Financial Reforms in China The Chinese Securities Markets An Overview Anthony Neoh Wharton School, Apr. 2002

Financial Reforms in China

The Chinese Securities MarketsAn Overview

Anthony NeohWharton School, Apr. 2002

Disclaimer

The views expressed here are personal and do not necessarily represent the views of any public or private institution in or out of the People’s Republic of China.

Table of Contents

Fundamental ideas behind securities laws – functions of securities markets.Structure of securities markets.Rationale for regulation.Objectives of regulation.Pre-conditions for effective regulation.Historical perspectives of the Chinese Securities Market.Core issues for the future.Recent regulatory steps. Performance of the market.

Functions of Securities MarketsThe Theory

1. Facilitate accumulation of capital and higher productivity, thus promoting economic development.


2. Allocate savings by way of investments in businesses and public enterprises which create the optimal expected returns (presumption of the ‘risk averse’ investor).

Rr =Rrf + β(Rm – Rrf)

Rr = Required Return

Rrf = Risk Free Return

Rm = Expected Market Return

β = Volatility of Investment over Market Volatility


3. Provide price formation mechanisms and set benchmarks for value in the economy.


4. Promote efficiencies in businesses and public enterprise (presumption of the rational manager who is aware of his cost of capital).

Functions of Securities Markets:The Practice

1. They do facilitate accumulation of capital, but that does not always result in higher productivity, but the ‘wealth effect’ of a growing market spurs consumption and creates economic growth in the short term.


2. Risk aversion is displaced by stories which turns out to be pipedreams (“The emperor’s new clothes syndrome” prevails over the presumption of “risk aversion” in a rational order).


3. They do provide benchmarks for valuation when the markets are mature, but even then, “apples with apples” comparisons are needed but are not often heeded.

=


4. Awareness of the cost of capital only arises when investors require it.

A test on Market Function

ProductivityAllocativeEfficiency

ValuationBenchmark

Awareness ofCost of Capital

US 8 8 6 8Japan 6 6 5 6China (Ex HK and Taiwan) 3 3 2 3

Structure of Securities Markets:The World Trend

1. Open architecture of investment instruments: All kinds of obligations can be transformed into transferable securities.

2. Open architecture of risk transfer: All kinds of future and option obligations are permissible.

3. Open architecture of trading, clearing and settlement: All kinds of price discovery and trading systems can be linked to all kinds of clearing and settlement systems.

4. Open architecture of authorisation: Multi-jurisdictional authorisation of public offerings and collective investments in sight, as are mutual recognition of qualifications of practitoners. The European passport is a case in point.

5. Open architecture in intermediation: Financial service providers are offering all kinds of financial services regardless of traditional classifications.

The Structure of Securities Markets:Emerging Markets

1. Closed architecture of investment instruments: Individual instruments require prior authorisation by different public authorities.

2. Closed architecture of risk transfer: Prior authorisation of individual instruments required and few are generally authorised.

3. Closed architecture of trading, clearing and settlement: Monopolistic arrangements are usually in place in the name of better supervision.

4. Closed architecture of authorisation: Strict requirements often favoring domestic entities.

5. Closed architecture of intermediation: Although strict Glass-Steagall type walls are falling, there is still institutionally divided regulation which makes it difficult for intermediaries to offer a wide range of financial services.

A Test on market structure

Range of instruments

Range of risk transfer insturments

Range of trading, clearing and settlement

Range of intermediaries


The rationale for regulation

1. The self regulation argument : That has prevailed in many markets. In London it survived till 1986.

2. The public law intervention argument: The industry is too self interested to police itself and so public law has to intervene to protect consumers among the general public.

3. The merit vs. disclosure argument: Those for “merit” protection argue that they should judge the quality of the products that should be unleashed on the public. Those for “disclosure” argue that the public should judge for themselves so long as the disclosures are full.

4. The private and public enforcement argument: few stand on opposite sides of this argument, but many emerging markets do not have the legal systems capable of private enforcement.

The IOSCO Objectives and Principles of Securities Regulation

1. Protection of Investors.2. Ensure fair, efficient and

transparent markets.3. Reduce systemic risks in the

financial system.

Protection of Investors

1. From misleading, manipulative or fraudulent practices, including insider trading, front running clients and misuse of client assets.

2. Ensuring full disclosure of information material to investors’ decision, a key part being accounting and financial forecast information.

3. Ensuring only qualified persons are allowed as intermediaries by a system of prior authorisation.

4. Exercising adequate supervision over intermediaries.

5. Enforcing the rules effectively.

Ensuring fair, efficient and transparent markets

1. Ensuring prior authorisation of marker operators.2. Ensuring fair competition in the operation of

markets.3. Ensuring timely and widespread dissemination of

trading information and that such information is fully reflected in the securities prices.

4. Ensuring transparency of all trading information.

Reducing systemic risk to the Financial System

1. Reduce the risk of failure of intermediaries.2. Knowing at all times the risks undertaken by

firms and ensuring that they have adequate systems to manage risks.

3. Ensuring that there are workable procedures to isolate single failures from contaminating the whole financial system.

UK Financial Services and Markets Act 2000 : Objectives

Promote confidence in the financial system.Promote public awareness of the financial system.Protection of consumers of financial services.Reduction of financial crime through better supervision of intermediaries and vigilant enforcement of the prohibition against unauthorized activities.

US 1933, 1934 Acts: Objectives

Provide full and fair disclosure of the character of securities sold in interstate and foreign commerce, and prevent frauds in the sale thereof (1933).

Provide for the regulation of securities exchanges and of over-the-counter markets operating in interstate and foreign commerce and through the mails, to prevent inequitable and unfair practices on such exchanges and markets (1934).

Chinese Securities Law: Objectives

To regulate the issue and trading of securities.

To protect the legal rights of investors.

To promote the development of a socialist economy

The necessary conditions for effective securities regulation

1. Openness and fairness: In allowing competition and application of the rules.

2. Cost benefit assessment : Ensuring that the benefit of regulatory measures is proportionate to the burdens placed on the market.

3. Effective legal system: With a commercial and civil code sufficient to deal with most contractual and tortious issues and a wide range of private and public law remedies.

4. Effective tax system: Effective collection and tax rates inculcating effective incentives.

5. Effective accounting framework: Allowing meaning to disclosures.

The necessary conditions for effective securities regulation (Cont’d)

6. Effective banking system: Allowing effective payment and custodian systems and firms to get short and long term capital.

7. Effective pensions and insurance systems: Allowing firms to manage the issue of retirement of their staff and their general risks.

8. Effective Companies and Bankruptcy laws: Allowing markets to nurture high standards of corporate governance and protection of shareholders and creditor rights.

9. Effective Dispute Resolution System: Both within and without the judiciary

A test on regulatory environment

Competitivenesscost benefitanalysis

legalsystem

taxsystem

accountingframework

US 9 8 8 8 8Japan 6 6 6 5 5China (Ex HK and Taiwan) 3 2 2 2 3

banking systempensions andinsurance

company andbankruptcy laws

disputeresolution


US

0

10Productivity

Allocative Efficiency

Valuation Benchmark

Awareness of Cost of Capital





Competitiveness

cost benefit analysis

legal system

tax system

accounting framework

banking system

pensions and insurance

company and bankruptcy laws

dispute resolution

Japan

0

10

Productivity


Valuation Benchmark






Competitiveness


legal system

tax system


banking system



dispute resolution

China (Ex HK and Taiwan)

0

10Productivity


Valuation Benchmark






Competitiveness


legal system

tax system


banking system



dispute resolution

Market Capitalization(100 million Yuan)

0

10000

20000

30000

40000

50000

60000

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Total Market Capitalization Market Float

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Total Cap 1048. 13 3531. 01 3690. 61 3474. 28 9842. 38 17529. 24 19505. 64 26471. 17 48090. 94 43522. 20

Market Fl oat 861. 62 968. 89 938. 22 2867. 03 5204. 42 5745. 59 8213. 97 16087. 52 14463. 17

No. of Listed Companies

0

200

400

600

800

1000

1200

1400

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Domestic(A、B share） Overseas（H share）

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Domesti c(A B share、） 53 182 291 323 530 745 851 949 1088 1160Overseas H share（） 6 15 18 25 42 43 46 52 55

Money raised in the Market(100 million Yuan)

0

500

1000

1500

2000

2500

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Total Money raised Domestic（A Share） Foreign（B、H Share）

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001Total raised 94. 09 375. 47 326. 78 150. 32 425. 08 1293. 82 841. 52 944. 56 2103. 08 1168. 61Domestic 50 276. 41 99. 78 85. 51 294. 34 853. 06 778. 02 893. 6 1665. 22 1097. 9Foreign 44. 09 99. 06 227 64. 81 130. 74 469. 53 63. 5 47. 17 576. 21 70. 2

Money raised by Red chips(100 million US dollars)

0

20

40

60

80

100

120

140

160

1993 1994 1995 1996 1997 1998 1999 2000 2001

1993 1994 1995 1996 1997 1998 1999 2000 2001Money rai sed 23. 42 12. 86 7. 07 23. 2 123. 15 14. 155 36. 6 142. 74 19. 2

Global Market ComparisonOrder Market Market Capitalisation

USD billionConcentration Turnover velocity

1. NYSE 11,535 57.1% 87.7%2. Nasdaq 3,597 75.9% 383.9%3. Tokyo 2,962 70.5% 58.8%4. London 2,475 78.3% 69.3%5. Paris 1350 86.2% 268.8%6. Frankfurt 1186 45.3% 128.6%7. Toronto 756 75.5% 75.0%8. China (HongKong) 624 65.4% 60.9%9. China (domestic) 622 2.73% 500%10 China (Taiwan) 237 52.9%% 259.3%

Notes:

1. All figures (except the figures relating to China’s domestic exchanges are takenfrom http//:www.fibv.com, the web site of the international organisation ofstock exchanges.

2. The figures relating to China’s domestic exchanges are taken from CSRC’sown database.

3. All figures relate to the period 1 January to 31 December 2000.4. Concentration means the total turnover of the companies making up 5% of the

total market capitalisation expressed as a percentage of the total turnover of thewhole market for the year. If liquid market capitalisation is taken into account,concentration is about 5% in China’s domestic markets.

5. Turnover velocity is the total turnover for the year expressed as a percentage ofthe total market capitalisation. Turnover velocity has in fact climbed downfrom the 1996 high of 913% in Shanghai and 1350.3% in Shenzhen.

8% 10% 16% 18% 20%32%

PetroChina Sinopec China Unicom China Mobile CNOOC China Aluminum

5-day turnover after the IPO date/IPO size (Non lock-up portion)

13%5%

151%123%122%

66%

Shanghai PudongDevelopment Bank

Shanghai PortContainer

Sinopec China Minsheng Bank Huaneng Power Bao Steel

5-day turnover after the IPO date/IPO size (Non lock-up portion)

Investor behaviour (“flipping”) analysis for selected A-share stocks

Investor behaviour (“flipping”) on selected H-share/Red-chip stocks

Low quality demand is visible in the after market

Source: Bloomberg, Bondware, JPMorgan estimates

Core issues for the future

Creation of better regulatory environment.

Create a more complete market structure.

Dealing with pensions and life insurance.

China (Ex HK and Taiwan)

0

10Productivity


Valuation Benchmark






Competitiveness


legal system

tax system


banking system



dispute resolution

US

0

10Productivity


Valuation Benchmark






Competitiveness


legal system

tax system


banking system



dispute resolution

Savers and Dis-savers

United Kingdom

20%

35%

30%

2000 20502010 2020 20402030

25%

United States

10%

30%

20%

1950 20501970 1990 20302010

Japan

15%

40%

25%

20%

35%

30%

1990 20502010 2020 204020302000

Australia

15%

35%

25%

1990 20502010 2020 204020302000

China

5%

35%

15%

25%

1990 20502010 2020 204020302000

Source: US Census Bureau

15%

35%

25%

Canada

2000 20502010 2020 20402030

Prime Savers(40-59 yrs)

Dissavers(60+ yrs)

The Pensions System

Pillar I : A Publicly administered defined benefit basic retirement benefit to all workers to be funded though a social security tax.

Pillar II: A Publicly administered defined contribution retirement benefit based on contribution by workers to their own individual accounts.

Pillar III: Privately run retirement supplementary schemes.

Social Security Fund

Set up to invest Government assets, including proceeds from IPOs, Government owned shares (to be sold thru ETFs or individually).

Initial investment restricted to risk free assets.

Will in time need to loosen restrictions to achieve reasonable return.

Bank Deposits by individuals(in units of 100 million RMB)

0

10000

20000

30000

40000

50000

60000

70000

Total Cities Farmers

Outstanding Government Bonds(100 million Yuan)

02000400060008000

10000120001400016000

Recent Regulatory Steps

State Council in Feb. 2001, allowed Chinese residents with foreign exchange deposits to buy and sell B shares. CSRC cracking down on market manipulation and insider trading.Central Bank crack down on illegal loans for stock market speculation. Article 133.CSRC crackdown on guaranteed investment return schemes by stock brokers. Article 143.CSRC crackdown on stock investment by listed companies.CSRC from July 2001 approving 7 public offerings of Govt. owned shares, but stopped in October 2001.CSRC requiring double audits (by PRC CPAs and international ‘Big 5” CPAs) for companies listing and making secondary offerings.

Performance of the A and B share markets Jan.1999 to Jan.2002

.SSEA, Close(Last Trade) [Line] .SSEB Daily04Jan99 - 01Feb02

Jan99 Mar May Jul Sep Nov Jan00 Mar May Jul Sep Nov Jan01 Mar May Jul Sep Nov Jan02

PrCNY

1200

1300

1400

1500

1600

1700

1800

1900

2000

2100

2200

PrUSD

20

40

60

80

100

120

140

160

180

200

220

Comments welcomed

[email protected]

Documents

Financial Reforms in China The Chinese Securities Markets An Overview Anthony Neoh Wharton School, Apr. 2002