase the
relative emphasis on the former category. Focus on a wholesale investor base
will permit the offer period to be reduced, and will permit the eventual adoption of an auction system. The present distribution system, parcel sizes and title
transfer systems are poorly suited to a wholesale market, or to the development
of a liquid secondary market. An effort should be made to gauge wholesale investors' demands for bonds,
and their preferences in maturities. Bonds should then be targeted for sale to this group, and retail investors should
be treated as a residual. The government must also assess its own short and long-term financing
requirements, and its cash flows.
For its term financing requirements, the government should have a pre-
announced issue calendar for the year for its debt issues, spread over the year.
This will also help to improve liquidity management at the level of the wholesale
buyers, and assist the development of a ben~hmark .~ Government and institutional liquidity management would be further assisted
by regular issues of short-term debt (one to twelve months maturity), to meet
short-term liquidity needs. In addition, the central bank (PBC) can issue short-term paper, on an as-required
basis, to help liquidity management. Electronic registration and transfer of title should be adopted as the standard
for wholesale issues. The yield at issue should be related to current secondary market yields, rather
than to deposit rates. The government can then move gradually to an auction system, auctioning a
part of its bills, and selling the rest on a non-competitive auction or average
price bid basis.
For retail investors, a savings bond issue should be designed, available on demand
at any time of the year, which would have the effect of spreading retail sales over
the year. The interest rate offered could be altered to stimulate or dampen retail
demand. Since such an 'on demand' issue will be difficult to trade because of the
variety of maturity dates, it should be possible to redeem them early at a penalty.
For corporate bonds, the determination of capacity to issue has been based more
on evaluations from credit rating agencies than quota-driven decisions by local
authorities.
For equities, attention to primary markets also implies a greater role for market
forces:
The decision to issue new equities should be left more in the hands of risk-
taking enterprises, subject to compliance with rules established by the
exchanges, and the central regulatory authority. The large role of local
governments in the selection of such enterprises (in accordance with prevailing
policy priorities) must be reduced, and the frequently continuing role of local
authorities in the pricing of new issues must also be curtailed. Any remnants of the lottery-based system of share allotment must be phased
out, preferably in favour of a discriminating price auction. The selection of underwriters should be left to issuing enterprises, and
underwriters should be allowed to competitively bid for terms.
The present 'firm commitment' underwriting system should be gradually
abandoned in favour of systems where the enterprise and underwriter are better
able to share risks, such as the 'best effort' or auction methods. The length of time from offer to opening should be reduced.
The bunching of new issues should be avoided, and,
Fees for application forms should be done away with.
The third area for action i s secondary market development. Many of the problems
here stem from underlying primary market problems. In the bond market, the
problem of poor liquidity impedes price discovery and i s reflected in the ill-defined
present yield curve. China has still to develop a benchmark issue to enable more
efficient securities pricing: These problems will be assuaged by the measures
recommended above, for the primary market, especially with the introduction of
issues more evenly spaced out over the year, on a pre-announced schedule, targeted
primarily towards wholesale investors. Additionally (although detailed
recommendations are beyond the scope of this book), constraints on the operation
of the money market must be addressed.
Regional market segmentation in the bond market, and regional price differentials,
have greatly improved, but will not be eliminated unless the government either:
sets up a centralised depository for all government bond issues, or
requires the adoption of mutual recognition of share certificates from different
trading centres. The former i s the route adopted by most mature economies,
including large economies such as the US.
In the secondary market for equities, the key problem of volatility also stems in
part from features of the pririary market, and the measures described above
(reduced reliance on lottery-style IPOs, competitive underwriting, etc.), wil l help
address this problem. Additional measures which can be taken include:
Reintroduction of daily price limits.
Introduction of (an ideally short-term) capital gains tax on share trading. If it i s
not administratively feasible to implement this, a share turnover tax can be
imposed as a second best alternative.
Payment of cash dividends. In February 1995 the government announced its
intention to introduce this, and the intention should be implemented and
monitored.
Improved disclosure, in terms of both quality and timeliness. An emphasis on press responsibility. A more proactive stand against front-running and market manipulation.
Most of all, the government must be more aware of its own 'announcement effects',
which demonstrably have the capacity to send markets soaring or plummeting.
Some government interventions undertaken in the market, such as sudden
announcements of bans on new share issues, would be regarded as market
manipulation in mature economies.
Apart from the problem of volatility, the issue of regional market segmentation
remains a large issue in the equities market. It is recommended that:
dual listings on the presently recognised exchanges be permitted
new trading centres be allowed to open, provided they can comply with all
requirements laid down by the central authority, and provided, the establishment of regional offices of the CSRC be permitted, and the present
conflicts between central and regional regulations be removed, with a single,
centrally-based regulatory authority.
The problem of different share classes is also an issue, and the present distinction
between state, legal person, and individual shares should be done away with. It is
encouraging that the new Companies Law (unlike the former Standard Opinions) makes no reference to such distinctions.
Fourth, all parts of the market would benefit from the development of an
institutional investor base, and here the government should further encourage flexibility in the uses of funds for contractual savings institutions (the new insurance
law already goes some way towards this and encourage further competition in
insurance by more clearly separating the spun-off subsidiaries of PlCC from the
parent. The greatest challenge in this area lies in augmenting the sources of funds,
through pension and social security reform, where the mobilisation of funds is
limited, due to the prevalence of pay-as-you-go pension systems. China today is well situated to take a major step forward here, by introducing a multi-pillar,
funded social insurance and pension system. Housing funds should be permitted to offer more attractive returns. In addition, the present ill defined regulatory framework for mutual funds needs clarification, and ad hoc government interventions in mutual fund regulation should be discouraged.
Fifth, regarding the participation of foreign investors in China's securities markets:
China can afford to, and should, encourage foreign portfolio equity investment
today, vis-2-vis foreign direct investment; and should reduce the fiscal incentive
bias in favour of FDI. The present uniquely Chinese distinction between A and B shares should be
removed. The requirement of a freely convertible currency in this regard is not
critical; there are countries which have restrictions on convertibility which do
not impose such restrictions (eg Bangladesh). The few countries which used to
maintain such distinctions (the Philippines, Finland), have now abolished them.
While the aim of controlling foreign participation in the domestic equity market
(and consequently capital inflows and outflows) is understandable, this aim
can be realised by other means (see Chapter 5). China should continue to broaden its base in overseas listings, on a variety of
exchanges, but should also try to encourage dual listings (eg, with Hong Kong),
to ensure adequate liquidity. Present restrictions against foreign participation in the domestic debt securities
market should be maintained, until the domestic bond market is considerably
strengthened.
Sixth, in the area of regulation, it i s recognised that the details of regulations are
not in themselves a problem, and most are sound by international standards. The
first key issue here is the fragmentation of oversight; horizontal, vertical, and
functional. To address these problems, it is recommended that:
The present dual regulatory regimes maintained by the centre and by local
authorities should be removed, and the CSRC should be given jurisdiction,
through its own regional offices, over regional trading centres (both the present
two officially recognised exchanges and any others that may be established
and recognised in the future). Present overlap in jurisdictional oversight between the PBC and CSRC must
be addressed, and consolidated under a single authority. While the role of the
PBC in this area is recognised to be the outcome of the historical evolution of
the market, its continued and overlapping authority impedes efficient oversight. The problems of more clearly defining certain areas of oversight are particularly
acute for certain types of securities; (bonds are more affected than equities,
and corporate bonds are the least clearly defined), as well as for certain market
participants; notably, securities dealers and intermediaries, and for institutional
investors such as mutual funds. In these areas, the underlying laws themselves
need to be clarified.
A key legal issue to be addressed is the clarification of the separation of bank and
non-bank activities. So far this appears to have been handled by administrative
regulations under the PBC, but in view of the close institutional ties between
deposit taking institutions and securities dealers, as well as the rapid growth of
the latter, a clarification and strengthening of these laws i s required. This has
been addressed in the Commercial Bank Law of 1995, but the implementation of
the separation i s still incomplete.
Finally, if the new framework of regulations and recommendations is to be
effectively implemented, the government must strengthen the CSRC, which at
present, with its single Beijing-based office of some 120 staff, i s not adequately
equipped to effectively discharge its responsibilities.
The last issue discussed here is, what structure of priorities should the government
adopt in implementing these recommendations? First of all, it is recommended
that the government address the fundamental questions regarding the enabling
environment. Next it should address the problems of the domestic primary markets,
and third, examine issues pertaining to secondary markets and international
investors. The development of institutional investors and strengthening of the
framework of regulation and oversight should proceed in parallel.
Endnotes
1 While volatility has been most apparent in the equities market, there was a spectacular recent
(February 1995) escalation of bond futures trading, due to a speculative bubble in a single futures
contract (see Chapter 2). Trading in the underlying spot markets for bonds also grew as a
consequence.
2 Some World Bank studies shed more detailed Iighton some of these issues concerning the 'enabling
environment' including an informal study on interest rate liberalisation (April 1994); a study on
state enterprise reform (August 1994), as well as a study on Public lnvestment (which includes an
evaluation of the State lnvestment Plan and State Credit Plan) (November 1995).
3 To avoid a large number of issues of different maturity dates, and hence improve liquidity, some
countries have adopted an 'on-the-run' issue system, in which bonds issued at different dates in
the year all mature on the same date.
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Appendix Table A l . l China: debt securities issued and outstamding (Rmb100 million)
Treasury bonds
lssued
Redeemed
Outstanding
Treasury bills
lssued
Redeemed
Outstanding
Fiscal bonds
lssued
Redeemed
Outstanding
National
construction
bonds
lssued
Redeemed
Outstanding
National key
project con-
struction bonds
lssued
Redeemed
Outstanding
Special national
bonds
lssued
Redeemed
Outstanding
Appendix Table Al . l China: debt securities issued and outstanding (Continued)
Inflation-proof
bonds
lssued
Redeemed
Outstanding
National investment bonds
lssued
Redeemed
Outstanding
National investment
corporation bonds
lssued
Redeemed
Outstanding
Government-owned
enterprise bonds
lssued
Redeemed
Outstanding
Financial institutions debt
lssued
Redeemed
Outstanding
Financial bonds
lssued
Redeemed
Outstanding
Trust fund
securities
lssued
Redeemed
Outstanding
Appendix Table A1 .I China: debt securities issued and outstanding (Continued)
Investment fund
securities
lssued
Redeemed
Outstanding
Enterprise bonds
lssued
Redeemed
Outstanding
Local enterprise
bonds
lssued
Redeemed
Outstanding
Short-term paper
lssued
Redeemed
Outstanding
Domestic bonds
lssued
Redeemed
Outstanding
Housing construction
bonds
lssued
Redeemed
Outstanding
Local investment
corporation bonds
Issued 4.37
Redeemed
Outstanding 4.37'
Subtotal
Issued 48.66 43.83 41.58 42.53 65.61 192.51 236.87 419.18 382.36 394.15 695.41 1,197.67 381.31
Redeemed 0.00 0.00 0.00 0.00 0.00 27.88 75.83 108.38 127.27 203.58 260.41 465.09 123.29
Outstanding 48.66 92.49 134.07 176.60 242.21 406.84 567.88 878.68 1,133.77 1,324.34 1,759.34 2,491.82 2,749.84
Appendix Table A l . l China: debt securities issued and outstanding (Continued)
Stocks
Total
of which:
A shares
B shares
H shares
Large sum negotiable CDs
Issued
Redeemed
Outstanding
Note: "The balance outstanding for treasury bonds cited here does not equal last year's balance plus net new issues,
because of a difference between the redemption amount and settlement amount, owing to a split year
adjustment.
1994, Rmb75.11 billion of bonds were issued by the newly established State Development Bank, to other
financial institutions. The bonds are non-tradable, are of three and five-year maturities, and have coupon
rates of 12.5 per cent and 14.0 per cent, respectively.
Source: State Council Securities Committee, circular dated August 1994
Appendix Table A1.2 China: trade in securities (Rmb100 million)
Treasury bonds
Treasury bills
Fiscal bonds
National construction bonds
National key project construction
Special national bonds
Inflation-proof bonds
National investment bonds
National investment
corporation bonds
Key enterprise bonds
Capital construction bonds
Financial bonds
Local enterprise bonds
Short-term enterprise
negotiable certificates
Subtotal debt securitiesa
Enterprise stockb
Jumbo CDs
Total all securities
Note: "Bond trading is estimated on a gross basis.
bEnterprise stock trading includes officially recognised centres only.
Source: State Council Securities Committee, circular dated August 1994
Appendix Table A1.3 China: securities trading on the Shanghai Exchange in 1994 (January 1994 to January 1995) (Turnover, Rmb million)
Equities Treasury bonds Funds Total
A shares B shares Spot Repurchase Futures
Source: Shanghai Securities Exchange: Monthly Market Statistics
Appendix Table A1.4 China: Securities markets and the financial sector (Rmb billion ) (1 989-1 994)
Assets
Financial institutions
Specialised and universal banks:
total assets
of which, loans
Credit co-operatives: assets
of which, loans
Nun-monetary financial institutions
TICS: assets a
lnsurance companies
Non-monetary financial institutionsc
NMFl Assets 1%) Liabilities
Deposits at financial institutions
Specialised and universal banks
Credit co-operatives
Securities (annual issues)
of which, debt securities
Securities outstanding
of which, debt securities
Securities issued /Total deposits (%I Securities outstanding /Total deposits (%)
CDP at market prices
Securities outstanding1 CDP (%)
Notes: "Data are available specifically for finance companies, securities companies and leasing companies only for
1992, when their assets were Rmb 19 billion.
bData for 1993 are estimated.
'Data for 1995 are reclassified in a new format, for all 'non-monetary financial institutions'taken together.
Sources: (1990 to 1994) bank and credit co-operative's assets and liabilities: IMF 1995 Article IVstatistical tables.
1994 data are from the end of September. 1994 data on non-monetary financial institutions are hrom the
same source. (1989) Bank and credit co-operative's assets and liabilities: IMF 1994 Article IV report.
lnsurance company data: Almanac of China's Banking and Finance; P/CC annual reports. Securities data are
from the State Council Securities Committee (see Appendix Tables A 1. 1 and A 1.2)
Appendix Table A1.5 Financing of the Government deficit: contribution of bond issues (1 988-1 994) (Rmb billion)
Year 1988 1989
Government budget deficit Budgetary revenue (Rmb billion) Budgetary expenditure Visible deficit Financing of the visible deficit ~omestic: Gross PBC borrowing " Change in treasury deposits Purchases of Government bonds by state banks Other domestic financing Other domestic financing not
elsewhere-classified Foreign Consolidated deficit PBC Lending to financial system (a) Policy loans, lower bound % GDP (b)Policy loans, upper bound '% GDP Consolidated deficit: lower bound Consolidated deficit: upper bound Government debt securities issues Treasury bond issuesd
Redemptions Net treasury bond issues Net issues of treasury bills Treasury bond net issues
% of visible deficit % of consolidated deficite
Treasury bill net issues % of visible deficit -21 .O -11.5 % of consolidated deficite -9.3 -4.9
Overseas sovereign bond issues (Rrnb billion) (US$ billion)
% of foreign financing of visible deficit Memo item: GDP (Rmb billion) 1407.4 1599.8 Exchange Rate (Rmb per US$) 3.722 3.765
Notes: a Figures for 1993 and 1994 are estimates.
b,c Defined as 60 and 80 per cent of PBC lending to financial system.
Treasury bonds include treasury bills special national bonds (and include inflation indexed bonds), as well as
bonds issued to financial institutions (fiscal bonds) and bonds earmarked for specific investments (National
Construction Bonds and National Key Project Construction bonds).
'Lower bound.
Sources: Data pertaining to the government deficit and its financing are based on IMF (7 995 and earlier years) Article
IV; estimates of the consolidated deficit are based on World Bank, CEM, 1994 (both using CFS definitions).
Data on securities issues are from the State Council Securities Policy Committee
Appendix Table A1.6 China: contribution of securities markets to investment (Rmb mil lion) (1 987-1 993)
lnvestment
Total investment in state owned units
Capital const. inv. in state owned units
lnvestment in key state projects
lnvestment financing through securities
1. Treasury bondsa
of which, earmarked investment bondsb
2 . Investment bondsc
3. Enterprise bondsd
% Treasury bonds in total SOU inv.
% Tbonds+investment bonds in total SOU inv
% Enterprise bonds in total SOU inv.
Total contribution of bonds to SOU
investment (YO) ' Equity: annual new issues
Total contribution of equity to SOU
investment (%)
Memo items: financing of SOU investment
State budget %
Domestic loans %
Foreign investment %
Self-raised funds and other %
Notes: "These include bonds used for general financing, such as treasury bills, fiscal bonds, inflation-proof bonds, as
well as some bonds earmarked for construction projects (see b below). See Appendix Table A 1. 1.
bNational Construction bonds and National Key Project Construction bonds.
'Earmarked investment bonds issued by provincial governments to aid regional development, as well as
bonds issued by the now largely defunct State lnvestment Corporations.
dThese include bonds issued by central enterprises (Government-owned enterprise bonds in Appendix Table
A l . 1) as well as local enterprise bonds, commercial paper, housing construction bonds, and also, i'ocal
investment corporation bonds (see Appendix Table A 1.1).
eThis is the upper bound, assuming all government bond issues are used to finance investment. The actual
proportion of bond issues used for investment financing is clearly likely to be lower.
Sources: Data provided by the State Council Securities Committee and the State Planning Commission
Appendix Table A1.7 China: overseas debt and capital markets (1 987- 1993) (US$ billion and O/O)
1987 1988 1989 1990 1991 1992 1993
% 70 Yo Yo Yo Yo 70 ANRF ANRF ANRF ANRF ANRF ANRF ANRF
Aggregate net resource
flows (ANRF) 8,575 10,272 9,685 10,047 9,777 23,785 41,235
LT debt 6,052 6,773 6,047 6,312
Disbursements 8,044 9,092 8,43 1 9,649
O/W bonds 1,064 12.4 782 7.6 450 4.6 277
commercial banks 4,605 53.7 4,470 43.5 2,014 20.8 3,244
Repayments 1,992 2,319 2,384 3,337
O/W bonds 0 0 11 0.1 33 0.3 325
commercialbanks 468 5.5 754 7.3 867 9.0 808
Net flows 6,052 6,773 6,047 6,312
bonds 1,064 12.4 771 7.5 417 4.3 -48
commercial banks 4,137 48.2 3,716 36.2 1,147 11.8 2,436
Direct FI 2,314 27.0 3,194 31.1 3,393 35.0 3,487 34.7 4,366 44.7 11,156 46.9 25,800 62.6
Portfolio equity foreign
in vestment 0 0 0 0 0 0 0 0 653 6.7 1,194 5.0 2,278 5.5
Grants excl. TA 209 304 245 249 242 327 360
Aggregate net resource
flows (ANRF)" 8,575 10,271 9,685 10,048 9,777 23,785 41,236
Commitments 10,335 10,149.7 8,338.2 9,979.2 8,286.7 16,830.8 21,798.8
bonds
(%commitments) 993.5 (9.6) 781.8 (7.7) 727.0 (8.7) 0.0 (0) 260.4(3.14) 894.2 (5.3) 2,656.9(12.2)
Note: "Aggregate net resource flows = long-term debt+direct foreign investment + portfolio equity foreign
investment + grants excluding technical assistance.
Source: Calculations based on data from the World Bank, IEC
Appendix Table A2.1 China: structure of securities regulation
I STATE COUNCIL I ( 0 final approval o f new exchanges and overseas listings )
ilJC F1 -7 FI FI .supervision of markets e
investment funds and
securities licensing and regulating accountants
I - CSRC
I ,
National companies
I I I regulation listings I
I Accountants I I
I I I 1-1 ~awyers I securities companies
I l~hanghai I Shenzhen 1 - 4 - - I 1 u
I supervision (but licensing) I I
regional enterprise bonds issued by regional enterprise companies
Shanghai Shenzhen
I I Local stock trading centres
Appendix Table A2.2 Structures of regulation in Asian securities markets
Regulator Bangladesh Hong Kong India Indonesia Korea Malaysia
Government Controller of BAPEPAM MOF MOF
capital issues (for SE
and MOF Governance)
Other agency SFC SEBl
Board of regulator The office of 10 persons of 6 persons
controller of whom 5 are including
capital issues staff and the representatives
others are non- from the
government Ministry of
Finance,
Ministry of
Law, Justice
and Company
Affairs, the
Reserve Bank
of India, and
2 government
appointments
Power to prosecute
MOF
To whom the
regulator reports
MOF Exco
Industry bodies
concerned with
self- regulation No No
Stock Brokers'
Association
MOF
No
SEC SC
(exec.body is SSB)
9 persons of
whom 6 are
appointed by the
present
(recommended by
the Ministry of
Finance], 3 are
full time.
The appointees
include the
Governor of the
Bank of Korea, the
Chairman and
CEO of the
Korean Stock
Exchange and the
Vice Minister of
the Ministry of
Finance
9 persons
including 4
from the
government
and 4
appointed by
the Ministry of
Finance
No
No
MOF
securities bureau MOF
KSDA
No
Appendix Table A2.2 Structures of regulation in Asian securities markets (Continued)
~~~~~
Regulator Pakistan Philippines Singapore Sri Lanka Taiwan Thailland
Government Corporate law
authority
Other agency
Board of
regulator
Power to
prosecute
To whom the
regulator reports
S EC MAS SEC
4 persons, the 5 persons. All Controlled 10 persons. 7
Chairman is a appointments are wholly by the appointments
civil servant. 3 made by the government. including one
persons president. All The Chairman is Deputy
appointed by the appointments are the Minister of Governor of the
Ministry of full time. Finance. Central Bank.
Finance. 3 are ex officio;
the Deputy
Secretary of the
Treasury, the
Registrar of
Companies and
the President of
the Institute of
Chartered
Accountants.
No
MOF
Industry bodies
concerned with No
self- regulation
Yes
Yes
Dept. of Finance
MOF
PASBD (rather
inactive)
SEC SEC and office
14 persons, of
whom 7 to 9 are
full time. They
include persons
from the
Ministries of
Finance,
Economic
Affairs, Justice,
the Central Bank,
the Planning
Council and the
Economic
Council.
MOF
TSDA
Up to11
persons. The
Chairman is from
the Ministry of
Finance. Other
institutions
represented are
the Central Bank
and Ministry of
Commerce. 4-6
appointments are
by the
government.
No
MOF
AMSET
Source: International Securities Consultancv
Appendix Table A2.3 Minimum listing requirements of major stock markets
Market Trading record Profits record Minimum market capitalisation Minimum net assets
Hong Kong 3 yrs Yrs 1 and 2: Aggregate US$12.8 million (with at least N/A
profits attributable to US$6.4 million public shares)
shareholders lie, after tax)
of at least US$3.8 million
Yr 3: Profits attributable to
shareholders (ie, after tax)
of at least US$2.6 million
Australia
Singapore
SES
Tokyoa
1 st section
3 yrs
5 yrs
3 yrs
Stocks are assigned to
the 1 st section from
the 2nd section based
on their trading levels
and dividend record
Aggregate Profits before
tax for past 3 financial
years of US$0.7 million
with at least US$0.3
million profit before tax in
latest financial year
Cumulative consolidated
US$1.423 million
Profit before tax of Capital*: US$2.6 million
US$4.858 million for the <US$30 million = 20% paid up
last 3 years, with a share
minimum US$30-US$67million =greater
Profit before tax of of share capital
US$0.647 million in each US$6.7 million or 15%
of these years >US$67 million = greater of
US$l Om or 10%
N/A
-
Note: *Percentage of shares in hands of holders with between 500 and 10,000 shares
Appendix Table A2.3 Minimum listing requirements of major stock markets (Continued) - Market Trading record Profits record Minimum market capitalisation Minimum net assets
2nd section 5 yrs Profit before tax US$10 million N/A
Yr 3:US$2.0 Min shareholder's equity
Yr 4:US$3.0 million
Yr 5:US$4.0 million
5 yrs
OTC 1 vrs
United Kingdom
London Stock 3 yrs
Exchange
Unlisted securities 2 yrs
market
USA
NYSE
3 yrs
Profit before tax in each US$100 million
of last 3 years Min shareholder's equity
of at least US$20 million
US$1.0 per share
12.5% of shares to be offered to US$2 million
the public
N/A
US$1.035 million
(can have made losses)
N/A (can have made N/A
losses)
Either
Profit before taxYr 1: US$18 million
US$2 million, Yr 2: US$2
million ,Yr 3: US2.5
million
Or:
aggregate profit before
tax in the last 3 years of
US$6.5 million and at
least
US$4.5 million in Yr 3
(all three years must be
profitable)
Note: *Percentage o f shares i n hands o f holders with between 500 a n d 10,000 shares
283
Appendix Table A2.3 Minimum listing requirements of major stock markets (Continued)
Market Trading record Profits record Minimum market capitalisation Minimum net assets
AMEX 3 yrs Profit before tax of US$3 million
US$750,000 in last FY or
in 2 of last 3 years
NASDAQ 3 yrs Profit before tax of US$3 million
US$750,000 in last FY or
in 2 of last 3 vears
US$4 million
US$4 million
Canada
Toronto NIA Profit before tax for
industrial companies in
last FY of either:
(a) US$72,186 with a (a) Public shares of at least (a) USS0.722 million
pre-tax cash flow of US51.449 million Or
US$0.285 million
Or
(b) N/A (b) Public shares of at least (b) US$3.493 million
Or US$1.527 million Or
(c) US$0.142 million (c) Public shares of at least (c) NIA
with a pre-tax cash US$1.449 million
flow of US$0.362
million
Note: "October 1994.
Source: International Securities Consultancy
Appendix Table A3.1 China: Securities trading by region Trading value (1 992) (Rmb million)
- - --- -
National investment Local Local Large-sum
Treasury corporation enterprise Financial enterprise Enterprise Itime-deposit bills bonds bonds bonds bonds Total Percent stocks certificates
Beijing Tianjin Hebei Shanxi Inner Mongolia Liaoning Shenyang Dalian Jil in Changchun Heilongjiang Harbin Shanghai Jiangsu Nanjing Zhejiang Ningbo Anhui Fujian Xiamen Jiangxi Shandong Qingdao Henan Hubei Wuhan Hunan Guangdong Guangzhou Shenzhen Guangxi Hainan Sichuan Chengdu Chongqing Cuizhou Yunnan Ti bet Shaanxi Xian Cansu Qinghai Ningxia Xinjiang Total
Note: Estimated on a net basis.
Source: Almanac of China's Finance and Banking (1993)
Appendix Table A3.2 Monthly transaction volume in the interbank market (Rmb bill ion)
Non-bankd financial All financial
Year Month State banksM% Other banksbc O/O institutions % institutions
Total Total 1992
Total 1993
Total 1994
Total
1990 1991 January February March April
May June July August September October November December 1992 January February March April May June July August September October November December 1993 January February March April May June July August September October 1994'
Notes: "State banks include lndustrial and Commercial Bank of China, Agricultural Bank of China, Bank of China,
People's Construction Bank of China, Bank of Communications and ClTlC lndustrial Bank.
banks include non-state-owned commercial hanks and regional banks.
'Data on other banks and non-bank financial institutions available from 1993.
dNon-bank financial institutions include rural and urban co-operative credit agencies, trust and investment
companies and accounting firms.
'January to October only.
Source: SEEC, 1995
Appendix Table A3.3 Assets of financial institutions engaged in the interbank market (Rmb billion)
State bank Other bank NBFIC
Year Quarter assets YO assets YO assets YO Total"
Total
1991
Total
1992
Total
1993
Total
1994
Total
Notes: "Totals for 1990-1 992 include only state bank assets and non-bank financial institutions assets.
bJanuary-Septernber only.
'Non-bank financial institutions
Source: SEEC, 1995.
Appendix Table A4.1 China: Key characteristics of the equities markets of Shanghai and Shenzhen
Shanghai Shenzhen
1991 1992 1993 1994 1991 1992 1993 1993 1994
A. Quantitative indicators
Number of listed companies (Nos) Number of listed stocks (Nos)
of which A of which B
Market capitalisation (Rmb billion) of which A
of which B Value of trades (Rmb billion)
of which A
of which B Number of shares traded (million)
of which A
of which B Members of exchange (Nos) of which members outside
exchange city
B. Trading rules and characteristics Year founded Hours
Quoteslclearance
A shares B shares
Typical type of listed company Listing criteria Minimum value of issues Operating performance
Individual share of equity ( mini Settlement
A shares B shares
Clearing Round lot Registration Total dealing costs (two-sided) Short-selling Capital gains tax Dividends tax
1990 M-F 9:30-ll:30 1 :30-3:30
Rmb US dollars Large industrial (State-owned)
Rmb 50 million 3 years of profits
25%
T + 1 A-shares T + 3 B-shares Book-entry 100 shares Beneficial Ownership
1.52% t Prohibited 20% " 0%
1991 M-F 9:OO-l l:00 2:OO-3:30
Rmb HK dollars Small/export oriented
Rmb 20 million 3 years operating record
T + 1 A-shares T + 3 B-shares Book-entry 2,000 shares Broker's Name (Nominee) 2.1% + Prohibited 20% 0%
Source: Shanghai a n d Shenzhen Stock Exchange.
288
Appendix Table A4.2 China: Size and growth of China's equities markets (1 991 -1 994)
Year
Shanghai Shanghai Shenzhen Shenzhen Hong Kong
A shares B shares A shares B shares Total H shares Total
1. Number of
listed stocks (Nos)
1991
Q1
Q2
Q3
Q4 1992
Q1
Q2
Q3
Q4 1993
Q1
Q2
4 3
Q4 1994
Q1
Q2
Q3
2. Total market
capitalisation
(Rmb million)
1992
1993
1994
~ - pp
Source: Calculations based on data provided by the Shenzhen and Shanghai securities exchanges
Appendix Table A4.3 Trading value of equities (1 991 -94) (Rmb million)
--- - - -
Source: Calculations based on data from the Shanghai and Shenzhen securities exchanges
Total Trading Value Per Quarter Average Daily Trading Value
Year
Shanghai
A shares 1 B shares
Total
Shanghai Total
Shenzhen
A shares 1 B shares
Shenzhen
A shares ( B shares
Hong Kong
shares
Total
Shenzhen
Total
China
Hong Kong
shares Total
Shanghai
A shares 1 B shares
Appendix Table A4.4 China: Trading volume of securities per day (1 991 -94)
Average number of daily transactions
Year Shanghai A shares Shanghai B shares Shenzhen A Shenzhen B Hong Kong
Trlday Shlday Trlday Shlday Shlday Shlday Shlday
(000) (000) (000) (000) (000) (000) (000)
Source: Calculations based on data from the Shanghai and Shenzhen Stock Exchanges
Appendix Table A4.5 Trading value of inter-linked trading centres (Linked to Shanghai) (January 1995)
Stocks Funds Bonds T-bond futures
Trading trading value trading value trading value trading value
centre (Rmb million) % (Rmb million) % (Rmb million) % (Rmb million) %
Beijing
Sichuan
Fujian
Jiangsu
Zhejiang
Qingdao
Nanfang
Shenyang
Hunan
Anhui
STAQ
Harbin
Xian
Shenzhen
Guangxi
Henan
Shandong
Hubei
Hainan
Chongqing
Ningbo
Total
Shanghai
Source: Shanghai Stock Exchange: Monthly Market Statistics, January, 1995
-- -
Appendix Table A4.6 China: Stock trading centres
Name Founded Approved by No. of listed instruments Number of members
1. Tianjin Securities Trading Centre
2. Shenyang Securities Trading Centre
3. Dalian Securities Trading Centre
4. Wuhan Securities Trading Centre
5. Hainan Securities Centre
6. Hunan Securities Trading Centre
7. Fujian Securities Trading Centre
8. Zhenang Securities Trading Centre
9. Chongqing Securities Trading Centre
10. Harbin Securities Trading Centre
11. Xi'an Securities Trading Centre
12. Tai Yuan Securities Trading Centre
13. Zi Bo Securities
Automated Quotation Systems
14. Quingdao Securities Trading Centre
15. Sichuan Financial Market Securities Trading Centre
16. Southern Securities Centre
17. Beijing Securities Trading Centre
8 August1992 Municipal government Tianjin branch of PBC
28 April 1992 Municipal government Shenyang branch of PBC
May 1992 Dalian branih of PBC
April 1992
20 December 1991 (operating from
20 January 1992) 28 October 1993
December 1992
8 November1 992
9 October 1992
18 March 1993
Hubei provincial branch and Wuhan City branch of PBC Hainan provincial Branch
of PBC
Hunan provincial branch
of PBC Fujian provincial branch of PBC
Provincial branch of PBC
Chongqing city branch of PBC
Heilong Jian provincial branch of PBC (Jointly operated by provincial branch, with the city branch playing the main role)
8 July 1993 Shanxi provincial branch of PBC (not operating yet)
Prepared in 1992 Shanxi provincial branch of PBC (not operating yet)
18 August 1993 Zibo Municipal Trial operating government September 27, 1993 (founded)
25 December1993 Qingdao municipal government (not operating yet) and Qingdao city branch of PBC
September, 1991 Provincial government (According (founded) to the opinion on trail opening on 26 November 1991 securities trading market jointly (started operation) signed by provincial restructuring
committee and provincial branch of PBC)
1 June 1993 Cuangdong provincial branch (founded) of PBC
18 August 1993 (trial operation) At preparatory stage Beijing branch of PBC
5
None
4
?
T-Bonds (no trading)
None
None
Stocks = 12
None
20
Source: International Securities Consultancy (Hong Kong)
293
Appendix Table A4.7 Shanghai Securities Exchange: trading summary of sectoral stocks
Turnover Turnover Turnover No. of shares
No. of listings (%) value (Rmb m) (%) per listing (No. of shares) (%)
January-December, 1994
Industrial 119 58.62 279,195 48.68 2346.2 39,883.6 60.73
Commercial 35 17.24 89,862 15.67 2567.5 9,953.7 15.1 6
Real estate 12 5.91 68,413 11.93 5701.1 3,887.6 5.92
Utilities 13 6.40 48,626 8.48 3740.4 4,393.2 6.69
Misc. 24 11.82 87,412 15.24 3642.2 7,557.8 11.51
Total 203 100 573,507 100 65,676 100
January, 1995
Industrial
Commercial
Real estate
Utilities
Misc.
Total
Source: Shanghai Stock Exchange: Monthly Market Statistics, January, 7995
Appendix Table A4.8 Initial public offering quotas (1 993) Regional utilisation of provincial and municipal quotas (end 1993)
1. Hunan
2. Hubel
3. Cuangdong
4. Anhui
5. Fujian
6. Henan
7. Liaoning
8. Hebei
9. j i l in
10. Shandong
11. Cuizhou
12. Canshu
13. Shanxi
14. Yunnan
15. Cuangxi
16. Heilongjiang
17. Ningxia
18. Zhejiang
19. Jiangsu
20. Neimenggu"
21. Hainan"
22. Sichuana
23. Qinghaia
24. Xizhanga
25. Xinjiang
26. Shaanxi
27. Jiangxi
28. Wuhan
29. Cuangzhou
30. Dalian
31. Shenyang
32. Tianjin
33. Qingdao
34. Nanjing
35. Ningbo
36. Xiamen
37. Chengdu
38. Beijing"
39. Xi'an"
40. Harbina
41. Chongging
42. Shanghai
43. Shenzhen
44. Changchun
Total
II. A share quotas used by H share companies (at par value)
1. Shanghai Petrochemical 150
2. Qingdao Brewery 100
3. Maanshan Steel & Iron 600
4. Cuangzhou Shipyard 126.48
5. Kunming Machinery 60
Total 1,036.48
- - - pppp
Note: There have been no public offerings in these provinces and independent municipalities.
Source: China Securities Regulatory Commission
Appendix Table A4.9 China and other emerging equity markets: relative size and market liquidity (1 994)"
Number Market No. Average Market Value
of capital shares Value daily Turn- capitalisation/ traded/
Market listed isation Traded traded Traded trading valued over GDPe GDPe
name stocks (US $ million) ratio (US $million) (US $ million) (US $ million) ratio (per cent) (per cent)
China 247
Other Asian
emerging
economies
Indonesia 186
Korea 696
Malaysia 427
Philippines 184
Taiwan 292
Thailand 361
India 3,734
Latin America
Argentina 168
Brazil 544
Chile 281
Mexico 195
Europe
Greece 161
Portugal 186
Turkey 160
Hungary 32
Poland 2 7
264.1 408
242.3 1,087,778
185.8 N.A.
986.8 2,381
Notes: "Average of 12 monthly observations, November 1993-October 1994.
bDefined as (price per share) x (total outstanding shares).
'Defined as market capitalisation/listed shares.
dDefined as value traded/number of trading days in the period.
' 1 993 end of year data.
Source: Calculations based on data from the IFC Emerging Markets Database and data from the IEC, World Bank
Appendix Table A4.10 China and other emerging equity markets: growth (1 989-1 993)
Number of listed shares
(Nos)"
1989 1991 1993
Value tradedb
(US$ million)
1989 1991 1993
Market capitaliisation
(US$ million)
1989 1991 1993
China
Other Asian
emerging
economies
Indonesia
Korea
Malaysia
Philippines
Taiwan
Thailand
India
Latin America
Argentina
Brazil
Chile
Mexico
Europe
Greece
Portugal
Turkey
Hungary
Poland
- - - - - --
Notes: dAs of the end of the period.
bT~ta l value of shares traded during the period.
'Defined as [price per share) x (total outstanding shares), as of the end of the period.
Source: Calculations based on data from the IFC Emerging Markets Database
Appendix volatility
Table A4.11 China and other emerging equity markets: (1 993-1 994)
-- - - - -
Co-efficients of variation Sharp Mean COV
Daily ratio Mean COV market market
trading Turnover return on PIE PIE dividend dividend
value ratio index ratio ratio yield yield
China 1 .06 0.92 0.03 203.73 0.75 4.20 0.43
Other Asian economies
Indonesia 0.38 0.32 0.42 17.09 0.11 17.09 0.11
Korea 0.36 0.32 0.47 12.90 0.05 1.48 0.05
Malaysia 0.60 0.54 0.34 34.19 18.98 1.37 0.1 7
Philippines 0.61 0.32 0.43 40.58 0.07 0.90 0.08
Taiwan 0.56 0.44 0.31 3.47 28.73 0.56 0.36
Thailand 0.62 0.53 0.25 15.19 0.06 3.24 0.1 1
India 0.57 0.42 0.35 27.83 0.1 3 1.41 0.20
Latin America
Argentina
Brazil
Chile
Mexico
Europe
Greece
Portugal
Turkey
Hungary
Poland
Source: Calculations based on data from the IFC Emerging Markets Database
Appendix Table A5.1 International B and H share offerings by Chinese issuers
Issuer Announcement date Listings Value (Rmb) US$ equivalent
1. B shares: Shenzhen and Shanghai
China Southern Glass Co
Shenzhen Properties & Resources
Development (Group) Ltd
Shenzhen Petrochemical (Group)
Shareholding Co Ltd
Victor Onward Textile industrial Co Ltd
Shenzhen Zhongchu Co Ltd
Shenzhen Shenbao Industrial Co Ltd
Chiwan Wharf Holdings Ltd.
Shenzhen Fiyta Holdings Ltd.
Shenzhen Tellus Machinery & Electronics Co Ltd
China Merchants Shekou Port Service Co Ltd
Shenzhen Vanke Co Ltd.
Shenzhen Gintian Industry Co Ltd
Tsann Kuen (China) Enterprise Co Ltd.
Zhuhai Special Economic Zone Lizhu
Pharmaceutical Group inc
Shenzhen Lionda Holdings Co Ltd.
Shenzhen Special Economic Zone
Real Estate & Properties Ltd
Subtotal for Shenzen Exchange
Shanghai Tyre & Rubber Co Ltd.
China Textile Machinery Stock Ltd.
Shanghai Refrigerator Compressor Co Ltd.
Shanghai Jinqiao Export Processing
Zone Development Co Ltd.
Shanghai Outer Gaoqiao Free Trade
Zone Development Co Ltd.
Shanghai Dazhong Taxi Co Ltd.
Shanghai Lian Hua Fibre Corp
Shanghai Jin Jiang Tower Co Ltd
Shanghai Forever Bicycle Co Ltd
Shanghai Phoenix Bicycle Co Ltd
Shanghai Haixin Co Ltd
Shanghai Yaohua Pilkington Glass Co Ltd
Shanghai Dajiang (Group) Stock Co Ltd
Appendix Table A5.1 International B and H share offerings by Chinese issuers (Continued)
Issuer Announcement date Listings Value (Rmb) US$ equivalent
Shanghai Hero Co Ltd
Shanghai Diesel Engine Co Ltd
Shanghai Friendship & Overseas Chinese Co Ltd
Shanghai Industrial Sewing Machine Co Ltd
China First Pencil Co Ltd
Shanghai Shangling Electric Appliances Co Ltd
Shanghai Steel Tube Co Ltd
Shanghai Material Trading Centre Co Ltd
Shanghai Automation Instrumentation Co Ltd
Shanghai Posts & Telecommunications
Equipment Co Ltd
Shanghai Lujiazui Finance & Trade
Zone Development Co Ltd
Huaxin Cement Co Ltd
Subtotal for Shanghai 7,627.681 920.922
2. H Shares: Hong Kong
Yizheng Chemical Fibre Co Ltd
Tianjin Bohai Chemical Industry (Croup) Co Ltd
Dongfang Electrical Machinery Co Ltd
Dongfang Electrical Machinery Co Ltd
Luoyang Glass Co Ltd
Luoyang Class Co Ltd
Zhenhai Refining & Chemical Co Ltd
Shanghai Hai Xing Shipping Co Ltd
Shanghai Hai Xing Shipping Co Ltd
Harbin Power Equipment Co Ltd
Harbin Power Equipment Co Ltd
Zhenhai Refining & Chemical Co Ltd
Chengdu Telecommunications Cable Co Ltd
Chengdu Telecommunications Cable Co Ltd
Subtotal for Hong Kong 8,756.700 1,132.975
Notes: Listings :
HK : Hong Kong
H : Shanghai
SZ : Shenzhen
Source: World Bank. IEC
Appendix Table A5.2 China's overseas share listings (Hong Kong and New York)
- Company Amount Listing
China Southern Airlines
(One of China's three largest airline groups based in Shanghai)
China Eastern Airways
(A core enterprise of the China Eastern Airlines group based in Shanghai)
Datang Joint Stock Power Company
(A power supply company incorporated in Hebei province)
Huaneng International Joint Stock Company
(A Beijing-incorporated power supply company, Sino-foreign joint-venture)
Shandong Huaneng Electricity Joint Stock
(Sister company to above. Beijing-incorporated)
Shandong lnternational Power Development Co.
(Power supply company incorporated in Jian, Shandong Province)
Dongfeng Motor Corp.
(Ranked the eighth largest Chinese industrial enterprise in 1993, with a staff
of over 90,000)
Qingling Automobiles
(A Sino-foreign joint-venture between Chongqing Autonlotive Corp and
Japan's lsuzu Motors and United Capital of Japan)
Wuhan Iron and Steel
(Ranked China's fifth largest enterprise in 1992 and the country's largest
producer of steel sheets)
Tianjin Steel Tube Company
(A manufacturer of steel pipesfor use in oil drilling, less than two years in operation)
Cuangzhou-Shenzhen Railway
(The most profitable railway line under the auspices of the Ministry of Railways)
Xian Aircraft lnternational
(An alrcraft industrial company incorporated in Beijing, with plans to inject the assets of
ten more aircraft enterprises into the listed vehicle)
Zhenhai Petrochemical
(Under the auspices of the state refiner China Petrochemical (Sincopec).
47th largest company ranked in 1992)
Jilin Chemical Industrial Co.
(The 13th largest Chinese industrial company incorporated in Jilin Province)
North East Electric Transmission
(A transformer manufacturer incorporated in Liaoning Province)
China Harbin Power Plant Equip Joint Stock Co.
(Based in the northeastern province of Heilongjiang. Makes oil boilers,
steam turbines generators and hydroelectric equipment)
Appendix Table A5.2 China's overseas share listings (Hong Kong and New York) (Continued)
Company Amount Listing
lingwei Textile Machinery Plant
(Produces textile machinery for garment manufacture. Based in Shanxi Province)
Shanghai Hui Zing Shipping Company
(One of a dozen companies under Shanghai Shipping Group. Provides ships and
freight forwarding for the domestic market)
Chengdu Cable Plant
(Produces telecommunications cable. Located in Chengdu, Sichuan Province)
Luoyang Glassworks
(One of China's three largest glass makers)
Guangdong Foshan Ceramics Joint Stock Co.
(A construction materials producer incorporated in Foshan, Guangdong Province)
Nanjing Panda Electronics Joint Stock Co.
(A manufacturer of televisions, videos and telecommunications equipment
incorporated in Nanjing)
-- -
Source: Euroweek, 13 May 1994
Appendix Table A5.3 Country funds: trends in total returns Developing countries' best performing closed-end funds (O/O average total return)
1992Q4 199341 1993Q2 199343 1993Q4 1994Q1 1994Q2 1994Q3
Asia 5.29 0.33 -1.68 4.03 19.75 - 1 4.5 2.23 10.74
Brazil -1 0.55 3.21 3.43 4.92 1.03 34.61 -18.36 57.95
Chile 6.8 -6.21 7.56 1.81 13.64 3.05 13.08 1 3.45
China 3.04 -1.63 -5.5 2.48 15.51 -23.03 -5.12 9.41
Emerging global -0.2 -1 .82 3.21 2.52 14.8 -7.1 5 -3.92 17.28
India -8.22 -9.26 -1.62 3.94 10.21 10.66 7.23 6.45
Indonesia -0.05 2.89 4.98 2.89 12.65 -14.57 -7.97 5.66
Korea, Republic. of 8.1 3 0.73 0.1 1 6.09 9.04 0.2 6.08 9.76
Latin America 0.33 5.31 5.95 2.87 11.5 2.82 -7.5 22.61
MalaysiaISingapore 5.29 1.76 -4.64 5.2 20.8 -25.08 2.86 20.66
Mexico 11.73 6.99 2.93 -4.85 15.04 -9.76 -5.96 16.81
Pakistan 0.71 -6.81 7.02 3.08 16.38 12.25 -4.36 nia
Philippines -0.97 -2.7 -1.86 5.1 1 40.62 -20.3 8.52 12.79
Thailand 8.65 -7.02 3.32 1.8 28.07 -20.08 4.39 16.1 9
Source: Lipper International Closed-End Funds Service
Appendix Table A5.4 Credit ratings of Chinese borrowers
Announcement date Issuer full name
Ratings
Listing Standard and Poors Moodys
Bank of China
Bank of China
ClTlC
ClTlC
ClTlC
People's Republic of China
GlTlC
People's Republic of China
Bank of China
Bank of China
CITIC
Bank of Communications
A3
Baal
Baal
Baal
BBB Baal '
A3
BBB Baal
BBB A3
BBB
BBB
BBB
BBB
Notes: TO : Tokyo
LX : Luxembourg
LN : London
UQ: Unquoted
NY : New York
51 : Singapore
H : Hong Kong
Appendix Table A5.5 Sovereign ratings of selected developing countries Sovereign foreign currency debt (1 994)
Moodys Standard and Pators
Investment grade
Chile
China
Colombia
Cyprus
Czech Republic
Greece
Indonesia
Korea, Republic of
Malaysia
Malta
Portugal
South Africa
Thailand
Below investment grade
Argentina
Brazil
Hungary
India
Mexico
Philippines
Slovakia
Trinidad & Tobago
Turkey
Uruguay
Venezuela
Baa2
A3
Bal
n.a.
Baa2
Baa3
Baa3
A1
A2
A2 '
A1
Baa3
A2
B1
B2
Bal
Ba2
Ba2
Ba3
n.a.
Ba2
Ba3
Bal
Ba2
BBB+ (1)
BBB (2)
BBB- (2)
AA- (1)
BBB+ (2)
BBB- (1)
EBB- (2)
A+ (3)
A (2)
A (1)
AA- (1 )
BB (2)
A- (1
BB- (2)
n.a.
BB+ (1)
BB+ (1)
BB+ (2)
BB- (1)
BB- (1)
Notes: ( I ) Stable ou t l ook
(2) Positive ou t l ook
(3) Negat ive outlook
w o o 0 0 2 9 " 8 2 0 0
m h o m o l LD 0
N L O O N n 0 - m N o J N w - N - ' O LO - N
P - - . 9 9 2 2 2 3 0
n w " 0 - - - L O N - -f 0
0 1 h L O C O ? g " - m n i~ 2 2 a-
?- LON V! m
1 - ~ ~ n m h N N LO
N - - - * N - m 03
Appendix 85.1 Limits on equity participation by foreign investors
Korea
(i) General restrictions
Foreign investment i s l imi ted to a
maximum of 12% of the outstanding
shares, except for some special cases.
Foreign portfolio investment is allowed
for up to 30% of convertible issues of
smaller and medium-size companies
listed on the Korean stock exchange.
Foreign shareholders are not allowed to
buy or sell stocks on the margin or serve
on the board of directors.
(ii) Approval regulations
Non-residents can participate only
through approved mutual funds. Foreign
investors must register with the Korean
Securities Settlement Board and appoint
either the Korean Securities Settlement
Corporation, a Korean bank, a Korean
broker or the Korean branch of a foreign
securities company as custodian.
(iii) Equity participation l imit
Since January 1992, foreign investors
have been allowed to own up to 10% of
the shares of most l isted Korean
companies but a single foreign investor
i s limited to 3% of the shares outstanding
(except i n Korea Electric Power
Corporation and Pohang Iron and Steel
Corporation where the foreign and single
ownership l imi ts are 8% and 1%
respective1 y).
(iv) Other restrictions
The Securities and Exchange
Commission has the powers to impose
specific restrictions.
Taiwan (i) General restrictions
Foreign portfolio investment is permitted
only through authorised trust funds.
Overseas investors must enjoy foreign
institutional investor status and should
be: among the world's 1000 largest
foreign banks; insurance firms with 5 years in business; or fund managers with
minimum assets of $300 million and 3 years in business.
(ii) Approval regulations
All foreign institutional investors must
apply for prior approval from the SEC to
be allowed to invest in Taiwan.
(iii) Equity Participation Limit
Foreign institutional investors may hold
a maximum of 5 % i n any listed
company and the total foreign holdings
of each quoted company may never rise
above 1 0%.
(iv) Other restrictions
In 1993, the maximum investment
allowed per single foreign institution was
raised from US$50 million to US$200
million and requirementsfor investment
foreign institutions were also relaxed.
Foreign investors are allowed to sell
stocks one day after purchase, a change
from the earlier rule of allowing sales
only after physically taking delivery.
Appendix B5.1 Limits on equity participation by foreign investors (Continued)
India
(i) General Restrictions
India's equity market opened up to
overseas inst i tut ional investors in
September 1992. Foreign port fo l io
investors were allowed to invest directly
in listed Indian securities. Foreign
investors are not permitted to short sell
in the market.
(ii) Approval regulations
Investment in securities is possible only
through investment trust funds estab-
lished in India, authorised by the Central
Bank and registered with the Securities
and Exchange Board of India.
(ii i) Equity participation limit
Maximum of 5% per foreign investor for
any indiv idual company. Total per
company may not exceed 24% of the
company's issued capital.
(iv) Other restrictions
Normally, 40%. Higher ceilings can be
possible in priority industries.
Thailand
(i) General Restrictions
Foreign brokers must channel
transactions through Stock Exchange of
Thailand member firms.
(ii) Approval regulations Registration o f foreign port fo l io
investment i s required.
(iii) Equity participation limit Foreign lnvestment is restricted to no
more than 49% of any indiv idual
company's equity, with the limit lowered
to 25% for commercial banks and
finance companies.
(iv) Other restrictions
A proposed future change in structure
would not allow foreign investors to
enjoy voting rights.
Indonesia
(i) Approval regulations
Foreign portfolio investment i s possible
without prior approval.
(ii) Equity participation limit
The limit on foreign ownership is 49%
of the listed share capital.
(iii) Other restrictions
The articles of association of some listed
companies contain further restrictions.
Gradual transfer of equily by the foreign
investor to an Indonesian party i s
required.
Argentina
(i) General restrictions
There are n o restrictions on foreign
acquisition of shares in existing local
companies quoted on the stock market.
(ii) Approval regulations
lnvestment in Argentina is no longer
subject to the approval of the Argentine
government. But pr ior approval is
needed for the purchase of unquoted
shares.
(ii i) Equity participation limit There are no limits on the amount of
foreign investment or on the percentage
of capital that may be acquired.
(iv) Other restrictions
Mass media i s the only sector that i s
entirely off-limits to foreign investment.
S0urc.e: World Bank data
Appendix 85.2 Foreign exchange controls on portfolio investment capital gains and dividends
Korea
(i) Capital
Free repatriation of capital i s guaranteed
and is permitted on a dollar for dollar
basis regardless of the exchange rate.
(ii) Capital gains, dividends and interest
Guaranteed unlimited transfer of profits
at the prevailing exchange rate.
(iii) Currency and others
No foreign exchange controls unless the
country is havingdifficulty in maintaining
the balance of payments, there i s a
sudden change in the exchange rate or
the repatriation of funds is detrimental to
the domestic financial market.
Argentina
(i) Capital
Repatriation of capital i s freely allowed.
(ii) Capital gains, dividends and interest
Remittances of dividends and capital are
made via dollar denominated bonds
purchased from the Central Bank. In
general there are now no restrictions on
the movement of funds in and out of
Argentina, nor are there any constraints
on the repatriation of income and capital
gains.
(iii) Currency and others
Official exchange rates apply to al l
transactions. There is no minimum time
limit for foreign investment in Argentina
and free currency conversion through the
foreign exchange markets exists.
India
(i) Capital
Repatriation of capital i s permissible
except when specifically precluded
under the original investment approval..
(ii) Capital gains, dividends and interest
Provided that investment in securities i s
shown to have originated in an inward
transfer of foreign exchange, du ly
registered w i t h the Central Bank,
permission for repatriation i s given once
tax and reserve requirements have been
met.
(iii) Currency and others
Each remittance of redemption proceeds
to foreign investors requires central bank
approval.
Thailand
(i) Capital
Free repatriation
(ii) Capital gains, dividends and interest
Guarantee of annual d iv idend
remittances o f a maximum of the
equivalent of 15% of paid up foreign
capital.
(iii) Currency and others
Prior approval of the Central Bank is
needed for outward transfer of foreign
currency for any purpose. Transfer up to
$500,000 in capital gains and dividends
per transaction may be done without
central bank approval.
Appendix B5.2 Foreign exchange controls on portfolio investment capital gains and dividends (Continued)
Taiwan
(i) Capital
Repatriation of capital can be effected
one year after the capital has been
remitted to Taiwan.
(ii) Capital gains, dividends and interest
For approved investments, investors can
freely remit capital gains and dividends
without restrictions.
(iii) Currency and others
As of November 1994, Central Bank;
authorisation is necessary for overseas
remittance of proceeds from securities
transactions in foreign currency in excess
of $1 million.
Indonesia
(i) Capital
Repatriation of capital i s permitted only
after tax concessions given to the foreign
investment company have expired,
unless the funds remitted are derived from
the sale of shares to an Indonesian citizen.
Guaranteed repatriation of capital.
(ii) Capital gains, dividends and interest
Repatriation of profits by the foreign
investor is permitted at any time. Foreign
investors repatriat ion of profi ts is
guaranteed under the terms of the Foreign
Capital Investment Law of 1967, as
amended.
(iii) Currency and others
N o restrictions on foreign exchange
which would restrict remittances in or out
o f the country. Currency freely
convertible. Proceeds are remitted at the
exchange rate at the time of transfer
unless the firm's investment agreement
specifies another rate.
Chile
(i) Capital
Capital may be repatriated one year after
its entrance in Chile since December
1992.
(ii) Capital gains, dividends and interest
Dividends and net realised capital gains
can be remitted any time. There is no
restriction on the remittance of profits.
(iii) Currency and others
Remittances are made at of f ic ia l
exchange rate via the Central Bank.
Foreign exchange controls require all
foreign investments to be registered in
order to secure the remittance
of income and capital. Investors are
guaranteed access to foreign exchange
markets but there are no guarantees for
variations in fiscal regulations.
Mexico (till November 1994)
Currency and others
Foreign investments are subject to the free
market exchange rate and no particular
exchange contro l regulations are
applicable.
Source: World Bank data
Appendix B5.3 Taxation of dividends and capital gains of foreigners investing in emerging markets
Korea (i) Capital gains tax without tax treaty Those from countries without tax treaties are subject to a tax of 26.875% on capital gains, or of 10.75% of the value of transactions, whichever is lower. (ii) Capital gains tax with tax treaty Investors from countries with tax treaties pay no tax or a lower tax. (iii) Dividends and interest without tax treaty 25% withholding tax on dividends. (iv) Dividends and interest with tax treaty Withholding tax may be reduced to 10 - 15% when a tax treaty is in force (v) Fees and other taxes No fees. All investors subject to 0.2% tax on the value of their stock sales
Taiwan (i) Capital gains tax without tax treaty No capital gains taxes are levied (ii) Capital gains tax with tax treaty No capital gains tax (iii) Dividends and interest without tax treaty For approved investments, there i s a 25% withholding tax on dividends and interest. For unapproved, the tax i s 35%. (iv) Dividends and interest with tax treaty There i s a withholding tax on dividends and interest of 20%. (v) Fees and other taxes Transfer of shares i s subject to a securities transaction tax of 0.1 %-0.3%.
Mexico (i) Capital gains tax without tax treaty No capital gains tax. (ii) Capital gains tax with tax treaty No capital gains tax.
(iii) Dividends and interest without tax treaty Withholding tax on dividends i s 35% if paid from untaxed profits, otherwise zero. (iv) Dividends and interest with tax treaty No withholding tax on dividends. (v) Fees and other taxes Sales through the Mexico Stock Exchange of shares considered as available to the general investing public are exempt of withholding tax.
Thailand (i) Capital gains tax without tax treaty Retail investors are exempt from payment of capital gains taxes arising from transactions on the Stock Exchange of Thailand. Local companies are taxed at the corporate tax rate of 30% while overseas insti tut ions pay a 15% withholding tax on capital gains. (ii) Capital gains tax with tax treaty 25% for non-residents. Residents of a country which has a double taxation treaty with Thailand (26 countries), may be eligible for exemption or lower rates. (iii) Dividends and interest without fax treaty Foreign investors are subject to a 10% withholding tax on dividends and 15% on interest (iv) Dividends and interest with tax treaty Withholding tax on dividends is lo%, intcrest 3-1 5%. (v) Fees and other taxes VAT.
Indonesia (i) Capital gains tax without tax treaty Capital gains on the sale of Indonesian
Appendix 85.3 Taxation of dividends and capital gains of foreigners investing in emerging markets (Continued)
securities by non-residents are not presently subject to withholding tax. (ii) Capital gains tax with tax treaty No capital gains tax. (iii) Dividends and interest without tax treaty The withholding tax on dividends or interest i s 20% for residents of countries which do not have tax treaty w i th Indonesia. (iv) Dividends and interest with tax treaty 10-20% withholding on dividends and interest. (v) Fees and other taxes Average VAT of 10% applies to transfers.
Argentina (i) Capital gains tax without tax treaty Income derived f rom the sale and exchangeof securities are income exempt for Argentine individuals and foreign beneficiaries per Decree 2284191. (ii) Capital gains tax with tax treaty No capital gains tax. (iii) Dividends and interest without tax treaty Dividends are no longer subject t o income tax per Law 24073 as of 1 April 1992. Withholding tax on interest i s 12%. (iv) Dividends and interest with tax treaty N o wi thholding tax on dividends. Withholding tax on interest is 10-1 2%. (v) Fees and other taxes Dividends and capital gains can be remitted up to 12% of the investment per annum. Excess profits tax of 15 - 25% is levied on remittances exceeding the limit. Transfer of securities tax and stamp tax within the jurisdiction of the city of Buenos Aires has been abrogated by
Decree 2284191 and Decree 114193 respectively.
Chile (i) Capitalgains tax without tax treaty There i s no withholding tax on net realised capital gains that are reinvested in Chile. For those that are not reinvested, the tax i s 15%. (ii) Capital gains tax with tax treaty No withholding tax. (iii) Dividends and interest without tax treaty No withholding tax on dividends that are reinvested in Chile. For those that are not reinvested, the tax is 10% on interest and 20% on dividends. (iv) Dividends and interest with tax treaty No withholding tax. (v) Fees and other taxes No fees. FClF Law subjects foreign investors to only 10% withholding tax at the moment of remitting profit.
India (i) Capital gains tax without tax treaty Long term capital gains (where stock has been held for a year or more) attract a tax of 10%. The 1993-94 budget reduced the short term capital gains tax for the foreign investor from 65% to 30%. (ii) Capital gains tax with tax treaty Dividend and interest income taxed at 20%. (iii) Dividends and interest with tax treaty Withholding tax on dividends 10% and interest 25%. (iv) Dividends and interest with tax treaty Withholding tax on dividends 0-25% interest 7.525%.
I Source: World Bank data I
Appendix Table A6.1 China: lnsurance premium growth (1 986-92)
Year Premiums (Rmb billion) Growth rate (per annum) % GDP
Source: Niu (1 994)
Appendix Table A6.2 China: International comparison of insurance premiums ( 1992) (per cent of GDP)
Asia Latin America Africa
China
Korea
Japan
Taiwan
Malaysia
Singapore
Philippines
Thailand
1 .O Brazil
12.3 Panama
8.6 Chile
4.8 Venezuela
3.8 Uruguay
3.7 Colombia
2.3 Argentina
2.0 Mexico
4.3 South Africa
3.3 Zimbabwe
3.0 Kenya
2.2 Morocco
2.0
1.8
1.6
1.5
Source: Sigma, World Insurance in 1992, Swiss Reinsurance Company, March 1994
Appendix Table A6.3 China: Comparisons of growth of insurance penetration (1 970-92) (annual premiums as per cent of GDP)
East Asia
South Korea
Taiwan (China)
Malaysia
Singapore
Philippines
Thailand
Indonesia
China
Latin America
Brazil
Chile
Colombia
Argentina
Mexico
- - - - -
Source: Sigma, Swiss Reinsurance Company, April 1992, June 1992 and March 7 994
Appendix Table A6.4 China: Comparisons of the structure of life and non-life insurance (1 992) (per cent of total premiums)
Life ( per cent) Non-life ( per cent)
East Asia
South Korea
Taiwan (China)
Singapore
Philippines
Thailand
Malaysia
Indonesia
China
Latin America
Chile
Mexico
Colombia
Argentina
Brazil
Africa
South Africa
Zimbabwe
Kenya
Morocco
Source: Sigma, Swiss Reinsurance Company, March 1994
Appendix Table A6.5 China: Comparisons of the performance of the insurance industry in selected countries
Expense ratio Combined ratio
Non-life China (1 992)
Argentina (1 992)
Canada (1 987-89)
Mexico (1 985-89)
United States, (1984-88)
Life China (1 992)
Argentina (1 992)
Canada (1 987-89)
Mexico (1 985-89)
United States (1 985-89)
(Loss ratio)
65
53
76
80
83
(Payback ratio) 107
68
128
78
119
Source: World Bank Staff Estimates
Appendix Table A6.6 China: Assets and liabilities of the People's Insurance Company (1 992/93)
Assets Rmb billion YO
1992 1993 1992 1993
Liabilities Rmb billion YO
1992 1993 1992 1993
Liquid assets 22.2 23.1 46.2 39.5 Equity 8.2 8.0 17.1 13.7
Investments 10.1 15.6 21.0 26.7 Policyholders 28.4 36.0 59.1 61.5
Fixed 5.8 7.8 12.1 13.3 Reinsurers 2.8 1.5 5.8 2.6
Premiums receivable 0.9 0.7 1.9 1.2 Sundry creditors 8.6 13.0 17.9 22.2
Interest receivable 2.5 2.9 5.2 5.0
Reinsurers 1.6 1.8 3.3 3.1
Sundry debtors 5.0 6.6 10.4 11.3
Total 48.0 58.5 100.0 100.0 Total 48.0 58.5 100.0 100.0
Source: PlCC Annual Report 1992
Appendix B6.1 Investment patterns of contractual savings institutions
1. Pension funds and insurance
companies. The role o f institutional investors in the securities markets differs considerably from country to country,
ref lect ing histor ical tradit ions and differences in regulation. United Kingdom: Fund managers have
been subject to the 'prudent man' rule
without detailed investment regulations.
A preference for equity investments has
developed, mainly in response to the high
rates of inflation of the 1960s and 1970s. Pension funds invest over 66% and life insurance companies over 50% of their assets in corporate equities. Pension funds and life insurance companies
accounted in 1988 for 60% of corporate
equities. United States: Fund managers are also
subject to the 'prudent man' rule but (i)
pension fund regulations impose stricter
funding and accounting obligations on sponsoring companies and (ii) insurance
regulations impose tighter limits on
investments. As a result, pension funds invest less than 45% of assets in corporate
equities. Insurance companies invest less than 10% of their assets in equities.
Contractual savings institutions hold only about 25% of corporate equities in the
US, though they account for well over
50% of corporate bonds.
European countries: Similar to US life insurance companies, the largest part of funds are placed in government,
corporate and mortgage bonds, as well as long-term loans. In Switzerland, the Netherlands and Germany, insurance
companies and pension funds place between 60% and 70% of assets in these
instruments. Investments i n foreign
securities are affected by regulations such as foreign exchange controls or prudential controls. Fol lowing the
removal of exchange controls and the
relaxation of investment rules, pension
funds in several countries have built up substantial holdings of foreign equities
and bonds.
Percentage fo re ign securit ies h e l d by
institutional investors o f different countries
Hong Kong 55% Netherlands 22%
United Kingdom 26% Japan 17%
Australia 25% Canada 13% New Zealand 23% United States 11%
2. Mutual funds. The composition o f
mutual funds also reflects diversity i n regulations and traditions.
United States: Mutual funds are equally divided between money market mutual
funds, bond funds and equity funds.
United Kingdom: Nearly all the mutual funds are equity funds. Germany: Bond funds account for 8O0/0
of mutual funds.
France: Money market mutual funds
represent nearly 60% of mutual funds,
mainly because o f the cont inuing imposition of ceilings on retail deposits with banks.
Appendix B6.1 Investment patterns of contractual savings institutions
3. Insurance and pension funds in developing countries. Their ro le is
shaped more forcefully by regulation and government d i rect ion. I n certain
countries, the funds o f contractual savings
insti tut ions have been used for
development purposes.
Singapore and Malaysia: Nat ional
provident funds invested over 90% of their funds in government securities,
although these earned a barely positive real rate of return. However the Central
Provident Fund of Singapore has also operated as a compulsory national
mutual fund, investing in foreign assets. Individual members of the CPF have long
had the right to withdraw funds in order
to purchase a home or finance education
or medical expenses. In recent years, they
have also been allowed to invest directly
i n approved domestic and foreign
securities. Malaysia: The successfuI implementation
of economic growth policies has ensured a reasonable real rate of return on the
balances of the Employees Provident
Fund, especially in the 1980s. More recently, w i t h the decl ine in the
borrowing needs of the Malaysian state, the EPF has diversified its assets into
corporate bonds and equities as well as mortgage instruments. Egypt:The resources of the social security system have been placed w i th the Nat ional lnvestment Bank, the investments of which have generally suffered from negative returns. The
provident funds in African countries
(Ghana, Nigeria, Kenya and Zambia) and nearly all the partially funded pension
systems of developing countries have
invested their resources almost
exclusively in government bonds and low interest loans to members. Real returns
on accumulated funds have been highly negative and in some cases the real value
of balances has been completely wiped out.
4. Mutual Funds in Developing Countries. These are mostly invested in
equities. Bond and money market mutual funds have developed more slowly,
main ly because of the absence of
enabling legislation and the hostility
toward their authorisation by the banking
sector. The latter continues to hold a
dominant posit ion in the f inancial systems of most developing countries and
is concerned about the loss of deposits to bond and money market mutual funds that would not be subject to reserve requirements, interest rate controls and
other regulations and would thus be able
to offer higher returns than those offered
by banks. Monetary authorities have also been reluctant to authorise bond and money market mutual funds because of concern about the potential loss of monetary and credit control and a feared higher volatility and instability of interest rates and government bond prices.
Source: Vittas (1992) and Davis (1993)
CHINA'S EMERGING CAPITAL MARKETS
Authoritative analysis ofperformance and prospects
There has been exceptional growth and regulators in Beijing, as well as from market di\w-sification in China's capital markets participants, local a~~thori t i t .~, exchanges in the 1990s. Yet the fundamental and trading centres at Shangl~ai, Shenzl~cn, determinants of market structure or Wuhan, Tianjin and Hong Kong. It presents bchaviourarepoorly~lnderstood.Market cr)mprehensi\rc data and statistics to analysts, financial institutions and other illustrate and support its analysis and potential investors, policy advisors and conclusions. observers of China's economy are thwartcd by insufficient information and inadequate This book clearly explains the context of analysis upon which to base thcir recent capital market develnpments in judgements and strategic decisions. China and e\~aluates the effect of regulatory
changes on the performance of the securities Q What factors affect the efficiency and market and the key players in each sector. It
growth of China's capital markets? makes clear recommendations to the government, to investors and to financial Q What is the potential for foreign institutions, suggesting how strategies can
investors in China's equity and bond be formulated to strengthen the
markets? fundamentals of the capital market and Q Which government agencies regulate open it up to wider, and mare profitable,
this sector and how d o their actions domestic and international participation. control the degree and direction of securities markets growth?
China's Emerging Capital Markets is the result of a joint investigation by the staff of FINANCIAL TIMES the World Bank, its consultants, and the Firlurtcilri Publblisl~in~
China Securities Regulatory Commission A i u P ~ ~ t - i f i t
into China's securities markets. It draws on Providing essential information and objective primary data from the government and analysis for the global finance industry.