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H I N E S E
J ) T 0 C K
A R K E T S
A R e s e a r ch H a n d b o o k
T>ongweiSu
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C H j p % S E
S T 0 C K
M A R K E T S
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C) H
t J C %
S E
Is) T 0 C K
:M) A R K E T S
A Research H and boo k
v >
(Dongwei
Su
Department of Finance
JiNan University, China
*
World
Scientific
New Jersey London Singapore
Hong Kong
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Published by
W orld Scientific Publishing Co . Pte. Ltd.
5 Toh Tuck Link, Singapore 596224
USA office:
Suite 202 , 1060 Main Street, River Edg e, NJ 07661
UK office:
57 Shelton Street, Covent Garden, London WC 2H 9H E
Library of Congress Cataloging-in-Publication Data
Su, Dongwei.
Chinese stock m arkets : a research handbook / Dongwei Su.
p.
cm.
Includes bibliographical references and index.
ISBN 9810245122 (alk. paper)
1.
Stock exch ang es-Ch ina. 2. Stock s-Chin a. 3. Securities-Ch ina. I. Title.
HG5782 .S8 2003
332.64'251-dc21 2002033184
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library.
Copyright 2003 by W orld Scientific Publishing C o. Pte. Ltd.
All rightsreserved.Thisbook,or parts thereof, may not be reproduced in any form or by any means,
electronic or mechanical, including photocopying, recording or any information storage and retrieval
system now know n or to beinvented, without written permission from the Publisher.
For photocopying of material in this volume, please pay a copying fee through the Copyright
Clearance Cen ter, Inc., 222 Rosewood Drive, Danvers, MA 01 923 , USA . In this case permission to
photocopy is not required from the publisher.
Printed in Singapore by World Scientific Printers (S) Pte Ltd
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to Jinyu Su, Yuande Lin and Dongyang Su
V
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Vl l l
Preface
emerging markets?
(2) Are Chinese stock m arke ts volatile? Does stock -ma rket re tu rn
volatility change over tim e? How frequent are "big surp rises" in
Chinese stock m arkets ? W ha t are the causes for these "big sur
prises"
?
(3) What explains differences in prices and expected returns between
the classes of shares that can be bought by Chinese citizens and for
eign investors? Is the time-series variability in the spread between
domestic and foreign share returns consistent with differences in
risk exposures and expected risk premiums?
(4) W hy are dom estic shares mo re volatile th an foreign shares? How
are the variation in volatil i ty-related expected intensity of informa
tion flows and the amount of informed trading related to informa
tion correlates, such as the number of investors, change in profits,
and firm size?
(5) Was the extraordinarily large IPO underpricing caused by bribery
and insider trading, high level of government policy uncertainty, or
government 's desire to encourage wide public participation in the
equ ity m ark ets? W h at explains th e cross-sectional differences in
underpricing? Why the degree of underpricing is much smaller for
foreign-lis ted IPOs? Why do Chinese IPOs perform much worse in
the long-run than those in other countries?
(6) What are the critical differences in firm characteristics (liquidity,
leverage, and investment opportunities) between firms that issue
new shares after their IP O s and those th at d o no t? Am ong t he
firms that do issue new equities after their IPOs, do agency costs,
political costs and information asymmetry affect their choices of
different financing m eth od s? How can we exp lain th e varia tion
in ab no rm al ann ou nce m ent da y re tu rn s across different financing
methods?
(7) Is accounting information value-relevant in the Chinese stock mar
kets? Why do investors over-react to earnings release in domestic
markets? To what extent have analysts ' earnings forecasts affected
the market valuation of s tocks?
(8) What are some of the debates on privatization and reform of s tate
enterprises? W ha t was Ch ina's past experience? How can lis ted-
companies deal with owner and manager relationships and organize
efficient corporate governance structure? Will China jump into the
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Preface
IX
sea of private enterprise or remain suspended in a trance-like s tate
under the notion that market socialism will solve its problems?
Chinese Stock Ma rkets: A Research Hand book is the first to provide a
comprehensive study of the aforementioned issues in a technical manner
drawing upon rigorous theoretical and quantitative analyses. A salient fea
ture of this handbook is i ts breadth of coverage. While individual chapters
may be narrow but deep in scope, the handbook as a whole encompasses
diverse subjects and cuts across a number of f ields in f inance-investments ,
f inancial markets and institutions, international f inance, r isk management,
cor po rate finance, and corpo rate governance. T he han db oo k is intend ed
as a specially compiled research monograph and a benchmark of reference
which, I hope, will be of considerable use to academia, practit ioners , and
policy-makers interested in issues surrounding state enterprise reform and
equity market development in China.
This handbook has nine chapters . Every one except the f irs t two chap
ters brings together a set of rigorous academic research studies on issues
that enhance the existing body of knowledge in emerging markets . These
chapters typically begin with a discussion of the economics and finance
theory underlying the application, outline issues in econometric implemen
ta t io n ( including measurem ent issues) , and then deta i l im po rtant empir ical
findings. Ea ch chap ter engages read ers in a carefully designed top ic in
volving replication and extension of cutting-edge research in a coherent
framework.
This handbook has benefited from the comments and insights of a large
number of people, particularly my dissertation advisors at Ohio State Uni
versity. N um erou s colleagues an d friends have also prov ided co nst ruc tive
and challenging suggestions. I owe special th an ks to Yu ande Lin, wh o
read each chapter with great care and offered many terrific suggestions.
I take pleasure to thank the following people in numerous ways: Torben
Andersen (Northwestern Univers i ty) , James Ang (Flor ida Sta te Univer
sity) , Warren Bailey (Cornel l Univers i ty) , Prasad Bidakota (Kansas Sta te
University), David Brasington (Tulane University), Zhiwu Chen (Yale Uni
versity), Gregory Chow (Princeton University), Georgio DeSantis (Univer
sity of Southern California), Xinghai Fang (Shanghai Stock Exchange),
Yue Fang (University of Oregon), John Fernald (Board of Governors of
the Federal Reserve System), Belton Fleisher (Ohio State University), Yan
He (San Francisco State University), Gary Jefferson (Brandies University),
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X
Preface
Pok-sang Lam (Ohio State University), David Li (Hong Kong University of
Science &: Techn ology), J. Ho usto n McC ulloch (O hio Sta te U niv ersity ),
Barry Naughton (University of California at San Diego), Masao Ogaki
(Ohio State University), Min Qi (Kent State University), Bruce Reynolds
(Cornell University and Union College), Jay Ritter (University of Florida),
Alan Viard (Federal Reserve Bank at Dallas) , Xin Zhang (China Securi
ties Regulatory Commission) and Zhenlong Zheng (Xiamen University and
University of California at Los Angeles).
The experience of transforming a manuscript into final book form is
due in large part to the dedication, thoroughness, and highest professional
standards of the publishing team in World Scientific. In particular, it is a
pleasure for me to thank my editor, Joy Quek, for her meticulous work and
great professionalism.
DS
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C o n t e n t s
Preface vii
C h a p t e r 1 D e v e l o p m e n t o f C h i n e s e S t o c k M a r k e t s 1
1.1 Intro du ctio n 1
1.2 Settin g th e Scene: Sh ang hai an d Shen zhen in the Earl y
Reform Period 3
1.3 T he Es tablish m ent of Secondary M arke ts 5
1.4 T he Pa rticip atio n of Inte rna tion al Investors 11
1.5 T he Role of M utu al Fun ds and O ther Insti tutio nal Investors . . 19
1.6 After th e Fifteenth N ation al Con gress: Increasing Re versa l to
Capitalism 22
1.7 Prob lem s and Dilemm as 26
C h a p t e r 2 S t r u c t u r a l a n d I n s t i t u t i o n a l C h a r a c t e r i s t i c s 3 3
2.1 Intro du ctio n 33
2.2 Re gula tory Framew ork 35
2.2.1 O rganiza tions in Ch arge 35
2.2.2 Securities Laws an d Re gu lation s 38
2.2.2.1 P.R .C. Com pany Law 39
2.2.2.2 P.R .C. Securities Law 41
2.3 Ow nership s truc ture 44
2.4 Lis ting Stan dard s and Proced ures 49
2.4.1 Re qu irem ents for Stock Listings 49
2.4.1.1 A Shares 49
2.4.1.2 B-S hare s 50
xi
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xii Contents
2.4.1.3 O ve rse as 'L istin g of Foreign Shares 53
2.4.1.4 Red Ch ip Listing 54
2.4.2 Pr oc ed ure s for Stock Listin g 55
2.5 M arket M icrostru cture 58
2.5.1 Re gis tratio n of Stock Dea lers 58
2.5.2 Ge neral Rules for Tra din g 59
2.5.3 Takeover of Listed Co m pan ies 64
2.5.4 Settlem ent, Clearing and Pay m ent System 66
2.5.5 Accou nting System 67
2.5.6 Ta xes an d Fees 70
2.5.7 Suspension and Term inat ion of Lis ted Com panies . . . 72
C h a p t e r 3 R i s k , R e t u r n a n d R e g u l a t i o n i n C h i n e s e
S t o c k M a r k e t s 7 5
3.1 Intro du ction 75
3.2 Stock-M arket R etu rn and Volatil i ty P at te rn 76
3.3 D ay of th e W eek Effect 82
3.3.1 An alysis of Va riance A ppro ach 82
3.3.2 Moving Average A ppro ach 83
3.4 M ark et Efficiency H yp oth esis 86
3.4.1 Ra nd om Walk Hy pothesis 86
3.4.2 Co integ ration -Ba sed M arke t Efficiency 90
3.5 GA RC H Mo dels 93
3.5.1 M odel Specification 94
3.5.2 Character iz ing Variance in Chinese Stock M arkets . . . 94
3.5.2.1 No rmal D istr ibutio n 95
3.5.2.2 Stan dardiz ed t-distr ib utio n 95
3.5.2.3 Stab le D istrib utio n 96
3.5.3 W orld Versus Local Fa ctor s in Vo latility 96
3.6 Es tim atio n and Em pirical Resu lts 97
3.6.1 Model Com parison 98
3.6.2 Pa ram ete r Es tim ates 102
3.7 Gov ernmen t Reg ulation and M arket Volatil ity 105
3.8 Volatili ty A sym m etry and Spill-over I l l
3.8.1 A Pa rtia l Ad justme nt Mo del with As ym me tries 113
3.8 .2 Asymm etric Behavior on Return s and Volat il ity . . . . 116
3.8.3 Stock -M arket Vo latility Spill-over Betw een M ain lan d
Ch ina and Hong Kong 118
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Contents xiii
3.9 Su m m ary 121
C h a p t e r 4 O w n e r s h i p R e s t r i c t i o n s a n d F o r e i g n
S h a r e s D i s c o u n t 1 2 3
4.1 Introdu ction 123
4.2 Ow nership Res trictions in Chinese Stock M arke ts 125
4.3 A Price Discrim ination Mo del 135
4.3.1 M odeling Ow nership Res trictions 135
4.3.2 Inve stors ' M axim ization Pro blem s 137
4.3.3 Firm s ' M aximizat ion Problem s 141
4.3.4 Corn er Solutions for Dom estic Fir m s' Max imiza tion
Problems 144
4.3.5 Relaxing Ow nership Res trictions 146
4.4 An Int erte m po ral Ca pital Asset Pricing M odel 148
4.4.1 Stock Pric e an d R etu rn Dy nam ics 148
4.4.2 Inte rtem po ral M axim ization by Do me stic Investors . . . 149
4.4 .3 In te r tempora l Maximiza tion by Fore ign Investors . . . . 151
4.5 Tes table Imp lications From th e M odels 154
4.6 Em pirical Res ults 156
4.6.1 E stim atin g Be tas 156
4.6.2 Erro rs-in-V ariable s an d Tests for B-s hare Pr em iu m s . . 159
4.6.3 Id ios yn cra tic V arian ce Effect an d Fi rm Size Effect . . . 164
4.7 Su m m ary 165
C h a p t e r 5 E x c e s s V o l a t i l it y i n D o m e s t i c S h a r e M a r k e t s 1 6 9
5.1 Intro du ctio n 169
5.2 A Modified M ixture of D istr ibu tion Ap proach 170
5.3 Es tim ation : Generalized M etho d of M om ents 173
5.4 D at a Ad justm ents 175
5.5 Em pirical Resu lts 193
5.6 Cross -Sectional An alysis 200
5.7 Tim e-Series An alysis 209
5.8 Su m ma ry 210
C h a p t e r 6 T h e U n d e r p r i c i n g o f I n i t i a l P u b l i c O f f er in g s 2 1 5
6.1 Intro du ctio n 215
6.2 T h e New -issue an d Offering Pro ces s 217
6.3 T he Role of Finan cial Variables in th e Pricing of IP O s 221
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Contents
6.3.1 T he Chinese D at a 221
6.3.2 A Be nch m ark Regression 224
6.4 T he Adv erse-Selection M odels 227
6.5 T he Signaling M odels 235
6.5.1 Em piric al Im plicatio ns from th e Signaling M odels . . . 235
6.5.2 Co rrelation Between IP O R etu rns and IP O Proce eds . . 238
6.5.3 Co rrelations Am ong IP O Un derpricing and Issuer 's In
tr insic Value, Fractional Ownership and Project Variance 240
6.5.4 IP O Un derpricing and SEO s 241
6.6 Bribe ry and Lo ttery Hy pothe ses of IP O Un derpricing 246
6.6.1 Bribe ry Hy pothesis: U nderpricing of Chinese IP O s are
Gifts to Pu blic Officials or Favo red Pu rch ase rs 246
6.6.2 Lo ttery Hy pothesis: L otte ry M echanism in Share Allo
cation Co ntrib utes to High IP O Un derpricing 249
6.7 Un derpricing of Foreign-Share IP O s 251
6.8 Lon g-run Performan ce of IP O s 256
6.9 Sum ma ry 260
C h a p t e r 7 C o r p o r a t e G o v e r n a n c e a n d P o s t - I P O F i n a n c i n g 2 6 7
7.1 Share hold ers ' Behavior and C orp ora te Go vernance 268
7.1 .1 Organiza t iona l S t ruc ture and Board Compos i tion . . . . 269
7.1.2 T h e Role of Go vernm ent 270
7.1.3 Ow nership Co nce ntration an d Fi rm s' Performance . . . 274
7.2 Political Co sts and Agency Costs of Eq uity Finan cing 277
7.2.1 T he Failure of M anag em ent Resp onsibili ty Co ntra ct Sys
tem 278
7.2.2 Co ope rative Shareholding System 279
7.3 Choices of Po st- IP O Finan cing 285
7.3.1 Soft Bu dget Co nstra ints an d Th e Role of De bt 285
7.3.2 Co sts of Eq uity 289
7.4 Th e Information Con tent of Different Financing Choices . . . . 295
7.5 Ins titutio nal Trans forma tion to Imp rove C orp ora te Gov ernance 299
7.5.1 Priv atiza tion 299
7.5.2 D enation alization 301
7.5.3 Dive rsification 302
7.6 Sum ma ry 304
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Contents
xv
C h a p t e r 8 A c c o u n t i n g I n f o r m a t i o n a n d S t o c k P e r f o r m a n c e 3 0 7
8.1 Intro du ction 307
8.2 Roles of Fin anc ial Disclosure for Perform ance Ev alua tion . . . 309
8.3 Co rpora te Disclosures M ade by Lis ted Chinese Com panies . . . 312
8.3.1 A Brief H istory of Ac cou nting Develop men t 312
8.3.2 Finan cial Re portin g Prac tices 314
8.3.3 Ca pital M arket Infrastru cture 318
8.4 Stock Re turn s Aro und Ea rning s Releases 320
8.4.1 Informa tion Co ntent Analysis 321
8.4.2 Earn ings A nno unce m ents and Stock Price Rea ctions in
China 322
8.5 W hy Do mestic Investors Ov er-react to Earn ings Release? . . . 331
8.5.1 Go vernm ent and M anag em ent as Informed Investors . . 331
8.5.2 Inv esto rs ' Sen tim ents 332
8.5.3 M arket Valuation and Tra nsp arenc y 333
C h a p t e r 9 I n t e r n a t i o n a l i z a t i o n o f C h i n e s e S t o c k M a r k e t s 3 3 5
9.1 Foreign Investm ent in Dom estic B-Share M arket 335
9.1.1 M arket M icrostru cture Issues 336
9.1.2 Risk s Involved 338
9.2 Ov erseas Listing of Ch inese Stocks 339
9.2.1 Cros s-Listing of H-S hares 340
9.2.2 Red Ch ips Rising 345
9.2.3 Overseas Lis ting in the U.S. , U.K. and Singapore . . . . 347
9.3 Con cerns T ha t Em erged 352
9.3.1 M arket Segm entation an d Foreign Exc hang e Co ntrol . . 354
9.3.2 A Lack of Foreign Pa rticip atio n and Co m petition in Fi
nancial M arkets 357
9.4 Ch ina Moving Tow ard W orld Ca pital M arket: Strategic Issues
and O ption s 359
9.4.1 En ha nc ing th e Inte rest of Ov erseas Investo rs 359
9.4.2 Im prov ing the Role of Fin anc ial Interm edia ries 361
9.4.3 Introd ucing Insu rance Ca pita l to Securities M arket . . . 363
9.4.4 Streng thenin g Ch ina Investm ent Fun ds 365
9.4.5 Reforming Pen sion Sys tem 369
9.5 Liberalization of Ca pital M ovem ents 370
9.5.1 W ha t th e Th eory Says 371
9.5.2 Ch ina's Exp erience 373
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9.5.3 Policy Issues 376
A p p e n d i x A S e c u r i ti e s L a w 3 8 1
A .l Introdu ction 381
A.2 T he Role of th e Stock M arket 383
A.3 Re gulatin g th e Chinese Stock M arket 384
A.4 Ca pita l Form ation 387
A.5 Securities Trad ing and Information Disclosure 388
A.6 Ac quisitions 390
A.7 M arket Infrastru cture 392
A.8 Investor Pro tectio n 395
A.9 Ov erseas M arkets 397
A.10 T h e Role of Law yers 398
A.11 Sum ma ry 398
A p p e n d i x B S u m m a r y o f P . R . C . T a x e s 4 0 1
A p p e n d i x C M a j o r E v e n t s i n C h i n e s e S t o c k M a r k e t s 4 0 5
Bibliography 415
Index 425
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C ha p t e r 1
D ev e lop m en t of C h ines e S tock
M a r k e t s
1 . 1 In troduc t ion
China has experienced unprecedented growth in Gross Domestic Product
(G D P) from 1987 to th e presen t, growing at an average rat e of 9.5% per
year (see Fig ure 1.1). Its economy tod ay is m ore th an four time s as large
when the reforms were first introduced in 1979. The reform has affected
all sectors of the economy and has lifted a enormous number of people out
of s tarvation and into the consumer middle class . The commercialization
of the Chinese economy has also opened it up to foreign direct investment.
The continuous market development has been impressive by any standards.
Prior to 1978, the entire financial system in China was controlled by
sta te owned ban ks. Investm ents were channeled thro ug h direct grants
from the state budgetary funds or from government allocated bank credits .
Therefore, China's move towards market economy with modern financial
market was a remarkable breakthrough in terms of ways of rais ing much
needed capital for economic development.
In 1990, th ere w ere no stock m ark ets. As of O ctob er 31 , 1999, 930 com
panies were listed in the Shanghai Securities Exchange (SHSE) and Shen
zhen Securities Exchange (SZSE), with a market capitalization of US$340
billion or abou t 30% of GD P, approxim ately th e same as th at of Sing apore,
Th ailan d, Malaysia and Indonesia put togeth er. Th ere were 38 million
individual s tockholders , second in number only to the U.S. . In addition,
there are 43 H-shares and 42 Red Chips lis ted in the Hong Kong stock
excha nge, wit h a m arke t c apitaliz ation exceeding US$86 billion, or 17% of
th e Hong Kong m arket capitalization. W ith the retur n of Hong Kong in
1
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2
Developmen t of Chinese Stock Ma rkets
R e a l G D P G r o w t h
Percfn
1987 :
Fig. 1.1 Real G D P Gr ow th
1997, the mainland inherited a world class financial center, with developed
and mature banking and securit ies markets. Because China continues to
have a high savings rate of 36% of GDP and a high current account surplus,
much domestic savings have been pumped into domestic capital markets.
Bank assets and securit ies market capitalization ( including equity and bond
m ark ets) accou nted for 139% and 4 1 % of G D P in 1999, respectively.
Considerable achievements have also been made in the legal and regula
tory framework for domestic capital markets. In addition to the enactment
of the banking and central bank legislation, and the
PRC Company Law,
the latest piece of law is the
PRC Securities Law.
Fur thermore, pr ivate
enterprises are now permitted to go public in China, and more state-owned
corporations are allowed to raise funds in international capital markets.
Because these f irms have to adhere to more str ingent accounting standards
and disclosure requirements, they usually have better corporate governance
practices and are more responsive to market needs. Needlessly to say, such
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Setting the Scene: Shanghai and Shenzhen in the Early Reform Period 3
commercialization and corporatization better prepare Chinese firms to meet
global challenge and com petitio n. It is increasingly recognized th a t sto ck
markets will play an important role in China's transition towards a market
economy with modern financial system and create tremendous amount of
investment opportunities for domestic and international investors .
1 .2 Se t t in g th e Scen e : Sha ngh ai and Sh en zh en in th e Ear ly
R e f o r m P e r i o d
The development of the s tock markets is one of the most important el
em ent s of C hi na 's reform in th e financial syste m . Before 1949, Sh ang hai
was a major banking and financial center with a stock market similar in size
to that of Tokyo and considerably larger than that of Hong Kong. Fluctu
ations in the Shanghai stock exchange over the period 1919-1949 had a lot
of influence on other world-class financial markets. In fact, Shanghai was
the world's third largest after New York and London.
For approximately three decades after the Communist Party took power
in 1949, th e governm ent strictly co ntrolled virtu ally all chan nels of invest
ment. All investments made by enterprises were either from direct grants
from the state budgetary funds or from government allocated bank cred
its. Shanghai 's previous role as an international f inancial and commercial
center was reduced to a domestic Chinese industrial center. During those
three decades, the entire Chinese financial system was dominated by the
state-owned banks, such as the People 's Bank of China (PBOC), a few spe
cialized banks and their local branches. The official process that allocated
investments across regions and industrial sectors was often bureaucratic,
and in many cases, caused inefficient use of resources.
Before the economic reform was embarked, Shenzhen was just a small
remote town close to Hong Kong in southern C hina. W hen C hina began
its open-door economic policy, Shenzhen became one of four Special Eco
nomic Zones (SEZs), receiving a lot of preferential policies from the central
government and attracting a consistent f low of investment from Hong Kong
and abroad. After many years of economic development, Shenzhen became
one of th e m ajor m etro po litan cities in Ch ina. Its pop ula tion is close to
3 million and ha s one of th e highest skilled work forces in Ch ina . B oth
Shanghai and Shenzhen has established themselves as sound investment
places for domestic and international investors.
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4
Developm ent of Chinese Stock Markets
As the structural reform in China continued, the central government
experienced a decline in fiscal revenues. Th is pro m pte d th e Min istry of
Fin an ce (M O F) to sell bo nd s to cover its bud get deficit. T he issua nce of
long-term treasury bonds in 1981 was the government 's f irs t experiment
in raising capital and signified the official re-opening of China's securities
markets . The dis tr ibut ion of t reasury bond issues was through mandatory
purchase quotas divided among local governments, enterprises and individ
uals .
1
Since the early 1980s, China's financial sector experienced major in
stitutional changes. The PBOC ceased its commercial banking functions
and turned into China's central bank. Four major subsidiaries of PBOC,
namely, the Industrial and Commercial Bank of China, the Agricultural
Bank of China, the Peoples Construction Bank of China, and the Bank of
China were turned into commercial s tate banks, and a number of urban and
rural credit unions were established as subsidiaries of the four commercial
sta te ban ks. As the central bank , the PB O C controls the money supply,
determines interest rate, and handles foreign exchange reserves through
its division, th e Sta te A dm inistratio n of Exch ange Control. Com mercial
state banks passed on PBOC's policy and replaced the government budget
funds as th e main financial channels for ente rprise inve stm ents . In add i
t ion, China Internat ional Trus t and Inves tment Corporat ion (CITIC) and
its subsidiaries were established throughout the 1980s and became the ma
jor consulting firm and investment bank in China. CITIC invested and lent
funds raised from international financial institutions, such as the World
Bank and Internat ional Finance Corporat ion. The whole banking sys tem
was decentralized, and inter-ban k com petition was encouraged . However,
interest rat e remained und er gov ernm ent 's control. M on etary and credit
policy continued to take the form of a credit plan that was implemented
by PBOC through a set of credit quotas for each commercial s tate bank.
All levels of government still constantly intervene the daily businesses of
virtually all financial institutions.
During the early reform period, government saving has dropped sharply
in response to deteriorating financial position of state-owned enterprises.
However, household saving has increased very rapidly in response to the
1
Al thoug h the re was no second ary ma rket to t r ade t r easu ry bo nds a t th a t t im e, the
issuance of bonds paved the way for fur ther fund rais ing act ivi t ies by s tate-owned and
private enterprises, eventually leading to the f irst publicly issued stock for Beijing's
T ianq iao Depar tment S to re in 1984 .
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The Establishment of Secondary Markets
5
new op po rtun ities created by trans ition . Individ ual incomes were higher,
but there was a lack of alternative f inancial instruments. Individuals were
forced to either hold cash or deposit in the state banks where interests were
controlled at levels lower th an th e mark et rate . N aug hton (1987) found th at
total household saving, including both in-kind and financial saving, jumped
rapidly from 7% of household income in 1978 to 17% in 1982, and have
continued to increase steadily since. Even more crucially, financial saving
triple d, increasing from 2.3% of househo ld incom e in 1978, to an average of
6.8% in the years 1980-83. As of 1995, households were generating 70% of
domestic saving, over 25% of GDP. There was 2194 billion yuan in deposits
in banks, accounting for 38% of the GDP.
In response to the changes in savings pattern, China's f inancial reform
deepened as more competition was introduced into the banking system.
In 1981, th e central government began to issue trea su ry b on ds to f inance
deficits . Shortly thereafter , the authorities permitted the issuance of other
types of bonds-including various provincial and local government bonds
and enterprise bonds. Enterprise bonds were str ictly controlled in order to
avoid conflicts w ith th e priorities set in the cred it pla n. As of th e end of
1989,
the total issue of securities amounted to 166 billion
yuan,
of which
99%
were bonds.
In 1984, as China began to experiment further economic reform, the
issuance of bonds paved the way for s tock issues as alternative methods
of raising cap ital. T he first real ste p was tak en in 1984, w hen 11 st at e-
owned enterprises (SOEs) became shareholding corporations. This led to
the first publicly issued stocks by Feile Acoustics in November 1984, with
10,000 shares at 50 renminbi yuan per share. Two months later , Yenchung
Industr ia l Corporat ion and Beij ing Tianqiao Depar tment Store both issued
shares to the pub lic. However, the re was no over-the-counter m arket in
China and virtually no trading of s tocks and bonds before 1986.
1 .3 T h e E s t a b l i s h m e n t o f S e c o n d a r y M a r k e t s
The secondary markets for securities s tarted when over-the-counter (OTC)
markets were set up in Shanghai, Beijing, Tianjin, Shenyang, Harbin and
Guangzhou to t rade corporate bonds and shares in 1986. At that t ime, the
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6
Developm ent of Chinese Stock Markets
markets dealt exclusively with bond trading.
2
The turnover was thin and
the liquidity was low because the public had very little knowledge of the
concept of equity markets . Despite that, Shanghai quickly emerged as the
major bond trading center in the nation. By the end of 1987, eight trading
counters had been opened in Shanghai. Four professional brokerage houses,
namely, the International Securities Corporations, the Haitung Securities
Corporation, the Shenyin Securities Corporation, and the Chenshing Secu
rit ies Corporation, were established in late 1980s. They helped government
issue bonds and firms issue stocks.
On December 19, 1990, the first government-approved securities market,
Shanghai Securities Exchange (SHSE), was established to allow investors
and enterprises to participate in s tock trading. I t adopted a non-profit cor
porate membership sys tem and deal t with spot t ransact ions , not including
derivative securities. It recruited members nationwide so that it might serve
as a nationwide securities transaction center. Most of the lis ted companies
on SHSE are based locally in th e Shan ghai area. T he establish me nt of SHSE
not only marked the beginning of organized securities sales, but also her
alded the firs t use of com puters in s tock and bo nd tra din g in Ch ina, there by
putting an end to all paper transactions by offering investors the improved
efficiency of computer-aided investing. Quickly after trading started, SHSE
was doing so well that their was excess demand over supply of securities
which led to dramatic increases in share prices. A few issues skyrocketed
to more than 800 percent t imes their original issuing price. Public interest
on stocks was, to say the least, piqued.
3
In 1987, th e Shenzhen D evelopment b ank b egan to issue shares to t he
public. In the next three years, five more issues were floated and actively
trad ed in th e O T C market in Shenzhen. Th e unique role of Shenzhen
in the Chinese economy led to the formal establishment of the Shenzhen
Securities Exchange (SZSE) in July 1991. Most of the companies lis ted
on SZSE were based in industrial and commercial cities in inland China.
SZSE was subject to identical regulation and trading procedures as the
SHSE with respect to debt and equity issues. For example, both securities
2
Because of a ve ry smal l number of shares out s t anding in a few corpora t ions , s tock
t ransac t ions only represented 1%, 2%, and 1% of to ta l s ecur i t i e s t ransac t ions in 1986,
1987, and 1988, respectively.
3
As early as the c los ing month of 1990, more than 400,000 res idents in Shanghai had
take n pa r t in secur i t i e s t rad ing (Fang, 1991) .
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The Establishment of Secondary Markets 7
exchange operate under an auction market environment without specialis ts
or m arket-m akers . Th e highest auth orit y of bo th securities exchanges is
the general meeting of members and the board of directors , which consists
of the chairman, vice-chairman, president and three managing directors .
A supervisory comm ittee oversees the day- to-day trading op erat ion. Th e
president is the legal representative who controls daily operation of the
exchange.
In 1992, th e SHSE and SZSE further s tand ardize d their tran sac tion s
through a sophisticated over-the-counter computer network known as the
Securi t ies Trading Automated Quotat ion System (STAQS), based on the
U.S. N A S D A Q .
4
Under this network, brokerage houses located throughout
th e cou ntry could pu rchase and sell s tocks and bon ds on behalf of investors ,
just l ike how the NASDAQ market worked in the U.S. . Trading is continu
ously conducted by an order-driven computerized matching system. Buy or
sell orders are put into the central computer either through the terminals
on th e floor or th e rem ote term ina ls at the brok er's office. T he bid and
offer prices and other transaction information are shown on every terminal
and transmitted through a satelli te system to all the member brokers na
t ionwide.
5
In that year, "share fever" really took hold. The trading volume
increased tenfold and the SHSE index quadrupled.
The business scope for SHSE and SZSE includes providing place and
facilities for trading and managing the settlement and delivery for all listed
stocks. The main duties of the exchanges include: (1) to formulate trading
rules; (2) to publish the trading information; (3) to report business and
management to relevant authorities; (4) to take technical and temporary
measures to suspend or s top the trading; (5) to deal with supervision; and
(6) to supervise lis ted companies and corporate members.
There are mainly two types of s tocks traded in SHSE and SZSE: A-
shares, which are bought and sold only by Chinese investors; and B-shares,
which are restricted to foreign investors.
6
Th ere is a com plication in B-
4
The sys tem provided members wi th rea l - t ime pr i ce quota t ions , d i rec t and indi rec t read
ing faci l i t ies , c learance and set t lement , t rading informat ion, f inancia l news and other
re la ted services .
5
Rea l - t ime qu ota t ion s from SHSE an d SZS E can now be p icked up anyw here on th e
m ain lan d , even in T i be t . Some 800 l is t ed com panie s , la rge and sm al l , can be b ou gh t
and sold by Chinese cit izens in any of the offices of the 700 brokerage firms that dot
China ' s towns and c i t i e s .
6
While the domes t i c share marke t has a t t rac ted the in te res t of more than a few loca l
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8 Developm ent of Chinese Stock Markets
shares trading since foreign exchange is under s tr ict control by the State
A dm inistra tion of Ex chang e Co ntrols . Subsc riptions, dividen ds, and cash
distributions to foreign shareholders are paid in foreign currencies (in U.S.
dollar at SHSE and in Hong Kong dollar at SZSE), based on the same-day
official exchange rate. Besides A- and B-shares, a company can issue shares
traded in foreign exchanges (subject to relevant authorities ' approval, of
course). The following is a list of China-related equity shares:
A -Shares: Th ey are sha res solely available to dom estic C hinese
investors . A-shares are denominated in the Chinese currency, ren
minbi (RM B), subscribed for and trad ed in RM B by dom estic in
vestors. A-shares can be further classified into four categories ac
cording to the ownership: s ta te shares (held by the governm ent
or its agencies), legal-person shares (held by other companies or
institutions), employee shares, and individual shares (held by the
public) . Currently, shares held by the general public are the only
shares that can be traded on the exchanges, although a few em
ployee and legal-person shares are traded on STAQ. By the end of
1998, there were 842 lis ted A-shares in SHSE a nd SZSE with a to ta l
market capitalization of RMB 1,950.6 billion, equivalent to
24.43%
of GDP;
B-Shares: These securities have exactly the same ownership and
dividend rights as do A-shares but can be purchased (and held)
only by holders of foreign passports (including by those who hold a
Hong Kong passport) . The separat ion of A- and B-share markets
reflects the central government's policy of restricting the foreign
control of vital SOEs and its desire to prevent manipulation of
Ch ina's fledgling stock m arkets from ab road. M aintainin g a distinct
stock market for foreign investors in which they participate using
their own currency also helps prevent the devaluation of renminbi
from excessive sales. As of December 1998, there were 103 Chinese
companies selling B-shares worth U.S.$4.37 billion
H-Shares: Th ese are the s tocks of SOE s incorp orated in mainla nd
but l is ted on the Hong Kong Stock Exchange (HKSE). H-share
specula tors , s t a t e t reasury b i l l s represent the mos t v iab le inves tment a l t e rna t ive for the
average r i sk-averse Chinese inves tor . As a resu l t , China ' s bond marke t s have deve loped
rapid ly s ince SHSE and SZSE were es tab l i shed . The annua l ra t e of i s suance has r i s en
dr am at ic al ly from 19 bi l lion yuan (US$2 .3 bi l lion) in 1991 to mo re tha n 190 bi ll ion
yuan (US$22.9 bil l ion) in 1996.
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The Establishment of Secondary Markets
9
issuers are subject to more stringent disclosure rules than A-share
issuers . H-shares are denominated in Hong Kong dollars and can
be traded by any investor. By the end of 1998, 43 firms had issued
H-shares.
Red C hips: Similar to H-sh ares, red chips are listed on th e HK SE .
Red chip issuers are typically companies controlled by mainland
government or SOE s but incorpo rated in Hong Ko ng. T he Hong
Kong entity is usually a shell corporation of the mainland coun
terpart and is capitalized through the public offering. It is usually
able to purchase assets located on the mainland through what is
know n as an "asset injection". T h e m ana ge rs of m any red chip
companies have excellent polit ical connections with the mainland
centra l adminis tra t ion.
L-Sh ares and N-S hares: Th ese are th e stocks of Chine se enterp rises
th at have chosen to list on either the Lon don Stock Exch ange (LSE)
or New York Stock Exchange (NYSE), respectively
7
N-shares are shares in Chinese companies that trade in the form
of American Depository Receipts (ADRs), especially those listed
on the NYSE. These companies are the best managed and most
profitable companies in China.
8
Table 1.1 and Figure 1.2 present ownership structure based on different
share types in Chinese stock markets .
As Tables 1.2, 1.3, and 1.4 and Figures 1.3 and 1.4 indicate, the amount
of capital raised, trading volume, turnover ratio and the total market cap
italization of the Chinese stock markets have increased significantly over
t ime. By th e end of 1998, the re were 842 com panies listed in the SHS E
and SZSE with market capitalization of RMB1,950.6 bill ion, equivalent to
24.43% of GDP. There were 1,011 listed securities including equity shares
(A- and B-shares), securities investment funds, government bonds (for both
spot and repo trading), corporate bonds, and corporate convertible bonds.
China's listed companies had issued a total of 74.61 billion shares in the
7
The f i r s t N-share l i s t ed on the NYSE was Br i l l i ance China Automot ive Hold ings , which
wen t publ ic in 1992. O ne L-share ex is ts on th e LSE , and is join t ly l i s ted in Hon g Ko ng.
8
Nine Chinese companies a re l i s t ed on the NYSE: Be i j ing Yanhua Pe t rochemica l Co. ;
China Eas te rn Ai r l ines Corp . ; China Southern Ai r l ines ; Guangshen Ra i lway Co. ; Hua-
neng Power In te rna t iona l Co. ; J i l in Chemica l Indus t r i a l Co. ; Shandong Huaneng Power
Dev e lopm ent ; Yan ahou Coa l Mining Co. ; and Shang ha i Pe t roc hem ica l Co. . An othe r
19 N-shares a re t rad ed over - the -counte r .
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48
Structural and Institutional Cha racteristics
Tab le 2 .2 Ow nersh ip of Shares on the Shangh a i and Shenzhen Secur i t i e s Exc han ges
1992
1993
1994
1995
1996
1997
Government
63.1%
59.9%
51.3%
56.7%
49.2%
45.7%
Percentage of Shares Held by
Legal Entities
9.9%
10.7%
18.0%
14.9%
17.5%
20.8%
Domestic
Individuals
21.0%
22.4%
9.8%
14.0%
17.6%
17.0%
Overseas Funds
& Individuals
5%
7%
20.9%
14.5%
15.8%
16.5%
jority stake in any listed company. Table 2.2 presents ownership of shares
on the Shanghai and Shenzhen Securities Exchanges. As shown on the ta
ble, of the o uts tan din g sh ares for any firm, only 30% can actually be tra de d
in Shanghai or Shenzhen. Government agencies own a large proportion of
to ta l stock, 46% in 1997, down from 63 % in 1992. T h e categ ory of legal
entities refers to legally co ns titut ed au ton om ou s org aniz ation s. It is cru
cial that in the Chinese case these legal entit ies are generally not mutual
funds, pension funds, or insurance companies, but are generally holding
companies established by government agencies as a management tool for
government-owned stocks. Thus, most Chinese observers consider them as
secondary government ownership of shares. Shares classified as government
of legal-entity owned are no t allowed to circulate on th e exch ange . T hu s,
approximately two-thirds of total share value on the securities exchanges
did not circulate.
6
8
I t should be noted tha t a f t e r the F i f t eenth Na t iona l Congress , re s t ruc tur ing of SOEs
involved a m uch mo re rapid ra te of ow nersh ip convers ion, increased pr iv at iz at io n, an d
much grea te r use of jo in t s tock corp ora t io ns . Go vernm ent l imi ta t ion s requi r ing th a t
the s t a t e main ta in major i ty or cont ro l l ing in te res t s were repea led .
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Listing Standards and Procedures
49
2 .4 L i s t in g S t a n d a r d s a n d P r o c e d u r e s
2 .4 .1 Req uirements for Stock Listings
Options available to a company for a stock exchange listing include:
Dom estic listing of A-shares;
Dom estic listing of B-shares;
Ov erseas listing of Foreign Inve stm ent Shares;
Re d-chip listing which can take various forms.
A company could list its domestic investment shares (in the form of A-
share s) or foreign inve stme nt shares (in the form of B-sha res) in Sha ng hai or
Shenzhen or its foreign investment shares on exchanges which have signed
a Memorandum of Understanding with the CSRC or under take a red-chip
listing. The relevant laws and regulations governing stock listings are the
Adm inistration of the Issuing and Trading of Shares Ten tative Regulations,
P.R.C. Com pany Law, and P.R.C. Securities La w.
2.4.1.1
A Shares
A-shares are different from other categories of domestic investment shares
such as state-owned shares. A-shares are domestic investment shares issued
by Chinese companies which are l isted on the SHSE and SZSE. A-shares
may only be subscribed by and traded among Chinese cit izens and/or en
t i t ies.
Under the
Adm inistration of the Issuing and Tra ding of Shares Tentative
Regulations prom ulga ted on April 22, 1993, before listing on th e SH SE or
SZSE, a shareholding company (also referred to as a joint stock limited
com pany) m ust first be established. Th e proced ure and requirem ents for
establishing a shareholding co mpa ny a re set out in th e Company Law. Note
that the minimum amount of registered capital is
renminbi
10 million which
has to be paid up in cash at the time of filing application and supported
by capital verification certificates.
A shareholding company must comply with the following criteria in
order to apply for listing:
The shares must be issued to the public (as opposed to a private
placement) ;
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50
Structural and Institutional Chara cteristics
T he to ta l sha re ca pital after a public offering m ust not be less th a n
renminbi
50 m illion;
The amount of share capital subscribed by sponsors must be at
least renminbi 30 million and m ust represe nt a t least 35% of th e
total share capital issued;
At least
25%
of th e shares must be issued to the public an d not m ore
th an 10% of this am oun t m ay be subscribed by the staff a nd work
ers. For Chinese companies with an issued share capital totaling a
nominal value of more than
renminbi
400 million, the perce ntag e
of shares issued to the public must account for not less than 10%
of the total shares of the company;
There must be more than 1,000 individual shareholders holding
shares with a nominal value of over
renminbi
1,000 and the total
nominal value of shares held by those individuals must be at least
renminbi
10 m illion;
Ex ce pt for a newly-formed com pan y limited by sha res, th e Chin ese
company must have made profits in each of the last three years;
If a shareholding is established by restru cturin g an existing e nter
prise, the existing enterprise must have a three-year track record of
earning profits;
Any other conditions imposed by the CSRC. (See the P.R.C. Se
curities Law.)
T h e
Securities Law
st ipulates that Chinese companies proposing to is
sue and l ist their A-shares must f irst be approved by the CSRC. The CSRC
must make a decision within three months from the date on which an ap
plication is received. The stock exchange from which a company is seeking
a listing is required to verify applications and make a final decision within
six m onth s from t h e da te on which an application is received. T he com
pany and the stock exchange should arrange for the procedure regarding
the listing of the shares once an application is approved. The Securities Law
also sets out general regulation on securities trading, continuing disclosure,
insider dealing and other prohibited trading acts on A shares.
2.4.1.2 B-Shares
Foreign investment shares may be l isted as B-shares on the SHSE or SZSE.
The term "B-shares", "domestically l isted foreign investment shares" and
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Listing Standards and Procedures
51
"special renmOT& z-denominated sha res" all refer to th e sam e th in g- or di na ry
shares of Chinese shareholding companies tha t are deno m inated in
renminbi
but traded in foreign currencies, such as U.S. dollars, on a Chinese securities
exchan ge. B-sha res can only be subscribed by and tra de d am ong foreign
legal and natural persons and other enti t ies, legal and natural persons from
Hong Kong, Macau and Taiwan, and Chinese cit izens who are resident
abroad.
The regulatory framework surrounding the issue of B-shares was sim
plified by the State Council in December 1995 by the introduction of Pro
visions on Listing of Foreign Investment Shares Inside China by a Share
holding Company
on December 25, 1995 and the
Provisions on Listing of
Foreign Investment Shares Inside China by a Shareholding Com pany: Im
plementing Rules on May 3, 1996. These provisions clarified the procedures
involved in applying for approval to issue B-shares. They also set out the
application procedures and approval requirements for companies seeking
to issue B-shares in order to increase their sha re cap ital . T he provisions
contain important matters such as information disclosure, and the trading
of B-shares by stock brokers and agents.
The key contents of the provisions on B-Share listings include the fol
lowing:
The CSRC is responsible for the regulation and supervision of the
issuing and trading of B-shares and related activities in relation to
B-shares;
In addition to the directors, supervisors and m anag ers of a B -share
company, other senior management personnel, including a share
holding company's chief financial officer, secretary and other exec
utives specified in the company's articles of association, owe duties
of good faith and diligence to the company;
Chinese citizens residing outside mainland Ch ina may purcha se B-
shares;
Th e derivative forms of B-shares, including w arra nts and dep ository
receipts, may be circulated and traded outside China.
The B-Share listing implementing rules set out further detailed provi
sions governing the issue and trading of B-shares. They expand upon the
application procedures set out in the B-share listing provisions to gain ap
proval for the issuance of B-shares and l ist the documents to be submitted
to the CSRC in support of an application. The key contents of the B-share
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52
Structural and Institutional Chara cteristics
listing implementing rules are as follows:
An over-allotment option (commonly known as a "Greenshoe") may
be granted by a Chinese shareholding company to the underwriters .
W ith the approval of th e CSR C, a comp any m ay set aside up to 15%
of th e tota l am oun t of the proposed B-share issue which con stitute s
th e option . Such reserved shares will be considered as pa rt of th e
issue;
T he distr ibu tio n period for B-sh ares may not exceed 90 day s;
T he governing law of the un derw riting agreement mu st be Chinese
laws;
W ith in 15 days after the closing d at e of th e initial sha re di stribu
tion, the lead underwriter must submit to the CSRC a distr ibution
report and a list of the 10 largest holders of its B-shares, and details
of their holdings. The distr ibution report must contain details of
the distr ibution process;
Domestic brokerage houses are required to report to the CSRC
details of the number of B-shares held by them as a result of par
ticipating in the underwriting of a B-share issue;
In addition to appo inting Chinese accounting and aud iting firms, B-
share companies may also appoint foreign accounting and auditing
firms that comply with the Chinese regulations to audit or review
their f inancial s tatements;
B-share companies must give prior notice to their auditors of dis
missal or non-renewal of appointment and the auditors are entit led
to present their views on any matter concerning the company's
financial s ituation before the company's shareholders in the an
nual meeting. The P.R.C. Securities Law (Article 213) s tates that
shares of Chinese companies designated for subscription and trad
ing by foreign investors (B-shares an H-shares) are governed by
measures separately formulated by the State Council .
B shares are subject to a s tr ict annu al qu ota system. Each year, the
State Council decides the amount of B-share quota in U.S. dollars for that
year. For example, the quota was US$1 billion in 1993. The B-share listing
provisions did not s tipulate l is ting venue. In practice, the Shanghai Securi
ties Exchange attracted bigger and more reputable companies to lis t their
shares.
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Listing Standards and Procedures
53
2.4.1.3 Overseas' Listing of Foreign Shares
All foreign listings must be approved by the CSRC and the foreign stock
exchange (and regulatory authority, such as the SEC in the case of a U.S.
listing ). Foreign shares (such as H-shares) m ust be issued in registered
form and denominated in renminbi even though they are traded in foreign
currenc ies. De pos itory receipts issued over H-sh ares are also tre at ed as
foreign shares.
Before a Chinese company can undertake an overseas listing at a desired
overseas exchange by means of a direct listing, the overseas exchange has to
sign a Memorandum of Understanding (MoU) with the CSRC. The MoU
deals with cross-border regulatory issues such as supervision, disclosure
requirements and securit ies enforcement.
In addition to complying with the requirements prescribed by the stock
exchange on which the shares are listed, a company seeking to list overseas
must also comply with the Articles of Association of Com panies Seeking
a Listing Ou tside the P.R.C. Prerequisite Clauses issued by the Securities
Office of the Restructuring Commission and effective as of September 19,
1994,
P.R.C. Company Law, and P.R.C. Securities Law. Key contents of
the Prerequisite Clauses include the following:
State enterprises to be restructured into shareholding companies
may have fewer than five promoters;
T he period betw een an overseas listing and a subse quen t issue m ay
be less than 12 months;
A 45-day w ritte n notice is required to convene sha reh old ers' m eet
ings;
A quorum of 50% of voting shares is required to convene a gen
eral meeting and shareholders must give a 20-day notice of their
intention to attend a general meeting;
T he articles of association are binding not only on a com pan y a nd
its shareholders, directors, supervisors and general managers, but
also on other senior officers including the chief financial officer and
secretary to the board;
Sha res issued outside C hina m ay be in th e form of w arra nts or othe r
derivatives subject to the approval of the State Council Securit ies
Com mission. An over-allotment optio n of up to 15% of th e t ot al
issue may be granted by an issuer to the underwriters;
Div idend s on overseas foreign share s should b e declared in renminbi
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54 Structural and Institutional Cha racteristics
and paid in foreign currency;
The register of holders of foreign invested shares listed outside
China may be kept abroad and maintained by an agent.
Cooperation between Hong Kong and mainland stock market regulators
sta rted in 1993 when th e issuance of H-shares on Hang Seng Stock Ex chan ge
was first pro po sed. By 1994 Hon g Kong was able to u p da te its legislation on
listing requirements of PRC issuers. In November 1994, legislators added to
Chapter 19 of Hong Kong Stock Exchange Ordinance a sub-clause known
as Chapter 19a, which was solely devoted to PRC issuers. Once listed on
the Hang Seng Stock Exchange, a PRC issuer is subject to all relevant Hong
Kong laws and requirements , including the Hong Kong code on takeovers
and mergers .
2.4.1.4 Red Chip Listing
Red-chip companies are those incorporated in Hong Kong and lis ted on the
Hong Kong Stock Exchange but with controlling shareholders from main
land Chinese entities. In the early stage of development in Chinese stock
markets, some companies had successfully bypassed the official listing chan
nels and gotten listed either through a backdoor listing or by acquiring a
Hong Kong "shell" company. After the CSRC was established, mainland
and Hong Kong regulators s tarted to cooperate and coordinate on red chip
issues. Both sides agreed that before granting lis ting to a mainland Chi
nese company, each side would inform the other of the nature of the listing,
comp any ty pe and other related information. Now adays red chip compa
nies are generally diversified conglomerates which have grown rapidly by
the injection of assets from their parent companies in mainland China.
Red-chip companies include China Telecom, Beijing Enterprises Holdings,
China Everbright, Shanghai Industrial Holdings, China Resources Enter
prises and the "window-companies" or "International Trust and Investment
Corporations (ITICs)" of provincial governments.
Until very recently, red-chip companies did not, strictly speaking, fall
within the supervision of main land Chinese auth orities . Therefore, th ey
were able to conduct restructuring and raise funds from overseas for new
investme nts easily. In J un e 1997, th e CSRC in conjunction w ith th e Sta te
Council introduced the Notice on Further Strengthening the Adm inistration
of the Listing and Issuing of Shares Overseas (also called the "Red Chip
No tice"). T he purpos e of the Red Chip Notice was to protect dom estic
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Listing Standards and Procedures 55
assets from being channeled overseas and from being sold off indirectly to
overseas investors at a discount. Th is is accomplished by pu rpo rtin g to
more str ingent requirements for reporting to, and obtaining approval from,
Chinese authorit ies. The Red Chip Notice targets both l isted and unlisted
companies registered outside mainland China.
The main content of the Red Chip Notice is as follows:
If a foreign listed com pan y is registered and co ntrolled by C hinese
shareholders and is undertaking a spin-off listing or additional issue
of shares, i t is subject to the supervision of the CSRC and the
major i ty shareholder must repor t to the CSRC.
Domestic shareholders that have held foreign and domestic assets
for three years or more who seek to inject their assets to a red chip
company may do so provided that prior consent is obtained from
the local provincial government or relevant department of the State
Council. Domestic assets held for less than three years may not be
used in connection with foreign share issues unless there are special
ci rcumstances that the CSRC deems to be appropr iate .
Consent on restructuring and subsequent equity offerings must be
obtained from the provincial government or relevant State Council
depar tment and a repor t must be made to the CSRC for examina
tion and final approval.
Acq uisit ion, sha re swap or othe r me tho ds of injecting assets into a
foreign Chinese holding company require similar relevant consent
f rom the CSRC.
7
2.4 .2 Procedures for Stock Listing
Although the capital markets in China has developed rapidly over the past
seven years, the central government st i l l commands considerable authority
over many structural aspects of market operations. A key element of this
authority is the l ist ing requirements and procedures which the CSRC con
trols. Together with the State Planning Commission, the State Council ,
the State Commission for Restructuring the Economy, and the Ministry of
Finance, the CSRC sets an annual quota for the total value of shares to
be brought to market. Once the quota has been established, a share of the
7
The CSRC has made i t c l ea r publ i c ly tha t i t s cons iders as se t in jec t ions as an unautho
rized sale of state assets , and approvals will only be issued in special cases.
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56
Structural and Institutional Cha racteristics
total allowance is allocated to each province, which then make their own
selections am ong local com panies who have applied for stock issues. T he
decision of th e provincial a uth orit ies rests ma inly on two factors: th e size of
the share-capital quota allocated to them and whether or not the company
is in a "key industry" which the government has chosen to promote. Hav
ing been selected, the selected enterprises are recommended to the CSRC
which will then review the selections made by individual provinces for final
approval.
This heavily-regulated method of selecting firms that go public has been
criticized by many experts as not being in the best interest of the public
investors . Critics point out that SOEs with capable management and fun
damentally sound balance sheets might be passed over in favor of other less
commercially viable f irms which happen to be in the government 's latest
key indu stry category. Altho ugh companies to be lis ted are required to
have earned annual profits of 10% per year for the past three years prior to
their initial public offerings and are supposedly the most promising SOEs,
those receive permission to issue shares are actually part of the slowest-
growing sector of the economy-a sector which accounts for only about 30%
of the cou ntry 's indu strial ou tp ut . Nevertheless, the CSR C has found its
control over the supply of shares useful in influencing market conditions
and investor sentiment. For example, when key market indices have gone
up sharply in June 1996, authorities began voicing their concern over the
formation of a bubb le in s tock valuation s. W hen their wa rnings did not
serve to s low the market 's r ise towards new highs, the CSRC announced it
would double the issue volume in 1997, allowing 30 billion renminbi (US$3.6
billion) worth of A and B -shares to be placed. By increasing th e sup ply
of s tock available for purchase, the CSRC hoped to soak up the specula
t ive demand rampaging in the market , thereby promoting a more s table
investing environment.
T he re are two steps involved in selecting an issuer for A share s. T h e
first stage involves provision of share issue quotas by the CSRC to each
provincial government, autonomous zone, municipality directly controlled
by the central government, and municipality with a separate economic plan.
Factors taken into consideration when allocating share issue quotas include
(1) the development of the economy of a particular province or a specific in
dustry, which is typically a result of the macroeconomic conditions at that
time; (2) applications by prospective A-share issuers to the local municipal
government or the relevant industrial department of the State Council; (3)
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Listing Standards and Procedures 57
recommendation by local municipal government or the relevant industrial
depar tment of the Sta te Council to the CSRC; (4) prel iminary examina
tion by the relevant departments of the CSRC; (5) opinion of the relevant
ministry which governs the industry in which the prospective A-share is
suer has made the petition; and (6) issues exceeding US$30 million must
be approved directly by the State Council .
T he second s tage involves gainin g initial approval from t h e relevant local
government or State Council ministry, submission of formal application
materials to the CSRC, review and approval by the issuing department
of the CSRC, and examination by the issuing examination committee of
the CSRC. Once the issuing examinat ion committee approves the A-share
issue, the CSRC decides the specific timing of the IPOs and will issue a
formal approval certificate.
The selection and approval process for B-share issuers is pretty much the
same as that for A-shares. The selection process involves recommendation
by the local municipal government or relevant industrial department of the
Sta te C ouncil and pre-selection by the CSR C. Th e approval process involves
initial exam ination by local mu nicipal government or the relevant ind ustria l
department of the State Council , submission of application materials to the
internat ional bus iness depar tment of the CSRC, examinat ion and approval
by the internat ional bus iness depar tment of the CSRC, and examinat ion
by the issuing examination committee of the CSRC.
All foreign listings must be approved by the CSRC and the foreign
stock exchanges on which listings are sought before any listing application
is made. In the past, Chinese companies have been approved by the CSRC
in batch es. T he latest ( the 5th) batch of Chinese comp anies when th is
book is w ritten included Wenzhou Infrastructu re, Ning bo Port , Zhejiang
Tourism, Hebei Expressway, Shandong Expressway, Guangdong Agricul
ture, Heilongjiang Agriculture, and Beijing Capital Airport.
In addition to the CSRC approval, any Chinese company seeking to
list its shares on an overseas stock exchange may have to receive approvals
from the State Council , the State Assets Bureau, the Ministry of State
Land and Resources, the State Development and Planning Commission, the
State Economic and Trade Commission, the prospective issuer 's supervising
ministry, and the overseas stock exchange on which the securities will be
lis ted. Typically the issuers ' advisors will undertake the preparation work
for the public offering before all of the aforementioned approvals have been
issued.
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Structural and Institutional Chara cteristics
A Chinese company seeking to issue and list foreign investment shares
outside China must complete a three s tage procedure. The firs t s tage in
volves mak ing an app lication to the local mun icipal government or th e m in
istry or department-in-charge of the relevant industry, which will review the
application and if the company is deemed appropriate, i ts application will
be sent to the CSRC. The second stage will involve a selection process
conducted by the CSRC in consultation with the relevant local municipal
governments or ministry or department-in-charge. A short l is t of success
ful com panies will be notified and th en released to th e public. T h e final
stage comprises the examination and approval by the CSRC during which
the CSRC will review prescribed documents in accordance with applicable
securities laws and regulations.
2 .5 M a r k e t M i c r o s t r u c t u r e
2.5 .1 Registration of Stock Dea lers
One of the most successful pieces of reform recently enacted by the State
Council included regulations to establish standards within the brokerage
industry. In addition to formally prohibiting insider trading and requiring
that all companies publicly disclose news which could affect share prices,
th e Manage men t Regu lations for Securities Industry imp osed th e following
provisions on all securities firms dealing with A-shares trading:
5% of all profits mu st be kept as reserves or m arg in s.
Adequate r isk-monitoring systems must be developed.
No m ore tha n 80% of a firm's as sets can be held in stocks.
Tw o-th irds of a securities firm's ma nag ers mus t be certified b y th e
CSRC.
No securities firm can buy m ore th an 20% of the o uts tan din g float
of a listed company during any given trading day.
Regulations for securities firms doing business in B-shares and H-shares
have also been issued recently. An imp ort an t p art of th e regu lation is
to require companies that have already lis ted their B-shares to undergo
an annual f inancial auditing based on International Accounting Standards
(IAS). Under these regulations, both foreign and domestic brokerage firms
must meet the following criteria to do business in China:
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Market Microstructure
59
Stock broke rs mu st have assets of at least 50 million
renminbi
(or
U.S.
$6.0 million).
T he y mus t have suitable trad ing sites and an extensive network of
sales and research staff.
Ov erseas brokers mu st be licensed by the C SRC every two years.
Dom estic brokers mu st be authorized by the Sta te A dm inistr ation
of Foreign Exchange (SAFE) to do business involving foreign cur
rency transact ions .
In addition to regulating the market by imposing rules on brokerage
houses, securities authorities have recently launched a crack-down on il
legal practices by investors , particu larly at the Shenzhen exchange. Th e
CSRC now officially prohibits the ownership of B-shares by P.R.C. citizens,
a l though many continue to mask such purchases by routing them through
a series of accou nts at different b an ks. In a further a tt em p t to prev ent
the rampant speculat ion in A-share markets , the PBOC has prohibi ted a l l
forms of margin trading.
8
2 . 5 . 2 General Rules for Trading
Securities that have been approved for listing and trading must be quoted
and traded on stock exchanges, and trading must be conducted by a public,
centralized post at competing prices. Securities firms cannot provide loans
or lend securities to th eir cu sto m ers . Officers a nd em ployees of stock ex
changes, securities firms, securities registration and clearing companies, and
securities regulatory authorities may not engage in s tock trading, whether
directly or indirectly.
9
Similarly, professionals who issue documents in con
nection with a share issue (e.g., audit reports, legal opinions, and so forth)
may not purchase or sell shares during and six months after the offering
period.
A company applying to list its shares must first be approved by the
CSRC, and the CSRC may authorize the s tock exchanges to verify and
8
U nd er th e cur ren t P .R .C . l aw, margin t rad ing is a c r imina l offense pu ni sh able as em
bezz lem ent . Al tho ugh t he Ch inese secur i t i e s indu s t ry i s no t rea lly governed by c r im ina l
l aw a t present , th i s ru l ing is pa r t i cu la r ly h a rsh as the embezz lem ent of mo re tha n 20 ,000
renminbi (US$2,400) ca r r ies the de a th pen a l ty .
9
T h e
P.R.C. Securities Law may
appear draconian to have imposed such a res t r i c t ion ,
but in fact s imi lar regulat ions had appeared in var ious regulat ions enacted in 1993.
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60
Structural and Institutional Cha racteristics
approve applications for l is ting of shares in accordance with s tatutory con
dition s and pro ced ures . T he stock exchanges will verify and decide on
applications and will , within s ix months after the applications have been
received, arrange for the shares in successful applications to be listed. The
government may encourage new listings of qualified enterprises in key in
du stria l sectors it deems ap pr op riat e. If a listed com pan y ceases to m eet
the conditions for listing prescribed in the
P.R.
C.
Company Law,
the lis ting
of its shares will be suspended or terminated. Furthermore, the CSRC may
autho rize the s tock exchanges to suspen d or term ina te lis tings in accordan ce
with the law.
After a company is listed in a stock exchange, it is required to prepare
and annou nce interim repo rts and ann ual rep orts . If a major event not
known to investors has occurred that may have serious impact on the price
of shares of a listed company, the listed company must immediately sub
mit a report to the CSRC and the relevant s tock exchange detailing the
occurrence of the event. Examples of major events include:
a ma jor change in th e com pany s business policies or scope of busi
ness;
a decision by th e com pan y on a ma jor inv estm ent or asset pu rcha se;
or
conclusion of a m ate rial con tract t h a t m ay have a m ajor effect on
the companys assets, liabilities, rights, interests or business results.
There is an exception under which a listed company having sufficient
reason to believe that the disclosure may harm its interests and that non
disclosure will not lead to major fluctuations in the share price, is not
required to make disclosure subject to the consent of the relevant stock
exchange.
T h e
P.R.C. Securities Law
s tr ictly prohibits people with knowledge of
inside information on securities trading from carrying out securities trans
actions by making use of that information.
10
No person w ith knowledge
of inside information on securities trading, and no person who has illegally
1 0
The te rm " ins ide in format ion" means in format ion , no t known to the pub l ic , tha t
rela tes to th e co m pa ny s busines s or f inancial affairs or th a t m ay have a ma jor effect
on the pr ice of th e com pan ys secur i t ies . T he desc r ipt ion "people wi th knowledge of
inside information on secur i t ies t rading" refers to : (1) d irectors , supervisors , managers ,
de pu t y man ager s and o ther sen io r mana gem ent per sonnel of a l i sted com pany ; (2 )
shareholders holding 5% or more of the shares in a company; (3) people who are able
to obtain company information concerning the t rading of i ts secur i t ies by vir tue of their
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Market Microstructure
61
obtained inside information, can purchase or sell securities of the relevant
company, divulge such information or counsel another person to purchase
or sell such securities.
Under the present
Securities Law,
the actual knowledge of inside in
formation is irrelevant in determining whether a person is a "person with
knowledge of inside inform ation" . In oth er words, a perso n is deem ed a
"person with knowledge of inside information" by virtue of the positions
and offices the person holds, and the duties and functions the person per
forms, in listed companies, professional intermediary firms and securities
regu latory auth orit ies . However, thi s inte rpre tatio n of th e definit ion cre
ates an anomalous result when applied to the ar t icle of the
Securities Law
that imposes an absolute prohibit ion on sale and purchase of securit ies by
a "person with knowledge of inside information". Th us , a person who is
able to obtain company information concerning the trading of i ts securit ies
by vir tue of the posit ion held in the company but who has not actually
obtained such information is prohibited to purchase or sell securities of the
company. I t is doubtful w hether th is anoma lous result is indeed intende d
by the legislators.
11
Apart from the prohibit ion on insider dealings, the P.R.C. Securities
Law
also proh ibits ma rket m anip ulation activit ies, the m aking of false state
ments in the trading of securit ies, and activit ies amounting to deception of
clients. Fu rthe r , the new law proh ibits state-owned a nd state-controlled
enterprises from engaging in share speculation.
Because the SHSE and SZSE are located in the same t ime zone, t rading
takes place in more or less the same hours, with only little differences in
each othe r 's ope ning, mid-session and closing tim es. Th e official tr ad in g
hours of the SHSE are from 9:30 AM to 11:30 AM and 13:00 PM to 15:00
PM for stock trading; 10:15 AM to 11:45 AM and 13:00 PM to 15:30 PM
pos i t ions in the com pany ; (4) pe rsonn e l of the CS RC and o ther regu la tory bod ies ; and
(5) re levant personnel of profess ional intermediary f i rms and securi t ies regis t ra t ion and
clear ing ins t i tut ions who part ic ipate in or oversee securi t ies t rading.
u
A t presen t , inside r dea l ing ac t iv i t i e s a re regula ted by the Provisional Measures on the
Prohibition of Dec eptive Secu rities Dealing Activities
( the
Deceptive D ealing Mea
sures)
of 1993. Al l f i rms and individuals are prohibi ted from engaging in the issue and
trading of securi t ies by making use of ins ide informat ion wi th a view to making profi ts
or avoiding losses . Actual knowledge and use of ins ide informat ion must be present for
an act of ins ider deal ing to occur . The Deceptive Dealing Measures does not con tain
an absolute prohibi t ion on sale and purchase of securi t ies in terms as broadly def ined
as those of
theP.R.C. Securities Law.
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62
Structural and Institutional Cha racteristics
for treasury bond; and 13:00 PM to 15:30 PM for treasury bond futures.
Trading holidays include January 1, the New Year 's Day; Chinese lunar
New Year 's week-long holidays; May 1, the International Labor Day; and
October 1-2, the National Day holidays. The official trading hours of the
SZSE are from 9:30 AM to 11:30 AM and 13:00 PM to 15:00 PM. The
SZSE has the same holiday schedule as the SHSE.
The trading cost is approximately 1.05% of the total value of the trans
action on the SHSE. This includes a brokerage fee of 0.7% of the gross
consideration (with a minimum trading fee of renminbi 5), a transfer fee
of 0.1 % of face value (minim um US $1), sta m p d ut y of 0.3% of the gross
consideration, and a clearing fee of US$4 per execution for individuals and
corporations (US$8 for custodians). There is no registration fee. The trad
ing cost is 1.00% of the total value of the transaction on the SZSE, a bit
less than the SHSE.
According to China's securities regulations, the lis ted securities in the
SHSE and SZSE must be t rade d thro ugh t he centra lized com peti t ive m ethod .
The securities exchanges are entit led to formulate trading rules which be
come effective after approv ed by th e S tat e Coun cil 's . Un der thes e rules,
investors who want to participate in the centralized competitive trading
must follow the procedure of opening accounts , entrustment, conclusions,
clearing and delivery, and transfer of accounts.
12
To trade in the SHSE and SZSE one must open separate securities
and cash accounts . At the end of a trade, adjustments on the amount of
securities and cash will be made in those accou nts . Investors must apply
for accounts directly through the registration department of the securities
exchanges or their securities dealers. However, both domestic and foreign
investors may entrust domestic and foreign securities dealers or agencies to
open an account of
renminbi
special share. The capital account is issued
for deposit of cash, clearing and receiving dividend. It must be opened by
th e investo rs at th e selected securities dea ler 's business place. T he ca sh
in the account is deposited in a bank by the dealers as current deposit ,
and the interests will be automatically put in the account. Investors have
a magnetic card and a deposit card for their securities account and cash
1 2
The method of non-cent ra l i zed compet i t ive t rad ing re fe rs to the process under which
inves tors t rade thei r securi t ies through buying and sel l ing, bid or auct ion in the rec
ognized marke t s out s ide the exchanges . Non-cent ra l i zed compet i t ive t rad ing marke t s
include securi t ies dealer ' s bus iness counters , local securi t ies exchange centre and secu
ri t ies offering price system.
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63
account.
In buy ing and selling secu rities, th e comm ission principa l (inve stor) shall
fill in th e comm ission shee t. T he com mission sheet is printe d by th e dealers
according to the requirements set forth by the exchanges. The commission
sheet shall list the name of the commission principal, shareholder 's code
number, the date and time of commission, the kind of securities, the volume
and face price, the commission price, effective date, etc.. The commission
may be m ade throu gh writ ten form, by telephone, fax, cable, etc. . In
Shanghai and Shenzhen, securities dealers are prohibited from accepting
the full commission which delegates the dealers with the power to decide
the kind, volume and price of the traded securities. Securities dealers are
also prohibited from accepting the commission of trust trading.
Although both the SHSE and SZSE use computer systems to reach con
clusion through centralized competitive price, they have some differences
carrying out orders. On the SHSE, the representatives of the dealers, who
sit in the exchange hall , are the actual operators who make the conclusion
throu gh the comp uter system. On the SZSE, despi te th at th ere are rep
resentatives of the dealers who sit in the exchange, the actual operators
are the dealers themselves who may enter the orders from their business
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