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Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized

Anjali Kumar Kwang Jun Anthony Saunders Susan Selwyn Yan Sun Dimitri Vittas David Wilton

FINANClAL TIMES Financial Publishing Asia Pacific Published by FT Financial Publishing Asia Pacific An imprint of Pearson Professional Asia Pacific

Suite 1808 Asian House 1 Hennessy Road Wan Chai Hong Kong Tel: (852) 2863 2600 Fax: (852) 2520 6646 Internet: [email protected] Web: www.pearson-pro.com.hk

O 1997 The World

Conditions of Sale All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, ortransmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the Publishers.

No responsibility for loss occasioned to any person acting or refraining from action as a result of the material in this publication can be accepted by the Author or Publishers.

First edition 1997

Printed in Hong Kong

ISBN 962 661 048 4

Publisher's note The findings, interpretations and conclusions expressed in this study are the results of research supported by the World Bank, but they are entirely those of the author and should not be attributed in any manner to the World Bank, to its affiliated organisations, or to members of its Board of Executive Directors or the countries they represent. CONTENTS

vii Tables in Text. .. . Figures in Text Vlll Statistical Appendix X Equivalents, Fiscal Year, Weights and Measures xii Acronyms and Abbreviations xiii Acknowledgements xvi

1. THE CONTEXT OF CAPITAL DEVELOPMENT 's Capital Markets: Central Questions The Growth of China's Capital Markets The Role of Capital Markets in China's Economy

2. THE REGULATORY FRAMEWORK

Introduction Principles of Securities Market Regulation: Relevance for China The Regulatory Framework Regulation of Securities lssue and Trading: An Evaluation Regulation of Participating Institutions Distribution of Oversight within the Government Annex 2.1 China: Laws and Regulations Related to Securities Activities Annex 2.2 Central and Local Authorities' Approvals Required for Annex 2.3 Central and Local Regulations: Listing Criteria Annex 2.4 The Trading Systems Annex 2.5 Restrictions Against Insider Dealing Annex 2.6 Regulation of Securities Dealers

3. DOMESTIC MARKETS Introduction The lssue Method Secondary Markets in Securities 4. EQUITY MARKET PERFORMANCE

Introduction: Equity Markets and the Shareholding System Characteristics of China's Equity Markets The New Issue Process and Public Offerings Price and Returns to lnvestors Market Integration: Current and Potential Other Issues: Enterprise Debt Securities Annex 4.1 Clearance, and Depository Systems Annex 4.2 Technical Note on the Analysis of Equity Markets

5. INTERNA1-IONALISKrION OF CHINA'S SECURITIES MARKETS

The Scope for Safe Participation in lnternational Securities Markets lnternational Participation in China's Equity Issues The Performance of China's Overseas Equity Listings Opening of Fixed-Income Securities Markets China's Access to Overseas Securities Markets Trading in Derivative Instruments on lnternational Markets

6. INSTITUTIONAL lNVESTORS

Institutional lnvestors and Securities Markets The Insurance Industry in China The Pension System Housing Funds Mutual Funds Annex 6.1 Glossary on Contractual Savings Institutions Annex 6.2 Institutional lnvestors in Hong Kong

7. CONCLUSIONS AND RECOMMENDATIONS Conclusions Suggested Policy Changes

REFERENCES

STATISTICAL APPENDIX TABLES IN TEXT

Contribution of Capital Markets to Real Sector Investment Purchases: Households and Non-Households Treasury Bill Rate, Deposit Rates and Comparison of Coupon and Deposit Rates, and Comparison of Coupon on Treasury Bills Sales by Purchaser: Households, Enterprises, and Financial Institutions Tradability of 1994 Treasury Bill Issues China: Spot and Futures Trading of Bonds Ratio of Bond Trading Value to Stock Outstanding Trading in Repurchase Agreements Concentration Ratios of Member Firms Trading on the Shanghai (January 1995) Concentration of Trading on China's Securities Exchanges China's Equity Markets: Underpricing of New Share issues IPO Underpricing Worldwide Trading on China's Equity Markets: Returns and Volatility Chinese Companies with ADR and GDR Programmes (December I 994) China Closed-End Country Funds: Discounts/Premiums Average Spread on Floating Rate Medium and Term Bond lssues China Underwriting Performance of the People's Insurance Company of China (1 992193) China and Other Countries: Basic Equation of Social Pension System China Projected Basic Equation of Social Pension System FIGURES IN TEXT

Growth of Securities Issued and Outstanding (1981 -1 993) 2 Volatility in China's Securities Trading 4 Growth of the Equities Market 6 Secondary Markets in China's Securities 7 China and Other Emerging Equity Markets: A Comparison (1 993) 8 Securities Markets in China's Financial Sector 11 Central Government Budgetary Deficit and Treasury Bond Issues 16 Share of Bonds in China's Overseas Borrowing 20 China: Composition of Outstanding Debt Issues 82 Outstanding Debt Composition Disaggregated 84 China: Trading Value of Bonds 100 Ratios of Trading Volume of Debt to Debt Stock and to GDP 101 Ratios of Debt Stock Outstanding to GDP: China and Other Countries 102 Regional Bond Yield Differentials (1 990) 108 Yield Differentials between Treasury Bills on Principal Markets: 1994 (Shanghai, Wuhan and Shenzhen) 108 China: Secondary Market 11 0 China: Bond Yield, Deposit Rate and Inflation 11 1 Equity Index and Average Bond Yield 11 2 Average Daily Trading Value of Shares 122 Shanghai Securities Exchange 125 China: A Stylised IPO Process: Post-Offer to the Beginning of Trading 130 Initial Offerings of Shanghai A and B Shares 132 Risk-Adjusted Returns to lPOs at Shanghai 135 China: Shanghai and Shenzhen Share Indices and Volume of Trade 143 Shanghai and Shenzhen: Share Price Variance 1 44 Spreads between Shanghai and Shenzhen A and B Shares 150 Discounts on Shares Listed in Overseas Exchanges 151 Private Capital Flows to China 179 China and Other Emerging Markets: Participation in International Capital Flows 180 China and Mexico Inflows 181 Country Funds - Average Discount 193 lnternational Bond Issues by Chinese Borrowers: Currency, Type and China: lnternational Syndicated China: Maturities and Spreads on lnternational Syndicated Loans China: lnsurance Premium Growth (1986 -1 992) China: lnternational Comparison of lnsurance Premiums (1 992) China: Comparison of the Life and Non-life Structure of lnsurance with Selected Countries China: lnsurance Premiums by Line (1 992) China: Comparisions of the Performance of the lnsurance Industry in Selected Countries STATISTICAL APPENDIX

Al.l China: Debt Securities Issued and Outstanding A1.2 China: Trade in Securities A1.3 China: Securities Trading on the Shanghai Exchange in 1994 (January1994 to January 1995) A1.4 China: Securities Markets and the Financial Sector A1.5 Financing of the Government Deficit: Contribution of Bond Issues A1.6 China: Contribution of Securities Markets to Investment A1.7 China: Overseas Debt and Capital Markets (1987 -1 993) A2.1 China: Structure Of Securities Regulation A2.2 Structures of Regulation in Asian Securities Markets A2.3 Minimum Listing Requirements of Major Stock Markets A3.1 China: Securities Trading by Region A3.2 Monthly Transaction Volume in the lnterbank Market A3.3 Assets of Financial Institutions Engaged in the lnterbank Market A4.1 China: Key Characteristics of the Equities Markets of Shanghai and Shenzhen A4.2 China: Size and Growth of China's Equities Markets (1991 -1 994) A4.3 Trading Value of Equities (1991 -1 994) A4.4 China: Trading Volume of Securities Per Day (1991 -94) A4.5 Trading Value of Inter-Linked Trading Centres (Linked to Shanghai) (January 1995) A4.6 China: Stock Trading Centres A4.7 Shanghai Securities Exchange: Trading Summary of Sectoral A4.8 Initial Quotas (1993) A4.9 China and Other Emerging Equity Markets: Relative Size and Market Liquidity (1994) A4.10 China and Other Emerging Equity Markets: Growth (1989 -1 993) A4.11 China and Other Emerging Equity Markets: Volatility (1993 -1 994) A5.1 International B and H Share Offerings by Chinese Issuers A5.2 China's Overseas Share Listings (Hong Kong and New York) A5.3 Country Funds: Trends in Total Returns A5.4 Ratings of Chinese Borrowers A5.5 Sovereign Rating Selected Developing Countries A5.6 China: Overseas Bond Issuing lnstitutions B5.1 Limits on Equity Participation by Foreign B5.2 Foreign Exchange Controls on Portfolio lnvestment Capital Gains and B5.3 Taxation of Dividends and Capital Gains of Foreigners Investing in Emerging Markets A6.1 China: lnsurance Premium Growth (1986 -92) A6.2 China: International Comparison Of lnsurance Premiums (1 992) A6.3 China: Comparisons of Growth of lnsurance Penetration A6.4 China: Comparisons of the Structure of Life and Non-life lnsurance (1 992) A6.5 China: Comparisons of the Performance of the lnsurance Industry in Selected Countries A6.6 China: Assets and Liabilities of the People's lnsurance Company (1 992193) B6.1 lnvestment Patterns of Contractual Savings lnstitutions CURRENCY EQUIVALENTS

Currency Unit: Renminbi (Rmb)

(Nominal Official Period Average Rates)

Year Rmb per US$

1996 (January to June) 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986

FISCAL YEAR

1 January - 3'1 December

WEIGHTS AND MEASURES

Metric System ACRONYMS AND ABBREVIATIONS

ABC Agricultural Bank of China ADD American Depository ADR American Depository Receipts AIA American lnternational Assurance AIG American lnsurance Group AMEX American Stock Exchange AMSET Association of Members of the Stock Exchange of Thailand BAPEPAM Badan Pelaksana Pasar Modal ( Executive Agency) (Indonesia) BOC Bank of China BOCOM Bank of Communications BOT Build-Operate-Transfer CAlC Chinese American lnsurance Company CBOE Chicago Board Options Exchange CD Certificate of Deposit CIB China lnvestment Bank ClTlC China lnternational Trust and lnvestment C PA Certified Public Accountant CPF Central Provident Fund CPlC China Pacific lnsurance Company CSRC China Regulatory Commission CSTS China Securities Trading System Corporation Ltd DM Deutschemark D R Depository Receipt DTC Depository Trust Company FDI Foreign Direct lnvestment FlBV Federation Internationale des Bourses de Valeurs FSD Financial Sector Development Department (of the World Bank) GATT General Agreement on Tariffs and Trade GDP Gross Domestic Product GDRs Global Depository Receipts GlTlC Guangdong Industrial Trust and lnvestment Corporation GNP Gross National Product lBCA lnternational Credit Agency (originally; today officially IBCA. An international headquartered in London). ICBC Industrial and Commercial Bank of China IEC lnternational Economics Department (of the World Bank) IFC lnternational Finance Corporation IF1 lnternational Financial Institutions IMF lnternational Monetary Fund IOSCO lnternational Organisation of Securities Commissions IPO ISC International Securities Consultancy lTlC lnternational Trust and lnvestment Corporation ITS lntermarket Trading System JCR Japan Credit Rating Agency Limited KS DA Korean Securities Dealers Association LTS Local Tax Service MAS Monetary Authority of Singapore MlCEX Moscow Interbank Currency Exchange MOF Ministry of Finance MOFTEC Ministry of Foreign Trade and Economic Relations MOU Memorandum of Understanding National Association of Securities Dealers Automated Quotation System NETS National Electronic Trading System NBFl Nonbank Financial Institution NIS Nippon Service NSCC National Securities Corporation NYSE OEC D Organisation for Economic Co-operation and Development OTC Over-the-counter PAlC Ping An lnsurance Company PASBD Philippine Association of and Dealers PBC People's Bank of China PCBC People's Construction Bank of China PDB Pudong Development Bank PlCC People's Insurance Company of China Portal An OTC cross-border clearing system PRC People's Republic of China QlB Qualified Institutional Buyers RADRs Restricted American Depository Receipts S&P Standard and Poors SAEC State Administration for Exchange Control SC Securities Commission (Malaysia) SCRES State Commission for Restructuring the Economic System SCSC State Council Securities Policy Committee SDB State Development Bank of China SEAQ Stock Exchange Automatic Quotation System SEBl Securities Exchange Board of India SEC Securities Exchange Commission SEEC Securities Exchange Executive Council SES Stock Exchange of Singapore SESDAQ SES Dealing and Automated Quotation System Market SETC State Economic and Trade Corporation SEZs Special Economic Zones SFC Securities and Futures Commission (Hong Kong) SFR Swiss Franc SHSE Shanghai Securities Exchange SlTlCO Shanghai International Trust and lnvestment Corporation SOEs State-Owned Enterprises SOU State-Owned Unit SPC State Planning Commission SRC System Reform Commission SSB Securities Supervisory Board (Korea) STAQS Securities Trading Automated Quotations System SZSE Shenzhen Stock Exchange T Bill Treasury Bill T Bond Treasury Bond TICS Trust and lnvestment TSD A Taipei Securities Dealers Association TSE UCC Urban Credit Co-operative US United States of America YTM ACKNOWLEDGEMENTS

This study is the outcome of an investigation of China's capital markets undertaken jointly by the World Bank and the China Securities Regulatory Commission. Its results are based on the findings of a preparatory visit to China in August 1994, followed by a fully-fledged investigative study in October 1994. In addition to discussions in Beijing, the team visited securities trading centres and market participants at Shanghai, Shenzhen, Wuhan, Tianjin and Hong Kong.

Numerous persons have contributed to this study. The World Bank team was led by Anjali Kumar of the China and Mongolia Department (task manager); and included David Wilton, (bond markets) and Dimitri Vittas, (contractual savings) of the Financial Sector Development Department; Kwang Jun (international aspects) of the International Economics Department; and consultants Professor Anthony Saunders (Salomon Centre, New York University; equities markets), Susan Selwyn (International Securities Consultancy, Hong Kong; securities regulation); and Sun Yan, (Columbia University; equity market data analysis). Edgardo Barandiaran and others at the World Bank's Beijing office organised the work in China, and Vikram INehru participated in the mission. Julia Li provided major inputs on the marco framework and on equity markets; Subir Lall helped with the analysis of China Funds and China's overseas bonds; Bo Wang helped to decode bond data; Don Mclsaac provided the glossary on insurance; Yan Wang undertook equity market comparisons with other countries; Cathy Song helped with mission preparation and Adelma Bowrin undertook the considerable responsibility of report production. The report benefited from the generous information and comments provided by the IMF (notably Marc Quintyn and Michael Spencer) and the excellent collaboration of the IFC (Peter Wall, Sara Ugarte, Rashad Kaldany, Ravi Vish, Jiansheng Wang, Jun Zhang, Claudia Morgenstern), in terms of sharing data and co-ordinating technical assistance and investigative studies.

The Chinese team was led by Fu Feng Xiang, (Vice Chairman, CSRC), and Bei Duo Guang, Deputy Director of the International Department, and principal counterpart to the World Bank. Numerous other persons from the CSRC contributed, particularly, Xu Ya Ping, Nie Qing Ping, Yang Zhi Hua, Jesse Wang, Gao Xi Qing and Song Li Ping. Zhong Rongca, Wu Qing and Yan Wen organised and accompanied all the mission's meetings. Particularly valuable insights to the study were provided by Ma Zhong Zhi (SCSC) and Gao Jian, (Ministry of Finance). Particular thanks must also be extended to Liu Bo, executive vice president of the Shanghai Securities Exchange and Cavin Xue of its data department; Zhang Ning, of the Shanghai Municipal Government Securities Administration Office; Xia Bin, president of the Shenzhen Securities Exchange, Lian Quan Kun, president of the Wuhan SecuritiesTrading Centre, Vivian Gu, also of the Wuhan Securities Trading Centre; and Hu Li Yun, of the Tianjin Securities Trading Centre. Officials from many other agencies and institutions in China also contributed, notably, the PBC, Ministry of Finance, CITIC, BOCOM, Pudong Development Bank, domestic securities trading firms including Guo Tai and Wan Guo, and -the Chengxin securities rating agency. Background papers for the report were contributed by Zhang Bing Xun of the Securities Exchange Executive Council (SEEC), and Mr He Dexu, of the Chinese Academy of Social Sciences.

The authors extend their gratitude and appreciation to all the officials from the various government agencies and securities companies with whom they met. In Hong Kong, particular thanks must be extended to lris Leung and lris Cheung of the Hong Kong Securities Exchange, Jane Tam of the Hong Kong Securities and Futures Commission, and many executives at jardine Fleming, jP Morgan, MerriII Lynch, Peregrine, Sassoon, UBS, and other securities dealers.

The authors would like to thank numerous colleagues who lent support and encouragement to this effort. lsmail Dalla and lshrat Husain of the World Bank urged the presentation of the analysis as a freestanding volume in a study on Asian bond markets, and Andrew Sheng of the Hong Kong Monetary Authority encouraged its presentation as part of an international seminar in Hong Kong in June1994. Last, thanks must be extended to Mr Nicholas Hope, Director of the World Bank China and Mongolia Department, for his support for extending the availability of this volume to a wider audience, through its publication in its present form.

CHAPTER 1

China's Capital Markets: Central Questions

China first resumed the issue of domestic securities in 1981, shortly after the launching of its economic reform programme, after a twenty year hiatus. Since then, and especially over the last five years, the growth of China's capital markets has been exceptional, even by Chinese standards. Market development began with debt securities, and from 1981, when China resumed the issue of domestic debt, to 1986, the stock of outstanding debt securities increased eightfold, from Rmb5 billion to Rmb40 billion. Debt on issue then accelerated to nearly Rmb300 billion, by the end of 1993. The rate of growth of debt on issue over 1987 to 1993, at 31 per cent per year, far outstripped the rate of growth of GDP, of 17 per cent per year, at current prices. From 1994 debt securities issues escalated further, with Rmbl I3billion of new treasury bills in 1994 and Rmbl50 billion of planned issues for 1995.

The growth of equities, meanwhile, has been even more remarkable. The value of new issues increased from Rmb3 billion to Rmb30 billion between 1989 and 1993; a tenfold increase in four years (Figure 1.l, and Appendix Table A1 .I).The number of stocks listed grew from 14 in 1991 to 336 by the end of 1994. Market capitalisation on the two exchanges exceeded Rmb560 billion by the end of 1994.' Shareholding has spread rapidly among domestic investors. In October 1994, a survey of 500 households in Beijing by the Municipal Statistical Bureau showed that the average Beijing household had Rmb17,551 in capital assets of which Rmbl2,800 was in bank savings, Rmb1,271 in cash and Rmb3,474 in securities.

The motivation for the reintroduction of securities issues in China, in the early 1980s, was the emergence of a budget deficit, and the need to raise financing for the deficit. Early treasury issues aimed at resource mobilisation bore a strong Figure 1.1 Growth of securities issued and outstanding (1981 -1 993)

Rmb 100 Rmb I00 million Debt securities million Equities

3.000 2,500 2,000 1,500 1,000 500

500 mmr- mm mmmm mmm -mm~z - ~22

Source: State Council Securities Committee and PBC

resemblance to taxes; subscription to bonds was obligatory, and quotas for bond placement had to be fulfilled by enterprise and by administrative district, in parallel to tax contracts under the fiscal contracting system. Bonds were non-negotiable and non-transferable. Early share issues had similar restrictions. Enterprises sometimes to employees in lieu of wage or bonus payments, and shares were not tradable. Ownership rights, especially voting rights, normally conferred on shareholders were not encouraged to be e~ercised.~

But while the mobilisation of resources is one of the functions of a capital market in a market economy, capital markets have other, more specialised, functions: aiding the efficient allocation of resources, by increasing the transparency of pricing, of risks and returns, and assisting investors with risk-management. The function of resource mobilisation is in fact subordinated to the effective channelling of large volumes of resources, which can be mobilised by a variety of means, to specific ends, and in periods of time. The central question is, to what extent do China's capital markets fulfil functions of aiding efficient resource allocation, efficient pricing of risks and returns, and efficient risk management.

A first concern in this regard is, how well are capital market regulations defined and how adequately do they provide a framework for market operations? To what extent do these conform to international norms and are there areas which are still ill-defined? Do they provide adequate investor protection? An understanding of the regulatory framework of the securities market in China is essential for understanding issues specific to the operation of different segments of the market, not only in terms of types of securities but also in terms of market participants, regional structure, and oversight. This book will evaluate the present regulatory environment, and explore the extent to which the present framework, and in particular the role of government oversight, supports the stable and efficient development of the market.

Can China's capital markets today fulfil their originally conceived function of helping to finance the government's deficit? This question is of great concern to the government today, as a major reform undertaken in 1994 was the decision to eliminate reliance on borrowing from the for the financing of its deficit, and at the same time, reducing quasi-fiscal operations and transferring 'policy lending' to the budget. If these aims are to be realised, it is critical that the government secures stable and additional sources of financing. In this context, this book examines the extent to which bond markets can be developed to provide financing for the g~vernment.~Markets for debt securities (although currently dominated by government issues in China) are also important for providing appropriate leverage for enterprise financing, and the constraints on the overall development of debt securities are investigated.

Equities markets are as important as markets for corporate debt for China's new shareholding companies, where the notion of appropriate gearing will have to be faced as soon as the possibility of financial failure () becomes real. In this book we will first investigate the primary issue process in China's equity markets, focusing on the observed phenomenon of underpricing, and next examine the issue of secondary market instability. One feature of China's capital markets which has disquieted both local authorities and investors is the high degree of volatility observed in secondary markets (Figure 1.2). This is particularly acute in the A share market, for domestic investors. Although the bond market has not normally displayed such volatility, there was a remarkable episode of greatly escalated trade in China's bond futures in February 1995, accompanied by a marked contraction of equity markets. A third feature of the equities market examined here is the unique market segmentation of the ordinary share market due to multiple share categories.

What is the potential for foreign investors in China's capital markets? This book examines the extent to which China's securities markets have opened up to foreign participation, and also the extent to which China itself is a participant in overseas equity markets. The issue investigated is, on what terms and conditions has foreign capital entered China, and what alternative methods are available for safely Figure 1.2 Volatility in China's securities trading

A share indices B share indices

Index Shanghai Ashare index lndex Shenzhen A share index 2,000 T

Treasury bond trading on the Shanghai Exchange (Jan 94 -Jan 95)

trade Futures trade

1 Source: Data provided by the Shanghai and Shenrhen securities exchanges

increasing China's capacity to participate, as an investor and as a recipient, in international securities markets.

To what extent can the observed volatility of China's securities markets be ascribed to the absence of institutional investors, and why have they not developed?It has been claimed that the investor base in China is composed largely of small individual retailers with a tendency to speculate. We examine the extent to which the nature of the investor base, relative to other factors, is a reason for secondary market instability, and the nature of present constraints on the development of large scale institutional investors; specifically, insurance companies, social security and pension funds. Data sources and plan of the study

Data used for the analyses of securities market behaviour were obtained principally from the exchanges of Shanghai and Shenzhen, both of which provided details of daily trading of all listed equities and bonds from the inception of the exchanges until mid September 1994. A similar, but more limited sample of comparative data on bond trading, was provided by the trading centre of Wuhan. In addition, numerous government and institutional sources provided both published and unpublished information on other economic and capital market variables. Data sources are cited in figures as well as annex tables. Finally, information on China's overseas securities issues, as well as on the performance of overseas China funds are compiled by the World Bank's International Economics Department.

The present chapter first presents an overview of China's capital markets, and their role in the Chinese economy. The next chapter describes and evaluates the framework of regulation and oversight for China's securities markets, and forms a basis for the understanding of the following chapters. Chapters 3 and 4 analyse the operations of China's bond and equities markets respectively, and Chapter 5 examines issues relating to the internationalisation of China's securities markets. The development of contractual savings institutions, and their present and potential contribution as participants in China's securities markets, is evaluated in Chapter 6. Finally, Chapter 7 examines the issues raised in the preceding chapters from a systemic perspective, across all market segments. It points out the principal conclusions of the study and prescribes recommendations to policy makers for strengthening the functioning of the market.

The Growth of China's Capital Markets

Diversification of primary issues

Diversification in securities issued increased rapidly from 1986 until 1993. Debt securities in China consisted entirely of treasury bonds until 1985, and new issues amounted to around Rmb5 to 6 billion per year. From the time of their introduction in 1986, corporate debt issues averaged around Rmb8 billion per year, until 1990, accelerating to an average of Rmb37 billion per year over 1992 and 1993. 'There was also a diversification in the variety of treasury bonds issued, by issuer, by end use and by maturity. Aggregate treasury bond issues rose, reaching almost Rmb40 billion in 1992. By the end of 1992, the proportional contribution of treasury bonds to total debt was 38.5 per cent, while financial bonds (issued by financial institutions) and corporate bonds (issued by state enterprises) accounted for another 6.4 per cent and 43 per cent respectively (Appendix Table A1 .I). After 1993, the government reduced the varieties of debt issues, and new issues declined to a virtual halt. The proportional role of treasury bills has rapidly increased again, especially with the large new issues of 1994 and 1995.

In the equities market, China also introduced a bewildering variety of shares:

A shares for domestic individual investors B shares for foreign investors (but listed and traded on domestic securities exchanges) C shares for 'legal persons', ie, enterprises holding shares in other enterprises, and H and N shares for overseas investors in Hong Kong and New York.

Only A and B shares are listed on the two official exchanges of Shanghai and Shenzhen, although the number of B shares listed on the two exchanges (28 and 23, in Shanghai and Shenzhen respectively) is well below the number of A shares

Figure 1.3 Growth of the equities market

Nos Number of listed stocks 1BO 160 140 120 100 BO 60 40 20 0 Q1 Q2 Q.3 Q4 01 Q2 0.3 Q4 01 Q2 Q3 Q4 Q1 Q2 03 1991 1992 1993 1994 ) Shangha~A shares Shanghal B shares Shenzhen A shares Shenzhen 6 shares I Market capitalisation Rmb billion Annual trading value Rmb billion

~EJ ~EJ Ashares BBshares Ashares B shares

Source: Shanghai and Shenzhen Stock Exchange data (169 and 11 6). In terms of numbers of listings, B shares accounted for 15 per cent of total listings. The contribution of B shares to market capitalisation and trading value has been lower. At the end of 1994, B shares accounted for less than 3 per cent of market capitalisation at Shanghai and Shenzhen (2.4 per cent and 2.6 per cent respectively) and a remarkably small proportion of annual trading value (1.8 per cent and 0.7 per cent) (Figure 1.3). C shares cannot be listed on the official exchanges, but a small number are listed and traded on China's over-the-counter electronic trading systems, STAQS (ten shares) and NETS (7 shares).

Development of secondary markets

The development of secondary markets in securities began with the trading of domestic debt, in 1988. From 1989 to 1990, annual trade in debt on issue increased almost fivefold in a single year, from Rmb 2.2 billion to Rmb10.5 billion. Within two years, by the end of 1993, annual trade in debt had further dramatically increased, to Rmbl05 billion. Trade in equities, first permitted officially from December 1990, accelerated even more rapidly. From Rmbl.8 billion in 1990, it exceeded Rrnb730 billion in three years, by the end of 1993. The volume of trade has been 25 times as high as the volume of equities on issue. In co'ntrast, in 1992, the ratio of traded debt to debt outstanding was less than one. Until 1993, it appeared that the primary market was clearly dominated by debt, but equities dominated secondary markets. Equities accounted for less than a tenth of securities on issue, but the value of trade in equities, by 1993, was five times as high as trade in debt (Figure 1.4, and Appendix Table A1.2). Yet, shortly after, there was an apparent reversal of this trend in early 1995, when bond trading seemingly exceeded trading in equities fourfold (Appendix Table A1 .3).4

Figure 1.4 Secondary markets in China's securities

Rmb million 800

600

400

200

0

1 Source: State Council Securities Committee and PBC China relative to other emerging markets

Although the burgeoning of China's equities markets occurred in parallel to many other emerging markets, the size and growth of these market in China has been remarkable even by these standards. At the end of 1 9935, market capitalisation in China, at US$42 billion, stood in a league comparable to the Philippines (US$41.5 billion), Argentina (US$44.3 billion) and Chile (US$52.4billion). China had already outstripped some Asian countries such as lndonesia (with a market capitalisation of US$35.9 billion), although it is still some paces behind the more mature East Asian countries such as Thailand (US$123 billion), Korea (US$I58 billion) and Malaysia (US$201 billion). Average daily trading value, at US$386 million, not only exceeded Indonesia, Argentina, Chile and the Philippines, but also exceeded Brazil (US$343 million) and Mexico (US$376 million). Relative to the size of the Chinese economy, however, capital markets have a limited role. Market capitalisation in China stood at 7 per cent of GDP at the end of 1993, lower than all the above countries, although higher than other transitional economies such as Hungary and Poland (2.4 and 3.1 per cent of GDP respectively) (Figure 1.5).

Figure 1.5 China and other emerging equity markets: A comparison (1993)

Number of shares Average daily trading value 1 Korea Taiwan Malaysla Korea Thailand Malaysia Taiwan Thailand Chile Philippines lndonesia Indonesia Philippines Argentina Argentina Poland Hungary Chile Poland Hungary China China 0 100 200 300 400 500 600 700 (Number) (US$ million)

Market CaDitalisation Turnover ratio

Malaysia Taiwan Taiwan Korea Korea Poland Thailand Thailand Chile Malaysia Argentina lndonesia Philippines Philippines Indonesia Argentina Poiand Hungary Hungary Chlle China China 0 50,000 100,000 150,OW 200,000 250.000 I (USS million) LSource: Calculations based on data from the IFC Emerging Markets Data Base Overseas investors in China's securities markets

Foreign investors have been eager to participate in the sudden and rapidly accelerating securities markets of China in the early 1990s. From 1991 to 1994, a total of US$1.3 billion was invested in China through its B share listings, with each listing raising an average of US$25 million. Meanwhile, as investment in the domestic economy accelerated, Chinese enterprises sought other means to raise capital overseas. With the legalisation of the overseas listing of Chinese shares in 1993, larger sums of foreign capital were raised through H share issues in Hong Kong (which at US$350 million on average, were considerably larger than B share issues), and through the issue of shares and ADRs in New York. By the end of 1994, Chinese companies had raised an estimated total of US$3.7 billion overseas. Other exchanges have been soliciting the listings of Chinese companies, notably London, Tokyo, Singapore, Melbourne and T~ronto.~

Since 1992, the Chinese have also become active in the international market in debt securities. Although the domestic bond market remains closed to foreign investors, China's new overseas bond issues have grown remarkably fast. From less than US$2OO million per year over 1989-91, the annual volume of new overseas bond issues grew on an unprecedented scale; to over US$2 billion per year over 1992-94. In 1994, overseas bond issues reached an all-time high, at US$3.5 billion.

Securities market institutions and market participants

With the growth of securities on issue, a number of formal and informal trading centres and exchanges have sprung up for the trading of securities. At the core of the market are the two securities exchanges of Shanghai and Shenzhen, which trade not only equities but also government and enterprise bonds, futures, mutual funds and warrants.' In addition, 1 7 regional securities trading centres trade bonds and mutual funds, and two electronic networks, STAQS and NETS, provide the means to trade 'C' or legal person shares and government bonds. The largest centre for trade in government bonds is at Wuhan, and since the listing of bonds on the exchanges of Shanghai and Shenzhen was permitted, these, especially Shanghai, have grown to follow the Wuhan centre in rank. Bonds are also traded in over-the-counter markets in over 40 regional centres (Appendix Table A3.1). Major trading centres have links to the trading floor in other cities; for example Shanghai has 21 centres linked by satellite and telephone to its exchange. The rapid growth of capital markets has been accompanied by a sharp expansion in the number of market participants, in the form of investors, brokers, dealers, and underwriters of securities. Although most of the end holders of securities in China today are individuals, the bulk of trade in securities takes place between wholesale dealers and institutional owners. By January 1995, the Shanghai exchange had 541 members, of whom around 500 were estimated to be from outside Shanghai. The Shenzhen exchange had around 425 members in 1994. Many of these are members of both exchanges, and stem from the ranks of the large and rapidly growing number of China's non-bank financial institutions, and a large number of the principal brokerage houses and dealers were established as non-bank subsidiaries of banking institution^.^ Yet the number of large scale institutional investors with investible funds based on contractual savings in China today is limited. Although there are now allegedly 1 9 insurance companies in China, they are virtually all spun off from a single parent organisation which still retains a holding company style majority or minority ownership in them, and competition is limited. The lack of funded pension and security systems has implied that funds are not available from such sources, which form the core clientele of capital markets in mature economies.

The Role of Capital Markets in China's Economy

Role in the financial sector

Various approaches can be applied to the assessment of the role of capital markets in China's financial sector. First, through 'stock' estimates of the size of capital markets relative to the size of other elements of the financial sector. In terms of assets, this implies the measure of the assets (loans) of financial institutions such as banks and credit co-operatives, relative to the assets held by securities institutions. In terms of liabilities, it implies a comparison of deposits at financial institutions with the volume of securities issued. Only very broad orders of magnitude can be estimated, because of data limitation^.^ The results are summarised in Figure 1.6 (details are available in Appendix Table A1.4).

From these points of view, the role of capital markets in the financial sector today appears small but has been growing. Total assets of non-monetary financial institutions, as defined here, grew from 6 per cent in 1989 to a high of 8 per cent in 1992, of the financial sector's assets, declining once again to 5 per cent by 1994. The pattern reflects the growth of enthusiasm for securities with the Figure 1.6 Securities markets in China's financial sector (Rmb billion)

Assets

6,000 5,000

4,000 3,000 2,000 1,000 tal assets of financial institutions

sets of non-monetary financial institutions

Liabilities

Deposits at financial institutions ecurities outstanding ecurities (annual issues)

Note: Securities outstanding data for 1994 are estimates. Source: World Bank and IMF data legalisation of exchanges and high returns to equities from the end of 1990 to mid 1993. With the introduction of the 16-point programme in the latter half of 1993, and the squeeze of credit to the non-bank financial institutions, their levels of activity declined. By early 1994, the decline was exacerbated by the increase in deposit rates offered in the banking sector. Data on the annual issue of securities, compared to the liabilities of the financial sector, indicate a similar pattern and similar relative size: (a 4 per cent share in 1989, rising to 6 per cent by 1992, and declining to 2 per cent in 1993). Note however that the cumulative share of securities on issue has been increasing. Both sets of estimates however clearly reinforce the officially expressed , that the Chinese government's approach to the growth of capital markets has been 'experimental' and is still an experiment on a small scale. The banking sector without doubt dominates resource flows to the real sectors. Another possible measure of the relative size of the emerging securities market is through alternative measures of .1° Recently, attention has been paid to the changing composition of China's broader monetary aggregates (M,), and the increasing importance of non-monetary components of M, (money + quasi money) or alternatively, looking at the non-monetary components of even broader monetary aggregates, which include deposits of urban credit co-operatives, or trust and investment corporations. These measures suggest that these broader monetary aggregates have rapidly become less money- like over time.

The second and more interesting question concerning the relationship between the securities market and the financial sector is the dynamic or 'flow' issue of the extent to which links exist between the banking sector and securities markets, and the impacts of these links on financial sector efficiency, systemic risks, and on the support provided to the real sector. The question can be broken down into a number of components:

What are the institutional links between banks and securities dealerships To what extent do they permit the flow of funds between these institutions? Are there any dangers of systemic risks because of the increased exposure of banks to securities markets? Specifically, are depositors' funds at risk?" Can securities markets 'displace' bank lending, and if so, which provides a

better vehicle of finance to the real sector? l2

These are major questions and a comprehensive answer can lie only in a study which simultaneously examines the behaviour of both the banking andnon-bank segments of the financial system. The present response is therefore preliminary.

Firstly, the principal institutional links between the real sector, the banking system, and capital markets are provided by members of the large group of 'non-bank financial institutions' (NBFls) (or non-monetary financial institutions, according to the new PBC definition). NBFls include a variety of Trust and Investment Corporations (TICs) finance companies, leasing companies, as well as insurance companies and securities dealers. Not all these institutions participate in the capital market, but a number of large securities dealers come from the ranks of the TICs. Moreover, many of the TICs, and most of the largest securities dealers, were set up as wholly or partially owned subsidiaries of China's specialised or commercial banks. Several were bank departments and were spun off as independent companies as their operations grew. BOCOM is the only bank that provides 'universal' banking services, incorporating both retail banking and securities management.13 It should be noted that China's urban credit co-operatives (UCCs) are also participants in securities markets. UCCs lie somewhere between banks and NBFls in a conceptual sense. While they are not permitted to take deposits from stated-owned enterprises (SOEs) (or joint venture companies), they are permitted to accept individual and private (collective) enterprise deposits. Moreover, UCCs participate directly on securities markets. Of the 80 UCCs in Shanghai at the end of 1993,26 were registered brokers of the Shanghai Securities exchange, 58 were dealers in state bonds, and 23 were involved in the insurance business as policy agents. TICS and securities companies can undertake a range of capital market functions; brokerage, dealing on their own account, and underwriting securities issues. Banks have also participated directly in certain capital market activities, acting as 'underwriters', since 1992, for the issue of government bonds by certificate. Bank branches have been used as the vehicles for distribution to retail investors. 'Underwriting' in this system in reality implied the distribution of a quota among a number of pre-selected banks, rather than any competitive process of bidding for terms. Banks thus acted essentially as (fixed) commission agents. l4

In view of these close relationships, the second question, of financial flows and systemic risks, is clearly legitimate. Preliminary evidence gathered suggests that administrative regulations of the PBC effectively prevent easy transfers of funds (apart from the initial equity) from parent to subsidiary, borrowing from the parent company, or maintaining close managerial ties. The pattern of separation employed so far suggests the 'holding company' model, with restrictions on the transfers of funds from parent to subsidiary. While the 'firewallst appear to be fairly effective so far, it is disquieting that they take the form of administrative regulations rather than law.15 A draft law on commercial banking was prepared by the authorities in 1994, but it made little reference to the issue of banks and their subsidiaries operating in securities markets. Supervision is clearly an issue (see Chapter 2). While the PBC licenses securities dealers and other NBFls, their operations on the securities markets are monitored by the CSRC (which can penalise them, but is not empowered to revoke their license^).'^

The principal vehicle for the transfer of funds between banks and NBFls appears to have been the interbank market. China's interbank market, which permits surplus and deficit financial institutions to lend and borrow funds to and from each other, has permitted the participation of banks as well as NBFls.17 The principal instruments on the interbank market are short term loans, although since 1992, a growing repurchase agreement (repoj market is emerging. There are two channels of transfer; a formal channel, through PBC administered 'financial centres' (which operate in 44 major coastal and interior cities and are equipped with facilities for the electronic transfer of funds between them); as well as an informal channel, of direct contacts between financial institutions.18

Although loans on the interbank market are intended to be strictly short term, for liquidity management purposes, short term loans have tended repeatedly to become long term, through 'roll-over' agreements, which the PBC periodically attempts to curtail (see Chapter 2). NBFl participation on the interbank market was virtually unrestrained prior to the 16-point programme of 1993, and was identified as the principal source of credit 'leakages' responsible for the overheating of the economy in 1993. A part of the credit thus 'leaked' found its way to the securities market; the rest went to 'non-priority' investments, real estate, and other high-return areas of the economy. hlBFl access to the interbank market has been curtailed since the announcement of the 16-point programme in July 1993. Restrictions have been imposed on both the volume of their borrowing (a form of 'capital adequacy' requirement, which requires that their total borrowing, including interbank borrowing, cannot exceed their capital); and the term of loans. NBFls are now restricted to borrowing for a maximum maturity of seven days, compared to four months for banks. But their access to the market continues and their share of total outstanding interbank loans is now estimated to be about 25 per cent. Since most NBFls are owned either by branches of specialised banks or by local governments, these institutions have a vested interest in their support.lq

The third question regarding the dynamic relationship between the banking sector and securities markets concerns the extent to which depositors transfer funds between banks and the capital markets. Outside the interbank market, NBFls certainly do compete with banks for individual and enterprise deposits, to divert funds towards high return non-priority areas20 While funds can also be attracted for investments in securities, the first key consideration here is that in China today the total volume of securities issued, as well as total bank credit, is still regulated under the credit plan, so that the extent to which such transfers can occur is effectively '~apped'.~'Secondly, the extent to which funds are channelled towards either bank deposits or other securities can be, and is, manipulated today by the government. This is undertaken through the complex web of controls on relative returns; controls on interest rates on bank deposits and loans, the determination of coupon rates on government debt securities (which constitute the bulk of securities issued), which have little reference to secondary market yields, and through rate caps on certain securities issues (such as corporate bonds). As such, these controls regulate the flows of funds between these segments of the financial sector, rather than market forces. The consequence is that the extent to which capital markets can make a real contribution to the allocation of resources or pricing of risks and returns is constrained. Besides, even when 'large scale'transfers of funds have allegedly taken place from banks to capital markets, the relative size of capital markets has been small, as demonstrated above, and the rise in their share of financial sector liabilities has also been small. Finally, the experience of other countries suggests that capital market growth need not 'crowd out' bank lending, and in many cases, with financial deepening, the two grow in As long as the relative growth of both banks and securities remains embedded in the credit plan, the question is only of limited relevance for China.

Macro-economic role

When China first resumed the issue of domestic debt in 1981, the primary purpose was to finance the budget deficit of the central government. In 1994, the objective of issuing government debt to finance the budget deficit took on new significance, due to the decisions to:

cease to resort to deficit financing through loans from the central bank, and gradually transfer subsidies to state enterprises, hitherto funnelled largely through commercial bank lending, to the budget.

New issues of treasury bonds in 1994 increased almost threefold over the previous year, to Rmb113.2 billion (compared to Rmb38 billion in 1993). The amount is particularly large in view of the fact that the total stock of outstanding treasury bonds at the end of 1993 amounted to only Rmbl67 billion. New issues planned for 1995 are estimated to be Rmbl50 billion. The first question raised here is, to what extent have bond issues been able to contribute, in terms of volume of issues, to the financing of the government's budget deficit?

As Figure 1.7 suggests, the contribution of bond issues to the financing of the budget deficit in the past has not been very large. Measurement difficulties preclude a precise measure of the proportion of treasury bond issues used for this purpose, Figure 1.7 Central government budgetary deficit and treasury bond issues I -- I

Net issues of treasury bills I Overseas Bond Issues

Source: World Bank and IMF data 1

especially as in earlier years, bonds were frequently earmarked by purpose, and linked to construction projects or 'key investment' projects. A broad comparison of orders of magnitude is presented here (details of definitions and data used are in Appendix Table A1.5). Looking first at the visible budget deficit, net issues of treasury bonds (gross new issues less annual redemptions) have had a highly variable volume, relative to the size of the overall deficit; over 50 per cent as early as 1988 and 1989, when net annual issues were Rmbl7 and Rrnb21 billion respectively. In 1990 and 1992, the relative size of bond issues fell to around a third. But in 1994, the estimated end-of-year visible deficit was Rmb85 billion, and (gross) new issues of treasury bonds amounted to Rmb113.2 billion; or around 133 per cent of the current year's deficit.

Taking account of quasi-fiscal operations of transfers to state enterprises, which should in a conventional accounting framework be financed through the budget, but which have instead been financed through PBC lending to the banking system, we can estimate the consolidated central government budget deficit.23 If, at a lower bound, 60 per cent of PBC lending to the banking sector is estimated to cover the financing of 'policy loans', the (consolidated) deficit increases, and the size of annual treasury bond issues compared to the (consolidated) deficit consequently falls. The annual volume of net treasury bonds issued over 1989 to 1993 has varied between 11 and 23 per cent of the consolidated deficit, while the annual volume oftreasury bills alone has varied between 5 and 23 per cent of the consolidated deficit. If quasi-fiscal operations are 'fiscalised', an increase in the scale of bond issues is likely to be required.

The government has recently augmented the contribution of securities markets to its financing, by enhancing its external bond issues. Following a long hiatus in overseas sovereign bond issues after 1987, the government made a comeback in overseas bond markets in 1993, with issues of around US$600 million (Rmb3.4 billion), and a huge increase in 1994, with issues of US$1.6 billilon (Rmb13.6 billion).24 If these are added to the measures of the relative size of government bond issues and the budget deficit, the role of securities markets increases; to around 38 per cent in 1993 (33 per cent from domestic bond issues, and another 5 per cent from overseas issues).

A second question concerning the macro-economic role of the securities market is the extent to which securities issues have helped establish appropriate pricing for government bond issues. That is, have government bond issues helped establish benchmark rates for the pricing of new issues of debt securities? This issue is dealt with in greater detail in Chapter 3. The broad conclusions are:

that the form of issue and design of debt securities so far have not been conducive to the establishment of a well-defined yield curve and, to the extent that a yield curve exists, yields on the secondary market have not been taken into account in the pricing of new issues of government securities.

In 1994, yields on the secondary market were well below interest rates offered on new government securities issues. The implication is that the government may today be adopting an unnecessarily expensive form of financing its borrowing. In the past, however, the government paid rates below those on the secondary market, and was able to do so because ofthe largely administrative placement techniques used. In the future, as the government moves away from administrative placement and as the stock of outstanding debt issues increases, the question of the cost of borrowing for government debt will become an issue of increasing concern.

A third issue regarding the role of capital markets and macro-economic management relates to whether the government can consider an increased use of treasury bills as indirect instruments of monetary control, which would permit a relaxation of reliance on the credit plan, and greater reliance on the control of base money for implementing macro-economic objectives. The ability of the government to conduct operations is also important for the use of sterilisation as an instrument for regulating the impact of external capital inflows. While these issues are of considerable importance, they are not covered in this book, as they form the subject of detailed technical assistance from the IMF. However, to the extent that financial institutions need to hold portfolios of (tradable) government bonds to be able to participate in open market operations, it must be pointed out that today such portfolio holdings are limited. Moreover, there is no benchmark issue to help the pricing of such instruments, and the limited development of the limits the liquidity available to financial institutions to finance the holding of a sizeable portfolio of government treasury bills.

Links to the real sector

To what extent have China's capital markets contributed to the investment needs of the real sectors of the economy? Attempts to measure this contribution are detailed in Appendix Table A1.6 and summarised in Table 1.1 below. The first conclusion from the figure is that the contribution so far has clearly been Looking at treasury bond issues alone, the volume of issues, relative to the volume of investments, was 5 per cent in 1987, increasing to 9 per cent in 1989, and fluctuating between 7 per cent and 9 per cent between 1990 and 1992. Adding 'investment bonds' (issued both by the treasury and by the erstwhile state investment corporations) to this, the upper limit for both categories rises to 10 per cent over the period 1987- 92.

Debt securities were also issued by state enterprises after 1986, and the outstanding stock of enterprise bonds amounted to about Rmbl95 billion by the end of 1992. The contribution of enterprise bonds to real sector investment shows a discernible upward trend between 1987 (just after they were first permitted), when their contribution was only 1 per cent, rising steadily to 11 per cent of total state- owned unit (SOU) investment by 1992. Adding all categories, the maximal possible contribution of debt securities to investment finance grew from 8 per cent in 1987 to 21 per cent in 1992. After 1993, there was a clamp down on the issue of new corporate debt, which would have led to a reduction in this percentage. Table 1.1 Contribution of capital markets to real sector investment (Rmb billion)

Total investment in state owned units 229.799 276.276 253.548 291.864 362.811 527.364 765.797 Treasury bonds issues 11.69 18.877 22.391 19.723 28.125 46.078 38.1 31 Investment bond issues 3 9 2.253 0.61 5 9.729 6.801 0 Enterprise bond issues 3 7.541 7.526 12.637 24.996 59.19 0 Equity issues 1 2.5 0.662 0.428 3.098 12.572 9.062

Source: State Planning Commission and State Council Securities Committee

Parallel to this issue is the question of the extent to which the equity market has contributed to enterprise development. One concern here is the extent to which these markets have helped enterprises raise finance, and the response here is, to a very limited extent. New (domestic) issues of equities contributed only around 2 per cent to total SOU investment in 1992, and less than that in 1993 (Appendix Table A1.7). The cumulative value of new equity issues has been around Rmb30 billion so far.26 About halfway through 1994, approved new issues of equities were banned from going to market by the government.

Apart from the strictly financial contributions of capital markets to SOU investment, the process of share issue and trade are sometimes considered to have other beneficial effects for enterprises in a market economy; they are stated to lead to improvements in managerial efficiency through shareholder appointment of a board of directors who represent their views. Both enterprises and their managers are said to be disciplined by valuations of their firms, and threats of mergers or take-over of inefficient firms.27 Certainly, listing on stock exchanges usually requires improved standards of information disclosure accounting and managerial practices, more in line with international norms, and provides enterprises with greater public exposure as well as scrutiny.

The extent to which enterprises in China have benefited from these aspects of securities markets so far is likely to be small. Firstly, enterprises list on the stock exchange in China exclusively for the purpose of raising new capital, and the extent to which real ownership rights can be exercised by the new shareholders is New share listings invariably take the form of initial public offerings (IPOs), as opposed to selling existing shares, or selling new shares through mechanisms such as private placement, which would be likely to lead to greater concentrations of ownership. The tendency towards a high degree of ownership dispersal is compounded by the lottery system of share allocation hitherto adopted for new share issue. Although the listing of enterprises in China undoubtedly represents a form of gradual privatisation, largely through the dilution of the state's share, there are no opportunities for new owners to become stakeholders, or significantly affect management.29Moreover the separation of 'state shares' from other ordinary shares, and the non-transferability or tradability of state shares, implies that control typically remains in the hands of the state.30

Chinese enterprises have also raised equity capital overseas, through the issue of overseas shares, and the amounts raised through such issues are estimated to have reached US$3.7 billion by the end of 1994; a significant amount compared to amounts raised through domestic markets. The real significance of overseas share issues however lies in the fact that overseas investors' requirements in terms of accounting and disclosure are more rigorous than in the more speculative domestic market, and these buyers have tended to place greater emphasis on the underlying fundamentals of the enterprises. As such the disciplining effect of these stock listings is likely to be greater than in the domestic market, although domestic investors too are exhibiting signs of 'maturing' in their decision-making, over time (see Chapter 4).

Figure 1.8 Share of Bonds in China's Overseas Borrowing

I W~otalcornmittrnents Bands I 1 WToIal mrnlttments Bonds 1 I Source: World Bank data. ~ Finally, Chinese enterprises have also approached the international bond markets for resources. Although direct access of individual firms to these markets has been allegedly relaxed, in practice, the bulk of foreign bond issues take place through the 'windows'; large TICS, and certain banks, which have been allowed access to the overseas bond markets by the SAEC3'

In terms of aggregate contributions to foreign resource inflows into China, international securities issues still account for a small share of China's total (Figure 1.8).Details of the share of portfolio investment are given in Appendix Table A1.7, and are discussed in detail in Chapter 5. The bulk of foreign capital inflows into China have taken the form of foreign direct investment. Portfolio equity only constituted 5.5 per cent of aggregate net resource flows to China in 1993, and bonds accounted for only 2.7 per cent of new borrowing commitments in 1993.

To conclude, the key factor to bear in mind, regarding the contribution of capital markets to resource inflows to the real sectors of the economy is that, at least at present, this contribution is controlled by the government, and embedded within the mechanisms of the investment and credit plans. Quotas are determined for the issue of domestic debt and equity securities, as well as for overseas bond issues, by a combination of the SPC, PBC, and in the case of overseas issues, the SAEC.32Thus the extent to which capital markets contribute is largely determined by the extent to which the government permits them to contribute, and the issuers of securities are determined by the distribution of quotas for each of these heads by the central and regional offices of these authorities.

Endnotes

1 Summary descriptions of the development of China's securities markets may be found in IMF (1991, 1994); International Securities Consultancy (1994); Bei Duo Cuang, Koontz, Lu and Xiangqian (1 992), and Bowles and White (1992, 1993). 2 Indeed, China was unique, in the 1980s, in the issuing of shares in the absence of any legal framework for shareholding companies, or securities. A description of the characteristics of early securities issues in China is available in Bowles and White (1993). 3 The extent to which securities markets can provide support for the adoption of indirect instruments of monetary control, although highly relevant, is however omitted from the scope of this book, apart from an investigation of the extent to which the bond market can presently provide support to this process through the establishment of benchmark issues which would assist the process of pricing of government securities issues. 4 This occurred in early 1995, when bond trading seemingly exceeded trading in equities fourfold (Appendix Table A1.3). However the escalation in bond trading was almost entirely in the bond futures market, due to an incident of on one specific security (see Chapter 3 for details). Liquidity in the underlying for bonds also rose as a consequence, but by a much more limited extent. 5 Latest year for which comparable data are available (IFC Emerging Markets Data Base). 6 Another indication of the rapid growth of foreign investor interest in China's securities markets is that at the beginning of 1994, foreign financial institutions from 15 countries had 298 representative offices and 98 managing offices in China from a near zero base in 1990. 7 Details are in Chapter 4 and Appendix Table A4.1. 8 China today is estimated to have over 1500 brokers, dealers, and underwriters, 400 trust and investment corporations, 40 finance companies, 52 mutual funds, 19 insurance companies, and 30 leasing companies. 9 The assets of securities institutions are not available as a separate category, but are partly subsumed under the larger category of Trust and Investment Corporations. TICS includes many, but not all, securities dealerships, and to this extent underestimate the result. But also, not all TIC business is securities business, which would overestimate the result. Until 1993, data on insurance companies was available separately. Moreover, in the present definition, Urban Credit Co-operatives are grouped with banks as they are indeed deposit-taking institutions (from individuals and collectives, although not from state enterprises), but thzy too participate in securities business. From 1994, data supplied by the PBC are supposed to cover all non-monetary financial institutions (See Appendix Table A1.4 for details of the numbers used). On the liabilities side, there is no separation of government securities issues and securities issued by enterprises, because of the conceptual difficulties in separating the bond issues by ownership in China. 10 The principal attempt to arrive at such estimates (until mid 19931, appeared in Montes-Negret, 1994. 11 Scott (1 994) summarises the key issues and their implications. 12 More detailed treatment, which elaborates alternative methodologies to these issues, and summarises earlier research in this area, may be found in King and Levine (1993, 1994), Levine (1 994), and Demirguc Kunt and Levine (1993). 13 Compared to the specialised banks, BOCOM management is relatively professional. Non- performing assets are estimated to comprise only a small share of its total assets and provisioning is applied to these. 14 From 1993, the government introduced a more flexible system of primary dealership, under which the competitive bidding for terms was included, and primary dealers had certain additional market- making responsibilities (see Chapter 3). The primary dealers belonged to a wider group, principally specialist securities firms, rather than banks. 15 Administrative regulations issued by the PBC have not always been successfully enforced (see Chapter 2, endnote 10). 16 Less obvious channels are available for resources to flow from banks to NBFls. One such channel would be for banks to lend to an SOE which would then place an entrusted deposit with an NBFI, with the instruction that the amount be lent for the ?on-priority project. Such arrangements undoubtedly exist but are virtually impossible to detect. 17 As well as some enterprises. Securities companies, however, as a special category of NBFI, are not allowed to borrow on the interbank market although they can lend surplus funds. 18 Further details on the interbank market are provided in World Bank (1995) and in Chapter 3. Much of the operations of this market substitute for intra-bank operations elsewhere, due to the problems with the payment system. Operations on the interbank market undertaken by bank branches for liquidity management purposes are supplemented by short term PBC loans, and in 1993 were supplemented by the issue of PBC bills. In October 1994, the outstanding amount loaned by PBC to the interbank market was estimated to be Rmb50 billion; roughly one third of the total amount outstanding in the financial centres. 19 The new commercial bank law, however (1 July 1995), strongly prohibits new commercial banks from investing in non-bank financial institutions. Separate implementing procedures are to be prepared by the State Council on investments already made by existing commercial banks in NBFls. 20 Supervision is sparse. In one case, a mutual fund operated by an NBFl was a major lender to a project owned and operated by the manager of the fund. 21 To the extent that the credit plan is an effective tool of monetary control. The real problem with financial disintermediation is that, at least until 1994, the PBC has stepped into supplement those banks which have an unfulfilled credit quota, but an inadequate supply of loanable funds. This form of PBC 'relending' is highly expansionary. 22 Demirguc-Kunt and Levine (1994). 23 See World Bank (1 995). 24 See Chapter 5. These included a Y30 billion Japanese bond with a maturity of 5 years and a coupon rate of 5.375 per cent (October 1993); a dragon bond of US$300 million of 10 years maturity and 6.1 25 per cent a year (October 1993); a offering for US$l billion, a maturity of 10 years and an interest rate of 6.5 per cent a year (February 1994); and a Japanese bond offering of Y60 billion, split up into a 5-year Y30 billion issue at 4.4 per cent a year and a Y30 billion offering for 10 years at 4.95 per cent a year. 25 There are problems of definition in arriving at a precise ratio, which are pointed out in the notes to Appendix Table Al.6. Earlier, treasury bonds for investment expenditures were earmarked, but this practice faded after 1987, particularly for 'key project construction', so that the separation of the part of Treasury bond issues used for investment presented here is an upper limit. 26 Although market capitalisation (forA and B shares combined, in October 1994) greatly exceeded this, at around Rmb600 billion (due to share price rises in the secondary market; see Chapter 4). 27 These potential benefits are controversial. Kumar (1993) provides one discussion of the debate. Especially when ownership dispersal is high, an enterprises' shareholders may not be able to effectively 'discipline' managerial performance. 28 Regulations today place restrictions on the acquisition of significant shareholdings of any single individual in an enterprise (see Chapter 2). 29 Moreover, since dividends are paid mostly in the form of rights issues and the Government has never chosen to exercise its rights, the capital market will gradually accelerate the dilution of the state's share in enterprise ownership. The Government has not acknowledged that the present process of erosion of the state's share deprives the Government of revenues from the effective sale of public assets. 30 Enterprises are required under the Companies Law to issue new shares equal to at least 25 per cent of existing . Yet even this ratio implies that the residual 80 per cent (after share issue) remains in the hands of the state. 31 There have been two cases where enterprises have directly issued (convertible) bonds overseas (in Sweden and Switzerland). The authorisation for such issues was apparently granted at a local level, and the appropriateness of this procedure is now being questioned. 32 A comprehensive discussion of the mechanism of China's credit plan is available in Montes- Negret (1994).

CHAPTER 2

Introduction

An understanding of the regulatory framework for China's capital markets is an essential prelude to the issues discussed in this book. The purpose of this chapter is to describe the present regulatory framework, and evaluate its impact on capital market performance. Key restrictions are identified and the extent to which they may be justified at the present stage of market development is evaluated. It must be pointed out that the CSRC and other regulatory agencies are highly knowledgeable and are aware of many of the matters raised here. It is also necessary to bear in mind that there is an inherent trade-off in terms of the impact of regulations on market participants. Sometimes high standards from the viewpoint of one participant can be considered detrimental and unduly ;&strilctive practice by another. Achieving the correct balance is the challenge facing a good regulator.

A first general finding is that the provisions of existing regulations for domestic securities are basically sound in terms of international comparisons, and fairly well defined, especially for equities. While the provisions sometimes have unusual features, and are sometimes in unorthodox places, these differences are generally dictated by pragmatic considerations. The chief difficulties here appear to be the substantial role and sometimes ad hoc intervention of the government, especially in primary issues, and the difficulties of ensuring compliance and enforcement. The absence of a national securities law makes the regulatory framework sometimes confusing, and its passage would aid regulatory transparency.

Second, a major present issue is the form of government oversight. In the present regulatory approach to capital markets in China, this is fragmented in three ways:

vertically, by the split between national and local regulation horizontally, for example, the regulation of securities dealers is split between the PBC (licensing) and the CSRC (secondary market activities) and, functionally, since approvals for different types of security are split between various government departments, and multiple approvals are required.

The distinction between national and regional regulators of securities, the multiple institutions involved, and the CSRC's lack of regional offices have weakened its authority, already limited by its lack of adequate staff.

Third, for equities, an official framework of secondary market regulation so far has been geographically limited to the two areas of Shanghai and Shenzhen, although the companies listed, brokers and investors are distributed throughout the country. Only two stock exchanges are recognised, and dual listing is not permitted. The development of OTC and informal markets has not been co- ordinated, leading to problems with the synthesis of the centres into a cohesive national system. Moreover the electronic markets have been restricted to bonds and C shares. There is no real national market and opportunities to participate in the development of the markets vary across the country. Given that the main role of a securities market is to mobilise domestic capital, the lack of a'nationally regulated market is a serious limitation.' Although the present arrangement may be justifiable at an early stage on the grounds of experimentation, in the longer run it will impede capitalisation. The split between national and regional regulation for equities should be eliminated and any duplication removed. The regional regulators should be branches of the central regulator.

Fourth, the present fragmentation of regulation particularly affects the bond market. This could contribute to a situation where (like some other Asian markets) the bond market is less well developed than theequities market, which will eventually limit the financing options and financial structure of enterprises. Although the present structure arose by historical circumstance, it should be reviewed. At this stage of market development, a single regulator may be beneficial.

Our fifth point is that the regulation of dealers in securities, and particularly, the role of the PBC in the licensing of intermediaries, in tandem with the role of the CSRC in monitoring their operations, should be reviewed. In practice this appears to be leading to a situation where limited de facto regulation is exercised.

A further point is that the links between securities dealers, non-bank financial institutions, and the banking sector, although greatly clarified by the new Commercial Banking Law for new financial institutions, have still to be spelled out for existing institutions.

Finally, the CSRC needs to be considerably strengthened to exercise its present mandate effectively.

Principles of Securities' Market Regulation: Relevance for China

The purpose of any regulatory scheme should be a framework in which business can be honestly and at the same time profitably conducted. A sound regulatory structure inspires confidence and is commercially beneficial for market participants.

Principles of regulation

The twin core principles of securities market regulators are investor protection and the protection of the rights of shareholders. However, there is also the concept of caveat ernptor, ie, that the buyer should beware, and that the investor must take some personal responsibility for his own decision to buy or sell. Probably the best protection for all market participants is the availability of promptly disseminated and accurate information about the listed enterprises and all trading that takes place in their securities. Advances in electronic communication have enabled markets to achieve high levels of transparency in recent years. In addition all relevant laws, regulations and rules must be properly and promptly promulgated and made available to those who need to understand them.

The regulator in a developing country has additional responsibilities: to assist in market development. Regulators need to be involved in proactive as well as preventative work and be able to work with practitioners to develop a high quality market.

International standards

There is no one set of international standards for securities regulation and legislation (as there is, for example, for the accounting profession). It is possible to distill an overall set of good standards, derived from forums such as IOSCO (International Organisation of Securities Commissions), FlBV (F6d6ration Internationale des Bourses de Valeurs), and the Group of Thirty. IOSCO attempts to set standards in areas such as capital adequacy of intermediaries, but they are not always successfuI

27 in encouraging implementation of their recommendations on a worldwide scale. It is difficult to get uniform standards in a line of business where regulatory arbitrage can be commercially beneficial. National exchanges may wish to lower their standards to attract particularly interesting overseas companies to list on their exchanges. Equally important are certain accepted modern practices, which ensure service to and protection of the investor and the overall minimisation of risk. The principles of 'full, fair and timely disclosure', 'transparency' of dealing information and 'minority protection' are all accepted as making a market attractive to investors. The existence of efficient trading, settlement and clearing systems can also add to a market's attractiveness.

Securities laws

These are less than a hundred years old; the oldest are those of the US, and the newest in a major developed market are those of the UK, which had no law until 1986. Types of laws adopted depend on the nature of the underlying legal structure, eg, whether there is a framework of common law, the nature of the prevailing companies law, etc. The necessity to take into account 'Chinese characteristics' is indeed important. Developing markets can adapt what suits them from the experience of overseas markets, based on the form of their overall regulatory infrastructure. History has shaped the securities laws of different countries in different ways. Economic, political and social realities have to be considered. Regulation cannot be considered separately from these issues especially in a developing market.

Regulation in a global environment

International and global markets increasingly do not lend themselves to regulation in the conventional sense. This is not yet a problem for China but it should be borne in mind for the future. Modern technology means that securities can be traded and settled on electronic systems which have only a limited physical presence in any one country. When such systems provide a global, screen-based market, it is difficult to determine how and where they should be regulated.

Enforcement The cornerstone to good regulation is consistent and thorough enforcement. However, a new market regulator will not always have the capacity to follow up every single misdemeanour. It is necessary to set priorities. All forms of are wrong but 'insider dealing' may not be the most detrimental to

28 the market on every occasion. The CSRC is in the process of introducing a sophisticated stockwatch system which will be linked with Shanghai securities exchange and Shenzhen securities exchange. This will be a major benefit in assisting enforcement. Both markets will have the same level of monitoring of information available to them and in turn this will be available to the CSRC.

The Regulatory Framework

National securities legislation and regulation

China today has no national securities law.2 Its securities markets are governed by a series of regulations, currently split between those that apply nationally and those that are set at local level.3 Early securities regulations were promulgated in 1987 and were supplemented by a State Council circular and PBC circular in 1989. The first national regulations on securities issuing and trading (the Interim Regulations on Share Issuing and Trading) were issued in May 1993 by the State Council Securities Committee (SCSC). This set of more than 20 regulations forms the framework within which the present regulators of securities markets, the SCSC and China Securities Regulatory Commission (CSRC) operate. A draft national securities law has been under preparation since 1993, and was put before the People's Congress in October 1994, but has still to be ena~ted.~Meanwhile, a major step forward for securities market regulation was the new national Company Law, which came into effect on 1 July1994. In the absence of a securities law, the Company Lawcontains several provisions regarding the issuing, trading and listing of 'public' securities which might more normally be included in the securities law. The law does not replace or abrogate previous regulations and must therefore be incorporated as a new layer into the existing legal framework.

National regulatory structure

Until 1992, all securities related matters were supervised by the Financial Administration Department of the PBC. The PBC was also closely involved at the regional level through its branch offices. Following the Shenzhen riots of August 1992, authorities decided to establish a new, national regulator for the developing securities markets. Details were promulgated in Document No. 68 issued by the State Council (1 7 December 1992). The new two tier structure has a first arm which consists of the State Council Securities Policy Committee (SCSC). The SCSC is responsible for macro policy issues relating to the securities markets. Such matters include the approval for the establishment of new Stock Exchanges and the approval of new securities legislation and regulations. It is also the body responsible for setting the level of securities issues over a given period both for bonds and shares at the national and provincial level, in conjunction with the SPC.5

The second tier is the executive arm of the SCSC, the China Securities Regulatory Commission (CSRC).6 The CSRC has been established to operate as an independent legal entity. As such, it has taken over most of the functions previously performed by the Financial-Administration Department of the PBC. The major functions of the CSRC are officially:

to draft securities legislation and regulations to supervise and administer the public issuance, listing and trading of securities (examination of prospectuses, business activities, etc.) to supervise and administer securities firms, custodians and institutions for settlement and delivery, mutual funds, and the professionals engaged in the securities industry to set up qualification criteria and issue licenses for securities professionals (such as accounting firms, asset valuers and legal firms engaged in securities business) to supervise and monitor companies which issue securities (including the acquisition and merger of public companies) to regulate companies which want to list on overseas exchanges and, to supervise the operation of securities exchanges and automated quotation systems.

The list of responsibilities is substantial, and the present staff of the CSRC, at a hundred and twenty persons, is not adequate to discharge them. Consequently the institution is severely stretched. Meanwhile, although most of the PBC's regulatory functions were transferred to these two new bodies from December 1992, the PBC remains responsible for the licensing of all financial institutions including securities intermediaries. The implication is that the role of licensing intermediaries and their on-going supervision is split between two bodies.

The scope of the work of the CSRC is broadly similar to other national securities regulators.' The one anomaly in China is the role of the PBC in licensing intermediaries. This occurred for historical reasons, since over 90 per cent of brokers originated as subsidiaries of banks. Regional regulatory structure

Prior to November 1992, regional regulation was carried out by the provincial governments, in conjunction with strong central regulation by the PBC through its local branches and other government offices. Local securities regulatory bodies were established in Shanghai and Shenzhen by the local municipal government, namely the Shanghai Securities Commission and the Shenzhen Securities Commission. The character and regulatory authority of these offices is illustrated by the example of Shanghai (Shenzhen is similar). In terms of its role as a regulator, the main points of note are:

The Shanghai Securities Commission does not have authority in any area where there is a national regulation. If, however, national regulations are silent on a point, then municipal regulations including any from superseded regulations can be enforced. In terms of links between the regional and national regulators, the Shanghai Securities Commission still reports on a day to day basis to the Shanghai Municipal Government and not the SCSC or CSRC.8 Yet it is responsible to the CSRC for the proper administration of the national regulations and is required to bring to the attention of the CSRC any observed breaches or problems within the CSRC's jurisdiction. In terms of three-way links between the central and regional regulators and the PBC, the position is complex, especially with respect to securities dealers. Although the PBC is responsible for the licensing of securities dealers, and their on-going financial soundness, the Shanghai Securities Commission also feels some responsibility for their business performance. At the same time, the direct operation of the secondary market is overseen by the SCSCICSRC, and if a broker is in violation of the regulations, the CSRC is responsible for investigation and penalties. In the most serious situations it can suspend a broker from trading. On the other hand, it is only the PBC that can revoke the license of the broker and only the authorities of the exchange that can remove the broker from the exchange floor.

The implication of the present regional and institutional division of responsibilities is that those who are actually in and near the exchanges and who know what is going on have no authority to investigate or penalise. The CSRC has the theoretical power but no branches nor has it delegated any authority to the regions. Effectively, the power is geographically separated from the action, and this can lead to inefficiency and duplication. On the other hand it avoids an over-familiar relationship developing between the regulator and the regulated.

3 1 The Shanghai Securities Commission

Some regulations on securities issued by the Shanghai municipal government. have been superseded by national legislation. These regulations are administered by the Shanghai Securities Commission. Regulations still in force (at the end of 1994) include:

Shanghai Measures for the Administration of Trading in Securities, 27 November 1990. Shanghai Measures for the Administration of Special Renminbi Shares (jointly issued by the PBC and the Shanghai Municipal People's Government) 22 November 1991 (and Implementing Rules) - these are commonly known as the B share regulations.

The Shanghai Securities Commission consists of 13 people, including representatives from the following commissions and ministries:

the Vice Mayor of Shanghai the Shanghai PBC the Shanghai Planning Committee the deputy director of the Shanghai Commission on Restructuring the Shanghai Bureau of the MOF Municipal Auditing Bureau Shanghai Foreign Investment Commission Municipal Office of justice the Director of the Office of the Commission Deputy Secretary General of the Municipal Government responsible for assets and, Shanghai Branch of the State Asset Management Bureau.

The Shanghai Securities Commission operates through the Shanghai Securities Administration Office which is headed by a director and has a staff of 22 people split into five departments:

The companies division which regulates existing companies and the lPOs of A shares. It is also responsible for overseeing the newly introduced coaching period for new companies wanting to issue shares. The market department which is responsible for regulating the B share market and the introduction of new financial instruments such as ADRs. It regulates B share brokers, granting them the licence to trade, and keeps up a close liaison with the Stock Exchange. The supervision department which looks into potential breaches of the regulations and deals with disputes between clients and brokers. There are no formal rules for the latter and the problems are usually solved by putting moral pressure on the parties involved. An average of ten such complaints per month are received, generally concerning the broker's failure to carry out a client's instructions. The conflicts are normally solved. (This informal method of solving disputes can be very effective in a small market and usually results in speedier conclusion than if there are bureaucratic procedures.) The remaining two departments cover research, the handling of confidential documents and general administration.

The office does not have any responsibility for the administration of company law.

The reguhtion of bonds

The SCSC and CSRC are essentially responsible for the supervision of equity markets, including equity ^.^ The regulation of debt securities is less well defined and more fragmented than the regulation of equities. The roles of various bodies in this context are set out in Document No. 68, according to which:

The MOF is in charge of the issue of state treasury bonds. The PBC is in charge of the approval of bonds issued by financial institutions and the securities of investment funds. The SPC is in charge of the inspection and approval of state investment bonds and bonds issued by state investment companies. The PBC and the SPC are together in charge of the approval of central enterprise (corporate) bonds and, Provincial or municipal governments are in charge of the approval of regional enterprise (corporate) bonds.

This division of responsibilities covers regulation only in the primary market, and its fragmentation reflects the great variety of government debt issued in China until 1993 (see Chapter 3). The PBC is responsible for bond trading activities only to the extent that it approves securities trading centres. Monitoring bond trading on a daily basis, to the extent that this occurs on the two officially recognised exchanges, is within the realm of the CSRC, which is meant to supervise the activities of the exchanges. But monitoring the actual trading of bonds, especially government bonds, has been a grey area. The PBC, while responsible for the trading of government securities, has not had the capacity for regular monitoring, and has tended to control by the issue of ad hoc regulations as problems manifest themselves.1° Even at the official exchanges, the CSRC has hesitated to intervene, as this could be regarded as an encroachment on the PBC. Outside the two official exchanges, the CSRC does not have any rights of intervention. The government was recently made aware of the lacunae by the government bond futures trading debacle on the Shanghai Exchange in February 1995 (see Chapter 3), and it is now drafting a Government Bond Law, which is expected to cover the supervision of bond trading activities.

Securities market regulation in the US

Through a combination of competition ITS, these exchanges are linked and direction from the SEC, the US electronically so that a securities dealer securities market has developed a can see on which exchange the best bid national market framework. This or offer price for a particular security is framework comprises three national available. The ITS system then directs the markets; namely the New York Stock dealer's order to the exchange where he Exchange (NYSE), the American Stock can get the best price at that moment in Exchange (AMEX) and the OTC market time. operated by the National Association of Securities Dealers, called NASDAQ. The national trading market is supported by a national settlement system. A The NYSE is America's largest exchange Depository Trust Company (DTC) and a and acts as the Big (or Main) Board. AMEX National Securities Clearing Corporation plays a more specialist role for medium (NSCC) have been set up by the NYSE, size companies and equity options and AMEX and NASD (amongst others). Other the NASDAQ market has specialised in exchanges like Chicago have their own providing development capital for small depository companies but with links to and innovative companies. In addition, the DTC. The DTC and NSCC provide there are several regional exchanges such the mechanisms to clear trades made on as Chicago (in the Mid-west) and the any of these exchanges and the DTC Pacific (on the West coast). The SEC has immobilises securities and enables those sought to ensure that there is a national trades to be settled between participants market framework through the by book-entry transfers, on a nationwide lntermarket Trading System (ITS). Under basis. Reguh tion of derivatives

Until February 1995, there was no specific legislation for financial derivatives in China. At present, stock index futures, and products such as options and swaps, are not permitted in China, and the principal form of financial 'derivative' securities has been the futures contracts on treasury bonds, which were first offered on the Shanghai Exchange at the end of 1992 (see Chapter 3). Following the incident of runaway speculation on these securities on 23 February 1995, China rapidly promulgated (1 March 1995, effective from 23 February 1995), new regulations on derivatives trading." The new regulations, inter alia, provide:

that only those individuals approved by the CSRC and the Ministry of Finance are eligible to trade that brokers cannot lend their seats on the exchange to smaller traders daily price variation limits (set at Rmb0.5 in Shanghai and Rmbl .O in Shenzhen limits on the number and volume of contracts for individuals, brokers, and institutional investors new deposit requirements, which increase as the settlement date approaches, and the right of regulators to change margin deposit requirements12 daily markings of contracts to market, and new disclosure requirements for brokers to their clients and to the regulators.

The nature of these provisions reflects international practice.

Regulations for overseas share issues

Special Regulations Relating to Shareholding Companies Issuing Shares and Listing Abroad were issued by the State Council, as implementing regulations under the new Companies Law on 19 August 1994. These regulations relate to foreign share offerings and overseas listings by Chinese companies and are intended to codify some of the practices and procedures which were developed to deal with regulatory grey areas during the first H Share issues. Under these regulations, shares which are issued to PRC investors and listed on a domestic exchange are defined as 'domestic shares', while shares issued to non-PRC investors, and listed overseas, are defined as 'foreign listed shares'. The regulations d~onot define B shares, which are issued to non-PRC investors but listed only on domestic exchanges. The regulations require all issues of foreign listed shares to be approved by the CSRC, to be issued in registered form, and denominated in Chinese currency, although they are sold and purchased in foreign .13 The regulations acknowledge that depository receipts may be issued over Chinese shares and these depository receipts are regarded as foreign listed shares. In many respects the regulationsformalise arrangements already put in place by the H share issuing companies. Thus the regulations empower the SCSC and CSRC to enter into Memorandums of Understanding (MOUs) with overseas regulators, but MOUs had already been signed with the Hong Kong and London Stock Exchanges, and the US SEC. Similarly the regulations permit a company to maintain its register of the holders of foreign listed shares outside China (on condition that a copy of the register is kept at the company's main office); a provision already agreed to for Hong Kong listings. The regulations empower the SCSC to specify certain mandatory provisions to be included in a company's articles of association if it is going to issue foreign listed shares. Again, these provisions will likely be similar to the mandatory article provisions stipulated by the Stock Exchange of Hong Kong for existing H Share issuers. In some respects the regulations represent a modification of the Companies Law; notably, they permit a company to increase its share capital and issue foreign listed shares at intervals of less than one year. This facilitates the initial public offering of shares to foreigners as well as subsequent issues of new shares to non-PRC investors. While they contain some provisions which would not be found in most countries, these provisions may be permitted in circumstances which may arise in China.14

Although the issue of the Company Law and related regulations has added some confidence to overseas investors, there is no doubt that the untried nature of the laws, their ambiguous overlaps, the lack of a national securities law and the lack of experience of Chinese companies in operating to international levels of management, efficiency, governance and accounting, remain deterrents. The absence of a national securities law and the periodic sensational incidents surrounding the market compound this effect. These factors are more likely to affect foreign investor confidence than the substance of the regulations, which is generally satisfactory.

Links to other regulations: The Company Law and securities markets.

Until the Company Law came into effect on 1 July 1994, China was unique in having shareholding companies and a securities market operating without either a companies law or a securities law. However, prior to this, there were national regulations on shareholding, issued by SCRES, as well as regulations issued by both the Shanghai and Shenzhen Municipal Governments, to cover the formation of companies limited by shares both within their municipal jurisdictions and for companies outside the municipality listed on their exchanges.

The main regulations issued in 1992 by SCRES were the Standard Opinion on Companies Limited by Shares and the Standard Opinion on Limited Liability Companies.15 The new Company Law of 1994 does not state that it replaces the Standard Opinion (or previous regulations) and it must therefore be incorporated into the existing legal framework of companies regulations. Effectively, two bodies of law regarding companies are in existence today and no organisation is in an authoritative position to say which prevails. Over 90 per cent of listed companies were formed under the Standard Opinion or previous municipal regulations.16 It should also be noted that the national Company Law makes no mention of the distinctions between A, B, C, H and N Shares and thus their only formal definition remains in the Standard Opinion. To the extent that this envisages the removal of such distinctions, which are increasingly uncommon in developing as well as developed company legal structures, this absence is appropriate. But if multiple share categories persist, the present laws are contradictory.

In the absence of a national securities law, the Company Law has some provisions which would usually be found in a securities law. Many of these provisions are valuable and offer investor protection in the absence of a securities law. But some others may be considered unduly restrictive.

Securities related provisions of the Company Law: some restrictions

Share issues A potentially restrictive clause of the Company Law is that all share issues to the public must be fully underwritten. This requirement may restrict the capital raising efforts of companies. This is because underwriting depends not only on the viability of the issue, but also on the size and availability of funds for underwriting. An otherwise viable equity issue could be prevented from going to market because of constraints originating from the nascent financial infrastructure in China. One possible alternative solution to completely underwriting an issue, is to pre-place a portion or all of the issue. Today the restriction on underwriting may have little impact because of the large role of the government in appointing underwriters (see Chapter 3). If underwriting were truly competitive, this restriction would have greater impact. A second restrictive clause with regard to share issues is the requirement that a company limited by shares may only make subsequent issues of shares if it has been profitable for the previous three years and there has been more than one year since the last share issue. This limits a company's ability to raise fresh capital, and may be particularly limiting if it needs new capital injection for rescue or restructuring.

Share transfers The Company Law requires:

all share transfers to take place through a securities trading exchange. This limits share trading to the Shanghai and Shenzhen Exchanges, and STAQS and NETS. This implies that the transferor and transferee have to go through the expense of a market transaction, eg, brokers' commissions. While this may reduce the possibilities of fraud, it could also be said to frustrate rights to pass on ownership unimpeded. Elsewhere, special arrangements are made for essentially non market (direct) transfers which reduce the cost burden. that directors of a company may not transfer their own shares during their term of office. This is one of the points that is in conflict with the Standard Opinion, which permits directors to transfer their shares after three years. While this reduces the channels for insider dealing and avoids the need for detailed regulations on the disclosure of directors' dealings (which may be important considerations in China today), it is not in line with normal international practice and is restrictive. Prohibiting directors from dealing will discourage them from having a financial interest in the company.

Share listing It is not usual to put minimum listing standards into a company law. In most countries these are set by the Stock Exchange, subject to standards approved by the relevant SEC. In China, this partly reflects the weak role of the exchanges in deciding upon listings (see Chapter 4). In the absence of a national securities law, however, it may be acceptable for the present. International comparisons are given in Appendix Table A2.2.

Corporate bond issues The law requires all bond issues to be approved by the Securities Administration Department of the State Council which will grant or withhold approval within limits prescribed by the State Council. Corporate bonds may be listed to facilitate transfers, although this is not essential (para. 170 of the Company Law). However, where the bonds are to be listed is not clear. Bonds may be bearer or registered bonds. Bond issues must be preceded by an Information Memorandum, and the Company Law sets out provisions relating to its contents, and also relating to app;oval documents which must be delivered to the Securities Administration Department; and the form and contents of the bond certificates themselves. The issuer is also obliged to maintain a Register of Bondholders. Bonds may be issued by all limited liability shareholding companies (with at least two shareholders which are state-owned entities) or by wholly state owned companies (para. 159 of the Company Law). The Company Law provides that a company may only issue bonds if it satisfies conditions on:

minimum a maximum ratio of bonds issued to net assets the ratio of distributable profits to interest payments the use of funds raised, which must be invested in industries which comply with the policies of the state, and may not be used to cover losses or non-productive expenditures the interest rate, which may not exceed the Iimit set by the State Council, and, any other conditions which may be imposed by the State Council.

A company will not be permitted to issue bonds if:

on the last occasion when it issued bonds, the company failed to raise the full amount required, or, the company has defaulted in payment of principal or interest on bonds already issued.

The State Council is also empowered to set limits on the scale of all company bond issues and the CSRC, as one of the organs of the State Council designated for this purpose, may only approve bond issues within this overall Iimit. Acompany can also issue convertible notes if it satisfies the conditions applicable to both a bond issue and a public share issue. The Company Law does not envisage companies issuing unlisted securities such as short-term floating rate notes issued to a syndicate of banks. Some of these provisions are unusual (eg, the restrictions on fund use or the interest rate, or on the success of the previous bond issue), and also the provision that the state council is empowered to set limits on the scale of company bond issues. They reflect the coexistence of central planning and the emerging market economy. Links to other regulations: banking laws and securities laws

The role of the central bank, the PBC, in securities regulation is at present defined in the securities legislation described above; primarily Document No. 68, and the Interim Regulations. A key issue of importance for China is the extent to which specialised or commercial banks should be allowed to participate directly, or through their subsidiaries, in securities markets. Links between banks or other financial institutions, and securities dealerships have very recently been spelled out in the new Commercial Bank Law, declared effective from 1 July1995. For the first time, the new law considerably clarifies in legal terms the degree of separation between banks and non-bank financial institutions. While new commercial banks are allowed to underwrite and trade government securities, they are not allowed to engage in any operations related to other securities. Dealing in stocks is expressly forbidden. Commercial banks are also forbidden to invest in trust and investment businesses or real estate, and are also forbidden from indirectly investing in non- bank financial institutions. Stiff penalties are detailed in case of contravention. However, the new law does not deal with existing investments of existing banks in non-bank financial institutions. these are to be covered, according to the law, by separate implementing procedures, to be prepared by the State Council. Given that the large banks in China have a substantial or majority stake in many of the most important and largest securities dealers, this is an important remaining lacuna and it is hoped that this area too will soon be clarified.

In the context of China today, there are several advantages in keeping the securities activities in separate subsidiaries:

the securities firm can more easily be regulated by the CSRC, without jurisdictional conflicts with the PBC the securities firm can be required to meet the usual capital adequacy requirements for brokers, with separate capital from the bank, and, the traditional deposit taking functions of banks can be protected from potential losses in the securities business."

Other issues which affect the effectiveness of regulation It is recognised today that market regulation depends not only on the legal framework, but also on other forces which have a defacto regulatory role, notably, first, the press and media.18 There are few international standards for press reporting and it is not normally the subject of special regulation. The press should educate their journalists with reasonable standards in financial reporting. The Shanghai Securities Exchange initially disseminated information through Friday meetings with journalists. These have been replaced by daily nationwide information dissemination which should improve the quality and timeliness of reporting. But in November 1994, the Shanghai government announced restrictions on the number of papers that could carry securities news. While the deliberate starting of false rumours is wrong, these new measures overlook the fact that education is the key to moderating rumours in the first place.

A second key factor is the education of the public. Investor awareness of the fundamentals of the companies they invest in, and of the possible consequences of speculation, must be raised. Speculation occurs in all markets, and should not in itself be an issue of concern. The aim should be to increase investor awareness so that they are in a position to judge if they wish. Investor awareness can take many years to build up, but in the final analysis is probably one of the most cost effective forms of investor protection.lg

Third, credible enforcement is required for any regulations to be effective. Rules and laws that are not enforced lose their effectiveness. Widespread and continuous lack of enforcement after a point can become legal defence for circumventing legislation, by citing 'common market practice' (which has occurred in Hong Kong). But the costs of regulation and enforcement must also be weighed, and an appropriate trade-off has to be found for each market. The maximum use of electronic surveillance mechanisms, which are currently being installed in the CSRC, Shanghai Securities Exchange and the Shenzhen Securities Exchange, should be made. A major problem is the lack of sufficient skilled regulatory staff, at the centre or the regions.

Regulation of Securities Issue and Trading: An Evaluation

Selection of enterprises for securities issues

Access to the emerging capital markets in China is restricted in several ways:

The State Council, through the SPC, regulates the volume of securities issued and their terms, by setting annual limits on the amount of shares that can be issued. The State Council also sets limits on the amount of bond issues and the maximum interest that can be paid on corporate bonds (see Company Law above).IO Access to overseas listings is restricted, and is subject to case-by-case approval. The local government of the province in which a company is located must approve companies for public offering of equities of bonds (local SPC approval is also required for bond issues). The SCRES and the CSRC must approve companies for public issue.21 The government can impose temporary bans on share issues to satisfy macro- economic objectives.12

The quota assignment for securities, and the multiple layers of central and local government approvals for listing (ie, approvals other than those required by the exchanges) reflect the continuing existence of the planning framework within the new market economy, and as such, reflect a policy choice. From a regulatory standpoint, the most serious of the obstacles to listing is (5) above; that the Government can stop agreed listings from going ahead to boost the market. This amounts to unwarranted market manipulation of a major nature.

Having made a public issue and met the specified criteria, a company may apply to the listing committee of an exchange for listing. Listing criteria are specified at a national level under the Interim Securities Regulations and the Companies Law (details are in Annex 2.3 and international comparisons are in Appendix Table A2.3). Local criteria are also provided for at Shanghai and Shenzhen. The criteria are broadly in line with international standards. According to the regulation, a decision on the application must be made within 20 days and the CSRC must then be notified of the decision. In practice, it is a merit regulation system and once the necessary regulatory approval criteria have been met, the exchanges do not exercise discretion in choosing their listings.

Trading The integrity of the trading, settlement and clearing systems is essential to ensure that brokers and thus investors are fairly treated (ie, that the orders from one type of broker are not given preference above those from another type of broker); to reduce the possibility of fraud and manipulation, and for the minimisation of overall risk. 'The electronic systems in both exchanges are relatively sophisticated (as well as STAQS and NETS) and are consequently much easier to monitor than old floor based systems and enhance the opportunities for good market transparency. The features of the system (eg, automatching, fair algorithm, surveillance and monitoring systems, adequate back up systems) are as important as the written rules. Details of how the trading systems operate are given in Annex 2.4. Details of clearance and settlement procedures are in Annex 4.1, which shows that present procedures in China are, on the whole, adequate. With effect from 1 January 1995, the CSRC abolished T+O settlement on the Shanghai Exchange. The measure, which was announced several months in advance, helps prevent speculation by abolishing day-trades. Problems in the trading system at present do not appear to be on account of either the regulations, or the trading systems, but rather, due to difficulties in ensuring compliance with rules. There have been allegations of brokers undertaking fixed-day trades without prior permission, undertaking unauthorised deals on their own account, of exchange members 'loaning' seats to others, and other transgressions.

Accounting and disclosure requirements

Under the new Companies Law,23 all listed companies must issue a financial report every six months.24 The CSRC also has regulations on disclosure, which, though not the same as regulations under the Companies Law, are of generally good standard. The CSRC has also issued a set of implementing regulations on the contents and form of annual reports. It is unusual for these to be set by a body such as the CSRC, and this is a reason why these annual report rules are not as detailed as the standards that are set in other countrie~.~~

Detailed accounting standards are currently being formulated in China. As far as possible the accounting standards should conform to those of the International Accounting Standards Committee. Any deviations from the standards should be clearly stated and explained in the notes to the accounts. Particularly if a company has issued B shares or H shares to foreign investors it should prepare its accounts in accordance with IAS for their benefit.

The difficulty again lies more in compliance than in the nature of the regulations. For the year ending 1993, only 75 of the 183 listed mainland companies submitted acceptable annual reports according to the CSRC. As at the end of July 1994, 14 companies had failed to submit a report at all and five submitted a copy of a newspaper clipping of financial reports.

Part of the problem stems from the shortage of qualified accountants in China. It is estimated that there are presently about 11,000 certified public accountants (CPAs), but there is a need for 300,000. The Ministry of Finance has instituted training courses run by foreigners to help rectify the problem, but this will take time. Compounding the problem is the fact that companies all have the same fiscal year ending, which serves to strain the limited resources further. The possibility of bringing in overseas accountants is limited by the relatively high costs involved. The CSRC has indicated their concern with the widespread problem and has threatened to suspend trading in non-conforming companies' securities.

The lnterim Regulations on Share Issuing and Trading as well as the CSRC's regulations provide for the disclosure of material events to shareholders and the public. On the occurrence of a 'significant event', a listed company must immediately submit all relevant documents to the stock exchange and the CSRC, and shall issue a public notice setting out the facts.26Again these regulations set good standards. The extent to which companies have adhered to them is debatable.

Disclosure requirements under the Companies Law and the lnterim Regulations provide that every offer of securities to the public to be supported by a prospectus. In addition, the CSRC has issued implementing regulations on the information to be included in a prospectus which are reasonably comprehensive in scope, called the Detailed Implementing Rules on the Disclosure of Information by Companies Making Public Offerings of Shares (for Trial Implementation).

All the above disclosure requirements are generally well framed. But in practice their effectiveness will depend on the way in which they are implemented.

Investor protection: individual and institutional investors

China's lnterim Securities Regulations require that no individual may hold more than 0.5 per cent of the issued ordinary shares of a listed ~ompany.~'Directors and supervisors are required to notify the CSRC of their shareholdings, and any changes therein, within ten working days. An institutional investor (legal person) who holds, directly or indirectly, more than 5 per cent of a listed company's issued ordinary shares must disclose hislher holdings to the company, the CSRC and the exchange where the shares are listed within three working days. Any change of 2 per cent or more in such holding must be reported and announced in the same way. These standards are sound. The CSRC publicises, to the extent to which information is supplied to it, reports on directors and substantial shareholdings. The role of a prospectus in the share issue process: China and other countries

Prospectuses have to serve two functions: style offer the securities are usually marketed through a syndicate of brokers marketing, and, with networks of retail sales staff. In compliance with disclosure addition, the overall philosophy between requ irements. regulatory regimes varies so there is not one overall international standard for the Regulatory regimes have differences in preparation of prospectuses although emphasis on these topics. In the US, the there are generally accepted good compliance function takes precedence principles. At the moment China uses a and so the document tends to be drafted UK/Hong Kong style public offering in the first instance by lawyers. In UK or mechanism. The prospectus rules are set Hong Kong, marketing tends to be out clearly and are good by international considered the prime purpose so that standards but the excess of demand over initial drafting is by merchant bankers. supply means that issuers regard the full This derives primarily from the fact that prospectus as merely a regulatory burden, in a UK/Hong Kong style public offer the ratherthan a marketing tool. This is likely securities are marketed to investors to change once supply and demand are through the prospectus, whereas in a US more equally balanced.

Insider dealing and market manipulation

Under the lnterim Securities Regulations, any director who holds more than 5 per cent of the voting rights of a company and who, within six months of a purchase of company shares, sells shares (or within six months of a sale, purchases more shares), and thereby makes a profit, must account for such profit to the company. This is similar to the US law on this issue.28 The lnterim Regulations also include other standard restrictions against insider dealing (Annex 2.5 has details). The issue regarding investor protection is to enforce disclosure of and anti- market malpractice measures.

Resolution of disputes and compensation schemes

The lnterim Regulations state that any dispute in relation to the issue and trading of shares may be referred, by agreement, to an arbitration institution for conciliation and arbitration. In late October 1994 the CSRC announced that rules governing disputes between brokers and exchanges and between brokers and brokers would shortly be issued, pursuant to the promulgation of the Arbitration Law in August 1994. The arbitration approach is preferred because the courts are not familiar with securities matters and legal action is likely to be very time consuming. Procedures are thus being set up. At a municipal level, client complaints are being dealt with by the local SEC.

There are no compensation schemes for investors in China at the moment. The existence of compensation schemes is held of paramount importance in the securities regulatory schemes of some countries. However, they can be costly to set up as eventually the investor is paying for his own protection and the rules about who can be compensated for what have to be very clear cut. A decision has to be taken as to whether investors alone can be compensated or whether there will be some sort of mechanism for intermediaries as well. A guarantee fund can be set up as part of a national clearing and settlement system. The other side of the argument is that the existence of such a fund encourages slackness. At present this is not a priority issue.

Corporate governance of the exchanges

The Interim Regulations contain provisions to stop the exchanges from operating in self-interest and there has been no reason to believe that the regulations are not enforced.

To summarise, in the absence of a securities law, and in the absence of many conventional aspects of a market structure, the interim Regulations, the parts of the Company Law which refer to securities, together with CSRC's implementing rules and municipal regulations, form a regulatory structure that covers the large part of securities regulation in a fairly standard framework, particularly with regard to secondary markets, despite the fragmentation, multiple sources, and sometimes overlap of regulation. The greater issues faced have been the large role of the central and local government, especially in the primary issue process; the possibility of ad hoc intervention by the government in the market; and the difficulties of enforcement and ensuring compliance with the regulations. Regulation of Participating Institutions

Brokers, dealers and underwriters: domestic securities The key issues here are that while the CSRC supervises most brokers' secondary market activities, the PBC licenses them in the first place. This separation is unusual in international terms. It arose because first, the PBC was the original regulator and second, most major securities dealerships were set up as bank subsidiaries, so that the PBC would be in the best position to monitor their capital adequacy. The situation is unusual. It would be acceptable provided that the PBC takes a proactive role in ensuring on-going compliance by brokers but at present it is not clear that it fulfils this role. The CSRC, however, also has problems in regulating brokerage activities as it has no branch offices and is thus effectively dependent on information provided by the exchanges and the local government. Approval of securities dealers is undertaken at a local level, by the respective branch offices of the PBC. Regulations governing securities dealers are also at the local level. Details of present regulations are in Annex 2.6. Rules are more detailed at Shenzhen relative to Shanghai, especially in terms of capital adequacy requirements. Within this framework, the Shenzhen rules mainly require the members to exercise self-regulation.

Securities dealers in the B share market

Domestic and foreign securities dealers may participate in the trading of B shares, but the rules governing foreign dealers restrict their role, relative to domestic dealers, and offer them fewer rights. In Shanghai, securities dealers engaged in B share business must be approved by the PBC. Securities dealers in Shanghai who are authorised to engage in B share business may only act as placement agents in an issue of B shares and as an agent in the trading of B shares. Special authorisation from the PBC must be obtained for the underwriting of B shares. Unless special approval has been given, domestic securities dealers may not deal in B shares for their own account.

An application by an overseas securities dealer for permission to act as agent must be supported by a recommendation from a domestic securities dealer. The paid-up capital of an overseas B share securities agent must be at least US$10 million and the agent must have carried on a securities business locally for more than five years, have a good business reputation and a sufficient number of special securities staff. An overseas B share securities agent acting for a domestic securities dealer must sign an agency agreement that sets out clearly the rights and liabilities of both parties, detailed operational procedures, and any liabilities for breach of contract. The agency agreement must be approved by the PBC. In terms of underwriting, an overseas financial institution may apply to the PBC to qualify as a B share sub-underwriter. Overseas securities dealers have pointed out that the inability to assume lead underwriter responsibilities is restrictive, especially as they would typically be expected to have a better knowledge of foreign investors than local underwriters.

The Shanghai Exchange has created a new category of membership, with the establishment of 32 special seats to deal in B shares. These special seats are available to foreign brokers, but have to be held in the name of a Shanghai broker nominee at the same fee rates as for full local members. These special memberships can send orders directly to their own traders on the trading floor of the Shanghai Securities Exchange. The local broker is liable to settle all the trades of the special foreign member and the commission is therefore shared between the two firms.

On the Shenzhen Stock Exchange, B share issues may only be handled by an authorised securities dealer, approved by the Shenzhen PBC to handle B share issues and to act as an agent to transfer B shares in Shenzhen. An authorised securities dealer may also organise the underwriting of B shares by overseas securities dealers approved by the Shenzhen PBC. Authorised securities dealers may also enter into agency agreements with overseas securities dealers, whereby the overseas dealer acts as the foreign agent of the authorised dealer to handle matters relating to the buying and selling of B shares by investors. With the approval of the Shenzhen branch of the SAEC, an authorised securities dealer may open B share accounts with banks (including foreign banks) in Shenzhen. The accounts are supervised by the Shenzhen branch of the SAEC. Unless specially approved by the relevant authority, an authorised securities dealer may not buy or sell B shares on his own account, nor underwrite B share issues. Foreign securities brokers (who can satisfy conditions on size, reputation, etc, and obtain PBC approval) can participate in the distribution of B shares. Approved overseas securities institutions may also participate in the underwriting of B shares and act as comanager for a B share underwriting syndicate. Since August 1993, the Shenzhen Securities Exchange has admitted 11 foreign brokers directly to the exchange as special members. Although the seats are held directly in the foreign broker's name, the brokers are not full members with voting rights (which would require approval from Beijing). Each firm has paid a Rmbl million (US$125,000)fee for the seat and a deposit of HK$500,000 (US$65,000) by way of a letter of credit, bank guarantee or cash, to cover settlement defaults. These members are not subject to any special capital requirements but must be a member of an international Stock Exchange and be an authorised B share broker.

Other professionals

Under regulations issued by the CSRC, any lawyers, asset valuers and accountants who are engaged in securities market business must be approved by the CSRC. The regulations set down certain minimum standards and size requirements for such approval. In general, professionals such as accountants, lawyers and asset valuers are regulated by the standards of their own professional body which may in turn be enshrined in the law of the country either directly, such as is the case with accountants in the US, or indirectly as in the UK. While the firms themselves may specialise in, or have departments which specialise in, certain aspects of securities business, it is not common for the securities regulatory body to impose specific qualifications on the professional firm or require them to obtain a permit for the purpose of dealing with matters relating to the securities industry.

However, in most countries, the professions of accountants, lawyers and asset valuers are older than the securities industry and they tend to have professional associations which have well established rules and standards going back in history to before the establishment of the first securities regulatory bodies. Once recognised as a qualified professional, most would regard themselves as equal as individuals (even if in the size of firm they are patently not). In countries such as Hong Kong, where it is not possible for the exchanges or regulatory authorities to designate experienced and approved individuals, difficulties have arisen. Thus, although regulation in China is unusual, it may be appropriate in view of the limited number of qualified and experienced professionals in these areas. Credit rating agencies

China Chenxing Securities Rating Company Limited and Dagong International Securities Rating Company Ltd. are the only two securities rating institutions approved by the PBC. Some 20 or so rating institutions have been approved by various local departments (at the provincial and municipal level) and around 80 or so institutions are said to offer rating services. However many of these do not call themselves rating agencies at present, but rather, consulting firms, accountants, etc. Due to the belief in implicit state guarantees on corporate bond issues, the role of credit agencies is still undevel~ped.~~

Distribution of Oversight within the Government

A key concern in the regulatory structure for securities markets in China today is the fragmentation of oversight, both functionally, for different segments of the securities markets, (and for different parts of the market for each security, ie, primary and secondary markets), and regionally, between central and regional authorities. The CSRC and SCSC are the principal central authorities. The PBC's role in securities regulation is largely effected through its branch offices. Additionally, the MOF has begun to assume a role in this area, and regional governments have powerful bodies of securities legislation.

The CSRC

Prior to October 1992, the Financial Administration Department of the PBC was the main regulator of securities in China. Day to day supervision was carried out by branches of the PBC in Shanghai and Shenzhen in close liaison with municipal governments which issued various decrees concerning company and securities legislation. Following the Shenzhen riots in August 1992 over a new issue, the decision was taken to establish a new, specific regulator for the developing securities markets, with two arms, the SCSC and the CSRC.30 Details were promulgated in Document No. 68 issued by the State Council on 17 December 1992. The SCSC and CSRC are responsible for the supervision of equity securities markets, including equity options.

Some unusual aspects of the CSRC's present structure, which have diluted its effectiveness and authority are: It has no regional offices, and its regional authority thus depends on input from autonomous securities' regulatory bodies for which it has no direct responsibility. It has neither the licensing authority for exchanges nor for securities industry intermediaries. It was established as a sub-ministerial level agency, and as such had limited authority.

There have been instances when the CSRC has meted out penalties for transgressing regulations, which offenders have refused to pay." In recognition of its inadequate status, the standing of the CSRC was raised in early 1995, to an institution directly under the state council. Whether the state council would wish to see a more conventional concentration of power for securities matters located with the SCSC/ CSRC at this stage is a political issue.

The PBC

Although the PBC no longer has a major role in the supervision of equity markets, it has retained responsibility forthe licensing of all financial institutions, including securities exchanges, 'stock trading centres,' and securities dealers, under Document No. 68, although it is required to report to the SCSC. However, this requirement does not apply to securities firms which exclusively trade treasury bonds since they are supervised by the MOF which has apparently said that the PBC's approval is not necessary. This means that the role of licensing intermediaries and the on-going supervision of dealers is split between the PBC and the SCSC/ CSRC. The PBC remains responsible for all bond trading activities, including financial futureson T Bills, and the supervision of mutual funds. Unlike theCSRC, the PBC has a regional presence, through its branch offices.

Other central government agencies

Responsibility for the issue of different types of government securities is primarily under the Ministry of Finance, and has also been delegated to other state financial institutions for a small part of the issue (see Chapter 3). Although the MOF has not required the PBC to license dealers in government securities, it has recently (under the new regulations of 23 February 1995) taken upon itself the authority, together with the CSRC, to license dealers in bond futures. Municipal governments

In the absence of a single strong central authority, municipalities have taken a powerful role in the regulation of securities business within their own jurisdictions. Document No. 68 provides that the Shanghai Securities Exchange and the Shenzhen Securities Exchange are to be administered by their respective local governments and supervised by the CSRC.

Comparisons with other countries

Most countries have a single principal securities regulator, who then comes under the authority of MOF or Central Bank. The regulator is usually responsible for licensing and supervising securities intermediaries (Appendix Table A2.2 has details). A key question here concerns the regulation of debt securities, which in China, like many other Asian countries, have been generally underdeveloped, compared to equities. The easiest way to ensure that inequalities do not develop between China debt and equity markets is to consolidate their governance under one regulatory authority. Both markets should evolve in tandem. Anomalies in this regard are already apparent. In theory debt financing in China should be more welcomed than equity. Not only is debt a cheaper source of financing, it does not dilute the ownership structure. To date, the amount of corporate debt issued has been very small. While there are other problems that constrict the development of the debt market (see Chapter 3, and also high inflation and relatively high pricelearnings ratios for equity securities), regulation can also distort the issuing costs for debt and equity. Slight variations are to be expected, but radical deviations can cause problems. If a situation evolves that is radically different from capital markets in market economies, PRC issuers would be at a disadvantage in global markets and also would not be able to adequately implement modern techniques. A sole regulator provides the most pragmatic approach for the developing securities market in China.

The different levels of legislation create an environment where national regulations may seem to conflict with regional rules, making interpretation difficult. In addition to inter-organisational fragmentation, there are also problems within regulatory agencies, notably the CSRC, which is significantly understaffed and has lacked adequate authority to impose its regulations, especially at a regional level. There is clear duplication between the CSRC and the municipal securities regulatory authorities. The current division of regulatory responsibilities between the CSRC and the PBC leads to instances where de facto there is little regulation (eg, in the monitoring and regulation of the activities of securities dealers). This has also led to problems of co-ordination. A recent example is the CSRC's market support package announcement at the end of July 1994, which included provisions for a line of credit for securities dealers. Although consulted prior to the announcement of the package, the PBC maintained strong reservations about the credit line, due to its concern over aggregate credit. the premature announcement damaged the credibility of the regulators.

The medium term: Government control versus self-regulation

Current self-regulatory framework in China There are no laws underpinning the concept of self-regulation, other than Document No. 68 and the Interim Securities Regulations referenced above. Draft versions of the proposed securities industry legislation have discussed the concept of a self-regulatory association with possibly mandatory membership for securities firms, but whether the self-regulation of stock exchanges is also contemplated is not known.

Various securities industry organisations in China (including the two formal exchanges, STAQS, NETS, the SEEC and the Securities Association of China (SAC)) are today referred to as self-regulatory organisations but, in reality, none of them completely fulfil such functions. In addition, it is suggested that a new self- regulatory organisation is being set up in Shenzhen, at the request of the Shenzhen Securities and Exchange Commission, to be known as the Shenzhen Association of Securities Dealers. This organisation has not yet commenced operations. There is some discussion that a securities association self-regulatory organisation be established in each province.

The two Stock Exchanges and the two trading systems regulate their marketplaces in terms of listing and trading rules, but do not appear to have any conduct regulations governing sales practices or other activities of their members. They do not perform regular inspections of their members to determine compliance with the law and their own rules. They do not have adequate staff to do so. In fact, the CSRC has raised questions as to the commitment of the exchanges to compliance by listed companies with continuing disclosure requirements. In this connection, it is noted that the exchanges are very competitive and do not want to lose listing to the other exchange. The CSRC also reports that the companies themselves are not conscientious in complying with disclosure requirements, as these represent a major departure from the practices they adhered to when they were state owned. Neither of the stock exchanges operates a market surveillance system but an advanced electronic system is in the process of implementation. STAQS does not operate such a system, and while NETS purports to, no details are available. NETS has very few listings at this time and surveillance should not be a problem. The SAC was established as a regulatory body but officials admit that it has been slow to fulfil this role. Its primary function at this time is training industry members. It has expressed that it intends to engage in member regulation and to conduct a periodic examination programme in the future. It also asserts that it plans to operate an arbitration programme.

New self-regulatory organisations Irrespective of the role SAC plays in the future of self-regulation in China's securities industry, it would be a mistake to create any additional securities associations with a view that they be self-regulatory organisations. The optimum situation and the least costly to the industry would be that there be only one such organisation nationwide. It may be that ultimately regional branches of the nationwide organisation would be necessary. With only one organisation rather than a multiplicity, not only would overall costs be lower, but uniformity of regulation could more nearly be guaranteed. Self-regulation does not properly serve its intended purpose if regulation is more strict or more lax in one part of the country than it is in another.

The status of the informal trading centres in this respect is uncertain. While these entities are considered neither exchanges nor self-regulatory organisations, they must be considered when looking at the potential self-regulatory structure of the securities industry in China. At some point their status will undoubtedly be clarified and it is not inconceivable that they will be considered exchanges or some variation thereof. As such they will probably be considered self-regulatory organisations at least regarding the operation of their marketplaces. At present, they cannot be regulated by the CSRC. The CSRC has stated that their status is currently under review and action to legalise them may be taken in the future. Self-regulation in securities markets

Self-regulation when applied to a Stock it requires a genuine commitment to Exchange implies that order will be self-regulation which may not be maintained, according to a prescribed set forthcoming in practice, even if in of rules, where standards are checked by theory the concept is welcomed. a regulatory authority, in parallel to a system of peer regulation by which Self-regulation may cease to be members discipline other members as appropriate: necessary, for any transgressions. It has been described as 'enlightened self- in start up situations, where interest' but the framework must also be participants are unfamiliar with capable of protecting the public interest. market operations in situations where the government Self-regulation has the following may have to make major macro- advantages: economic decisions which may be outside the scope of normal market the operations of the market are operations regulated by practitioners, ie, those where there are multiple exchanges, who are the most knowledgeable and some or all based on international up to date on the matters being electronic networks, unless regulated sophisticated arrangements for lead flexibility and adaptability, so that the regulation are already in place system can keep up to date with where there might be major market conditions, and duplication of effort (eg in the cost effectiveness, relative to a regulation of primary market complete scheme of statutory functions regulation, is another claimed where many international players are advantage. involved, thus increasing the opportunity for cross-border fraud. Its disadvantages are that: Some exchanges confuse self-regulation it can allow conflicts of interest to with an absence of regulation or arise, such as when an exchange legislation, and when stating that they are owned by its members regulates these pursuing self-regulation, are really aiming members. Various self-regulatory for the removal of legislation. There are organisations are said to have been few markets running without any specific 'taken over' by the industry which securities legislation. Thus self- they regulate, and then used to regulation, although presently enforce anti-competitive rules + widespread among securities exchanges, effective in exacting compliance with the and generally considered the best way spirit as well as the letter of rules and to operate among mature markets, is not regulations. Since the 1986 UK Financial always the most appropriate and needs Services Act was implemented, the strong statutory regulation to back it up. situation is considered by many to have deteriorated. With the advent of greater Mature markets: the UK and the USA formality in regulation worldwide there Self-regulatory schemes in developed has arisen a situation in which a regulated markets range from the US institutional person or organisation will tend to model where categories of market interpret the law to his own advantage, participants are defined and the duties leading to the imposition of new rules to which each type of participant must plug any gaps. There is thus a continuous undertake are specified, to the UK cycle of regulation, reaction and re- functional model, where the activities in regulation. need of supervision are identified and regulation for each of these activities is The situation in Asia specified. Self-regulatory status is granted Self-regulation is part of the manifesto of to exchanges and other industry bodies, only a few exchanges and the concept is in the US notably to associations of not particularly well developed in Asia. brokers, who are required to set rules No mention is made of self-regulation in which they must then enforce on their most Asian securities laws. In Hong members. At the moment it is widely Kong, the accepted that the SEC model in the US is claims it is a self-regulatory body but the less cumbersome than that in the UK. term 'self-regulatory organisation' is not Prior to the introduction of the 1986 Act, mentioned in the law. It is however one London used to be a good example of of the Hong Kong Securities and Futures almost 'pure' self-regulation. There was Commission's objectives to encourage a long established system of self- self-regulation. In practice it has had to regulation which was rigorously applied lead the Hong Kong Exchange on many by practitioners to themselves. The codes aspects of regulation. of honour and peer pressure were very

Endnotes

1 Although some Ashare issues in 1994 were also offered outside the region in which the company is based. 2 The legal framework for the financial system in China has generally taken the form of regulations, of which there are now more than 250. Legislation in China can be classified into regulations promulgated by, in descending order of importance: 1.The National People's Congress 2.The State Council and its ministries, and, 3. Provincial and municipal authorities. As a rule, the National People's Congress enacts laws which are general in nature. Authorities at a lower level in the hierarchy will, following the same principle, issue more specific rules and regulations, which fit the context of the local environment. Provisions issued by the lower level authorities are more specific in application and tend to have a more limited sphere of influence. The interlocking rules and regulations, though opaque at first glance, are not haphazard. Appendix Table A2.1 illustrates the structure of securities regulation in China. Annex 2.1 lists current laws and regulations relevant to the securities markets, pointing out which are of national and which are of regional/municipal scope. Responsibility for drafting the national securities law has been with a State Council group. The CSRC, although the proposed executor of this law, is able only to comment on the drafts produced by this group. Divergence between legal views and the view of experienced market practitioners is universal. Eventually, it is importantthatthe law should reflect market realities. The main areas of the national securities law still under discussion include: the relationship between the central and local government regulatory bodies the role of self-regulation, and, the scope for a national over-the-counter market for stocks that do not meet the listing requirements of Shanghai securities exchange and Shenzhen securities exchange. The SCSC consists of 14 representatives from relevant government departments, including the Ministry of Finance (MOF), the State Planning Commission (SPC), the Ministry of Foreign Trade and Economic Co-operation (MOFTEC) and the State Commission for Restructuring the Economic System (SCRES). The Chairman of the SCSC is the Vice Premier for economic affairs (Zhu Rongji). There is an interlocking arrangement of senior officials between the SCSC and the CSRC which facilitates co-ordination. For example, the Chairman of the CSRC is also the first Deputy Director of the SCSC. The Vice Chairman of the SCSC is common to the CSRC. The split structure is similar to that recently introduced in Thailand. Regulation in places like the United States and Hong Kong is operated through a single body, with executive commissioners, but there is no overall balance of benefit in a unified approach. The two-tier approach, with its inherent checks and balances may be preferable in a new market. Appendix Table A2.2 shows the structure of regulatory bodies in other Asian countries. Thus at present, the Shanghai Securities Commission is clearly not a branch of the CSRC. The draft national securities law envisages regional presences of the national body and it would be open to these municipal bodies to take on such responsibilities. In addition, the CSRC is responsible for supervising commodities futures trading. An example is the PBC's periodic regulations concerning the money market. An issue of concern for some years has been the tendency of interbank loans to lengthen in maturity. Thus in 1986, the PBC issued a regulation in which the term could be settled between the two parties. In 1987 the PBC limited the term of loans to less than four months. In 1988, the PBC reiterated that borrowing should be used only for short, rather than long term. In March 1990 the PBC limited the term to generally one, and not exceeding four, months. In February 1992, the term was limited to one month, and most recently, in June1993, the loans were limited todaily transactions in principle, not exceeding 7 days. Financial derivatives are under the jurisdiction of CSRC (Futures Department), but bond market trade surveillance is under the PBC. Overseas derivatives activities by Chinese entities are usually confined to exchanges acceptable to the CSRC, such as the CBOE and clearing members of the exchanges. Variable margin deposits had been recommended for China's commodities futures markets in World Bank (1 994). Dividends and other distributions to non-PRC investors must be denominated and calculated in local currency, but paid in a foreign currency. A company may provide in its articles for another company to make these foreign currency payments on their behalf. This enables H share issuers with foreign subsidiaries to utilise the foreign currency earnings of their subsidiaries to pay dividends, rather than having to repatriate and convert the foreign currencies into and out of local currency, For example, shareholders must indicate whether they will attend, and a meeting cannot be held, even if all shareholders attend, if they have not previously indicated as much. This is an unusual requirement, contrary to conventional principles of company law which hold that shareholders have an automatic right to participate in shareholders' meetings. Yet it is an example of a clause with 'Chinese characteristics' - a fundamental principle subordinated to pragmatism. There could be severe practical difficulties if the venue is too small. The Standard Opinions governed companies limited by shares and limited liability companies throughout China, excluding companies established under the authority of the Shenzhen municipality which 'may continue to implement the Shenzhen Interim Provisions'. In terms of legal status the Standard Opinion was equivalent to administrative measures promulgated by ministry level entities. In addition, there are regional companies regulations which are still in force; the first of which was the Shenzhen Company Law, followed by the Shanghai Company Law. The Shenzhen regulations, for example, are applicable not only to companies limited by shares established in Shenzhen but also to companies established outside Shenzhen with shares listed on the Shenzhen securities exchange. The law gives a grace period, unspecified, but understood by the CSRC to be from three to five years, for companies formed under the standard opinion to comply with the new law. The proper relationship between banking and securities broking is a contentious issue and the trend today in many developed countries is towards 'universal banking'. However the US Glass- Steagall Act still seeks to keep the traditional banking operations of deposit taking and loans separate from all securities business, although there have been calls forthe removal of this restriction, which has been seen as a competitive disadvantage in the international context. In Japan, which was based on the US model, a recent change has allowed banks to set up securities brokers as separate, wholly-owned subsidiaries. A detailed treatment of this subject is beyond the scope of the present study. Press education has been invaluable in a number of developing markets. Although scarcely of comparable size, Sri Lanka adopted a policy years ago that responsible financial journalism was one of the keys to their development and this campaign has been most successful. In Hong Kong in the early 19705, following the early amah boom and bust, the Securities Commission had a very successful 'Investigate before you Invest' campaign. In 1993, the CSRC sought to ensure an even distribution of the national share issuing quota by limiting each province to a maximum of two enterprises per year, but this was dropped in 1994, since the restriction (August 1994) on issuing A shares. Details of clearances for listing at the central and local levels are given in Annex 2.2. 22 The government's reaction to poor performance in the A share market has been highly interventionist. On 29 July 1994 the indices reached record lows of 328.85 on the Shanghai securities exchange (record low for post-1 992) and 95.26 on the Shenzhen securities exchange, after declining by more than 5 per cent per week for several weeks. On the same day, the CSRC, in consultation with the SPC, SCRES and the SETC, announced a series of measures intended to boost the market: a ban on all further issues of Ashares until further notice the provision of a RmblO billion (US$1.15 billion) credit line to securities firms to encourage trading new regulations for foreign securities firms aimed to eventually allow them to buy Ashares, and, the eventual merger of A and B shares. The proposals were not implemented. But meanwhile the market's reaction to the package was both immediate and extraordinary. By 8 August 1994, the indices had risen to record highs of 729.52 on the Shanghai securities exchange (an increase of 122 per cent in one week), and 163.79 on the Shenzhen securities exchange. 23 Article 174 states that 'a company shall establish its financial and accounting system according to the laws, administrative regulations and the regulations of the responsible finance department of the State Council'. Article 175 states that at the end of each fiscal year the company shall prepare a financial report which shall be examined and verified as provided by law. 24 The Company Law requires the financial report to include the balance sheet, profit and loss statement, statement of financial changes, explanation of financial conditions, and profit distribution statement. CSRC's requirements include: an interim report in the first six months of each financial year and an audited annual report. The reports must comply with the accounting standards of China and the relevant regulations of the CSRC. 25 In most countries, the detailed contents of annual reports are specified in a companies law (eg, UK) or in relation to companies that issue shares to the public in a securities law (eg, USA) with additional requirements imposed by the exchange where the company is listed. The accounting standards are normally set out in the accounting law or by the professional accounting body of the country and supplemented by detailed guidance on how to prepare annual (and other periodic) reports for public companies. 26 Significant events include instances when: the company enters into a material contract which may substantially affectthe assets, liabilities, rights or results of the company a substantial change in the business policy or operations of the company the company makes a substantial investment or acquires a long-term investment involving a large amount of money the company incurs substantial the company fails to repay a substantial debt the company incurs substantial operating or non-operating losses the company suffers a substantial loss of its assets there is a change in the production and business environment of the company newly-promulgated legislation, regulations, policies or rules, etc, substantially affect the business of the company there is a change of chairman, in over 30 per cent of the directors or in the general manager a shareholder who holds over 5 per cent of the ordinary shares in issue increases or reduces its holding by 2 per cent or more of the issued shares the company becomes involved in major litigation, and, the company goes into liquidation, or bankruptcy proceedings are commenced. When reported news is misleading and affects the market price of the shares of a listed company, the company must immediately issue a public clarification. 27 However, foreigners who hold B shares are not subject to this restriction. 28 However, the new Company Law states that the directors must declare their shareholdings to the company and may not transfer such shares during their term of office. These provisions are in conflict. 29 International rating agencies (eg, Standard and Poor's and Moody's) have been increasing activities in Asia. Standard and Poor's rates China at a BBB- and feels that this rating will continue until China clarifies its political structure. S&P, which opened an office in Hong Kong in early 1995, estimated that it would have rated 50 public Chinese and Hong Kong companies by the end of 1995. Moody's established an office in Hong Kong in mid 1994 and would be expected to assume a similar pace of development. 30 During 1992, there was much debate as to whether the PBC, which would be a major player in the capital markets, should also be the regulator of these markets. In particular, the State Commission for Restructuring the Economic System (which has been responsible for the reform of state-owned enterprises) is said to have lobbied hard for the creation of a separate regulator for securities markets. 31 In early March, 1995, the Shandong Bohai group, a state-owned conglomerate, refused to pay a Rmbl million fine imposed by the CSRC, after the company manipulated its own share price. Shandong Bohai pushed up its share price on the Shanghai Stock Exchange in August 1994 by 102 per cent, and earned Rmb5.9 million through illegal trades. The company said it had already paid Rmbl.6 million in fines to the Shandong provincial securities commission. The case also illustrates thedifficulties of overlapping central and regional regulatory authorities. (Bloomberg, 9 March 1995). ANNEX 2.1 CHINA: LAWS AND REGULATIONS RELATED TO SECURITIES ACTIVITIES'

Regulations of national scope

Accounting (1 ) Accounting Regulations for Selectedjoint Stock Limited Enterprises (1 January 1992) (2) Accounting Standards for Enterprises (1 July 1993) (3) Provisions on the Qualifications ofAccounting Firms and Certified Accounts in Securities Business (23 February 1 993) (4) General Financial Regulations for Enterprises (1 July1993)

Companies (1 ) Companies Law (1 July1994) (2) Standard Opinion on Companies Limited by Shares (Promulgated on 15 May 1992) (3) Addendum to the Standard Opinion on Companies Limited by Shares Applicable to Companies to be Listed in Hong Kong (24 May 1 993) (4) Measures for Trial Shareholding Enterprises (Promulgated on 1 5 May 1992) (5) lnterim Provisions for the Administration of State-owned Assets in Trial Shareholding Enterprises (27 July 1 992) (6) Interim Provisions on the conduct of Business Relating to Trial Shareholding Enterprises by Registered Accountants (17 September 1992) (7) Special Regulations Relating to Shareholding Companies Issuing Shares and Listing Abroad (made under the Companies Law) .

Securities regulations (1 ) Interim Regulations on Share Issuing and Trading (22 April 1993) (2) lnterim Measures Governing Securities Exchanges (7 July 1 993) (3) Provision on Qualification Confirmation for Asset Valuation Institutions Engaging in Securities Business (20 March 1993) (4) lnterim Provisions of the Ministry of justice and the China Securities Regulatory Commission on the Qualification of Lawyers and Law Firms Engaging in Securities Law Business (1 2 January 1993) (5) Detailed Implementing Rules on the Disclosure of Information by Companies Making Public Offerings of Shares (for Trial Implementation) (1 0 July1993) (6) Rules ofcontents and Format of Information Disclosed by Cornpanies Issuing Public Shares No. 1: Contents and Format of Prospectus {Experimental) (7) Rules of Contents and Format of Information Declared by Cornpanies Issuing Public Shares No. 2: Contents and Format of Annual Report (Experimental) (Promulgated 31 March 1994) (8) Rules on Rights Issues for Listed Companies

Bankruptcy law (1 ) Law of the People's Republic of China on Enterprise Bankruptcy (for trial implementation) (enacted on 2 December 1986) (Only covers state-owned enterprises)

Securities commission (1) Notice From the State Council Regarding Further Strengthening of the Overall Administration of the Securities Market-Document No. 68 (Promulgated on 1 7 December 1 992) (2) Code of Conduct for the Personnel of the China Securities Regulatory Commission (24 July1993)

Note: There are no national regulations on B share issues.

Regional/Municipal Regulations

Shanghai

Companies (1 ) Shanghai Interim Provisions on Companies Limited by Shares (1 July 1992)

Securities regulations (7) Shanghai Measures for the Administration of Trading in Securities (1 December 1990)

Stock exchange rules (1) Shanghai Securities Exchange Trial Implementation Rules for Trading Market Operations (26 November 1990) B shares regulations (1) Shanghai Measures for the Administration of Special Renminbi Shares (22 November I991 ) (2) Implementing Rules to the Shanghai Measures for the Administration of Special Renminbi Shares (25 November 1991 ) (3) Shanghai Securities Exchange Supplementary Rules on Trading Market Operations forspecial Renminbi Shares (Promulgated on 18 February 1992) (4) Shanghai Renminbi B Share Provisional Operational Principles, including Application Procedures for Special B Share Seats (May 1993).

Shenzhen Accounting (1) Shenzhen Special Economic Zone Accounting Standards (Trial Basis) (1 January 1992).

Companies (1) lnterim Provisions of Shenzhen Municipality on Companies Limited by Shares (17 March 1992) (2) Shenzhen lnterim Measures for the Supervision and Administration of Listed Companies (4 April 1992) (3) Regulations of Shenzhen Special Economic Zone Governing Companies Limited by Shares (2 October 1993)

Securities regulations (1) Shenzhen lnterim Measures for the Administration of the Issue and Trading of Shares (15 June 1991) (2) Shenzhen lnterim Provisions for the Administration of Securities Institutions (25 June 1991 ) (3) Shenzhen lnterim Measures for the Administration of Internal Share Instruments (26 February 1992) (4) Operating Rules of the Shenzhen Stock Exchange (22 June 1991) (5) Shenzhen Implementing Rules for the Centralised Custodianship (Promulgated on 28 December 1991) (6) Shenzhen lnterim Measures for the Administration of Special Renminbi Shares (5 December 199 1 ) (7) Shenzhen Stock Exchange Operating Rules for the Trading and Clearing of B Shares (31 January 1992) (8) lnterim Regulations on B Share Crossed Transactions on the Shenzhen Stock Exchange (10 October 1993)

Notes

1 Dates refer to effective date unless otherwise noted.

ANNEX 2.2 CENTRAL AND LOCAL AUTHORITIES' APPROVALS REQUIRED FOR LISTING

Central Authorities: the CSRC

According to the new Companies Law and the Interim Securities Regulations issued pursuant to Document 68 in all listings must be approved by the SCSC/ CSRC. Shareholding companies are selected after an exhaustive approval process under which the entities must meet criteria for assets, management and profitability. Among the documents required are:

an approval from SCRES three years' audited accounts an asset statement audited by an approved accountant certifying the company's net asset value, and, a statement as to the reasons for issuing shares.

The CSRC approval is then given pursuant to both the Company Law and the Interim Regulations. The lnterim Securities Regulations include the following provisions in relation to the issue of shares:

The issuer of securities must be a joint stock limited company which has been established, or which has been approved to be established, which is entitled to issue shares, and which complies with the following criteria:

it may only have one kind of ordinary share, all of which must carry the same rights and obligations the value of the shareholdings subscribed by the promoters must not be less than 35 per cent of the total number of shares to be issued by the company the shares to be subscribed by the promoters must not be less than Rmb30 million (US$3.75 million), unless otherwise provided by the state the portion issued to the public must not be less than 25 per cent of the total shares to be issued.

If the enterprise has recently been converted into a joint stock limited company, it must also meet the following criteria:

at the end of the year prior to the issue, the proportion of net assets must not be less than 30 per cent of the total assets, and the proportion of intangible assets must not be higher than 20 per cent of the total assets it must have made a profit in each of the last three years.

Public share issues must be underwritten by a securities institution.

Article 84 of the Company Law requires that when the promoters of a company offer shares to the public, an application for approval of the offer must be submitted to the SCSC/CSRC with the prospectus and:

documents proving the establishment of the company the company's articles of association the operating budget the promoters' names, the number of shares subscribed by the promoters, the type(s) of capital contribution and investment verification certificate names and addresses of the receiving bankers, and, the names of the underwriters and relevant agreements

This multiple set of approvals is complicated. In practice it occupies a substantial amount of regulatory time both at CSRC and Municipal level.

Listing In practice the CSRC state that approval for IPOs and listing are synonymous - a company cannot have an IPO unless it has a listing. This is along the US merit regulation lines.

Local Authority clearances for listing

Under Chapter 2 of the Shanghai Securities Regulations a company which wishes to issue securities to the public in Shanghai must obtain the prior approval of the SHSEC. At least 30 per cent of the company's shares must be subscribed by the company's promoters.

Under the Shenzhen Securities Regulations a company must obtain the prior approval of the SZSEC and the PBC (Shenzhen Branch). Article 1 5 of the Shenzhen Securities Regulations states that a company must meet the following conditions in order to apply for a public issue of its shares:

the establishment or restructuring of the company must have been approved by the relevant administration departments of the state the production and operation of the company must meet the requirements of the business and industrial policies of Shenzhen the financial status and business achievements must be good, and its net assets must not be less than RmblO million (US$1.25 million) the ratio of net tangible assets to gross tangible assets one year prior to the application must not be less than 25 per cent the promoters must purchase shares worth not less than Rmb5 million (US$625,000) or 38 per cent of the total issued shares of the company stock offered to the public should not be less than 25 per cent of the total issued shares of the company (the relevant authority can increase the ratio of the according to circumstances) the company must have not less than 800 shareholders, and, the applicant enterprise and its promoters must have had a clean legal record for the previous three years.

ANNEX 2.3 CENTRAL AND LOCAL REGULATIONS: LISTING CRITERIA

National Regulations: Interim Securities Regulations and Companies Law

Under the Interim Securities Regulations a joint stock limited company applying for a listing must meet the following conditions:

its shares must have been issued to the public the total amount of its share capital after the public issue must not be less than Rmb50 million (US$6 million) there may not be less than 1,000 individual shareholders each holding shares of more than Rmb1,OOO face value, and the total face value of shares held by individuals shall be not less than RmblO million (US$1.25 million) the company must have made a profit in each of the last three years (this requirement does not apply to a newly-formed joint stock limited company), and, any other conditions imposed by the SCSC.

The new Company Law also contains listing conditions which do not conflict with, but are not identical to, the requirements laid down in the lnferim Securifies Regulafions. The conditions require that the company:

has share capital of at least Rmb50 million (US$6 million) is newly-formed under the new Companies Lawou has a three-year track record has more than 1,000 shareholders who each hold shares with a nominal value of over Rmb1,OOO has offered at least 25 per cent of its shares to the public (or at least 15 per cent if the share capital of the company is more than Rmb400 (US$46 million)), and, has not committed any serious violations in the last three years.

The CSRC is named in the Company Law as the authority to which a listing application must be made and is given authority to suspend a listing if the company:

no longer has sufficient capital or distribution of shareholders makes no accounting disclosures, or makes false disclosures commits a serious violation of the law, or, suffers losses for three continuous years.

Regional listing conditions

For an enterprise to be listed on either the SHSE or the SZSE it must first be converted into a joint stock company limited by shares.

Once converted into a joint stock company, the cornpany must meet the criteria set out below to be listed on the SHSE or the SZSE. Basic conditions for listing on the SHSE Under the rules of the SHSE, to be listed on the Main Board, a company must meet, inter alia, the following criteria:

it must be registered with the Shanghai Department for the Administration of Industry and Commerce its paid-up capital must be at least Rmb5 million (US$625,000) at least 25 per cent of the total issued share capital must be issued to the public the company must have at least 500 registered shareholders it must have been operating profitably for at least two consecutive years prior to the listing it must be sponsored by at least one member of the SHSE, and, it must periodically announce its operating results in at least one newspaper in public circulation.

To be eligible for a second section listing, a company must:

have a paid-up capital of not less than Rmbl million (US$125,000) have at least 300 registered shareholders, and, be at least 10 per cent publicly held.

Listing B shares on the SHSE A company applying to issue B shares on the SHSE must be a company limited by shares, the establishment of which has been approved by the relevant authority. All issues of B shares on the SHSE must be approved by the PBC.

An issuer of B shares must, when satisfying the requirements setout in the securities regulations, meet the following conditions:

It must have obtained approval from the relevant authorities for its use of foreign investment or for its conversion into a foreign-funded enterprise. Funds raised from its B share issue must be applied in accordance with PRC laws and regulations relating to the administration of foreign investment. It must have a stable source of adequate foreign exchange income, and the total amount of its annual foreign exchange income must be sufficient to pay the annual dividends. The proportion of B shares to the total number of shares, in a company which has been restructured from a SOE, must not exceed the ceiling determined by the relevant authority.

Basic conditions for listing on the SZSE

A company applying for listing on the SZSE must meet the conditions required by the Shenzhen Securities Regulations for a public issue of shares (see above), as well as the additional conditions set out in Article 37 of the Shenzhen Securities Regulations.

The additional requirements set out in Article 37 of the Shenzhen Securities Regulations are as follows:

the principal business of the company should have a three-year trading record, and a continuous history of making profits the face value of the ordinary shares issued must not be less than Rmb20 million (US$2.5 million) the ratio of the net tangible assets to the gross tangible assets in the latest year of the trading record must not be less than 38 per cent and there should be no accumulated losses (there are specific requirements for special industries) the ratio of the profits after tax to the yearly paid-up capital for the first two years of the trading record must not be less than 8 per cent and that of the most recent year must not be less than 10 per cent, and, the shareholdings must be reasonably distributed. The number of registered shareholders must not be less than 1,000. All the shareholders who individually hold not more than 0.5 per cent of the total issued shares must together hold not less than 25 per cent of the total paid-up capital.

Article 38 of the Shenzhen Securities Regulations further provides that a company which has not yet made a public issue must have a three-year trading record, and its shares may not be transferred or traded until six months after thle public issue.

If a company applies for a subsequent issue of shares, the Shenzhen Securities Regulations state that the following conditions must be met:

its business achievements since the time of the previous issue must have been sound, and its application of funds must have been of a better standard in comparison with other companies in the same industry sector not less than one year must have elapsed since its last share issue the account of the further issue must not exceed the amount of its existing issued shares (ie a maximum one for one rights issue) its application of the funds previously raised must accord with the industrial policies of Shenzhen, and, the issue must be beneficial to the healthy development of the Shenzhen securities market.

The new National Regulations on Rights Issues will also apply.

Listing B shares on the SZSE

A company applying to issue B shares for listing on the SZSE must meet the following conditions:

it must have obtained written documents issued by the relevant PRC authorities approving its utilisation of foreign investment or its conversion into a foreign-funded enterprise (funds raised from its B share issue must be applied in accordance with PRC laws and regulations relating to the administration of foreign investment) it must have a stable source of adequate foreign exchange income, and the total amount of its annual foreign exchange income must be sufficient to pay the annual dividends the proportion of B shares, including the sponsors' shares, to the total shares of the company must not exceed the ceiling determined by the relevant authority, and, the company must have been operating for at least three years. This condition does not apply to those companies in the field of science and technology, or in other special areas as approved by the relevant authority.

ANNEX 2.4 THE TRADING SYSTEMS

Despite the fact that both Shanghai Stock Exchange and Shenzhen Stock Exchange retain floors, they both operate essentially floorless systems. The Shenzhen Stock Exchange is working towards eliminating the floor, so that brokers operate from their offices. This is the most efficient method provided there are adequate computer back up systems. The Shanghai Stock Exchange are increasing their floors to eight in number. They believe that they can keep a better control of the market by being able to physically watch what is going on, and they also prefer the floor approach as it gives a market atmosphere. There are merits in both approaches. The Shanghai Stock Exchange's approach is in line with modern trends and appears advisable for the present.

Shanghai Stock Exchange trading system for A shares

The Shanghai Stock Exchange is open Monday to Friday and has two trading sessions each day. Opening prices for Ashares are established during a preliminary group trading session that takes place from 9 am to 9.25 am. Although trading is computerised, the Shanghai Stock Exchange want to retain their trading floors so that management and supervision is easier and the atmosphere of a traditional market is retained. At present, the Shanghai Stock Exchange has seven trading floors and the eighth is about to open. The main floor has 21 5 out of the total of 3,154 seats to accommodate 527 members.

Trading in securities in Shanghai is limited to members of the Shanghai Stock Exchange. Only securities approved for trading by the Shanghai Branch of the PBC may be traded on the Shanghai Stock Exchange or over-the-counter in Shanghai. No futures or options trading in equity shares is permitted, as all trades must be spot transactions.

Before dealing on behalf of a client, a broker must open a stock account for the client which is registered with the Shanghai Stock Exchange. The investor is assigned an account number with the exchange and his shares are kept in the Shanghai Stock Exchange. An investor may use any broker to buy and sell.

Brokers may not accept discretionary accounts. Trading is conducted in board lots of shares with a face value of Rmbl times 100 shares ( Rmbl00) and bonds with a face value of Rmb1,OOO. Orders must be routed to the broker's dealer on the floor in strict time sequence.

The trading rules of the Shanghai Stock Exchange provide for trading by , bidding and computerised trading. Most trades are executed on the Shanghai Stock Exchange's computerised trading system except in special circumstances. Orders entered into the system are valid within the day. Orders are automatically matched on a strict time-price priority basis. Prior approval from the Shanghai Stock Exchange is required before a broker can execute a fixed-day trade.

Shenzhen Stock Exchange trading system for A shares

The Shenzhen Stock Exchange is open for trading from Monday to Friday and has two trading sessions each day. Trading on the Shenzhen Stock Exchange is fully automated. Computerised orders are entered through terminals and are valid within the day. The input of orders starts half an hour before the opening of the centralised market. After the orders are accepted by the main computer, automatic matching occurs, starting from the opening of the market. The matching of orders is on a price-time-order priority basis. Both centralised bidding and continuous bidding are used. Centralised order matching is used for the opening and closing of the market. Continuous order matching is used when the opening price cannot be generated from centralised order matching.

Once orders are transacted, a transaction slip is printed out on the relevant broker's printer, which contains the broker's code, order number, type of order, securities code, transaction quantity, transaction price, transaction amount, buy or sell order, trading as an agent or trading on own account, and the transaction time.

Shares are traded in board lots with a face value of Rmb100 and bonds in lots with a face value of Rmb1,OOO.

ANNEX 2.5 RESTRICTIONS AGAINST INSIDER DEAI-ING

No institution or individual can carry out the following activities:

illegally obtain insider information, disclose insider information, sell or purchase in accordance with such insider information or suggest to others to sell or purchase such shares (insider dealing) carry out share trading in places other than the securities trading venues as are authorised by the SCSCICSRC to carry out share trading (off market dealing) provide false or seriously misleading descriptions or omit to disclose significant information in the process of the issuance and trading of shares control the market prices of shares by conspiracy or by pooling together of funds, or by rumours or other methods affecting the issuance and trading of shares (price rigging) conspire with others in creating false share prices fail to transfer the ownership or actual control of the shares and thereby create false sales and purchases sell or offer to sell shares which it does not hold, disrupting the order of the share market (short-selling) through using official powers or other illegal methods, obtain or forcibly sell or purchase shares, or assist others to sell or purchase shares carry out the trading of options and futures on shares or share indices without approval not carry out the obligation to disclose and publish reports of relevant documents and information in accordance with relevant regulations make false business reports, financial accounts and other documents related to the trading of shares, or amend or destroy the same without authority participate in the illegal issuance and trading of shares and other related activities.

All of these are fairly standard prohibitions.

ANNEX 2.6 REGULA-TION OF SECURITIES DEALERS

Shanghai

In Shanghai, the Rules Relating to the Supervision of the Trading of Securities in Shanghai Municipality, prohibit all people from engaging in securities business without the approval of the Shanghai branch of the PBC. These rules were promulgated by the Shanghai Municipal People's Government on 27 November 1990 and effective from 1 December1 990, (the Shanghai Securities Regulations). Securities business is defined as consisting of:

distribution and marketing of securities buying and selling of securities for one's own account securities brokerage (ie agency work) investment trust business involving securities securities financing registration, certification, settlement and payment of securities, or acting as a central custodian, fiscal agent or registration agent of securities acting as a consultant on such matters as securities issuance and investment, and, other securities-related business.

To be approved as a securities dealer, the proposed dealer must:

meet the need to develop the securities business possess a complete set of articles of association and qualify as a legal person have professional personnel capable of running a securities business, and, have a paid-up capital that complies with the regulations, or, if it is to engage in securities business as a sideline, to have separately audited working capital.

When applying for approval to establish as a securities dealer, the following documents must be submitted to the PBC:

an application report and a feasibility study on the establishment of the securities dealer the dealer's articles of association the name and resume of the main responsible person for the securities dealer, and, any other documents which the PBC considers necessary to be submitted.

Shenzhen

In Shenzhen, the Shenzhen Interim Measures for the Administration of the Issue and Trading ofshares (the Shenzhen Securities Regulations), promulgated by the Shenzhen Municipal People's Government on 15 May 1991 and effective from 15 June 1991, regulate the licensing and activities of securities dealers, and the establishment. Securities dealers must be approved by the Shenzhen Branch of the PBC (SZPBC) and may engage in securities. Securities dealers may only engage in those forms of securities business and securities-related business for which they have been approved by the PBC.

To apply for a securities business permit, a securities dealer is required to submit an application to the PBC containing the following particulars: name and domicile registered capital the form of organisation business resumes of directors, supervisors and managers, and details of their shareholdings in the share company the articles of association and the internal rules and regulations details of the manner in which it will engage in securities business, and, any other particulars required by the PBC for investor protection purposes.

They will also be required to:

have capital of more than Rmb50,OOO comply with the requirements stipulated by the PBC in respect of its organisation and operating personnel agree to comply with the articles of association of the SZSE, and, pay a membership fee to the SZSE of not less than Rmbl million.

Under the Shenzhen Interim Provisions for the Administration ofSecurities Dealers, promulgated on the 12 June1991 and effective from 25 June 1991, authorisation by the PBC is contingent upon the applicant:

having a paid-up capital of not less than Rmbl 0 million (with Rmb5 million for each branch). (In addition, if the broker is authorised to deal on its own account, it must maintain a capital of Rmb20 million) having a minimum office size and facilities as required by the PBC having a minimum of 30 staff with a set number of economics university graduates, and, observing the following capital adequacy requirements: the capital use for buying securities must not exceed 60 per cent of the company's capital; the holdings of one type of stock must not exceed 20 per cent of the company's issued capital; and, the holdings of all securities of one enterprise must not exceed five per cent of the issued capital of that enterprise.

The PBC can close down any broker which breaches these capital requirements or, following warnings by the PBC, fails to remedy a breach of any regulation. A broker and its branches must submit daily reports of securities trading to the SZSE. Brokers (except those engaging in securities business as only part of their business) must submit a balance sheet and other information required by the PBC within one month after the end of each fiscal year. Changes of members' details (such as changes in the capital amount, the articles of association, the directors, the supervisors, the managers, or details of operation) must be reported to the SZSE, together with any relevant documents, within three days. Introduction

In parallel to the economic reforms which China embarked upon from 1979, the first signs of a capital market began, with the issuance of government debt in the early 1980s. Early government bond issues were essentially a revenue mobilisation effort, for the financing of the newly emerging deficit, and bond issues bore a strong structural resemblance to taxes. In some cases, payments for government bonds were deducted through payroll deductions or compulsory withdrawals from bank accounts. Bonds were distributed through administrative placement mechanisms, and their acquisition was involuntary. Rather like budgetary line items, bond issues were often targeted to specific investments, and earmarked by use, such as construction bonds for key national projects. Alternatively they were classified by the 'tax base' on which they were administered, and thus fiscal bonds were bonds which 'taxed' the banking system, placed at banks which were then prohibited from trading them. A bewildering variety of bonds thus emerged (Appendix Table A1 .I).

The development of a market in bonds began spontaneously, through the emergence of large numbers of multiple illegal curb markets in government paper, often at the doors of the PBC bureau charged with the task of administrative placement. Individuals would seek to sell their paper, at a discount, and use their increased liquidity for more attractive investments, emerging elsewhere in the economy. Such trade was gradually legalised by the government, which began to see the difficulties of placing paper on unattractive terms. Bond maturities declined and coupon rates increased, relative to deposit rates, as issues were gradually tailored to public preferences. The development of secondary markets was greatly boosted from 1990, with the establishment of official stock exchanges, which could list bonds, and the onset of regionally interlinked electronic trading through the STAQS system. China began to experiment with the use of more market-based distribution systems through underwriters and primary dealers, and in 1994 began to issue scripless bills. Since last year, the development of the bond market has achieved great prominence, as the government has accepted a restriction on financing its deficit through central bank borrowings, and is now obliged to turn to the bond markets for this purpose.

This chapter examines the functioning of China's bond market today, to see how it could better be equipped to meet its new role. The first broad conclusion is that the Chinese bond market today is a market in transition, and is confronting critical conflicts between the requirements of efficiently functioning capital markets, and features inherited from the former planning system:

the credit plan administratively determined interest rates, and, the absence of market pricing of risk.

Bond issuance is still essentially regarded as an alternative revenue mobilising system, and an extension of the budgetary process, in terms of financing options under the Credit Plan. Coupon rates are set with regard to the administratively determined deposit rate and do not reflect secondary market yields. Since the risk of enterprises is still relatively low, bond pricing has not adequately reflected risk differentials. In these circumstances, the link between bond market activity and underlying real sector developments, in terms of raising or pricing capital, is constrained, and the bond market cannot act as an efficient allocation mechanism for capital, or pricing mechanism for risk.

As a result, many of the market's features are contradictory. Secondary market in bonds using relatively sophisticated trading technology, futures contracts and repurchase agreements coexists with interest rate regulation in the primary market and the money market; a system of underwriters and primary dealers has been established, but these entities continue to use a retail distribution system that was originally used for forced placements of bonds; there are many credit rating agencies and government bonds are liquid enough to begin to provide an indicative benchmark interest rate, but the quantity of enterprise bonds issued is determined by the credit plan and, interest rate regulation aside, the virtual absence of a hard budget constraint on many state owned enterprises has blurred distinctions of credit quality. The second broad set of conclusions is that the primary process of bond issue in China still retains many features which arose from its historic origins as an obligatory tax mechanism. These features would require modification if bonds are to function as a capital market instrument. In particular, the lack of effective competition between underwriters, the large and infrequent nature of government bill issues, instead of issues based on a pre-announced year-round schedule, the targeting of the retail investor base rather than recognising and differentiating between wholesale and retail investors, the system of coupon determination, based on deposit rates rather than market yields, the lack of coupon payments and the method of determination of redemption amounts, and the continued use of quasi- administered placement (through bank distribution quotas, at above-market interest rates), are points to be addressed to improve the efficiency of the primary issue process.

In terms of the development of secondary markets, China has made considerable progress since 1990. Yet, there are still improvements to be made. The third set of conclusions is that the market needs to increase its liquidity and to achieve greater price unity. Key factors in improving market liquidity are the primary issue design features referred to above. In addition, present constraints on the operation of the money market need to be addressed, to provide funding for bond portfolios and a reliable short-term yield benchmark. Greater price unity across different regions today requires the creation of a centralised depository (or existing depositories will be required to agree on a common set of operating standards).

Fourth, to reduce speculative tendencies, the volume and quality of information in the market should be increased. This applies particularly to enterprise and financial bonds. This entails the improvement of disclosure requirements and the standardisation of listing requirements. Another element of this concerns the development of credit rating agencies. It also requires the development of a class of informed institutional investors (see Chapter 6).

Finally, bond markets need an appropriate environment in terms of a regulatory framework. Although this has already been dealt with in Chapter 2, it is reiterated here, as it is in the area of bond trading that the present regulatory framework still requires fortification. Recently issued regulations on futures trading are a change in the right direction and the proposed new Bond Law would be a major step forward. China's Domestic Bond Market Development: A Chronology

Phase 1: Bond issues resume, 1987: An illegal black market in treasury asapart of the State Credit Plan bills spread rapidly, spurred by rising inflation and more attractive alternative 1981-84 After more than twenty years, investments. Black market discounts on China resumed the issue of domestic treasury bills could be 50 per cent or bonds. The issue was s laced bv forced greater. allocation, via quotas assigned to state enterprises, collectives and local Phase 2: Official development governments, who subsequently placed of secondary markets the bonds with individuals. The bonds were non-negotiable and had a ten year 1988-9: The Ministry of Finance further maturity. Afifth of the issue was redeemed reduced the maturity of treasury bills, to by lottery each year, after the sixth year. three years. From April 1988, the trade In 1984, the Ministry of Finance (MOF) of treasury bills was permitted, two years extended the ability to issue debt after their issue. Over-the-counter securities to the People's Bank (PBC) and markets were permitted and by the end the State Planning Committee (SPC). Over of the year, all major cities had treasury the next few years a range of debt issues bill markets. However, only trade within developed, much of which was placed the locality was permitted. In the same involuntarily via administrative methods. year, the tradability of securities was extended to other major bonds, and also 1985: The Ministry of Finance reduced to shares, and treasury bill maturity to five years and certificates of deposit. Meanwhile the abandoned the lottery system for PBC permitted banks to issue short term redemption. The use of treasury bills as CDs to individuals (subject to PBC collateral was permitted. approval, and an overall local quota). In 1989, the Ministry of Finance issued the 1986: The People's Bank extended the first floating rate bonds. power to issue bonds to specialised banks (financial bonds) and enterprises 1990: Trade in treasury bills was (enterprise bonds), initially in five cities permitted as soon as a new issue was only. These bonds could be sold to completed. Later in the year, the transfer individuals on a voluntary basis. In of bonds between cities was permitted August 1986, an experimental market for (October 1990). The PBC established a enterprise bonds was established in Quotation Centre to provide market Shenyang, rapidly followed by markets volume and price data to dealers in in Shanghai and Shenzhen. These different regions. In November, STAQS measures led to an upsurge in non- began, providing a satellite link with real Government bond issues. + time prices to dealers in six cities. Bond launched a new method of voluntary prices began to converge. In December placement, via a system of 19 primary 1990, the Shanghai Stock Exchange dealers. Unlike previous bonds which officially opened, and permitted the paid a lump sum at maturity, the five-year listing and trading of bonds. the annual treasury bill issued this year paid annual volumeoftreasury bill tradingforthe year interest. The PBC took a more active was Rmb10.4 billion. interest in the debt market, issuing short term finance notes and lifting previous Phase 3: Voluntary placement restrictions on the holding of treasury bills of treasury bills; growth of by banks and insurance companies. The secondary markets PBC also had a major role in the establishment this year of the NETS 1991: In April this year, the Ministry of satellite trading system. Futures contracts Finance began experiments with the in bonds began, established at the voluntary placement of treasury bills. A Shanghai Stock Exchange. The treasury part of the years issue was undertaken bill trading volume for the year was by an underwriting syndicate which Rmb83 billion. placed the treasury bills with their clients on a voluntary basis. The volume of 1994: There was a dramatic rise in treasury bill trading for the year was volume of treasury bill issues this year, Rmb34 billion. due to the government's decision to cease to fund any part of the budget deficit 1992: The Wuhan Securities Exchange through borrowing from PBC. The Centre was officially established in April, Ministry of Finance issued treasury bills the nation's largest bond trading centre. with a range of maturities from six months Later, the newly established official to three years and experimented with the equities market attracted funds away from first paperless (annual interest-paying) the bond market, and consequently, treasury bill issue, aimed for the first time trading volume slumped. Nevertheless, at wholesale investors. Government bond treasury bill trading for the year had listing and trading on the Shenzhen grown to Rmbl05 billion. Securities Exchange began. The Ministry of Finance decided to issue exclusively 1993: At the beginning of the year, the treasury bills, moving away from the yield at issue offered on treasury bills was placement of other treasury bonds, fiscal unattractive due to the booming stock and real estate markets. Placements via bonds or special state issues. Bond trading in aggregate (including repos and syndicated underwriting fell considerably futures, which escalated rapidly at the short of target, and the Ministry of end of the year) has been estimated at Finance partially reverted to mandatory Rmb3,OOO billion for 1994. placement. The Ministry of Finance also

Sources: Bi (1993),Spencer (19941, IMF (1991, 7994),Zhang (1994),Bowles & White (1992), SEEC (7995). The Primary Market

Volume and composition of debt issues

Since 1984, the volume and variety of debt issue in China has grown rapidly. Total debt issues increased from Rmb48.7 million in 1981 to Rmb65.6 million in 1985, and to Rmb113.3 billion in 1994. New issues in 1995 amounted to Rmb 125 billion. As illustrated in Figure 3.1, from 1981 to 1987 the majority of the debt stock was in the form of government debt, particularly treasury bills, which remain the largest single category of debt on issue. Government debt in China is issued primarily by the Ministry of Finance (treasury bonds), and the part of this which is used for general budgetary purposes is referred to as treasury bills. State financial institutions and state enterprises have also been authorised to issue debt since the mid-1 980s. In 1992, treasury bills alone accounted for 33 per cent of the outstanding issue, treasury bonds as a whole comprised 38.5 per cent, while financial bonds and corporate bonds accounted for another 6.4 per cent and 43 per cent respectively (Appendix Table A1 .I). From 1994, there has been a significant increase in the value of treasury bills issued, primarily due to government's decision to cease to finance its deficit through borrowing from the PBC. Government debt issues, at over Rmbl I3billion, increased threefold over 1993. Government issues in 1995 were higher still, at Rmbl25 billion. Enterprise bond issues, meanwhile, were reduced.' Treasury bills are therefore estimated to be a larger part of the total today.

Figure 3.1 China: composition of outstanding debt issues

Rmb 100 Per cent million 1 mob 3500 90% 3000 80% Corporate 2500 70% 60% 50% 1500 40% Government 30% agency 1000 2040 10% 0% $' 8 8 @a @ $' $' .$$ @+ & .@ $' Years Years

Source: Data provided by the State Council Securities Committee Until 1992, the two major categories of debt in addition to treasury bills were certificates of deposit and corporate debt. The growth in corporate debt (comprising local enterprise bonds and short term enterprise bills) and financial bonds, issued by banks, is illustrated in Figure 3.2. The growth in the supply of this non- government paper reflected:

the increased liquidity of capital markets from 1990 and therefore the increased likelihood of using debt issues as financing instruments increases in bond prices, due to increased liquidity, which further raised their attractiveness for enterprises the desire of banks for funds to finance their own capital market activities, or those of their TIC subsidiaries, and, the use of debt issues to tap local sources of finan~e.~

Debt issues by the government have not been homogenous. Other treasury issues consisted principally of securities earmarked for specific budgetary purposes, broadly following the compartmentalisation of fund flows under the credit plan, rather than any significant difference in the issue terms.3 In some cases the compartmentalisation was based on the target market to be 'taxed'with the bond issue, rather than the end use.4 The coupon offered on a specific bond was not always homogeneous, but varied with the purchaser, typically with a lower coupon rate for enterprises, relative to individuals. The maturities offered have also varied from year to year. Such differentiation was feasible largely because of administered placement, combined with restrictions on tradability.

A consequence of the lack of homogeneity in bond issues has been that even after trading has been permitted in many bond types, markets have remained thin, due to segmentation. The government is aware of some of the drawbacks of the large variety of issues, and in recent years, there has been a trend towards reducing their variety, and placing more emphasis on treasury bills. This trend should be encouraged. Greater homogeneity in government debt issue will undoubtedly assist liquidity in the secondary market. However, administered placement of debt and focus on a retail investor base continue to have support and these factors encourage the persistence of 'targeted' (and thus differentiated) bonds. Figure 3.2 Outstanding debt composition disaggregated

Government bonds

Corporate debt Financial debt 900 900

800 800 State enterprise bonds Investment fund bond 700 700

600 Inter-enterprise debt 600 Trust income securities S 500 500 - -.- 'li 400 'i400 0 ,O 300 g 300 n n E 200 E 200 K a 100 100 0 0

Source: Data provided by the State Council Securities Committee

Issue Method

Treasury bills

Methods used to issue government debt have evolved over the past decade, reflecting attempts to move away from administered placement, towards more market-based methods. The degree of success achieved so far, expressed in terms of total debt issued, is still limited. Initially, all debt was placed administratively, and on a mandatory basis. Quotas were assigned by the Ministry of Finance (not markedly different from tax 'contracts') to financial departments of provincial and local governments, and at the local level, quotas were distributed among production units. These units in turn frequently 'levied' bonds on workers, as an automatic deduction from wages. Types of Debt Securities on Issue: A Summary

1 Government securities (treasury bonds) Treasury bills National construction bonds These were first issued in 1981, by MOF These were first issued in 1988, by MOF, in association with financing the State to the public, financial institutions and budget. Voluntary subscription is a recent enterprises, to provide funding for SOEs development. They are mainly in bearer and infrastructure. They have been form although a scripless issue was made tradable and are income tax exempt, for in 1994. Treasury bills are traditionally individuals only. issued over an extended period in the first half of the year at a predetermined Key national construction bonds coupon and price. The issue is primarily These were issued only between 1981 targeted at retail investors. Available and 1987, to fund major state maturities have varied, generally construction projects. downwards. In 1994, maturities ranged from six months to five years. Bills on Special national bonds issue are not homogeneous and formerly, These were first issued in 1989 and were bills issued to enterprises carried a lower merged with fiscal bonds in 1992. They coupon than issues to individuals. were issued by MOF to enterprises, Differences in issue methods have also insurance companies and pension funds affected homogeneity. Treasury bills are by mandatory assignment. They were tradable. The three year bond of 1994 is created to make a distinction between not tradable but early encashment, within treasury bills issued to individuals and six months, is permitted. Early those issued to institutions. They were not encashment (after three years) was also tradable but were interest tax exempt. permitted for the five year bond of 1993. Inflation-proof bonds Fiscal bonds These were first issued in 1989. Bonds These were first issued in 1988. No new with an inflation adjustment were also issues have been made since 1994. They issued in 1992 (Three year and five year), were mandatorily assigned to banks and 1994 and 1995. other financial institutions to raise funds for capital construction and to cover National investment bonds budget deficits. The 1988 issue was not These were first issued in 1991, by redeemed on maturity in 1991 and is provincial governments, with the regarded by the MOF as a permanent approval of the SPC, to fund regional . Their maturity has been two to five development. years. They were not tradable, but could be pledged. State investment corporation bonds

Key enterprise bonds Investment fund bonds These were first issued in 1987 by SOEs These are issued by provincial securities in petroleum, electricity and metals companies and TICS and are regulated industries, to client enterprises on a by PBC. mandatory basis. They were issued through state investment corporations Corporate bonds and guaranteed by the state government. They had a three to 15 year maturity and could be pledged. These were first issued in 1984 initially to employees and clients. Some pay Capital construction bonds interest in kind, others pay annual These were first issued in 1988 by the interest. More recently they have been State Energy lnvestment Corporation, the issued to a wider public. Issued by SOEs State Transport Investment Corporation under a quota administered by the local and the State Transit Railway. PBC and SPC, they are used to finance investment and have a two to five year maturity. They are tradable, with a very Financial institution bonds defau risk due to social ised

Financial bonds ownership of enterprises. These were first issued in 1985 by banks to individuals to provide liabilities on Short term enterprise financing bills which to base longer- term lending. They These are similar to local enterprise bonds were often project-specific and had a one but used to finance working capital. to five year maturity. Unlike treasury bills These have a three month to one year these often pay annual interest. 'They are maturity. tradable. Inter-enterprise bonds Transferable high-value fixed deposit These are issued by enterprises to their certificate employees to tackle short term liquidity These were first issued in 1988 by banks needs. Their issue is loosely regulated. to enterprises and individuals on the basis of a quota assigned by PBC. They have a Housing construction bonds maturity of 30 days to one year and are These are issued at the local level. There tradable. are no apparent regulations regarding their issue. Trust income securities These were issued by provincial securities investment companiesand TI,-^, ~h~~ are regulated These have been issued at the local level. by the PBC. There are no apparent regulations regarding their issue. + PBC bonds

Financing bills These were first issued in July 1993. The to redistribute bank excess reserves. total issuewas Rmb20 billion, with three, Proceeds from their sales have been lent six, and nine month maturities. They have to banks and NBFls in regions with a been placed through interbank centres shortage of reserves.

Sources: Hong Kong Stock Exchange (19931, Bi (1993).

Limits to the government's ability to force bonds on workers became apparent with the appearance of an illegal secondary market in bonds. As part of its attempts to tailor bond issues to voluntarily held instruments, the Ministry of Finance adopted an underwriting syndicate to launch a bond issue for the first time on an experimental basis in 1991. The syndicate was entrusted with the issue of Rmb2.5 billion, out of a total of Rmb19.9 billion of the treasury bond quota issue for that year. A private agency, the Securities Exchange Executive Council (SEEC), acted as co-ordinator of the underwriting, which involved 58 financial institutions.= -the underwriters received a commission of 0.1 5 per cent of the underwritten amount and sold the bonds on a voluntary basis to clienk6 Underwriting was used again in 1992, to distribute Rmb3.6 billion of treasury bills in combination with the traditional administrative allocation for the balance (Rmb36.7 billion) of the year's issue. Although this represented a larger absolute sum than the previous year, it represented a smaller proportion of total issues (9.7 per cent, versus 12.5 per cent in 1991), reflecting the government's hesitation to adopt large-scale change. The relative success of underwriting at the time can be partly attributed to the relatively attractive (fixed) coupon offered on bond issues, compared to other available forms of investments.

In the following year, 1993, underwriting failed to sell the desired quantity of treasury bills, due to competition from the booming equity and property markets and higher (unauthorised) returns on enterprise debt. The government reverted to mandatory administrative allocation; localities which did not meet their quota were severely discouraged from both issuing their own debt and from listing companies from their region on the stock exchanges. The government nevertheless made an effort to improve bond distribution and, accordingly, 19 financial institutions were appointed as primary dealers. In return for underwriting a certain volume of debt, primary dealers were entitled to receive privileges in kind, allowing them priority in bringing equity offerings to market. The selection of primary dealers was based upon guidelines which included capital adequacy and past performance, in terms of the previous year's trading volume on the primary and secondary market. In principle, primary dealers have an obligation to act as market makers, but this function does not appear to have been exercised in practice.'

With some revival in the bond market in 1994,8 the government ventured to experiment with four different methods of issue for treasury bills, representing a compromise between those who desired more market-oriented issuing procedures and those who doubted the effectiveness of the underwriting system in China.

Rmbl3 billion of six month and one year paperless treasury bills were issued via underwriting agreements. The underwriters (many of whom were designated primary dealers) were given a week to place the debt, after which it was listed on the Shanghai Stock Exchange. Rmb28 billion of two year bearer treasury bills were sold via local financial departments, which applied for allocation^.^ The balance of the year's planned issue then became available for distribution via other channels. The local finance departments signed 'underwriting agreements' with financial institutions at the local level, which then sold the securities to individuals and others. Rmb2 billion of five year bearer treasury bills were placed directly with institutions, but,

8 the largest part of the year's issue, Rmb70 billion, three years maturity, was issued in the form of certificates, allocated by PBC to the headquarters of the specialised banks which in turn allocated them to branches at various levels. The branches then sold the treasury bills locally to individuals and others. These certificates were redeemable at the bank of issue after six months, although their listing and trading was not permitted. This issue was the outcome of an intention to develop a purely retail debt instrument.1°

Of the four distribution channels used in 1994 the Rmb13.2 billion placed via underwriting is the furthest removed from the old administered distribution channels. Under this system, underwriters were supposed to compete for an allocation of treasury bills, through a three part bid covering the amount to be underwritten, the speed at which funds received from the sale of treasury bills would be repatriated back to government and the underwriting fee. The institutions involved in this part of the issue (mostly TICS)have more recent origins than the specialised banks and the local finance departments, and the target market, for the first time, is wholesale (institutions) rather than retail (individuals). However, this still accounted for only 11.7 per cent of the year's issue; even less than the 12.5 per cent placed by underwriting in 1991. The real difficulty is that entirely abandoning administrative placement systems is difficult, within the framework of the credit plan, since the fulfilment of 'placement' quotas could no longer be assured. Another major difficulty with the transition is the administered interest rate, and consequently bond coupon rate, which effectively removes a major plank of price competition for underwriters or primary dealers. Third, for reasons discussed further below, institutional buyers are not at present accustomed to government bond purchase. China is still a long way away from more sophisticated bond issue techniques, such as .

Enterprise bonds and short term bills

Approval to issue bonds is given to local state enterprises by the local State Planning Council and the local PBC, within the quota allocated to the locality by the credit plan. The aggregate volume of enterprise bond issues (permitted only to SOEs) is nominally supervised by the PBC head office. Central regulation of the quantity of local bond issues has not always been successful and the issue quantity has occasionally been larger than the aggregate quota, due to local governments' interest in boosting investment. The PBC also regulates the aggregate volume of issue of corporate bonds in response to liquidity conditions. On past occasions when enterprise bond issues have appeared to threaten bank deposits, or the banks' ability to meet lending quotas, the PBC has clamped down on enterprise bond issues. The allocation of the quota between companies is based on a combination of financial and (de facto) political criteria. While an acceptable rating by a credit rating agency is required, the priorities of industrial policy are given greater weight in practice.

Issue size, frequency and issue period

Another drawback of the primary issue process for government securities is that treasury bills typically have been offered in a small number of issues, in the first half of the year, rather than in several offerings spread over the year. Sales have been made over a period which typically takes several months. The sale of paperless treasury bills aimed at wholesale investors in 1994 was an innovation which permitted a much shorter issue period. Thus in 1994, the two paperless issues took less than a week each (the six month paperless issue was placed between 25 January and 31 January, and the one year paperless issue was placed between 1 February and 3 February). But the two year bearer issue took two months to place (1 April to 31 May) and the three year treasury bill certificate took longer still; from 1 April to 30 July, or four months altogether. For the paperless issues, the underwriters were required to sell the bills within a specified issue period, at the end of which funds for bills sold, together with any unsold subscriptions, had to be remitted to the Ministry of Finance. The issues were then declared tradable with immediate effect. By contrast, for the two and three year treasury bills with the long issue period, sales proceeds were remitted to the Ministry of Finance's account at the PBC by each underwriter, according to the terms of their individual underwriting agreements, rather than on a daily basis. The final payment occurred after the close of the issue period. The retail investor base to which most issues are targeted and the long distribution channels for this prolong the placement time and reinforce the tendency towards large issues spread out over a few months.

The current practice has several undesirable implications. Firstly, in the absence of regular maintenance of a sufficient volume of short term debt on issue, the development of a liquid secondary market is not possible. Consequently a short term market yield curve cannot develop. Moreover, the absence of a liquid short term market presents problems for the use of indirect methods of monetary control. Secondly, the absence of a regular supply of debt of any maturity to the market implies that there is no 'current' issue to provide a 'benchmark', either long or short term. Thirdly, since issues are made in the first half of the year, there is little scope for synchronising the timing of the sales with the State's cash flow requirements." This raises the cost of funds to the government.12 Fourthly, investors cannot plan orderly acquisitions of new issues over the year in line with their cash flows. A one-off issue period puts considerable strain on the liquidity management and risk management capabilities of banks and institutions. In a market economy such an issue pattern would limit the number of bidders and cause a liquidity squeeze, both of which would operate to raise interest rates and the government's cost of funds.

On account of these reasons, it would be more desirable for the government (Ministry of Finance) to:

announce a schedule for the year's issue of longer term debt, based on the government's term financing need, spread throughout the year, and in parallel, undertake regular issues of shorter term debt (one to twelve months maturity) to meet short term liquidity needs. In addition, the central bank (PBC) should issue short term paper as required, to meet short term liquidity management needs.

Challenges for China in moving towards a debt management programme for a market economy

First, the pattern of the government's cash Third, to meet the estimated demand of flows over the year would need to be the institutions which form the wholesale determined with sufficient accuracy. market, scripless treasury bill issues should be made according to a Second, the government should preannounced calendar at intervals differentiate between retail and wholesale throughout the year. A limited (but investors. Continued reliance on retail gradually increasing) amount can be sold investors necessitates prolonged issue on auction, with the rest distributed periods due to the administrative burden through average-price non-competitive of handling small sums of money. If the bids. As these institutions develop, government continues to rely on a retail increasing emphasis should be placed on investor base, it should design an 'on the wholesale market. demand' savings certificate available throughout the year, adjusting interest The development of a market in short rates on this issue periodically according term debt is dependent upon the to, not only deposit rates, but also the development of a wholesale market. government's desire to attract funds.

Maturity

When the government first resumed debt issue in the early 1980s, the maturity of government debt issues reflected exclusively, government needs. This was possible due to the administered placement mechanism adopted. By the late 1980s the authorities were forced to acknowledge investor discontent, expressed by the emergence of secondary markets where government debt traded at large discounts. In response, the government was obliged to progressively shorten maturities on treasury bills from ten to five, and then to three years. The 1994 treasury bill issue included six month and one year maturities for the first time, tailored to meet the needs of banks and wholesale investors for the balancing of short-term assets and liabilities. This demonstrates that while the market is still far from fully investor responsive, the authorities are now more conscious of investor preferences and the advantages of taking them into account when structuring an offering. There is still a need to widen the range of maturities offered to satisfy a wider range of investor preferences. On the shorter end, extending the range of short term maturities to include 30 and 90 day paper and increasing the volume of short-term offerings would assist financial institutions with liquidity management and encourage the development of a short term yield curve. Financial institutions in China are beginning to grow aware of the need for, and advantages of, liquidity management, especially as new options for investment develop. On the longer end, in view of the central and local governments accelerating need for financing infrastructure investment, there would certainly be an interest on the part of these authorities in the issue of long maturity bonds. However, from the perspective of the investor, there is a lack of enthusiasm for debt of long maturity today due to a number of reasons:

The lack of payment of coupons, and the long intervals to redemption.I3 High and uncertain rates of inflation, which make the real value of the redemption amount difficult to predict, and usually (in the experience over the last few years) less attractive than the nominal value. Due to the low incidence of default on most forms of investment within the framework of a planned economy, investor perception of, and allowances for, risks, are low. Consequently, the local markets focus on return rather than risk adjusted return, and as such the security of a long term government bond which may be attractive elsewhere carries little premium in China today. Liquidity in the bond market is still low. If liquidity increased significantly, investors would be more tempted to hold bonds of longer maturities.

The implication is that even if the government were to issue bonds of longer maturities today, it would find these difficult to sell, and would have to resort again to administrative placement.

The investor base for primary sales Historically and currently the majortarget market of debt sales is individuals. This stands in contrast to developed debt markets where the major target market of primary issues consists of wholesale investors such as banks, insurance companies and mutual funds. Table 3.1 gives estimated figures for the division of government debt sales between individuals and enterprises. The data cover a range of different government debt types including treasury bills, construction bonds and fiscal bonds.14 Table 3.1 Government debt purchases: households and non-households

Year Households Households Enterprises & Enterprises institutions (Rmb billion) (%) (Rmb billion) (%)

Source: Ministry of Finance and SEEC

The table shows that there is no systematic trend reduction in the proportion of debt issued to households, over time. Indeed, ratios for household purchases are high in the 1990s. The Rmbl3 billion paperless issue in 1994 was the first attempt to explicitly target wholesale buyers via voluntary treasury bill sales. Prior to 1993, the PBC did not permit banks to hold Government securities except those issued to them on a mandatory basis. Pension funds and insurance companies have also been encouraged to hold treasury bills since late 1993.

The PBC has recently begun to encourage institutions to hold treasury bills as it is examining its ability to control bank liquidity via secondary market treasury bill transactions. The PBC's interest in open market operations stems from a recognition that control of monetary and credit conditions via the credit plan is increasingly impractical. But before secondary market treasury bill transactions can be used as a policy tool, the relevant institutions must hold a stock of treasury bills and a liquid secondary market needs to exist.

Issue price and coupon Government bonds are issued at par and the majority carry a predetermined coupon. There is no auction process to determine the yield in the primary market. Coupons are administratively set at a margin above deposit rates of comparable maturity, without reference to the secondary market yield on issues of comparable maturity. The lack of reference to secondary market yields, reflects the administratively determined interest rate structure, and the role that debt issues continue to play in the Credit Plan.

Most government issues of three years or more in maturity, since 1992, have had a coupon related to the inflation rate; the 1992 three and five year bills; the 1994 three year issue of treasury bills in certificate form; and more recently, the issue of Rmbl06 billion for 1 995.15 Only a limited number of scripless treasury bills have paid an annual coupon; the five year 1993 issue and the scripless issue of 1994 are examples. Most bonds pay a redemption amount consisting of principal plus accumulated simple interest estimated on the basis of the coupon at issue. The authorities may see some advantage in paying the coupon in a lump at maturity as it makes it more likely that treasury bills will trade on the secondary market at a price above par. In a less sophisticated market this assists primary sales. Another explanation may be that since most bonds are held by individuals in the form of bearer certificates, there are no easy channels for coupon payment.

Table 3.2 compares coupon rates, comparable deposit rates and YTM at issue for bond issues to 1993. The yield to maturity (YTM) at issue is less than the coupon rate. For example, a Rmb100 bond with a 13 per cent coupon rate and a two year maturity would pay Rmb126 on maturity (before adding any inflation adjustment). This is equivalent to a YTM on a semi-annual basis of only 11.9 per cent (before adding any adjustment). If the inflation adjustment were known in advance, its inclusion would widen the difference between the two yield calculations. Table 3.3 compares these rates and in addition comparable secondary market yields for the 1994 treasury bill issues. In 1994 both the two and three year issues, aimed at retail investors, were issued at yields above those in the secondary market. The fact that they were sold at above secondary market yields indicates that there are potential benefits to the government from targeting wholesale investors (who dominate secondary market trading) and from taking account of secondary market rates. Had the two and three year issues been sold at secondary market yields the cost saving would have been in the region of Rmb3 billion per annum, not allowing for the inflation adjustment on the three year issue. The most market responsive way to take account of market yields would be to sell the bonds by auction. Bond yield calculations: Current YieM and Yield to Maturity

Bonds in China have some unusual Bond yields are normally quoted on a features in terms of interest payment as yield to maturity (YTM) basis. The YTM well as interest calculation, which reduce is the discount rate which equates current the transparency of bond yields. Treasury price with all future cash flows. The YTM bonds typically do not pay interest, but formula is obtained from: instead pay a lump sum at maturity. The lump sum payable at maturity is estimated by adding accrued annual simple (rather than compound) interest over the total period, plus any inflation by solving for i, where adjustment. i = yield to maturity p = market price Secondary market bond yield quotations in China are now available in some c = coupon publications, but these yields are quoted f = redemption value at maturity on a variation of a basis. n = number of periods to maturity This follows from the way in which the coupon is quoted in the primary market. In this study, daily yields for each This method is not consistent with individual issue have been estimated standard market practice and is deficient using a yield-to-maturity formula, from in that no account is taken of the time primary data on daily trading prices, value of money. maturity dates for each issue, and redemption value (in China this is the Secondary yields in China are quoted principal plus interest without using the formula: compounding), with coupon=O, and additional assumptions on frequency of compounding; assumed to be semi- annual, (which is the norm in most s = maturity value, which in China includes all interest payments as well as principle market economies), and the basis of payment calculation (actua11365). No p = market price allowance is made for the inflation n = time left to maturity in years adjustment, the full value of which is The formula does not recognise that the unknown until maturity. Daily yields further into the future a payment is have not been homogenous across received, the less its value is today. For different securities, and the 'average very short maturities (months) the formula yield' has been estimated as the will be adequate. The longer the time to average of daily yields on outstanding maturity the less appropriate the formula treasury bill issues, at a given point in becomes. time. Table 3.2 Treasury bill coupon rate, deposit rates and inflation

Year Maturity Coupon Yield at issuea Comparable Inflation: retail

(years) (%) deposit rate (%) price index (Oh)

1981 10 8 6.84 2.4 1982 10 8 7.92 1.9 1983 10 8 7.92 1.5 1984 10 8 7.92 2.8 1985 5 9 8.28 8.8 1986 5 10 9.36 6.0 1987 5 10 8.3s 9.36 7.3 1988 3 10 8.9 9.72 18.5 1989 3 14 12.0 13.1 4 17.8 1990 3 14 12.0 11.88 2.1 1991 3 10 8.9 8.28 2.9 1992(1) 5 10.5b 8.6b 9.00 5.4 1992(2) 3 9.Sb 8.9 8.28 1993(1) 3 1 3.96b 1 2.0b 12.24 13.0 1993(2) 5 15.86 12.0 13.86

Notes: "'Yield at issue'here implies the yield reestimated on a YTM basis. bFl~sthe inflation adjustment at maturity. Sources: Zhang (19941, IMF (19911, World Bank staff calculations

Table 3.3 Comparison of coupon and deposit rates, and secondary market yield" (At time ofissue: 7 994 treasury bill issue)

------Issue Maturity Coupon at Yield at Comparable Comparable secondary Retail price (years) issue (Oh) issue (Oh) deposit rate (%) market yield (%) index (%)

1994(1) 0.5 9.8 9.8 9 12.5 21.7 1994(2) 1 11.98 11.6 10.98 18.5 1994(3) 2 13.0 11.9 11.7 11 .O 1994(4) 3 1 3.96b 1 2.0b 12.24 9.6

Notes: "Yield at issue restates the coupon on a yield to maturity basis. Comparable secondary market yield is representative of the yield (YTM basis) of a bond of similar maturity on the Shanghai Stock Exchange during the primary issue period. bThe 1994(4) issue is inflation indexed and is non-tradable. The rates here are rates before index adjustment. Source: Zhang 1994, Shanghai Stock Exchange, World Bank staff calculations Prior to 1992 the coupon on debt sold by mandatory placement to institutions was less than that on debt sold to individuals. This is illustrated in Table 3.4. All treasury bills have carried the same coupon regard less of purchaser since 1 992.

Some enterprise and financial bonds pay an annual coupon while others pay on maturity.16 The coupon on enterprise bonds is restricted to no more than 40 per cent above the deposit rate." In addition the Ministry of Finance has imposed the restriction that the coupon should not exceed that on treasury bills in order to reduce competitive pressure on treasury bill sales. However, the restriction has been avoided by the use of fees and discounts. In practice corporate bond yields are two to three percentage points greater than treasury bill yields at issue. The more attractive rate offered on enterprise securities was one factor contributing to the failure of the voluntary placement of treasury bills in 1993. Until recently, enterprise bonds were particularly competitive with treasury bills as default was not significant.18

Table 3.4 Comparison of coupon on treasury bills sales by purchaser: households, enterprises, and financial institutions

- -- Year Households Enterprises Financial institutions (treasury bills) (treasury bills) (fiscal bonds)

Note: "Rate on special state bonds given for enterprises Source: IMF (7991)

Tradability

Another feature of bond design in China is that much of it has been non-tradable by regulation. lg The tradability of government bonds is affected by the evolving nature of the debt issue process which has resulted in lack of homogeneity in the outstanding stock of treasury bills. Even in recent years the treasury bill issue has not been homogenous. The 1994 issue of Rmbll3 billion was the largest issue to date and represents 55 per cent of the treasury bills outstanding at the end of 1994. However, a breakdown of the 1994 issue shows that the bulk of it is not tradable or is at least illiquid (Table 3.5). Trade in other issues, such as enterprise bonds, is often hindered by lack of issue volume for individual issues (Figure 3.4).

Table 3.5 Tradability of 1994 treasury bill issues

Value (Rmb billion) Percentage Form of issue Form of placement Comments

Rmb13.2 billion 11.7 Paperless treasury Registered on the Trading low due to bills Shanghai Stock Exchange insufficient issue volume

Rmb28 billion 24.7 Bearer treasury Issued via local Sold mainly to individuals bills finance departments who largely

Rmb70 billion 61.8 Certificate form Sold through Market listing not specialised banks permitteda

Rmb2 billion 1.8 Certificate form Institutional placement Market listing not permitted

Note: "Even illicit trade is difficult as the certificate is from an individual bank, which carries the responsibility for redeeming it, resulting in a diversity of instruments. Large investors (Rmb2Om and above) have faced delays in obtaining redemption. Source: Ministry of Finance

Bearer and scripless issues

The majority of debt securities are in bearer form. The exceptions to this norm are the 1994 experimental treasury bill issue (Rmbl3 billion) and non-tradable debt issued by mandatory placement to institutions. Bearer issues have contributed to the lack of liquidity in the secondary market. While depositories exist to record holdings in book entry form, lack of regularised registration procedures between localities cause friction in inter-regional trade. The difficulty of aggregating retail parcels has been exacerbated by the need to gather physical scrip.

Credit rating agencies

The development of credit rating agencies has been encouraged since 1 991. Rating companies must be approved by the PBC before they can publish their ratings. The PBCfs headquarters have approved only two agencies so far, although some other agencies have been approved by PBC at a local level. In all, 82 credit rating agencies have been approved, about 30 of which operate at a national level. Not all the rating agencies call themselves credit rating agencies; some are accounting firms and others are consultant firms. The ownership structure is also diverse, reflecting the variety of entry points into the new industry. Some regional rating companies are subsidiaries of the local PBC. Of the two credit rating companies in Shanghai, one is a subsidiary of the Shanghai Academy of Social Sciences and the other is a subsidiary of the Shanghai University Institute of Finance and Trade.

Rating agencies are used in the process of selecting the enterprises to be granted permission to issue bonds. At present their role is of marginal importance to the government and investors. In the debt issuing process rating agencies distinguish the poorly performing companies from those with an acceptable performance. However, among the acceptable companies the right to issue debt is not determined solely, or even primarily, on the basis of the rating agencies'assessment. The local PBC and SPC give weight to policy priorities. Investors do not place much weight on the rating agencies' assessments because of a general excess supply of investible funds and because enterprises rarely fail due to state ownership. As long as socialised ownership creates soft budget constraints on enterprises, the risk assessment role of rating agencies will be marginalised.

Secondary Markets in Debt Securities

The secondary market for China's debt securities has progressed rapidly, with the initial legalisation of trade in 1988, followed by the legalisation of inter-regional trading, the creation of the STAQS and the formal opening of the Shanghai Stock Exchange in 1990. The market has improved immeasurably since, in terms of increased I iquidity, greater geographic price unity and more sophisticated trading. But in comparison to debt markets in other countries the market remains illiquid; liquidity is not sufficient to meet the transaction needs of larger participants, and uniform pricing and trading practices across different exchanges and trading networks are still to be achieved. The concept of a benchmark issue has not developed, and trading activity and pricing continue to be driven largely by the weight of liquidity available.

Listing standards There are no unified standards for listing bond issues in China. Bond listing standards are not as strict as those for equities. All treasury bill issues are eligible for listing, the timing of listing being determined by the Ministry of Finance. Financial and enterprise bonds are listed according to the requirements of the local trading centre. The Shanghai Stock Exchange will list bonds provided the issue amount is greater than Rmb100 million, the maturity is greater than two years and the credit rating is A+ or higher.

Secondary market trading volumes and liquidify

The first aspect of secondary market efficiency examined here is the extent to which secondary markets have been able to achieve reasonable volumes of turnover, ie, the degree of market liquidity. As shown in Figure 3.3, annual treasury bill tradingvolume rose steeply from Rmb10.5 billion in 1990 to a peak of Rmbl05 billion in 1992. Although individuals hold the majority of bonds, institutions account for the majority of trading. Trading volumes declined in 1993 because of competition from high returns on equities and real estate. In July 1993, the PBC tightened liquidity by increasing its control over the interbank market and reducing the ability of provincial branches of the PBC to lend to other banks without approval from headquarters. This restricted the diversion of credit to uses outside the credit plan. In late 1993 the PBC permitted banks and insurance companies to purchase treasury bills freely for the first time. The rise in secondary market trading in Shanghai from 1994 (Figure 3.3) suggests that the reduction of the ability of banks to lend in the interbank market, declining equity and real estate returns, and the new ability of banks to buy treasury bills directly, have stimulated the secondary bond market.

Figure 3.3 China: trading value of bonds

-- Annual trading value: all China (1987-93) Trading value: Shanghai Stock Exchange (1991-94) 1

0 2 80 -- E Total -- g 60 F

ycmmo-cum -,""5.-N "5-N "5-cu" mmmmmmm Z?"?m mmmmmmmmmmmmmmm&-&&-&-gciigggggggg ---r--r--r-----

1 Source: Data provided by the PBC, the State Council's Securitites Committee, Almanac of China's Finance and Banking and the Shanghai Stock Exchange -- A The improvement in market liquidity since 1987 is illustrated in Figure 3.4. Both as a percentage of debt stock outstanding and as a percentage of GDP, China's bond market liquidity rose markedly from negligible levels in 1987 to over 120 per cent of outstanding stock and almost 6 per cent of GDP, in 1992. The diagram also illustrates the fall-off in 1993.

Figure 3.4 Ratios of trading volume of debt to debt stock and to GDP

Percentage of stock outstanding Percentage of nominal GDP Y 0 140 B ;120 .. - - + - - Tbills *. .. - -C --Local enterprise bonds ,, ',.. -g ? 80 -- AFinancfalbonds 5 60 -. -Short term ;2 '8 2 1 0 1987 1988 1989 1990 1991 1992 1993 1987 1988 1989 1990 1991 1992 1993 ;rA

LSource: Data provided by the State Council Securities Committee, World Bank

In addition to the cash (spot) market in bonds, China has bond futures markets, and a market in repurchase agreements. Futures contracts based on treasury bills trade mainly on the Shanghai (since 1993) and Shenzhen (since 1994) stock exchanges.20 Contracts are marked to market daily. The contract calls for physical delivery but the majority of contracts are closed out prior to settlement. Contracts are designed to hedge interest rate fluctuations on the secondary bond market. The PBC publishes an inflation subsidy each month which adjusts the interest rates on individual deposit accounts and the adjustment for inflation payable on most bonds of maturities of three or more years. Individuals have used the to speculate against the amount of the inflation top-up and the expectation of thetop-up has a large influence on futures trading2' The apparent large increase in bond trading in early 1995 was virtually entirely driven by futures contracts, which also enhanced the liquidity of the underlying spot market (Table 3.6).22 Table 3.6 China: spot and futures trading of bonds (Turnover, Rmb million)

1-bond spot 1-bond repurchases 1-bond futures

January 1994 February 1994 March 1994 April 1994 May 1994 June 1994 July 1994 August 1994 September 1994 October 1994 November 1994 December 1994 January 1995

Source: Shanghai Securities Exchange: Monthly Market Statistics

Yet, relative to more mature bond markets, the degree of liquidity is still poor. Treasury bills, relative to other debt instruments, are the most liquid security, but even for these securities, while a bid and offer price is always available, large cash trades can take time to complete.23 Other debt issues are much less liquid. Figure 3.5 compares the ratio of trading volume, as a percentage of GNP, with more mature markets. Debt on issue as a percentage of GDP exceeded 13 per cent in China, by 1992. But in the US and in Japan, debt stock as a percentage of GDP is on a different plane; 90 to 120 per cent in the US, between 1987 and 1993, and 60 to 80 per cent in Japan over the same period.

Figure 3.5 Ratios of debt stock outstanding to GDP: China and other countries (Percentage of G DP)

Per cent China Per cent Other countries 14 1 6 I

40 USA +Japan 20 -arnggg~mmo-~rn mzz:zcmzzzzz:ZEm m mmmm 1 Source: State Council Securities Committee, Salomon Brothers and lMF ~ Comparing the traded volume of debt to outstanding stock, the results are similar, even if developing countries are included (Table 3.7).

Table 3.7 Ratio of bond trading value to stock outstanding

- - Chinaa Japanb Koreac Indonesia

----

Notes: "All types of debt on issue. bJapanis reported on a net basis. 'Korea is reported on a gross basis. Source: World Bank Asian Bond Market study, Salornon Bros

Causes of the lack of liquidity: (I)Primary market practices

A first group of causes of lack of liquidity stems from practices alluded to above, in the primary market, and is itself a reflection of the uneasy coexistence of such markets with controls on the financial sector (eg the credit plan, and controlled interest rates), which are the legacy of planning. The impact of these primary market characteristics on secondary market liquidity is discussed below. First, the lack of homogeneity in the stock of debt reduces the amount of any one type of debt which is available to trade. Second, the focus on retail investors as the primary target market for debt issues reduces liquidity, because, while households hold the majority of debt securities, they do not trade as much as instit~tions.~~Treasury bills are sold in small parcels of Rmb100 to Rmb1,OOO to suit this market, and securities firms have a major problem in accumulating sufficient bonds from individuals to form a wholesale parcel. Third, the yield at issue is not related to secondary market yield. Due to linking the coupon to deposit rates, and issuing at par, the YTM of a treasury bill at issue may be either above or below the secondary market yield. If the issue yield is below secondary market yields, the treasury bill sells, as the coupon is competitive by comparison with alternative returns on deposits (for households) and loans (for banks). But an issue yield less than secondary market yield inhibits secondary market trading as investors are reluctant to sell at a loss. Table 3.3 above compared the coupon rate, effective yield at issue, secondary market yield and deposit rates for the 1994 treasury bill issues. In each case the coupon was greater than deposit rates of comparable maturity. However the effective yield at issue was less than the secondary market yield for certain issues; (the six month and one year issues) and greater for others (the two and three year issues). The six month issue sold well due to the demand for short term paper but the one year issue only sold with difficulty. This is not surprising given that the yield was nearly 700 basis points below the secondary market yield.

Fourth, the primary issue is not distributed over the year. the lack of a regular issue calendar inhibits liquidity in two ways:

Without a regular issue programme, there cannot be a continual supply of short dated money market paper (maturity under a year) from which a short- end yield curve can develop. This inhibits money market development, reducing the supporting role the money market plays to the bond market. There are no new issues to provide a 'trading' issue to act as a market benchmark. Typically as debt issues age, an increasing proportion is held by end-holder investment portfolios rather than trading portfolios.

Fifth, the limited range of maturities of primary issues also inhibits liquidity. The market is dominated by issues of original maturity of three to five years. There is a lack of money market paper to provide institutions with liquid assets to match their short term liabilities and an absence of long term paper. A greater variety of maturities would stimulate trading by providing investors with the opportunity to acquire assets of different maturities, ie, change the duration of their portfolios, as their view of future risks changed. For example, an investor anticipating a rise in inflation would want to sell longer dated debt and buy shorter maturities. With an inadequate range of maturities available such transactions will occur less frequently. The frequency of transactions for risk management purposes is also limited at present by the low level of development of treasury risk management functions in financial institutions.

Market participants are less likely to trade if they cannot easily agree on the price of a security. The method of coupon payment in China makes it difficult to accurately price treasury bills in the secondary market. The first cause of uncertainty is the correct basis on which to quote bond yields; payment of accumulated simple interest on maturity has led to bond prices being quoted on a current yield basis rather than a yield to maturity basis. The second and more important cause of uncertainty is the inflation subsidy. While inflation-like bonds may be easier to place in the primary market in some circumstances, the future payout on an inflation-adjusted bond will always be open to differing expectations, which makes pricing it in the secondary market difficult. In a more developed market, this would seriously inhibit trading. The speculative nature of the Chinese market reduces the extent to which pricing difficulties inhibit trading in China, and in fact increased trading volume over late 1 994 and early 1995. But this short-lived burst of liquidity does not negate the generally less liquid nature of indexed bonds.

Causes of the lack of liquidity: (2) Market infrastructure

The second group of causes concerns the supporting market infrastructure. First of all, the money market does not function in a manner which assists bond market liquidity. Normally, the money market plays an important role in assisting bond market liquidity through the provision of funding for bond portfolios via either loans or repurchase agreements. Repurchase agreements (repos) further assist liquidity by enabling investors to quickly obtain funds without having to sell their bonds.25 Trading in repos in 1994 is estimated to have reached Rmb314 billion as described in Table 3.8. This amounted to an estimated ten per cent of bond trading volume in 1994.

Table 3.8 Trading in repurchase agreements (1 994, Rrnb billion)

Trading centre Trading value

Wuhan Securities Trading Centre 160.0 STAQS 290.0 Shanghai Stock Exchange 63.0 Shenzhen Stock Exchange 1.3 Total 314.3

Source: SEEC

The more liquid the money market, the more certain bond owners can be that it is a stable funding source and the more they can rely on the short term yield curve as representing the cost of carrying a bond inventory. The money market in China fulfils this role to an extremely limited degree.26The core deficiencies of the money market, in terms of its potential support to the bond market are: Its geographic segmentation, which implies that funds in the provinces are unlikely to be available to finance bond transactions on one of the major exchanges, limiting bond market unity.27 Its institutional segmentation. Regulations control the parties permitted to transact and the maturities that can be offered.28Moreover, bank sub-branches manage their own liquidity on the basis of their allocated capital and credit. The lack of centralised liquidity management also acts as a factor preventing the development of a short term yield curve. Interest rate ceilings, on both loans and repos, preventing the development of a short term yield curve, as there is no regular supply of short dated treasury bills to provide a liquid low risk instrument to act as a short term benchmark. The treasury risk management capability of banks and other financial institutions is very thin due to a lack of incentives to manage risk. Developing this capability will be hindered by the cumbersome reserves methodology of the PBC.

The incentive and ability to manage liquidity risk and interest rate risk is necessary before a liquid money market can develop. Estimates of money market trading volumes and assets of users are available in Appendix Tables A3.2 and A3.3.

Despite these difficulties, the PBCfs financing centres (the 'tangiblef component of the interbank market), have fostered the achievement of nearly unified interbank rates across China, by acting as a market benchmark. The PBC is aware of the shortcomings in the functioning of the money market, and intends, in the medium term, to create a nationally integrated market, to enable the introduction of ^.^^

A second institutional difficulty hampering the achievement of secondary market liquidity concerns the lack of a common depository, which reduces inter-regional trade. Since the bulk of debt issues are in bearer form and of small denominations, depositories are vital to aggregate these into wholesale parcels that can be readily traded. Although regional depositories appear to function well in China, there is no central depository, or any mutual agreements between depositories, which would enable them to recognise each other's depository receipts as good proof of title. This inhibits inter-regional trading30

Secondary market pricing efficiency: price unity

The second major aspect of secondary market efficiency in China's bond markets examined here is the question of a specific aspect of price efficiency - regional price segmentation. The black markets prior to 1988 and the Government sponsored markets which followed them were characterised by significant price differences, especially between regions and between rural and urban areas, due to the lack of information and the difficulty of transporting large amounts of physical scrip and cash between markets. Local prices thus reflected local liquidity conditions.

China's bond trading centres

China's bond markets consist of four principal markets (Wuhan, Shanghai, STAQS and Shenzhen), and a number of lesser regional markets, whose size relative to the principal markets is gradually declining (Appendix Table A3.1). All the major markets trade as exchanges. Electronic over-the-counter trade (ie, trade directly between individual participants) has not yet developed except at STAQS. Each market has satellite links which provide members across the country with real- time quotation and ti.ansaction data. Order placement and confirmation is by telephone or fax on the Shanghai Stock Exchange, at Wuhan, and on STAQS, although the possibility of undertaking this through the satellite system is being explored. Dealers in Shenzhen place orders via remote terminals. Shanghai also has a unique system of record keeping and transacting using magnetic cards. The cards are mainly used for individual's equity transactions but the scripless treasury bills issued in 1994 can also be traded through this system. While repurchase business at STAQS has grown, its physical bond trading has tended to shift to the Shanghai Stock Exchange. The Shenzhen Stock Exchange (SZSE) has been active in developing a bond market since late 1993. The Wuhan, Shanghai and Shenzhen exchanges have an estimated common membership of 100-1 50 brokers. Many of these brokers will also belong to STAQS. Members cover the whole of China.

The opening of STAQS and the Shanghai Stock Exchange in late 1990 provided both a nationwide quotation system and an exchange with members from many regions. These developments greatly assisted price convergence. Prices on the Shanghai Stock Exchange began to act as a benchmark for regional markets. Figure 3.6 indicates the size of the arbitrage opportunities that existed in 1990. By the end of that year, there were signs of price convergence between the larger markets (Shanghai and Wuhan), although looking at a spectrum of ten regional markets, including smaller markets, overall price convergence was slower. Regional price differences at the end of 1990 could exceed 700 basis points. Figure 3.6 Regional bond yield differentials (7 990)

Highllow (1986 ByearTbill) Basis points

10 markets ~ncludlng Shanghai & Wuhan

Jan Feb March April May June July Aug Sept Oct Nov Dec I I 1 Source: Based on data from Bi (7993) 1

Price differences today are much smaller than those of the past. Prices on the major centres of trading (Shanghai, Wuhan, Shenzhen and STAQS) are very close to being unified. The barrier to unity in the major centres is the lack of a unified depository system. While quotation and execution of trading on the major markets is technically sophisticated, settlement procedures are lagging in relative terms. In the absence of a unified depository system, prices tend to be high in Shanghai, which has the greatest liquidity and a well regarded depository. Prices are relatively low in Wuhan, which has the least well regarded depository (Figure 3.7).

Figure 3.7 Yield differentials between treasury bills on principal markets: 1994 (Shanghai, Wuhan and Shenzhen) 7------7

Shanghai and Wuhan Basis points Shanghai & Shenzhen 500 7

-loo/ January 1994 September 1994 -100 f March April May June I

Source: Calculations based on data ~rovidedby the Shanghai and Shenzhen exchanges and Wuhan Trading Centre -- In early 1994, the Shanghai authorities grew concerned that depositories outside its system were permitting short selling, by issuing depository receipts when the scrip was not in fact registered. Consequently, in May 1994, the Shanghai Stock Exchange ceased to recognise depository receipts from depositories outside its own system. This increased market segmentation by preventing debt held outside the Shanghai Stock Exchange's depository system from trading on the Shanghai Stock Exchange. The effect of this event on yield differences is also shown in Figure 3.7. Between Januaryand September, the yield difference between Shanghai and Wuhan widened from around 100 to around 500 basis points. A similar increase in yield differences between Shanghai and Shenzhen appeared, after May 1994.

The Shanghai Stock Exchange signed an agreement on depository procedures with STAQS in October 1994 and now recognises their depository receipts. But by the end of 1994, no agreement had been reached with Wuhan, or the Shenzhen Stock Exchange. Problems associated with multiple depositories could be solved if the existing networks agreed on a common code of practice, or alternatively by the creation of a centralised depository. The Ministry of Finance has now embarked upon the process of creating a centralised depository, for government securities only. Ideally, depository practices for all classes of debt securities should be standardised.

Lack of liquidity in provincial markets especially affects debt issues which do not trade on the major markets, such as enterprise bonds and financial bonds, some of which trade only on a regional market. Provincial markets are also less technically developed and less informed than major markets. Consequently prices on regional markets tend to be lower than prices in the main trading centres.

Benchmark issues, market pricing, and the yield curve

The third aspect of the functioning of secondary markets for debt securities which is analysed here, is the extent to which bond market issues can provide a benchmark rate, and help establish a yield curve. The concept of a benchmark issue in relation to new debt issues is not operative in China today, due to, first, the administered setting of yields in the primary The operative benchmark in China today is the interest rate on bank deposits, which is administratively determined. The second factor which undermines the role of a benchmark issue is that the pricing of credit risk is poorly determined, due to the lack of a hard budget constraint on enterprises. It is hard to distinguish between the credit risk of a government owned company, and the risk of the government. Considerably greater interest rate flexibility, combined with enterprise reform which enables credit risk to be credible, will be required before benchmark issues can play a significant role in pricing debt.

Developing the role of benchmark issues in defining the secondary market yield curve requires:

a greater range of maturities32 a more regular issue calendar so that fresh issues come to market throughout the year, and, a greater focus on developing a wholesale market to enhance liquidity.

Due to the lack of a broad spectrum of maturities in the market, a yield curve has been discernible only since late 1992. The changing shape and position of the yield curve (YTM basis) is shown in Figure 3.8. Secondary market yields rose from June1992 to June1993 and then progressively declined; first at the long end of the curve (beyond one and a half years) and finally at the short end. The unusual shape of the curve, rising at the long end, reflects the lower liquidity in the treasury bill with the longest maturity. The lower liquidity itself suggests a preference for short maturities, due to inflation.

Figure 3.8 China: secondary markef yield curve

0 C I I 6 months 1 year 1.5 2 year 2.5 3 year 3.5 4 year 4.5 Years

1 Source: Catulations based on data provided by the Shanghai Stock Exchange Figure 3.9 China: bond yield, deposit rate and inflation

Average yield: YTM -1 year deposit rate - - - Average yield: simple Retail price index

/ Source: Calculations bared on data provided by the Shanghai Stock Exchange, PBC and the World Bank 1

The timing of the decline in yields, after June 1993, prima facie, is difficult to interpret, on two counts. First, the PBC acted to tighten access to funds by regulating the money market in June 1993. Deposit interest rates were increased at the same time. Second, inflation began to rise more steeply from the end of 1993, yet yields continued to decline. The trends in secondary market bond yields and inflation are shown in Figure 3.9.

One interpretation of these contrary developments is that the money market regulations of June 1993 resulted in a diversion of funds, away from the equity market towards the bond market. Banks' lending to securities companies and TICSvia the money market was curtailed and this reduced liquidity t'o the equity and real estate markets, which declined. In addition to this, banks themselves were for the first time given clearance to invest directly in bonds. Bonds are a relatively attractive investment for banks, compared to loans to favoured industries, as they offer higher returns. This suggests that the market from mid-I 994 to mid- 1 995 has been dominated by actions based on regulatory change. A third influence on bond prices which became more relevant in late 1994 was the high announced level of the inflation subsidy and the speculative fever attached to anticipating its final value on a specific bond; the three year bond maturing in June 1995. 33 Some evidence for the diversion of funds from equities to bonds is shown in Figure 3.1 0 which plots average yield and the Shanghai Stock Exchange A share index. The decline in equity prices is accompanied by a fall in yields. In conclusion, it must be pointed out that many of the problems faced by the bond market in China today are the problems faced by an economy in transition. Yet, even among transitional economies, there may be interesting differences in approach, and there are lessons to be learned from the experience of other countries.

Figure 3.10 China: equity index and average bond yield

Index Per cent

12 , , ' _- ->. . 10 800 *,,*---> ,-%, - -- \, \. '8 \. >, . . , ' 600 " ,.\'I 400 200 Average yield 0

Source: Calculations based on data provided by the Shanghai Stock Exchange

Government bond markets in Russia and China: a comparison

Russia, another large country in transition developed due to high inflation. between central planning and a market Virtually all debt issues are of three economy system, offers an interesting month maturities. By contrast, China contrast to China, in terms of bond market until 1994 had issued debt on two development. There are striking and three year maturities, and it was differences in the evolution of the two only in 1994 that it issued bills of six systems, and the problems which each month and one year maturities. The country faces: short end of the market is relatively undeveloped in China. The Russian bond market is much There are very few non-government smaller than in China. The volume of debt securities in Russia. Russian outstanding treasury bills amountsto firms can and do default on their only 1.8 per cent of GDP. obligations. Russian banks are In terms of maturity, debt issues are likewise very aware of the credit risk concentrated at the short end of the of clients and other banks, unlike market, and the medium and long Chinese banks. ends of the market have not been -9 Money markets in Russia are the shortage of screens restricts trade relatively free, with no interest rate to a virtual cartel of only 55 primary controls. There is no central credit dealers. Brokers cannot trade at the plan. The central bank has a discount exchanges, unlike China, which has rate, changes in which triggers other a large network of brokers, and screen interest rate adjustments. Russia based trading at all its several major issues its three month bills at regular bond trading centres. The primary intervals, of three weeks. The reason for this restriction is to preserve implication of these factors is that the integrity of the market against (unlike China) the short term yield fraud and default. curve is relatively well defined. The problem of developing a national Investors in government bonds in market in Russia is more severe than Russia, unlike China, are mostly in China, due to the huge problems wholesale, and mostly financial of the payments system, which imply institutions. that participants from regions outside Unlike China, Russia faces major Moscow havedifficulty accessing the difficulties in the trading of market. This is in contrast to the government bonds due to the lack of intercity linkages of the major trading technology which would permit a centres in China, and the unifying nationwide market. Virtually all trade effects of the electronic trading takes place at MICEX, the Moscow systems of STAQS and NETS. Interbankcurrency Exchange, where

Endnotes

1 This was due to the government's decision, in the latter half of 1993, to prevent a feared large- scale diversion of funds out of the banking sector and towards capital markets, due to their relatively attractive performance and higher returns in this year. The role of bank credit relative to enterprise bond issue, in terms of their assigned quota under the credit plan, was therefore increased. 2 Capital market liquidity increased markedly following the legalisation of inter-regional trading in October 1990 and the subsequent development of STAQS and the Shanghai Stoclc Exchange. 3 Thus National Construction Bonds were intended to finance infrastructure and state enterprise investment in general, while Key National Construction Bonds were targeted tmoward priority national projects. 4 For example, Fiscal Bonds were also intended to raise funds for capital construction projects, but were issued exclusively, and on a mandatory basis, to banks and other financial institutions. 5 The SEEC at the time assumed the role of a co-ordinating association for the securities institutions of China, in the absence of a national oversight body. Later that year the PBC and local finance bureaus also organised an 'underwriting syndicate' for a further Rmb4 billion of treasury bonds. Moreover, this underwriting by banks may have been closer to administrative placement, de facto. 6 The organisation of the underwriting syndicate however, seems to have precluded some of the benefits of underwriting, such as permitting underwriters to offer bids for prices, commissions, or terms, and as such was semi-administrative. Even the underwriting projections were fixed by the Ministry of Finance. 7 Primary dealers in China's bond market are defined as follows: they are qualified to participate in the national underwriting syndicate, they have the privilege of discussing issuance terms with the Ministry of Finance, they will have the privilege of underwriting open market operations and bond repurchase with the PBC, and they can set up investment funds in bonds. They also have the duty of protecting the liquidity of secondary markets and can actively undergo bond trading as commission agents, or on their own account. Underwriting is therefore just one of their functions. 8 Due to declining competition from equities and real estate, itself partly due to the government- imposed delay in the issue of new equities and certain types of non-government debt, as well as the clamp-down on real estate speculation. 9 One reason for the 'voluntary' application for quotas may have been the relatively attractive coupon, and hence ease of placement, combined with a small commission or fee. 10 In 1995, Rmb 25 billion of the year's issues of Rmb 125 billion was placed by a group of financial institutions, operating as primary dealers. This first was issued on 1 March, 1995. These three year bonds carried a coupon of 14.5 per cent with no inflation adjustment. They were paperless, tradable, and in book entry form. Another Rrnb 105 billion of government bonds issued at the same time, were placed though the five specialised banks for distribution on a retail basis through their local branches. These bonds were not tradable, they were issued in certificate form, and they did carry an inflation adjustment. The coupon rate before adjustment was 14 per cent. This issue thus resembled the Rrnb 70 billion of certificates issued in 1994. Two further issues were made later in the year, which were smaller in size; an issue of Rrnb 10 billion of one year paper in July 1995, listed on the exchanges and in book entry form, and placed with financial institutions, and finally, a small issue of Rrnb 2.6 billion in August 1995, placed for the first time with financial funds, issued in certificate form, with a 5 year maturity and an inflation index. 11 The present arrangement appears to be based on historical practice associated with the plan cycle. Another reason for lumpish issues may be a desire to avoid competition between different securities. 12 The central government has a surplus in the first half of the year and a deficit in the second half and so the Ministry of Finance, considering good debt management practice, would clearly prefer a different sale pattern. 13 Payment of a semi-annual coupon may make the debt attractive to more sophisticated investors, but secondary market trading prices suggest that the payment of an annual coupon on the five year 1933 treasury bill did not give it enough appeal to overcome investor disli,ke of long maturities. 14 The data are based on initial placement. Reliable data on end holders of debt securities is not available. The table will understate the proportion of debt sold to households in earlier years, as enterprises passed on some of their debt to workers and may overstate the proportion held by individuals in later years to the extent that: undetwriters have retained treasury bills for their own portfoliosor have sold them to institutions rather than individuals, and, secondary market trading results in a net transfer to institutions. 15 The inflation adjustment is published on the 20th day of each month; adjusted according to the inflation adjustments on the deposit rate, and a price index used by the PBC. In March 1995, the adjustment amounted to 11.87 per cent. The PBC index differs from the index prepared by the State Statistical Bureau; the former includes goods and services while the latter is based only on goods. Moreover, the PBC index is not published. The formula used for the inflation adjustments is as follows: Adjustment = [(w, /w,,)-1)- rx n]x 100 where w, = the monthly price index, at time of maturity wo = the monthly price index, at time of issue r = annual interest rate n = years to maturity 16 Bonds issued by provincial TICSdid not have the approval of any government department. They have a maturity of 5 to 20 yeqrs and are sold to both individuals and enterprises. 17 There are no specialised depositories for enterprise bonds. They are generally held in paper form. 18 In 1993 there was one prominent case of enterprise bond default; the Great Wall company incident. The bonds had a coupon of 24 per cent, which the enterprise was later unable to honour. 19 Trade in Fiscal Bonds is not permitted, and Special State Bonds cannot be listed, and most of the 1994 and 1995 treasury bill issues are not tradable. 20 The first bond futures contract in China was put on the market on 26 December 1992. After a year's experimentation and amendment to trading sales, it began real operation at the end of 1993. 21 Speculation on the inflation indexation of a treasury bond led to the recent tremendous increase in futures trading on the Shanghai exchange, which as shown in Table 3.6 had rapidly outstripped spot trading by January 1995. On 23 February 1995, the volume of futures trading on the bond market was nearly US$100 billion in a single day. Traders who had taken illicit short positions defaulted, leading to widespread disorder and temporary market closure. The implications appear to be that in China's present inflationary environment, index-linking, with a lack of transparency in the redemption amount, may not be advisable, and also, that trading in derivatives requires tighter regulation as well as supervision. Tighter regulations were drawn up rapidly after the incident, with the publication of a 'Regulation on Bond Futures Trading', within days of the incident. More details on international practice in terms of regulation of derivatives trading are available in Chapter 5. 22 By the end of 1994, bond trading volumes on Shanghai were reported to be 300 times their 1993 levels. 23 Treasury bill holders can obtain short term liquidity against their portfolios via the growing market in repurchase agreements. 24 In the early days of the market most trading was by individuals and, while individuals may still be relatively more significant as clients of the provincial trading centres, on the major exchanges where most turnover occurs it is institutions which dominate. For example, most of the bonds in the depository of the Shanghai Central Clearing Corporation (a strong indicator of availability to trade) belong to TICS, investment companies, banks and enterprises. Of the institutions, TICS are reported to be the most active traders. Banks and insurance companies have become more active from 1994 since previous restrictions on their holdings were removed after June 1993. 25 Trading in repos is conducted at the two major exchanges, Wuhan and STAQS. But trading practices can range greatly due to the lack of uniform national conventions or rules. In Shanghai, rep0 terms go from 7, 14 and 28 to 91 days, and bidding is on yield ratios. Wuhan has terms of 1, 2, 3, 6 and 9 months. On STAQS, both terms and prices are negotiated between dealers. 26 A general description of the money market in China today (other than repurchase agreements) is provided in a World Bank Country Economic Memorandum for China (Report No. 13399-CHA; October 1994). Much of the market is used to conclude transactions that would occur intra-bank in most market economies. 27 Internal transfers are complicated by the weak payments system and discouraged by the PBC's branch-level reserve requirements. Afurther factor which geographically segments the interbank market is intervention by local officials in reaction to the uneven rate of development across China. Officials in some provinces try to place restrictions on the outflow of funds from their areas towards others which may promise higher returns. The market is usually organised by provincial branches of PBC which can further encourage transactions to remain within a particular area. 28 The interest rate ceiling is set with reference to deposit rates. In 1994, the ceiling (which also applied to repos) was 1.098 (monthly rate) per cent. Loans to banks cannot exceed 40 days, and to NBFls, 7 days. In practice, longer maturities are achieved through roll-overs, and the lending ceiling has also been circumvented. Average maturity prior to 1994 is estimated, de facto, to have exceeded a year, in the absence of administrative intervention (SEEC, 1995). The central bank had repeatedly issued regulations to limit terms, usually to little avail (see Chapter 2). 29 The PBC is examining the use of open market operations as a mechanism for implementing . Two technical requirements for open market operations to work are that banks hold a portfolio of treasury bills and thatthe interbank market is an efficient channel for distributing system-wide liquidity. 30 By August 1995, the Shanghai Exchange had around 60 regional depositories and the Shenzhen Exchange had its own, numerous separate depositories. The Government of China is aware of the drawbacks of the present arrangement and is trying to establish a Depository Trust Corporation with help from the Central Bank. The new instiiution will offer custodial and settlement services to its members as well, and will be affiliated to the present exchanges. 31 A benchmark issue is an issue which provides a reliable indicator of the market yield for a given maturity due to good secondary market liquidity. Such an issue facilitates debt issuance by providing an indicator against which to price new issues. Benchmark issues of different maturities help to define the yield curve. 32 The volume of debt issued today is in principle sufficient. 33 Inflation peaked in October 1994 but remained high in early 1995. The government employed a series of measures to curb credit growth and further raised interest rates (PBC lending to financial institutions) in the first half of 1995. But bond trading volumes remained high and prices rose further, therefore, yields probably fell during this period. Introduction: Equity Markets and the Shareholding System

The development of a primary share market in China began informally in the early 1980s. Initially, stocks in China differed from the concept of equity as understood in a market economy in a number of ways. They usually carried a with a fixed maturity and were issued to raise funds for specific investment. In these respects, they bore a closer resemblance to bonds. The exercise of shareholders' ownership rights and privileges was given low weight. Stocks were initially issued largely to employees, rather than the public, sometimes in lieu of bonus payments. Public stock issue began from 1984' and an informal secondary market began shortly after, but did not really develop until 1988, when the government first permitted the trade of state treasury bills. Share trade was legalised with the formal recognition of the Shanghai and Shenzhen Stock Exchanges in 1990 and 1991. Numerous informal stock trading centres were also set up.

The concept of shareholding in China has now been formalised in the Company Law. Shares are now issued in perpetuity, to a cross-section of investors, and listed and traded on domestic and overseas exchanges. Yet, the issue and trading of shares in China still has some special characteristics. Unlike many emerging markets, government privatisation plans did not lead to the creation of, (unlike Eastern Europe) or even significantly stimulate (unlike Indonesia, or many Latin American countries) the development of China's equities markets. While the development of a private shareholding system has necessarily involved a degree of 'privatisation' in terms of dilution of the government's share in ownership, it is not referred to as such. Some limited privatisation is thus tolerated, but not, so far, encouraged.' 'The sale of existing government shares to private shareholders is still not permitted, and thus firms 'go to market' with new share issues. The primary aim of listing is therefore the raising of capital for investment. The proportion of shares held by private investors is typically small (although the new Companies Law requires at least 25 per cent of asset value for a new listing), and therefore the extent to which shareholders can be expected to influence governance is very limited. Using the stockmarket as a mechanism for merger or take-over threats is rare.

In many respects, equity markets in China evolved spontaneously and more rapidly than the government had foreseen, as enterprises sought new ways to raise capital. This is clearly illustrated in the description of China's share categories and their evolution. Government recognition, and the drawing up of appropriate regulations for the activities of the market, evolved expost facto. Officially, the Stock Exchanges of Shanghai and Shenzhen have been authorised by the State Council to operate strictly 'on an experimental basis', and equity markets are regarded as a controlled experiment. The government has retained a high degree of control on the listing of new enterprises, in terms of enterprise choice and the value of new stock issued, as part of the credit plan. The government is now closely monitoring the authorisation of new exchanges, and the overall degree and direction of growth permitted to the fledgling market.

The rapid growth of the market, in terms of the number of listed shares, trading value, and market capitalisation, has already been described in Chapter 1 (see also Appendix Tables A4.1 -A4.5). The present chapter first details additional key characteristics of these markets. It then analyses the efficiency of these markets, focusing in turn on three key areas:

the primary issue process for new equity the trading process or operation of secondary markets, and, the issue of market segmentation, in the context of China's multiple share categories for ordinary shares, and multiple exchanges.

The final section briefly examines some additional issues facing the efficient development of these markets.

Principal types of shares in Chinese shareholding enterprises

China is relatively unique among emerging market economies in having a number of different types of ordinary shares. There are five different types of ordinary shares in China at the moment. They are set out in the Standard Opinion (see Chapter 2) but are not described in the Company Law. A Chinese shareholding enterprise can issue more than one type of share; and all enterprises which have issued B shares or H shares (see below) also have A share issues. A shares, B shares, H shares and N shares all enjoy the same rights and obligations (ie rank par; passu) except that dividends on B, H and N shares are paid in foreign currencies.

A shares and domestic investors In terms of size and level of activity, the A share market dominates China's equity markets. These shares are equivalent to ordinary equity shares as generally accepted in market economies. In China they are also known as individual or natural person shares, to distinguish them from legal person or C shares (see below). A shares are Rmb denominated and traded, and are the only class of domestic share that can be legally traded on the two major domestic exchanges . A shares may only be bought and sold by individual or legal persons within China (but are distinguished from legal person shares which individuals may not purchase). Employee shares are also A shares. Because of the minority nature of A shares in enterprises'equity structures, A shares give investors voting rights with little if any prospect of control.

Although overseas investors are not permitted to purchase A shares, it is generally acknowledged that a small proportion of A shares are already in the hands of foreign investors, probably Taiwanese, by investment through locally registered companies. The size of such investment is likely to be very small. It was such clandestine entry into the domestic market by foreign investors which first prompted the government to authorise legal investment by foreigners, in the form of B shares. The possibility of permitting non-Chinese nationals to purchase A shares through specially authorised joint venture mutual funds was announced by the CSRC in late July 1994, but no firm details were issued.

B shares and overseas investors in China's equities markets B shares are ordinary shares bearing the same voting or ownership rights as A shares, denominated in Rmb but traded in either US dollars (in Shanghai) or Hong Kong dollars (in Shenzhen) and listed only on the SHSE or the SZSE. B shares may only be subscribed by, and traded among, foreigners, and residents of Hong Kong, Macau and Taiwan. The Chinese authorities are now proposing that B shares should be called domestically listed and foreign invested shares and that Chinese nationals with access to foreign currency should be allowed to purchase B shares as well as A shares. In reality, Chinese nationals have already been acquiring B shares through overseas relatives and Hong Kong entities and therefore such regulations would formalise and facilitate the current situation. The CSRC has stated that it is intended to abolish B shares as a separate category when the yuan becomes freely convertible.

H shares and the listing of Chinese companies in Hong Kong Some Chinese companies began to take stronger measures to access overseas equity financing, by acquiring controlling interests in Hong-Kong listed companies. Such 'back-door' listings of Chinese companies in Hong Kong (around 20 cases) were frowned upon by the authorities. A variety of companies based in Hong Kong are in fact controlled by mainland Chinese. These so-called 'red chips' or China plays include high profile groups such as CITIC Pacific and Guangdong Investment. Both these have blue-chip rank in the Hang Seng index.

Partly in response, to establish a legal avenue for overseas listing, a new category of shares was officially created in July1993 - H shares. H shares are listed on the Hong Kong Stock Exchange and traded in Hong Kong dollars. H shares may only be subscribed by, and traded among, foreigners and residents of Hong Kong, Macau and Taiwan. Such shares are effectively a primary listing of a foreign company on the Hong Kong exchange and are not unusual in principle. Their novelty lies in the fact that special arrangements have been adopted and in practice certain concessions have had to be made to accommodate the current lack of a conventional legal infrastructure in the PRC.

N shares and listings in New York Similar to back-door listing on Hong Kong, back-door listings of Chinese companies in New York began through overseas registered holding companies. After some two or three such 'Bermuda listings' had occurred, the legal registration and listing of Chinese enterprises on the New York Stock Exchange, using the form of American Depository Receipts (ADRs), was authorised (seechapter 5 for details). The term 'N shares' should refer legally only to these ADRs, but the term is sometimes used more broadly to include all China-related NYSE listings, and sometimes used more narrowly, to refer only to those New York ADRs which have no corresponding issue of A or H shares; ie, they are uniquely traded in the US. C shares: legal person shares These are a category of shares not found in ordinary market economies. They have been created in the PRC to designate holdings in SOEs by official bodies such as state institutions, other SOEs and government departments. Individuals are prohibited from holding C shares. But Chinese state institutions, enterprises and departments having legal person status are entitled to purchase A shares as well as C shares. C shares are traded over-the-counter on the hlETS and STAQS systems and are generally very illiquid. The effect is that firms with a large proportion of their capital structure in legal person shares are subject to higher costs of capital than if they had more A or B shares. By October 1994, there were only 17 C shares listed; ten on STAQS and seven on NETS, but it is estimated that over 4,000 joint stock companies have issued C shares by way of private placement. New listings of C shares have been banned since June 1993.

The official policy towards legal person shares has been under review. Many companies would now like to convert their C shares into Aor B shares. However, one of the over riding issues in this market has been official concern about allowing the transfer of state assets into the public domain (ie conversion to A shares) and perhaps more significantly foreign ownership (ie conversion to B shares, H shares or N shares). Another apprehension about allowing the conversion of C shares is that it could flood the usually sluggish securities market. At the same time, it is

Dazhong Taxi The issue of the conversion of C shares officials are still somewhat apprehensive to B shares became topical in 1994 when about approving conversions for all Dazhong Taxi company of Shanghai companies. Authorities cite the fact that expressed its intention to do so. Dazhong the shares converted in Dazhong's case proceeded to convert 10 million C shares represented a very small amount of the into 10 million B shares. C share holders overall shareholding structure of the stood to benefit the most as the holding company (7.9%) implying the importance of B shares afforded them the possibility of maintaining state control. Nonetheless, of capital appreciation (the trading Dazhong will now have foreigners inactivity on the C share market holding 47.6% of the shares as compared 1 effectively ruled out this possibility) and with the 44.4% held by the state. This it helped Dazhong to increase the foreign majority holding is a unique liquidity of its B shares. However even situation among Chinese companies. though the conversion was approved, argued that if C shares were allowed to be converted the proceeds from the conversion could be used to purchase other classes of shares and thus add to liquidity in the A and B markets.

Characteristics of China's Equity Markets

Turnover and market liquidity A key issue to note is the contrast between activity levels on the A and B markets. In contrast to the A share market, B markets are very thin, with low turnover compared to A shares. On the Shanghai Exchange, A share turnover activity, in terms of the daily number of shares traded, exceeded 1,250 million shares and Rmbl0,OOO million on a number of occasions in 1994. The average daily trading volume in the third quarter of 1994 was 577 million shares with a corresponding daily average value of Rmb4,772 million. By contrast, B share turnover only rarely exceeded 15 million shares and US$50 million The average daily trading volume in the third quarter of 1994 was ten million shares with a daily value of Rmb44 million. The implication is that in the third quarter of 1994 activity in the A share market, measured by the number of shares, has been approximately 55.7 times greater, and measured by value 108 times greater than for B shares.

Similar patterns of activity are to be found in Shenzhen. For A shares, the volume of trading often exceeded 700 million shares and Rmb5,000 million in 1994. The

Figure 4.1 Average daily trading value of shares

A shares B shares Rmb million Rmb million 400,000 6,000 - 350,000 Shenzhen B 5,000 - shares 300,000 Shanghai B 250,000 4,000 - shares 200,000 3,000 - 150,000 2,000 - - - 100,000 - 50,000 0 Q1 02 Q3 Q4 Q1 Q2 03 Q4 01 Q2 Q3 01 Q2 Q3 04 Q1 Q2 Q3 Q4 Q1 Q2 Q3 1992 1993 1994 1992 1993 1994

Source: Calculatio~isbased on data from the Shanghai and Shenzhen exchanges average daily trading volume for A shares in the third quarter of 1994 was 300 million with a value of Rmb2,028 million. The volume of trading in A shares on Shenzhen has therefore been approximately one-half of that on the Shanghai market, although there is enormous inter-day variability in volumes traded. For B shares the volume of trading on the Shenzhen Exchange fell in 1994 from peak- levels reached in 1993. In 1994 daily volume of trading peaked at around 2 million shares and RmblO million. This compares to peaks exceeding 15 million shares and Rmb400 million on the Shanghai Exchange. The daily average volume of trading in the third quarter of 1994 on the Shenzhen Exchange for B shares was 1.35 million shares and Rmb7.25 million.

A more meaningful measure of market liquidity is the relative turnover rate or turnover ratio on the two major exchanges, defined as average daily turnover (value) divided by outstanding market capitalisation. Since B share market capitalisation is much smaller than A share markets, the turnover ratio is a more relevant measure of market liquidity than absolute trading values. For Shanghai A shares the third quarter 1994 daily turnover rate was 4.72 per cent versus 4.5 per cent for Shenzhen. For B shares, the Shanghai turnover rate was 0.4 per cent versus 0.28 per cent for Shenzhen. Thus, A share markets have been much more liquid than B share markets, with respectively Shanghai and Shenzhen A (B) markets reflecting similar degrees of liquidity.

Table 4.1 Concentration ratios of member firms trading on the Shanghai Stock Exchange (January, 1995)

Market share (%) T-bonds T-bond Rank Total A shares Funds T-bonds futures B-shares repurchases - - - No. of firmsa 314 302 272 98 307 37 3 7

Rank of firms (Market share) Top 1 10.6 4.5 19.2 14.4 10.6 12.0 16.3 Top 5 23.0 15.2 32.3 51.2 23.0 45.1 49.6 Top 10 32.5 23.6 43.1 65.5 32.5 74.9 66.3 Top 20 44.2 35.3 54.3 77.1 44.3 95.7 00.6 Top 50 64.6 51.2 67.1 88.1 64.6

- -- Note: "Only the top 320 firms, in terms of total trading volume, were included in the sample. Source: Shanghai Stock Exchange: monthly market statistics, January, 1995 Concentration On both exchanges members can have more than one seat on the exchange. For example, the Shanghai Exchange has around 3,800 seats but only 540 members. Members from outside Shanghai are encouraged, and of the 541 members of the Shanghai Exchange, close to 500 are located outside Shanghai, in 21 centres linked to the trading floor by a communications satellite network and telephone (Appendix Table A4.5). Despite the large number of members, trading is highly concentrated among a small number of members. As Table 4.1 shows, the top ten members account for over 30 per cent of all trades placed on the Shanghai E~change.~

Trading is also fairly concentrated in terms of individual shares (Table4.2). Looking at five firm concentration ratios, the top five firms on the Shanghai Exchange accounted for almost one quarter (23.4 per cent) of total trading value, and 29 per cent of shares traded. Concentration was even higher on Shenzhen, with the top five firms accounting for 36.9 per cent of trading value and 31.3 per cent of share turnover. With the growth of the market, however, trading concentration declined to half, or less than half, of these levels.

Table 4.2 Concentration of share trading on China's securities exchanges (Five firm concentration ratios: percentage share of top five firms)

Number of Concentration by Concentration by Concentration by observations trading value trading volume trading volume (Nos.) (Turnover value) (Shares traded) (Lots traded)

Shanghai Exchange 1993 83 1994 195

Shenzhen Exchange 1993 61 1994 138

Note: Since the data available extended till early September 7994, the observations for both years are based on data for the first eight months of the year, to ensure comparability. Source: Calculations based on data from the Shanghai and Shenzhen Stock Exchanges Figure 4.2 Shanghai securities exchange

index (Index value as of 2711195) 3 7nn Sector Listings

lndustrial 120 Commercial 35 Utilities 13 Miscellaneous 24 Real estate 12

Industrial Commercial Utilities Miscellaneous Real estate

1 Source: Shanghai Securities Exchange data

Sectoral composition Sixty per cent of the shares listed on the Shanghai Securities Exchange are industrial companies. Commercial and miscellaneous companies account for another 30 per cent, while real estate and utilities enterprises each account for around 6 per cent of the number of firms listed. Yet, real estate companies have more than twice the turnover for listing of industrial or commercial firms (Appendix Table A.7). A sectoral disaggregation of stock indices in January 1995 also shows that the index for these enterprises was higher than for other sectors (Figure 4.2).

Clearance and settlement Settlement of transactions on both exchanges is aided by the book-entry nature of the share-depositories. As of 1 January 1995, A shares are settled at T+l on both exchanges. This is quite a technical feat given that on the Shanghai market, shares are registered at the individual level rather than at the broker-level (or nominee level) as in Shenzhen. Prior to January 1995, shares were actually settled at T+O. Currently, there are over 5.4 million separate shareholder accounts at the Shanghai depository compared to a few hundred broker accounts in Shenzhen. By contrast B shares are cleared at T+3 on both exchanges as a result of the need for payment to be made in foreign currencies and transactions to be recorded with global or regional custodians off-shore (eg, in Hong Kong). Currently, there are only 16,000 B shareholder accounts at the Shanghai depository, indicating the relatively institutional and international nature of the B share market compared to the predominantly retail and local A share market. Payment, clearance and settlement issues are analysed in greater detail in Annex 4.1 . Transaction costs Buying and selling shares on the exchanges is subject to commissions, fees and stamp duties. Commissions and stamp duties are paid by both buyer and seller. Like many Asian exchanges such as Japan, trades are subject to fixed commission charges. Estimating overall transaction costs is complicated by the prevalence of fees and other hidden charges by brokers but estimates suggest that total (two- sided) transaction costs (including a 0.3 per cent stamp duty paid by both parties) exceed 1.5 per cent on the Shanghai Exchange and 2.0 per cent on the Shenzhen Exchange. It is illegal for brokers to sell shares to buyers on margin. In effect, margin requirements are 100 per cent Margin-type loans have nonetheless been extended by brokers to favoured customers.

Taxation and payment Trades on both major exchanges are generally free of either capital gains or dividend taxation. While a 20 per cent capital gains tax exists as part of Chinese law it has never been levied on equity transactions. Tradingfor short term gains is encouraged by this very generous tax regime. In addition, there are no taxes on dividends. A remarkable feature of dividend payment in China is that cash dividends are rarely paid. When paid, dividends have taken the form of new stock (typically stock options). One reason cited for this is that enterprisesr cash flows from profits are constrained, by a series of required allocations to special funds for staff welfare, bonuses and enterprise expansion. The absence of meaningful dividends has encouraged transactions based on capital gains seeking. This in turn has tended to divorce stock prices from their fundamental values (the current and expected future values of dividends) and has enhanced market volatility.

Secondary markets for equities in China

*the Shanghai and Shenzhen Exchanges (see also Chapter 2, and Appendix Tables A4.1 and A4.2) The Shanghai Exchange was formally recognised on 19 December 1990, and the Shenzhen Exchange on 3 July 1991. Apart from trading A and B shares, they also trade debt securities (53 on Shanghai and 12 on Shenzhen), funds (12 and 8, respectively) and warrants (one, on Shenzhen). Both exchanges exclusively trade the shares listed on their own exchange. Companies from areas outside the respective municipalities are permitted to list on the SHSE and SZSE. There is no dual listing, and there are therefore effectively two official national systems. Both formal exchanges have members from every province ir, the PRC. The Shanghai Exchange now has interlinked trading centres in 20 cities, and is also linked to STAQS (Appendix Table A4.5). Trading centres outside Shanghai now account for 29 per cent of stocks, and 15 per cent of bonds traded on the Shanghai Exchange network. There is a substantial overlap in membership with approximately two thirds of brokers being members of both exchanges. Non-Chinese members have recently been admitted to both the SHSE and SZSE.

Electronic over-the-counter markets The Securities Trading Automated Quotations System (STAQS) was developed by the Stock Exchange Executive Council (SEEC) and launched on 1 July 1992. It has been described as a Chinese version of the National Association of Securities Dealers Automated Quotation System (NASDAQ) adopted in the US. However, STAQS is now based on four trading floors as earlier attempts to expand it as a fully electronic market were prevented by the lack of an adequate telecommunications network.

The National Electronic Trading System (NETS) was established by the China Securities Trading System Corporation Ltd (CSTS) on 28 April 1993. CSTS is owned by the People's Bank of China (PBC), four other big banks, the People's Insurance Company and three national securities companies. the system has been installed in a number of cities using the PBC's VSAT satellite network to link up the trading centres. CSTS has long term plans to extend the system into a national trading system based on its satellite communications network.

STAQS and NETS trade bonds and SOE held C shares. They do not trade the A and B shares of listed companies. Companies with C shares traded on STAQS or NETS are not permitted to issue or trade A or B shares. The CSRC does not regulate the STAQS or NETS systems, although its rules can affect them, as for instance in June 1993 when the CSRC banned the listing of further C shares on any markets. Since that date trading volumes on both systems have been mainly concentrated in government debt. The number of shares and volumes traded on these over-the-counter markets is small. STAQS lists ten C shares and had a peak trading volume of Rmb40 million in August 1994. Daily trading volumes were Rmb2-3 million per day in September 1994. hlETS lists seven C shares and has lower trading volumes than STAQS.

Stock trading centres Informal Stock Trading Centres have been set up in most large cities and this 'unofficial' market is now believed to be large. At the end of 1994, there were 17 such centres (Appendix Table A4.6). Apart from government bonds, much of the trading at these centres consists of locally formed closed end mutual funds. Tianjin, one of the larger exchanges, lists nine such funds. The Stock Trading Centres have an organisational structure, members, trading rules, trading sites and most other attributes of an exchange. But they are not considered self-regulatory organisations, nor have they been authorised by any agency of the government to operate as 'exchanges.' Each requires approval from the PBC to operate, and indeed many have been set up jointly by, and enjoy the support of, the local government, and local PBC office. However, the PBC has no regulatory authority beyond that and neither does the CSRC. The CSRC's view is that if they took responsibility for such markets it would incorrectly suggest they are officially recognised.

Future exchanges In early 1994, the two existing exchanges were not considered adequate to meet demand, especially in Northern China. Authorities in other cities have been lobbying to establish official exchanges. Hainan Island started an exchange which was rapidly closed by the authorities because of its weak regulatory structure. The current draft of the proposed National Securities Law suggests that additional exchanges may be established. But in late 1994, authorities publicly stated that a third exchange will not be established in the near future.

From 1997, of course, the Hong Kong Stock Exchange will be a Chinese exchange. A working group has been established to investigate possible areas where the Hong Kong Stock Exchange and the SZSE could cooperate. (Discussed further in Chapter 5).

The New Issue Process And Public Offerings

The first issue analysed in the present chapter concerns the listing process and the efficiency of the primary market. Enterprises in China are listed on stock exchanges primarily for the purpose of raising capital for investment, unlike many other state enterprises in transitional economies, where enterprises 'go to market' for divestiture or privatisation. All enterprises listing on stock exchanges in China have issued new shares. Virtually all new issues have been first time offerings or initial public offerings (IPOs). The present section examines the efficiency of both the pre-offer, or the initial selection mechanism, and the post offer, or the method by which the listing is undertaken, once an enterprise has been selected for listing. The pre-offer process

The aggregate value of new shares to be issued each year is a part of the national investment and credit plan (as discussed in Chapter I),with the new share issue quota for A shares determined jointly by the State Council Securities Committee (SCSC), the State Planning Commission (SPC) and the central bank (PBOC).4 In 1993 the A share quota was Rmb5.5 billion of which Rmb2.8 billion had been used by the end of 1993 (Appendix Table A4.8). A quota of Rmb5 billion was announced for 1994, but in July 1994 the government announced a moratorium on new 'A' share issues due to perceived instabilities in the stock market, leading to an under-utilisation of the year's quota. As the table shows, the quota is allocated by province as well as by 'independent-plan' municipalities. The criteria used for allocation among provinces appear to reflect a balance between balanced regional dispersion for distributional objectives, and a recognition of wide regional differences in the production structure and enterprise base.

Within each regional quota, the local securities authorities invite enterprises to request a listing, and make a selection based on criteria which combine good performance, as well as sectoral development objective^.^ Local government selection criteria take into account the profitability and performance criteria of the exchanges. As a result, the real selection of enterprises for listing occurs at this level. For example in 1 993, of around 100 firms which applied for A share listing in Shanghai, approximately 30 were approved by the Shanghai Securities Administration. Although these candidates are then required to seek the approval of the CSRC and the exchanges themselves, approval at these successive levels is virtually automatic. While in principle any enterprise going public can list on either exchange, this too is strongly influenced by local securities authorities.

€3 share quotas in 1993 were set at US$l00million for each of the two exchanges of Shanghai and Shenzhen. In 1994, a combined national quota of US$1 billion was announced.' In addition to approval by local authorities, companies desiring a €3 share listing also require the approval of the Ministry of Foreign Trade and Economic Co-operation (MOFTEC). Overseas listing (for H shares or IN shares) is not subject to a quota but requires case by case approval, which has to be given by the SCSC, the SPC (in view of the annual overseas borrowing plan), the SRC (for approval of state ownership dilution) and the SETC (for conformity with industrial policy). Nine companies were authorised to issue H shares in Hong Kong in 1993, and a further 22 companies were authorised for H share issues in 1994. In practice, constraints, in the form of the relatively low demand by foreign investors for B and H shares, has limited the number of new B and H issues. For example only 4 out of the 22 approved H share issues have been made in 1994. The targets for new B shares also have little chance of being met.

The process described above of the selection of enterprises for listing differs considerably from a more mature market economy, where the decision to list an enterprise would usually be determined largely by the exchange where it seeks a listing. The criteria adopted by the exchange would typically include size, performance, and the extent to which compliance with the rules of the exchange could be expected. The pre-offer process in China reflects the dilemmas of a transitional economy where the planning mechanisms for credit and investment are co-existing uneasily with new forms of markets. As a result, enterprises selected for listing, though perhaps more successful than the average state enterprise, are unlikely to be the same as the ones which would have been selected by the market. While the establishment of independent review panels attempts to reduce the arbitrariness of the selection process, it also leaves the system open to influence. If the soundness of underlying performance is not the sole, or at least major criterion, the result is a distortion in the efficient allocation of resources.

Figure 4.3 China: a stylised /PO process: post-offer to the beginning of trading

4 6-8 weeks w

IThe~ofa~~prospectus is Rmb Salesare divided proceeds between from forms the 1 state (65%) and the broker or bank (35%)

1 Source: Interviews with exchanges and listed enterprises ~ The post-offer process

Once an issue is selected, a filing is made with the CSRC. Afiling fee of Rmb30,OOO is paid by the enterprise and the CSRC undertakes a 'due diligence' type analysis of the enterprise. Although approvals are meant to be made within 20 days (similar to the US SEC) delays and refilings may stretch the filing period to two months or even longer. In October 1994, the CSRC had approved all 190 of its 190 filings. That is, the screening out of new applicants always occurs at the Municipal Securities Administration level rather than the CSRC level.

After the offer (IPO) is announced, there are a number of further steps before it starts trading. A stylised or representative example of the IPO underwriting process in China is shown in Figure 4.3. After the announcement, and publication of the prospectus, underwriters are chosen, largely at the discretion of the local securities authority, although the role of the local authority appears to have diminished towards the latter part of the period examined. Prospective investors obtain application forms from banks or brokers, at a small fee. In some cases, the fee was subsequently divided between the brokers (who retained around one third) and the state securities authorities. In other cases, brokers' fees were separately determined. Only retail investors are legally eligible to buy the application forms for a public offering8 Since the early lPOs were usually oversubscribed by a large multiple, a lottery was then conducted to determine the final allocation of available shares to investors.

New issues have tended to be made in 'lumps' or '' in which lotteries typically determine both whether an investor is eligible to apply at all, and which enterprise's shares he or she can buy. The histograms of new offering frequency on the Shanghai Exchange show considerable bunching around July 1992 and October 1993 (Figure 4.4).

Once the lottery has been completed, winning shareholders pay for their shares, through cash or advance deposits at banks. Share ownership claims are then allocated, and trading can begin on theexchanges. 'The stylised IPO underwriting new issue process has commonly taken as long as 11/2 months; not dissimilar from the time taken for new issues in Hong Kong, Singapore, Taiwan and Thailand. Figure 4.4 Initial offerings of Shanghai A and B shares

Number of new firms listed A shares

10 5 n s!? mm m r 7 m m v 7 ...7 7- $8 . Gz. s?e?- v 7 7 ..7 7 .(D r .m .co:a,- .e .m $! ii3 g r ?- Number of new firms listed - - 6 B shares 5 -- 4 -- - - 3 -- 2 --

Source: Calculations based on data from the Shanghai and Shenzhen exchanges

The efficiencyof the new issue process

How efficient is the new issue process? One measure of the efficiency of lPOs is to see how realistic the pricing levels achieved by the process are. The efficiency of new equity issue pricing, (ie, pricing at levels close to what the market would be willing to pay) is crucial for any emerging market ec~nomy.~First, an ill-designed new issue mechanism that results in significant underpricing, (ie, a public offer price well below the stock market's valuation of each new issue), implies in China that there is a large differential between the (administered) offer price and the market price, determined after trading begins. This limits the efficiency of the resource allocative function of these new markets. Second, if new issues are on average (or consistently) underpriced this raises false and unrealistic expectations among investors. Such expectations lead to herd-like behaviour, speculative bubbles and excessive price volatility. Third, to the extent that bank credit is used to fund the purchase of new issues, it can distort the allocation of credit as well as the money supply. Although in China, margin credit and bank credit for the purpose of stock purchases are prohibited, there appear to be many indirect channels through which credit and loans have been used to finance new issue purchaselo. Fourth, this results in a wealth transfer from the general public (represented by the state, as the initial sole owner of the enterprises) to a select group of private individuals. Finally, the to the firm is increased. 2 m d N LC 0 iD C! N ": 7 9 5 7 0 0 0 2 7

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7L N, T 2 '0 Y? w w !z w !z w The questions investigated here are:

How large has underpricing been in the Chinese equity markets vis 2 vis other emerging market countries? Do we see diffe~encesin underpricing among A and B shares, in view of the fact that B shares are purchased by supposedly more diversified and sophisticated foreign investors? Is underpricing evident only on the opening of trading? In particular, does underpricing decline as the issue gets seasoned in the aftermarket? As equity markets have matured, and local participants have become, more experienced, has the absolute degree of underpricing declined? What has been the underpricing experience of new issues by Chinese enterprises in Hong Kong (H-shares) or in New York (N-shares)?Specifically, has the relative degree of underpricing been less and if so why?

The key findings to the analysis are summarised below (details are available in Annex 4.2).

A shares First, examining the capital gains to those investors able to obtain application forms and win allocations at the lottery (rrl ), the average returns, or average degree of underpricing of A shares, is an extraordinary 732 per cent. That is, the opening price on trading has been more than seven times higher than the offer price (Table 4.3).

Second, the risk-adjusted returns for those investors who bought at the open of trading and sold at the close on the first day (rr2) were on average quite small (1.9 per cent). This suggests that, at least on average over the entire period examined, brokers and dealers who legally abided by restrictions prohibiting them from acquiring IPOfs in the lottery would have largely been precluded from enjoying the massive wealth transfers from the issuing enterprises (or the state) to investors. The very large returns to those who obtained forms in advance and the small returns to those who waited till trading began would suggest that there were huge incentives to brokers and dealers to circumvent the regulations and acquire shares before trading began. These large initial gains declined markedly towards the end of the period examined (see Annex 4.2).

Third, the returns to holding shares for longer periods of time were examined. If the price of a new issue at open of trading represents an overreaction or speculative bubble rather than the true economic or fundamental price, then we should witness a significant decline in the stock's return in the aftermarket. An analysis of the data showed relatively small declines. The return to a buyer of the average IPO on offer who holds it for 60 days (rr6) was 667 per cent, or not significantly lower than the gains to selling at the opening of trade. Thus, the undervaluation of share prices at offer is real, and not a speculative phenomenon.

B shares An analysis of the underpricing results for B shares shows that the absolute degree of underpricing for B shares has been less than that for A shares, but is still extraordinarily large by international standards.

On the first day's open, the average B share exhibited a return of 281 per cent over its offer price (rrl). Moreover, as with the A shares, returns to the 'honest broker'on day one are at least relatively low (85 per cent), and in addition, after- market seasoning made little difference to these returns with (market) risk-adjusted returns of 192 per cent over the offer price after two months (rr6).

A diagram of risk-adjusted returns to investors who are able to 'win the lottery' (ie, rrl) is presented in Figure 4.5. Mean returns for A and B shares are slhown on the x axis and relative expected frequencies on the y axis. Mean returns to both are positive, to A are higher than to B, and in both cases, especially for A shares, are widely dispersed."

Figure 4.5 Risk-adjusted returns to IPOs at Shanghai (Offer to opening price)

0% _ocpaycyocuqmmo-2zz2:3a%:% Mean returns Source: Calculations based on data from the Shanghai and Shenzhen exchanges Maturity effect (Annex 4.2, Tables 1a and 1 b). The above analysis is based on average returns over the entire period since listing and trading began on the Shanghai Stock Exchange. An important policy question is whether the absolute degree of underpricing has declined as the market has matured. If a market is maturing, and underwriters and enterprises learn to price new issues more accurately, we should expect to see the absolute degree of underpricing decline over time. Returns to new issues are therefore analysed separately for each year, from 1991 to 1994. For A shares, returns to lPOs offered in 1991 and 1992 were on average higher than those offered in 1993 and 1994. Average returns from offer to opening (rrl ) declined from 1,246 per cent for the 52 A shares brought to the market in 1992 to 239 per cent for the 50 lPOs of 1993, and further to 128 per cent for the 8 lPOs of 1994. Similarly, for B shares the degree of underpricing was considerably higher in 1992 (6 IPOs; 1,033 per centj versus those brought to the market in 1993 (12 new issues; 14 per cent) and 1994 (5 new issues; 17 per cent). Indeed, the underpricing performance of the 17 B share issues in 1992-3 is not very dissimilar from that experienced on many mature equity markets.

H shares and N shares

The results of the analysis of 11 'H' share issues by Chinese companies in 1993 and 1994 up to October 1994 shows underpricing is a relatively modest problem in this more mature market1*. Concentrating on the degree of underpricing between the offer date and the first day's open price (rrl), these lPOs were on average underpriced by 26.7 per cent (or 16.1 per cent, if one outlying observation is removed from the ample).'^ This degree of underpricing is not very different from that observed for B shares brought to the market in Shanghai in 1993 and 1994.

For N-share lPOs on New York, the offer price is usually set (less than) one day before trading starts, and share allocations are at the sole discretion of the underwriters. Data were available for only two N shares. For China Tire, the degree of underpricing is estimated at 5.14 per cent, and for Brilliance China Automotive Holdings, underpricing amounted to 25 per cent, or 15 per cent on a weighted average basis. This degree of underpricing is again broadly consistent with that found in Hong Kong for H shares and more recently Shanghai B shares. The results show clearly that by any international benchmark or holding interval one finds that the degree of underpricing of A shares has been excessive. It is particularly striking in view of the limited alternative investment opportunities available in China, and has certainly implied a loss of potential investible funds for the enterprises 'going to market.'

Comparisons with other countries

China is not alone in having its new issues underpriced (on average). Table 4.4 shows world-wide evidence of underpricing, defined as the percentage amount by which the price on the first day of issue (usually the opening price) exceeds the public offer price. More importantly, the evidence shows that underpricing is relatively high in Asian countries such as Hong Kong (1 8 per cent), Singapore (27 per cent), Taiwan (45 per cent) and Thailand (58 per cent). Yet, as the table also demonstrates, the average degree of underpricing in China over the entire period examined far exceeded that observed in other markets. The problem remains today although markedly less severe.

Table 4.4 /PO underpricing worldwide

Elapsed time Discretionary allocation Non-discretionary allocation (days) Country Underpricing (%) Country Underpricing (%)

US (firm commitment) France Netherlands (tender) Portugal (auctions) UK (offer by tender) Belgium Belgium (tender) UK (placing) Canada Germany UK (offer for sale) Japan (post-1 April 1989) Japan (pre-1 April 1989) 2 8 Australia Hong Kong or longer Brazil Singapore Korea (post-June 1988) Taiwan Switzerland China Shanghai A shares Shanghai B shares

Note: Elapsed time refers to the typical time period from the ?etting of the offer price to the issue date. Source: Loughran, Ritter and Rydqvist (1994) Given that significant underpricing remains a problem in the A share market, while B shares seem to increasingly exhibit international characteristics regarding the degree of underpricing, what policy reforms to the new issue process might be considered to improve the proceeds raised by enterprises and the allocation of new issue gains among investors? In addressing this question it needs to be recognised that underpricing will always be a feature of an emerging market in which considerable information imperfections and political uncertainties exist. INevertheless, the degree of underpricing observed in Thailand (around 60 per cent) might be viewed as a not unreasonable short-term benchmark for Chinese IPOs, compared to A share average underpricing of 128 per cent, even in 1994, on the Shanghai Exchange.

Causes of inefficiencies in the /PO process

Recommendations for measures to strengthen the IPO process in China first require an understanding of the factors leading to underpricing. First, as the table indicates, underpricing in other countries has been associated with a relatively long elapsed time lag between the public offer and issue date (exceeding one month). A second factor is a relatively high degree of investor uncertainty regarding the true quality of the firm going public, due to weakness in disclosure and auditing standards. Third, as also indicated in Table 4.4, the allocation mechanism adopted for the new share issue affects the degree of underpricing. Non-discretionary allocation of shares, by mechanisms such as a lottery, exacerbate the tendency to underprice. Afourth reason is that the underwriting procedures and process significantly affect the efficiency of pricing for new offerings.

Elapsed time lags

Because a long time period (usually one to one and a half months) has existed between the announcement of an offering and the lottery, and because new issues have been bunched, this has created classic conditions for information leakages and herding behaviour, ie, classic conditions for large-scale oversubscriptions and underpricing. Long lags make it easier for investors to observe the subscription demand of other investors (eg, news stories of queues or riots for application forms). It is interesting to note that two countries with relatively low degrees of underpricing are the US and France, which have a very low 'institutional lag' between the announcement of an offering and its actual offer. Efforts should clearly be made to reduce such institutional lags. The lottery system and non-discretionary share allocation

Two problems with the [PO process have clearly been the lottery system and the associated clustering of new issues. The combined impact of these two has been that investors do not even know which enterprises' shares they may acquire, making it impossible to undertake investment decisions based on fundamentals. The demand for equity is thus necessarily driven by speculation. While limited availability of information due to poor disclosure is certainly true, under this system investors would be precluded from using such information even if it were available. A first step would therefore be to avoid the bunching of IPOs. Second, authorities should then ensure that each new offer is backed by widely-available and reliable information about the fundamentals of the enterprise.

It has sometimes been suggested that the lottery system may provide revenues to local authorities (through the price charged for the form), and that this revenue will necessarily increase with the degree of oversubscription. Moreover, the system, sometimes adopted in the past, of sharing such revenues between the state securities office and participating banks or brokers who distributed the forms, tended to reduce the incentive of all agents other than the enterprise to raise the offer price, as the demand for application forms was reduced. While it is difficult to assess how widespread such revenue-sharing arrangements are today, one recommendation which emerges is that charging a price or fee for application should be discouraged.14

The underwriting process

Another factor concerning the underwriting process is the relative monopoly enjoyed by local underwriters. The selection of the underwriter is often guided by the local authorities approving an enterprise for listing. Regional authorities tend to choose two to three local underwriters to syndicate an offering. By comparison in some countries (such as the US) syndicates compete to become the new issue underwriters. Competition among underwriters has the potential of raising the offer price received by the issuer in a firm commitment underwriting mechanism, because in order to win the underwriting contract the underwriters are willing to take more risk. Local underwriters may be relatively inexperienced. Preferring to err on the side of caution, and ensure that the subscription is a 'success', in terms of high demand, it has been suggested that local authorities and underwriters tend to advocate low prices. Encouraging more competition in the underwriting process is recommended. It is recognised that if this process is pushed too far there is the risk of overpricing and . . among the least experienced local underwriters. To protect against this, appropriate criteria for permitting participation in the underwriting process should be developed.

In addition, foreign underwriters might be allowed to become members in A share underwriting syndicates. Foreign underwriters are already allowed to participate in B share underwriting, and this overseas experience may account for the lower degree of underpricing on the B share market. In most cases B share offers have taken the form of placements rather than initial public offerings, in which the overseas distributional networks of foreign securities firms such as Sassoon, JPMorgan etc have played a crucial role. It is recognised that a potential problem with foreign securities firms playing active roles in A share underwriting syndicates is the current restrictions on their overseas customers holding domestic A shares. The extent to which this is advisable is revisited in Section D below. It is also recognised that large-scale participation by foreign underwriters may discourage the development of the 'infant' domestic financial services sector. Cautious and limited collaborations with overseas underwriters could be launched in an initial phase.

The present 'firm commitment' underwriting mechanism usually adopted in China also needs to be revisited. This mechanism creates incentives for underwriters to set the price low, to ensure the placing of the whole issue with outside investors. As a result the costs (or benefits foregone) of underpricing are borne by the issuer (the enterprise) rather than the underwriter.15

In the US, the underwriter has completediscretion in allocating shares to investors (underwriting by the 'bookbuilding' method). Primary buyers of new issues tend to be largely wholesale buyers such as institutional fund managers. Such discretion would clearly be inadvisable in the current nascent stage of Chinese equity markets where there are already profound concerns about the social fairness of the current lottery system. Indeed, it would probably enhance the tendency of underwriters1 brokers to favour certain customers at the expense of the small retail investor. While this system of underwriting has reduced the US institutional lag (to around one day), China may prefer to consider the French system of allocation; the discriminating price auction. This is similar to the system used in many government bond markets. France has the lowest average degree of underpricing (4 per cent), and also enjoys an institutional lag of less than a day. At the end of 1994 there were two experiments with this type of auction in China, one on the Shanghai Exchange and one on the Shenzhen Exchange from March to April 1994. In the Shanghai auction the underwriters set a minimum reserve price and investors bid for the shares using the exchange's screen technology. Shares were allocated in descending order of price bid with the whole process being completed in a few hours. It is recommended that the municipal securities authorities, exchanges and CSRC continue to encourage experimentation with the auction process.

Credit availability

A parallel set of policy reforms could be aimed at further monitoring the leakage of credit to retail investors seeking to invest in new issues. Legally, banks cannot provide credit for stock purchase nor can brokers (implying an implicit 100 per cent margin requirement for stock purchase). However, reportedly there have been many indirect ways in which bank loans have been channelled into stock purchase and in which brokers have provided credit to favoured customers. While the problem is said to be less severe in primary than in secondary markets, it is recognised that these indirect channels are very hard to monitor and control, and require an examination of the 'firewalls' between the banking system and the non-bank securities firms, investment companies and trust and investment corporations that participate in the securities markets.

As China's financial markets mature and interest rates elsewhere in the economy grow more flexible, the appetite of Chinese investors for A shares as the 'only' investment that promises a possible return above inflation is likely to decline. In addition, as retail investors learn by experience and become increasingly sophisticated they will no longer chase every issue that comes to the market. Both these issues are likely to have a secular effect in reducing the degree of underpricing of A shares. As the analysis above of the IPO return data for 1993 and 1994 showed, such a process has already begun.

Stock Price Volatility and Returns to Investors

The second issue examined is the efficiency of trading on China's equity markets, and specifically, the low levels of returns to investors, and the efficiency of the pricing mechanism, and the high degree of variability of these returns, as evidenced by their volatility. An empirical examination of the behaviour of prices and returns on the Shanghai and Shenzhen A and B markets shows that, due to the different investment clienteles in the A and B markets (small local retail investors for A shares and foreign institutional and wealthy investors for B shares), there are significant differences in the return and volatility characteristics of the two share categories.

First, looking at returns to investors, the results are summarised in Table 4.5. The table shows that:

Returns (risk-adjusted)have, on average, been very low, on both share categories and on both exchanges.16 Returns on A shares are similar on the two exchanges (assuming a one-week holding period). There is a significant difference between returns to B shares and returns to A shares. Returns on B shares at both exchanges have been relatively poor. B share (one-week) returns are 0.0 on Shenzhen and negative on Shanghai. For longer periods, returns on Shanghai A shares improve, but returns on Shenzhen A shares deteriorate further. Risk-adjusted returns on H shares in Hong Kong are higher than on B shares in China.

Table 4.5 Trading on China's equify markets: returns and volafilify

Shanghai Shenzhen Hong Kong A shares B shares A shares B shares

Returns One week returns Mean returns Std deviation Risk-adjusted returns Ten week risk-adjusted returns Twenty week risk-adjusted returns Autocorrelation of returns One-week lagged auto corr. coefficient 0.1 7 0.27 0.38 0.026 0.28 sig. at 95 % sig. at 95% sig. at 99% sig. at 95 % sig. at 95 % Autocorrelation of volatilities First order squared returns 0.01 4 -0.036 not sig. not sig. significant significant not sig.

Source: Calculations based on data from the Shanghai and Shenzhen Exchanges

142 One measure regarding the efficiency of these markets concerns the degree to which these returns are autocorrelated over time. In a highly efficient equity market news is immediately impounded into stock prices. Since news arrives at random intervals (and can be good or bad) we would expect to observe a low degree of correlation between successive index returns." In less efficient markets, where trading is thin and news and information are dispersed among investors relatively slowly, we might expect to see some degree of autocorrelation among returns over time. The results show:

The markets are poor in terms of pricing efficiency, measured in these terms. The performance of the A share market in Shenzhen is much poorer in this respect than Shanghai. On Shanghai the implied efficiency of the B share market is much poorer than the A share markets, but in Shenzhen this appears not to be the case. These problems appear to be present in the Hong Kong traded China shares as well.

Figure 4.6 China: Shanghai and Shenzhen share indices and volume of trade

Shanghai A shares Daily turnover Shenzhen A shares Daily turnover (No of shares) Index (No of shares) (billion) Daily furnover (billion) la00 . r 1.80 400 - r non

Shanghai B shares (~~~f~~~;Shenzhen B shares Daily turnover (No of shares) (billion) Index r00D) IDaily turnover Index 9 Daily turnover [BlnllDl.dY) r 35 T I T 25,000

1 Source: Calculations based on data from the Shanghai and Shenzhen exchanges. Next, looking at market behaviour in terms of volatility, the problem of extreme price volatility, which the Shanghai and Shenzhen markets have exhibited since opening, is illustrated in Figure 4.6. For example, the Shanghai A share index more than doubled in a single day, from 61 7 on 20 May1 992, to 1266, on 21 May. By 17 November 1992 the Shanghai A share index had fallen back to one third of this level, to 393. More recently, this index was trading at the 400 level in July 1994 but by September 1994 it had risen above 900.18

More detailed analysis of the behaviour of the markets in this regard shows:

A share markets in both Shanghai and Shenzhen have exhibited far greater volatility than B share market.19 The absolute sizes of volatility 'jumpsfin the Shenzhen A market have generally been less than those in the Shanghai A market. Both these points are illustrated by an examination of the standard deviations of share prices on both exchanges (Figure 4.7). Volatility patterns in Shenzhen, in both the A and the B share markets, like the behaviour of returns, suggest that markets are thin and inefficient, and that information is dispersed slowly to invest~rs.~~ Particularly large daily jumps in volatility have been noted on a few specific dates.

While excessive volatility appears to be a common feature of equity markets in their formative stages, persistent and high levels of volatility can discourage a

Figure 4.7 Shanghai and Shenzhen: share price variance (Ten-week standard deviations)

Standard Shanghai Standard Shenzhen Deviation Deviation

Source: Calcubtionr bared on data from the Shanghai and Shenzhen exchanger ~ market's growth. In particular, more risk-averse investors are likely to seek alternative outlets for their saving^.^' The important questions to address, from a policy perspective, are: what factors give rise to the poor efficiency and high volatility of equity trading in the case of China, and, what action can regulators take to bring volatility under control?

First, through identifying the causes of volatility, it is clear that, as pointed out in China, a basic factor has been the short-term horizons and speculative behaviour of poorly informed retail investors who place little apparent value on underlying economic fundamentals of enterprises (such as dividends) in determining firm equity values. But this short-term behaviour itself is encouraged by a number of other factors, such as:

the IPO process, (as discussed in the previous section), including limited disclosure and the 'lottery process' associated with the bunching together of I POs. The tendency of wealthy investors and brokers to engage in front-running behaviour that is nothing less than overt market manipulation, itself the outcome of relatively limited supervision of intermediaries in the securities markets.22 The absence of an enforced capital gains tax, which would encourage shareholding for longer periods of time, also encourages short term speculation. The typical non-payment of cash dividends implies that the only way of realising cash gains is by capital gains rather than by the dividend income flow. The absence of large, stable institutional investors is certainly a factor, but as pointed out above, not a sufficient explanation for market behaviour.

In addition to these factors, a major contributant to market volatility has been the succession of regulatory 'events' generated by the government. As illustrated above, there have been specific instances of very big jumps in A share price volatility; notably, in the data above, May 1992, December 1993 and July 1994. The May 1992 and July1994 jumps are clearly attributable to government policy. The first jump followed the removal of the 5 per cent daily price change limits for individual stocks on 20 May 1992 which led to a one-day doubling of the Shanghai A share index. The July1994 jump reflects the 'market support' policies announced at the time by the CSRC which included:

a moratorium on new A share issues (to raise prices by restricting supply) easier credit availability for brokers in Shanghai through a special line of credit, and, stimulating the establishment of mutual funds, though the establishment of new funds and possible foreign participation in this industry.

The market support measures of July 1994 contributed to the near tripling of Shanghai A share index values in the following two to three months. The Shenzhen A market also showed a significant (but less dramatic) reaction to the July 1994 announcements. Most recently, the market had a dramatic negative reaction to the government's announcement banning same-day settlement, on 1 January 1995, followed by a sharp market reversal in February, with another announcement, requiring the payment of cash dividends.

It is ironical that many of these announcements were made with the intention of 'improving' market functioning, and reducing volatility. But in practice, polices such as the sudden lifting of individual share price ceilings in May 1992 and the July 1994 moratorium on new A share issues (plus other market support actions) appear to have actually enhanced volatility. This suggests that the Chinese government and CSRC must adopt a longer term perspective of the types of regulatory policies that would suppress rather than encouragevolatility, by inducing investors to taking a long-term view, linking their investment decisions more closely to underlying asset values of the enterprises in which they invest.

A first measure to be considered is the reintroduction of daily price limits. the success of this measure in the past is illustrated above, where it occurs that pre- May 1992 A share volatility levels appear to have been significantly below post- May 1992 volatility levels. Korea kept individual price limits on stocks for over 20 years, whereas they were removed in less than two years in China. The advantages of price limits is that they suppress volatility and allow investors the time to revise their expectations about any given news item. It thus prevents excessive over-reaction among relatively unsophisticated investors and limits the profit incentives of those who float such rumours. On the other hand, it must be remembered that price limits will interfere with genuine price adjustments and potentially create (considerable) autocorrelations or trends in daily price movements. A possible approach would be to set price limits with higher boundaries than those established in the pre-May 1992 period, to inhibit abnormal daily volatility. For example, normal daily volatility over the December 1990 to September 1994 period was 6.3 per cent (weekly standard deviation divided by K)on the Shanghai A share exchange; thus individual share price change limits could be set at that level or above. Second, appropriately structured taxes on capital gains can discourage speculation. In developed economies, where taxes are relatively easy to collect, a two-tier short versus long-term capital gains tax could be applied, imposing a higher tax- rate on short-term (under one year) capital gains versus long-term (over one year) capital gains. This type of tax structure existed in the US until 1986. However, in view of the potential difficulties of tax collection in China, such a tax might require ~implification.~~A more transparent tax might be imposed, Iinked to share turnover. Since ownership claims are computerised as book-entry items on both exchanges, it should be possible to monitor transaction behaviour of individual investors and traders through their accounts at depositories. A transactions tax inversely Iinked to the time a stock was held (speed of turnover) would penalise those investors who take a short rather than long-term view. A flat turnover tax (such as recently implemented in Israel) would probably not create sufficient incentives to deter gains trading. However, arguably, the information systems needed to accurately track and historically record the buy and sell orders of individual investors are not in place in China nor will they be for some time.

Third, the CSRC, the PBC and the exchanges must take a more pro-active stand on insider trading and front-running. The failure to prosecute all but a handful of cases has encouraged the most egregious types of manipulative behaviour. The effective introduction of the NYSEfs 'Stock Watch'system in Shanghai will provide a tool for monitoring the market and identifying offenders. However, monitoring is not enough without enforceable penalties.

The above policies are largely short term. Afourth, more secular policy to reduce volatility, is to create a market environment in which investors are encouraged to take a long-term view. This may be achieved by at least three different routes.

Cash dividend paying by firms must be en~ouraged.~~Currently, dividends appear to be very much a residual after a firm is required to make allocations

from profits to various /poolsf including investment, bonus and staff welfare. To make dividends more prominent, enterprises must be given more discretion on dividend payments (especially cash rather than stock dividends) and dividend announcements should be made at least annually. Foreign securities firms such as Merrill Lynch and Morgan Stanley should be allowed to trade A shares (as well as B shares). Such firms with their relatively sophisticated analytical tools and advice would be likely to add some degree of stability to the A share market at least in the long-run. The development of longer-term private pension and mutual funds should be encouraged (discussed in greater detail in Chapter 6). Such funds with their long-term horizons would counter balance the largely small retail-oriented investor equity markets that currently exist. Given appropriate income tax incentives, small investors may well choose, in the longer term, to invest in the equity market through mutual and pension fund vehicles rather than through direct share purchase. As discussed in Chapters 5, just such an institutionalisation of the equity market has occurred in the most developed equity markets, such as the New York Stock Exchange and the .

Market Integration: Current and Potential

The third key policy issue confronting the development of China's equity markets concerns market segmentation, both across different exchanges (geographical segmentation), and different share categories (segmentation by investor type). Today, cross-listing of shares at the two official Exchanges of Shanghai and Shenzhen is not permitted. The listing of enterprises at the other exchange-style trading centres (Appendix Table A4.9) is not recognised under national law. The multiple share categories in China which have already been described, separate shares according to whether their holders are resident or non-resident, individual or institutional, and whether the shares in question are traded in domestic or overseas exchanges.25 Geographical segmentation in China arose due to the fact that 'exchanges' were established independently at different locations, in the absence, initially, of a uniform national framework. Today while many core elements of a national framework are being put in place by the centre, the extent to which all individual regulations should be subsumed under a single national law is a serious issue. Segmentation by domestic and overseas investors has arisen because of fears, which have legitimate precedent, of the possibly destabilising impact of volatile capital inflows and outflows.

-the question today is whether the need for this type of segmentation still exists. The costs of market segmentation are a decrease in liquidity, and a likely decline in the pricing efficiency of the markets due to thinness of trading; reduction of access to available investor bases; and likely illegal transactions with 'leakages' arising due to the possibility of arbitrage across markets. Moreover, the government is aware of the potential advantages of a 'National Stock Market' and has been debating the possibility of allowing one of the present exchanges, such as Shanghai, to develop into such a national market. In this context, this section will first examine the extent to which market segmentation has existed, and its effects, and then discuss policy options for market integration, or the emergenc~eof a national market, in the future. On domestic exchanges, the emphasis is on the largest categories of traded shares; Aand B shares, in the two largest Exchanges; Shanghai and Shenzhen.

In the first section of this chapter, the significant differences in the liquidity of the A and B share markets were discussed. A second measure of the market integration across exchanges and share categories is to measure the correlation of share movements. Results show that:

A type share index movements are closely integrated across exchanges as are B index movements, however, the integration between A and B share index movements is B and H share indices are highly correlated, indicating that international investors tend to look at similar economic factors in making investment and pricing decisions about these two share classes. The slightly higher correlation of B and H for Shenzhen may reflect the fact that both are tracled in terms of Hong Kong dollars (Shanghai B stocks are quoted in US dollars).

The low degree of correlation between A and B share indices and returns is not surprising since these share classes have different investor clienteles with different investment and risk preferences. B share investors can more easily diversify risk internationally. They also have greater concerns about Chinese sovereign and political risks, such as expropriation, and they are exposed to foreign exchange risk as well as liquidity risk, given the relative thinness of trading in the B share market.

Although A and B shares only weakly move together over time, both classes have potentially the same dividend and voting rights. An important question which follows is, are their prices similar, and if not, which price is usually higher? That is, for Chinese enterprises issuing both A and B shares, what is the price premium or discount between A and B shares?This is the third measure of market integration examined here. In most emerging markets, foreign-owned shares have normally traded at a premium to domestically-owned shares2' Spreads between the price premiums and discounts between individual enterprise A and B shares on the Shanghai and Shenzhen Exchanges are shown in Figure 4.8. As can be seen, on average Chinese B shares trade at a considerable discount to A shares. In fact, the daily average discount of B shares relative to A shares over the period analysed was 21 3 per cent. Furthermore spreads have been lower in Shenzhen than Shanghai, by approximately half.

What can explain the reason for the discount on Chinese B shares while foreign held shares in other Asian emerging markets tend to trade at a premium? First of all there is the high differential in liquidity. Foreign-owned and domestic-owned shares can be traded back and forth among investors in Thailand, Singapore and Korea, while China is relatively unique in having two distinct classes of shares, and B shares have a relatively low capitalisation compared to A shares. A second reason is that foreign investors require higher risk premiums to hold Chinese shares, due to economic uncertainties and political risk.28

Figure 4.8 Spreads between Shanghai and Shenzhen A and B shares (Discounts of B shares to A shares)

% Discount of B shares to A shares Shanghai -0 450 - /D Discount of 400 -- 350 -- 300 -.

% Discount of B shares to A shares Shenzhen I - 250 -% Discount of B shares to A shares

50 -- n Q2 Q3 Q4 Q1 Q2 Q3 93 93 93 94 94 94

Source: Calculations based on data from the Shanghai and Shenzhen exchanges The analysis of premiums and discounts can be similarly calculated between A, B, H and N shares, in cases where a given firm issues or trades shares both domestically and internationally. Figure 4.9 shows the discounts on Hong Kong H shares relative to A shares issued by the same enterprise. For six matched H and A stocks, all H shares stood at discounts to their respective A shares. The daily average discount was 47.6 per cent.

Figure 4.9 also illustrates price differentials for a New York listed enterprise, Shanghai Petrochemicals, relative to both its domestic and Hong Kong market price. For the H shares, the daily discount averaged only 0.2 per cent. For the A shares, the daily discount averaged 1 5.3 per cent. Indeed, while the discount started high, it has fallen over time and for a short while was negative (ie, the A share traded at a discount). As will be discussed in Chapter 5, this enterprise presents a special case in some respects, and is considered to have a good performance relative to other New York listings. Since even in this case, the New York listing traded at a discount, it reinforces the finding that shares held by overseas investors trade at a discount to domestically held shares.

Figure 4.9 Discounts on shares listed in overseas exchange

% Discount of H shares to A shares % Discount of Shanghai Petrochemicals ADR to A shares 200- 120-

100.. -0 /. Discount of ADRs to A shares 60 ...... - %Discount of .. % Discount of shares to A shares 40 .. ADRs to H shares

-50 - 1993 1994

Source: Calculations based on data from the Shanghai and Shenzhen Exchanges and the New York Stock Exchange ~

What are the policy implications of these findings? First, the data on the correlation of returns shows that Shanghai A and Shenzhen A stock price indices and returns have tended to move together over time, and thus, they appear to respond to common news and economic factors. This raises the question of the potential for a fully national market for enterprises' shares. At the moment A shares listed in Shanghai are heavily associated with enterprises located in the Shanghai 'region' while Shenzhen and Guangdong enterprises are heavily represented on the Shenzhen Exchange. These are thus largely regional exchanges, reacting to some common factors and news. To create a more national market for shares the government and regulatory authorities should encourage cross-listing of A shares on the two major Exchanges.

Such cross-listings would potentially benefit investors and enterprises by creating a deeper and more liquid market for shares as well as giving an enterprise a national identity or brand label. Of course, the risk to each exchange is that the other exchange will attract the bulk of the volume of shares traded, marginalising the exchange that fails to compete effectively. Discussions suggest that today, this is perceived to be a danger at the Shenzhen Exchange, although exploratory discussions on the possibility have already begun. An alternative way for a national market to develop would be by direct government intervention, that is, through the government directing new issues and trading volumes to one particular exchange, and restricting trade at other exchanges. Arguably, cross-listing competition among exchanges would be likely to produce a slower path to a full national market, but such a process is potentially more beneficial, to both investors and enterprises, if the exchanges compete for business and national market share though lowering fees and commissions, and improving the efficiency of their trading services. Furthermore, some enterprises, due to the nature of their business, may only serve a regional area. Such enterprises then have the option of listing on a local exchange, possibly at a lower fee or with less onerous listing requirements.

The question which follows is, what are the current barriers to the cross-listing of A, or B, shares on the Shanghai and Shenzhen Exchanges? There are barriers of varying degrees of severity, at least four levels. The first set of barriers are at the issuer level. Here the problem is the regional equity quota allocation system. Since local municipal authorities determine share allocations, and since they have an interest and commitment to building up the business of local stock exchanges, they have a strong interest in getting those enterprises that receive a new issue quota to list on the local exchange. This effect can only be ameliorated, eventually, by eliminating the national quota system. That is, a reduction in the power of the municipal securities authorities may be a necessary step in moving towards a national stock market.

The second set of barriers are at the investor level. Today, shares on the Shanghai market are registered in the individual shareholder's name while those on the Shenzhen market are registered at the broker (nominee) level. Thus a system would need to be arranged whereby investors on one exchange could open accounts at depositories on the other exchange. This would allow them to trade and settle any given share on both exchanges, inhibiting price discrepancies and arbitrage possibilities. For example, Shanghai investors could open accounts with Shenzhen brokers (who settle on their behalf), while Shenzhen brokers could open direct accounts at the Shanghai depository. Interviews with depository officials suggested that at the technical level, the ability to undertake this exists already.

The third set of barriers exist at the member or broker level. Membership of an exchange gives a broker quasi-monopoly power (with other members) over trade in shares on that exchange. Indeed, franchise value is created by making membership as restrictive as possible. By giving access to a broker from a competing exchange (membership, or seats) the franchise value of existing brokers will fall. In China today, this difficulty may be eroding, as many large brokerage houses (an estimated 80 per cent in August 1995) already have cross-membership at the two exchanges. But one can expect to see opposition to cross-member access on exchanges by small local broker members.

The fourth barrier is technological. For an effective national market to develop, screen and other information technologies would need to be available to give investors speedy access to price and volume information on the same share in both markets. Not only would such information have to be available it would have to be widely available across a large set of investors (both wholesale and retail) at relatively low cost. The failure to develop the technology to make information widely available could result in considerable inefficiencies, with the same stock trading at widely different prices on the two major exchanges. Given the current quality of Chinese equity information technology it may be a number of years before a fully 'price' integrated national market becomes feasible for all but the very largest sized A share issues.

Other Issues: Enterprise Debt Securities

In addition to equities, Chinese enterprises are permitted to issue debt securities. But China's corporate bond market has failed to develop. Some of the factors inhibiting the development of this market are briefly discussed here. In theory, corporate bonds or enterprise bonds potentially give significant advantages over equity to both investors and enterprises. Yet few bonds have been issued and even fewer are traded. The over-the-counter bond markets at Wuhan and Tianjin trade almost exclusively government bonds and investment trusts. Relatively few corporate bonds are actively traded on the Shanghai, Shenzhen, NETS or STAQS Exchanges. In the third quarter of 1994, trading in enterprise bonds on the Shanghai Exchange amounted to Rmb1.46 million (US$200,000 or 56 transactions) while trading in financial bonds (issued by financial institutions) amounted to RmbO.616 million (US$80,000, or 15 transactions). In Shenzhen no enterprise bonds at all were traded in the third quarter of 1994.

Why is this the case? On the issuer side is the fact that Chinese enterprises have long relied on bank credit for leverage. The close links developed between 'main' bank lenders and associated enterprises has discouraged a switch to corporate bond debt. In addition, in many countries of the world the interest on corporate debt is tax deductible (as an expense) against enterprise profits or net income while dividends are not. In China, by contrast, bond interest paid by an enterprise provides no such tax shelter.

On the investor side the advantage of corporate bond debt is that it gives the holders (in theory) priority in bankruptcy over equity holders. That is, corporate debt is a senior claim on an enterprise's assets in most developed capital market systems. In China, bankruptcy laws have yet to be fully developed and bankruptcy, particularly with claimant losses, is virtually unknown, even though it is estimated that as many as 100,000 Chinese enterprises are technically bankrupt.

Moreover, there is a technical difficulty limiting the national growth of a bond market. This is the fact that coupons would have to be physically paid to and collected by an investor locally from an enterprise in the absence of a national distribution system for coupon interest. Such a system would require centralised book-entry records of owners and ownership changes on corporate bonds.29

For these reasons it is likely to be a number of years before a significant corporate debt securities market emerges. Nevertheless, it is worth recognising that even in highly developed countries, such as the US, with the largest corporate bond market in the world, less than 0.2 per cent of corporate bonds are traded on the New York Stock Exchange. When corporate bonds are traded, they are traded among major dealers, (such as Salomon Brothers and Morgan Stanley) on an over-the- counter screen-based system. Thus, we might expect that in the future any growth in trading is likely to take place in the form of OTC trading among institutional holders of these bonds rather than among retail investors on the two major Stock Exchanges. Endnotes

1 'In July 1984, China's first securitised corporation, the Beijing Tianqiao Department Stores Ltd., was registered in Beijing. The company, formed by merging two state-owned department stores and a wholesale store, openly issued Rmb3 million worth of shares to domestic institutions as well as individuals. The fixed assets of the original stores, which had belonged to the central government, became the government's share of the investment in the new company (51 per cent), while the rest of the shareholding was split among state-owned banks (26 per cent), other firms (19 per cent) and private investors (4 per cent).'Hu Yebi China's Capital Market, Chinese University Press, Hong Kong. 2 In a speech on 28 October 1994, Premier Li Peng appeared to suggest a more open acceptance of privatisation in the future, stating that by the year 2000, one third of all state-owned companies would be privatised or would otherwise face the prospect of bankruptcy. 3 Compared to the two major exchanges, STAQS has 388 members (1 50 seated at the exchange). NETS has 60 members connected to four micro-computers by a satellite dish, with no trading floor. 4 Quotas for new share issues have been low compared to quotas for bond issues and these are both low compared to the proportion of investment financed through bank loans. The relatively small size of the annual new equity quota reflects also the cautious and experimental approach adopted towards the development of the stock market in China. See Chapter 1, and also a World Bank study on Public Investment (Report No. 4CHAER058, November 1995). 5 The Shanghai Securities Exchange Commission (1994) first classified its applicants by sector, then appointed an 'expert team' for investigating each sector's applicants and assigning them a rank, and finally chose the top few performers per sector in accordance with state priorities. In 1993, infrastructure enterprises especially in electricity and water supply were deemed to be priority. In 1994, the persistence of fixed prices in these sectors led local authorities to hesitate to select them. 6 As a result, Shanghai has tended to attract mostly large industrial companies while Shenzhen lists smaller, export-oriented companies. 7 The aim was to encourage B share listings from outside the province. In mid 1994, of the 22 B shares listed at Shenzhen, only one was from a company outside Shenzhen. 8 However, discussions of the huge capital gains that have been evident on the first day of trading suggest that brokers may have unfairly directed these forms to favoured customers and/or put in illegal (disguised) bids themselves. 9 The Shenzhen riots of August 1992 were the consequence of an inefficient new issue process, which resulted in oversubscription by a multiple exceeding 600 times. 10 For example, evidence from Hong Kong and Singapore has shown money supply increases of 30 per cent or more around the time of major new issues. 11 The coefficient of variation, expressed as a percentage, is slightly higher for A shares (66 per cent) versus B shares (61 per cent). Note that in the diagram (Figure 4.5), a normal distribution of returns around the mean has been assumed. 12 A 12th issue, Shanghai Hai Xin Shipping Co. Ltd., was listed on 11 November 1994 and a 13th, Zhenhai Refining and Chem~cals,on 2 December1 994. Data on these were not available for the analysis. 13 Risk- adjusted for returns on the market, this time using the Hang Seng index (HSI) as the market benchmark. The outlying stock is the Kunming Machine Tool Company, which was underpriced on a raw return basis by 136 per cent and on a risk-adjusted basis by 128 per cent. 14 To the extent that fees are charged to cover processing costs, these can instead be charged to winners of the lottery afterwards, or to other costs recoverable from new or existing shareholders. 15 In the 'firm offer' method of underwriting, the underwriter guarantees a certain price to the issuing enterprise. Alternative underwriting systems include the 'best effort' method, in which the underwriter agrees to sell as many shares as possible, for a fee or commission, and the 'auction' method, underwhich a minimum price is set, and the underwriter agrees to buy acertain percentage of residual shares, if necessary, at the reserve price. 16 For ten week holding periods the mean weekly risk-adjusted returns on Shanghai A shares were 0.325 and for the 20 week holding period 0.284. 17 That is, stock returns should follow a random walk over time. 18 Early indications are that the introduction of the T+l settlement system in January 1995 has helped reduce volatility. 19 A detailed description of the estimation undertaken is given in Annex 4.2. 20 In other words, volatility is significantly autocorrelated over time, in the Shenzhen market, as Table 4.5 shows. 21 Excessivevolatility, where 10 per cent daily rises and falls in the market index areseen as 'normal,' has been common in other Asian equity markets at similar stages of develolment. For example, Hong Kong went through a period of considerable volatility in the early 197(1:, while the Korean and Taiwanese markets also exhibited considerable volatility in the 1960s and 1970s. 22 'Front-running' refers to market manipulation by brokerswho float rumours that are likely to sway the market, when they may be in a position to take advantage of such market movements. A classic case was a week in October when rumours about the health of Deng Xiaoping resulted in a fall of 40 per cent in the Shanghai A share index on one day, followed by a jump of 36 per cent in two hours the next day when the rumour was denied. By buying and selling in front of such news leaks large investors and brokers can make huge potential gains at the expense of small retail investors. 23 It is also recognised that policies towards capital gains on share trade cannot be imposed in isolation, and must be in line with tax policies towards capital gains elsewhere in the economy. 24 Policies introduced in 1995 to only permit stock dividends if cash dividends have been paid, allow stock dividends to be paid only once in twelve months, and only up to one-third of total dividend payment, are a move in the right direction. 25 See Chapter 1 and Chapter 4 Part A. 26 Details are in Annex 4.2. 27 A paper Bailey and Jagtiani (1 994) found that the premiums paid for shares by foreign investors were of the order of zero per cent to 30 per cent over the prices paid by domestic investors. 28 Bailey (1994) found some evidence of foreign investors demanding relatively high risk premiums on certain Chinese B shares. 29 See Chapter 3. This is one reason why Chinese bonds are typically non-interest bearing. ANNEX 4.1 CLEARANCE, SETTLEMENT AND DEPOSITORY SYSTEMS

Introduction

An efficient clearance, settlement and depository system (CSD) allows investors to maximise their asset allocation opportunities and enhance the liquidity of their asset portfolios. CSD services effect transfer of ownership to the securities buyer and payment to the securities seller. An efficient system does so promptly at low cost, with a minimum degree of uncertainty that the transaction will be concluded on the precise terms agreed to in the trade. The efficiency of clearance and settlement services determines a significant part of the cost to the investor of buying or selling a security.

Issues relating to CSD cannot be divorced from the national payment system. This is because while CSD services may be provided by an exchange, or its direct agent, the payments system will reflect the nature and the functioning of the banking system. The mirror image of every securities transaction will be some payment by the buyer. An inefficient payment system can therefore be as much a barrier to an efficiently functioning securities infrastructure as a poorly designed CSD system.

Clearance involves the determination of what each counter-party owes and is due to receive in a trade. This trade determination may or may not involve netting of trades among participants (bilateral netting) or with the CSD organisation itself (multilateral netting). Settlement is the actual transfer of securities from the seller to the buyer. Settlement can take anywhere from T+O (same day) on some exchanges to as long as a month on others (T+20). Payment is the cash side of the securities transaction and may involve check payments or wire-transfers on a national automated payment system. Depository services are the wide set of services relating to the registration and recording of ownership rights for financial claims. When securities are placed in a (central) depository they are said to be immobilised. When these securities are also held in book-entry form, rather than paper form (ie. are scripless), they are said to have been dematerialised. Some depositories also provide ancillary services such as corporate dividend processing and information announcement of corporate events(such as mergers).

The next section looks at the CSD structure of the four main equity markets in China: Shanghai, Shenzhen, NETS and STAQS. The following section analyses the efficiency of these systems and their risk implications in the context of the Group of Thirty's benchmarks for CSD efficiency. The CSD features of China's markets are compared with those found in other countries. The final section looks at other CSD issues-especially those relating to government bonds issued in China and the prospects for a nationally integrated CSD system.

CSD features of the four Chinese exchanges

The essential features of the current Chinese equity market CSD infrastructures are summarised in Annex 4.1 Table 1.

Annex 4.1 Table 1 China: Comparison of clearing and settlement procedures in the exchange and trading systems

Administration Settlement period Delivery and Clearing agency payment type Securities Cash Record Settlement Securities safekeeping Cash Funds custody account date date transfer Primary Secondary market market

SHSE Direct Indirect T+O T+ 1 Not Exchange Exchange ICBC Conventional access access Netting simultaneous settlement

SZSE Indirect Indirect Same as T+l Not Exchange Local ICBC Conventional access access above simultaneous registrar

STAQS Indirect Indirect Same as T+l Not STAQS Member ICBC Conventional access access above simultaneous securities Ind. firm Bank

NETS Indirect Indirect T+l T+l simultaneous STAQS ember PBOC Electronic access access securities firm

Notes: SHSE - Shanghai Securities Exchange SZSE - Shenzhen Stock Exchange STAQS - Securities Trading Automatic Quotation System NETS - National Electronic Trading Systems ICBC - Industrial and Commercial Bank of China

PBOC - People's Bank of China Direct Access means investors can open the account with the exchange while lndirect Access means accounts are opened through brokers. While securities on each of these exchanges have been immobilised and dematerialised (ie are in book-entry form) the registration of ownership or securities custody shows some important differences. The Shanghai Securities Central Clearance and Registration Corporation (SSCCRC) that provides the CSD services for the Shanghai market, allows for beneficial ownership of shares at the individual level. Thus, as of October 1994, the SSCCRC had to keep records on the ownership claims of some 5.4 million shareholders. By contrast, on the other exchanges registration is in the form of omnibus broker (nominee) accounts. The Shenzhen Securities Clearing Company Ltd. centrally administers accounts at the member or broker level (around loo), while individual accounts/records are kept at 30 regional sub-depositories. That is, Shenzhen exhibits central clearance with local registration or a so-called 'dual' system.

In addition to securities accounts, traders also need to establish centralised cash accounts which the appropriate CSD can access to ensure settlement of trades. These accounts have been established at ICBC (Shenzhen and Shanghai), ClTlC (STAQS), and the PBC (NETS). These accounts are established at the broker level, with individuals in turn keeping accounts at their major broker(s). A recent development has been the use of magnetic cards by individual investors on the Shanghai Exchange. These cards work in a similar fashion to debit cards, in that individual investors can use bank automated teller machines (ATMs) to pay directly for trades. This has replaced indirect access by direct access for some 1.5 million cardholders. Shanghai is thus moving toward direct access for the individual investor at both the securities and cash account levels. These ATMs are currently limited in number and location (20 ATMs, mostly in Shanghai) and the future growth of direct access will be linked to the development of a nationwide network of ATMs, and will also depend on whether there is any movement towards a national securities exchange.

Settlement is very different between A (local resident) shares ancl B (overseas investor) shares. All four exchanges use a form of 'automated matching'of trades (which in turn is very similar to the market micro-structures in other Asian countries such as Korea and Hong Kong). Investors contract with brokers to enter buy or sell orders for a given quantity of shares at a pre-set (limit) price. The exchange's centralised computer system then automatically searches for a match. As a result the Chinese exchanges can be viewed as order-driven rather than quote-driven markets. If an order is not matched, it will stay in the central order system until the investor cancels the order or until the end of the trading session. If an order is matched, the computer checks that the investor (broker) actually has sufficient shares in hislher account before confirmation.

Settlement for domestic (A) shares, on the major exchanges, takes place first among brokers (members) and then between the broker and his investor clients. The first, or primary, level of settlement (among brokers) takes place at the end of the trading day (at T+O). On the major exchanges the trades in any given share are netted among members and the exchange's CSD (multi-lateral netting). Secondary settlement, between the broker and his investor client, and the legal transfer of share ownership takes place the next day (T+I).

On both the major exchanges, the settlement of B shares takes place at T+3 and is a more cumbersome process. There are two reasons for this:

the institutional and international nature of the investor clientele, and, trades are conducted (and payment effected) in foreign currencies (HK$ in Shenzhen and US$ in Shanghai).

Moreover, the settlement system itself differs across the major exchanges.

On the Shanghai Exchange, notification of net trading positions among brokers are made at the end of the day (at T+O) as for Ashares. However, foreign custodians acting on behalf of the overseas investors in B shares must also confirm the trade and settlement details. This may include contacting their investor clients directly and seeking to resolve any mismatched trades. This is normally completed by the afternoon of T+2. Because payment is in US dollars through Citibank in New York, full settlement does not occur until T+3. By contrast B shares are not settled through the domestic CSD (the Shenzhen Registry Co.) on the Shenzhen Exchange. Instead all clearance and settlement details are handled by three foreign 'clearing' banks; Citibank, Standard and Chartered and the Hong Kong and Shanghai Banking Corporation. That is, the Shenzhen Exchange sends trading data to these clearing banks who effect clearance and settlement in Hong Kong dollars among their clients by T+3.

Settlement involves the transfer of legal title to a security from one investor to another. If a seller transfers a security without simultaneously receiving payment at the exact moment title is transferred, then one or other party is subject to a credit risk, or at the very least, has extended a short-term loan at no interest. Because settlement occurs through the exchange's CSD while payment occurs through transferring accounts in the banking system, it is very rare for an exchange to achieve exact simultaneous delivery versus payment (DvP). In fact payment normally occurs on the two major exchanges on the same day as securities are settled (T+I), however there is invariably a time-lag between the settlement and payment parts of the transaction. In many cases payment is delayed to T+2, especially between investors and member brokers.

The closest to DvP is achieved on NETS, partly owned by the China Securities Trading Systems Co. a joint venture that is in turn partly owned (12.5%) by the PBC. Because of its close links with the PBC, NETS utilises the same satellite system as the PBC as well as its national wire transfer payment network (the National Electronic Payment System (NEPS)).This potentially allows it to get close to DvP. As will be discussed in the next section, only the United States Federal Reserve Bank's (Fed) federal fund and securities wire-networks achieve full real time DvP simultaneity. This has been aided by the Fed's book-entry system for bonds. It might be noted that the MOF in China only began experimenting with book-entry government bonds in 1994. Prior to this, bonds were not dematerialised, ie, they were issued in paper form and immobilised at exchange depositories such as those at Shanghai, Shenzhen, Beijing, Wuhan and Tianjin.

The efficiency of China's current CSD infrastructures

In analysing the efficiency (and risks) of the Chinese CSD infrastructure, a comparison with the benchmarks for CSD efficiency and risk control established by the Group of Thirty (1989) is useful. This will allow us to identify areas in which Chinese CSDs are ahead of other equity markets (both developed and emerging) and areas in which they are lagging behind and/or exhibiting potentially worrisome risk exposures.

The Group of Thirty had nine principal recommendations. These are discussed below.

The first two recommendations were for institutional comparison of trades (reporting and checking) by T+1. All four markets have achieved these goals for domestic shares (A and C shares). Indeed, three achieve institutional comparison on the same day of trade (T+O). The third recommendation is for a centralised securities depository to be established. China is ahead of many countries (including the US) in both immobilising and dematerialising equities. The one feature of the current Chinese depository system that raises concern is that each exchange tends to have its own depository. Not only are clearance, registration and settlement rules different but important economies of scope and scale are lost. This potentially wastes resources and limits market growth and liquidity. By comparison the US has multiple exchanges but only one major depository, the Depository Trust Corporation (DTC). As was discussed in Chapter 4, the technological barriers are currently large but not insurmountable. It is recommended that the government and the CSRC play a proactive role in integrating the four exchanges and linking their depositories. A first step would be to rationalise the share ownership and registration rules across exchanges. A second step would be to encourage members on one exchange to open depository accounts on other exchanges (this has already happened in the case of brokers who are currently members of both the Shanghai and Shenzhen Exchanges). The danger of a single centralised national depository is that it possesses considerable monopoly power which may be reflected in high fees and charges. For example the US DTC has been accused of hampering technological innovation and is one of the main reasons for the delay in the US moving from T+5 to T+3 for equities trade settlement.

The fourth recommendation was for buy or sell orders for any security on any given day to be multi-laterally netted among the brokers at the end of the day. Such netting reduces broker exposures and the potential size of settlement risk exposures, eg, 'cherry-picking' good (winning) trades and defaulting on the settlement of bad (losing) trades. On the major Chinese exchanges, netting occurs at the end of the day. Interestingly, equities netting occurs in Japan and Thailand but not in Korea or Singapore.' Here, as well, the Chinese markets appear to satisfy the Group of Thirty benchmark.

The fifth recommendation concerns achieving simultaneity in delivery versus payment (DvP). Most Asian exchanges, including China, Hong Kong, Korea and Singapore achieve DvP on the same day but lack exact simultaneity. As noted above lack of simultaneity is equivalent to the securities seller 'lending' the securities free of interest to the buyer if securities are delivered before payment. If payment is made before securities delivery the buyer is extending an interest free loan to the securities seller. In an extreme case, lack of simultaneity can create incentives for one or other side of a transaction to default on settlement obligations. Only the US government bond market has managed to achieve full real time DvP simultaneity as a result of the Federal Reserve's book-entry securities system and the Fed funds and securities wire-transfer networks. Specifically, in the US, debits and to securities and money accounts in the Federal Reserve's book-entry system for US government securities are final (irrevocable and unconditional) as soon as they are posted; both the securities and the funds transfer systems are gross real-time systems. In contrast, at private depositories in the United States, both the securities and fund transfers in these systems are provisional. Participants receive final payment in the form of a claim on the Federal Reserve on a settlement bank. Payment typically must be made by the end of the day. Securities transfers in the system become final only when all participants in a net debit position have completed final payment.= Thus, the potential for China achieving full DvP simultaneity for equities in the near future is problematic, although the government bond market may have greater potential (this will be discussed further in the next section).

The sixth Group of Thirty recommendation concerned time to settlement. The immediate goal was for countries to achieve settlement by T+5 after a trade, with T+3 being viewed as the longer-term benchmark. The time to settlement is enormously important in controlling the credit risk related to settlement. In general, the longer the period between a trade and its settlement, the greater the incentives for one or other side of the trade to default on their settlement obligations. This is because buying an equity today with settlement sometime in the future is equivalent to a . As spot prices move away from the contracted price at the time of trade, one or other side of the contract has an incentive to default. Moreover, the greater the volatility of stock prices the greater will be the default incentives. Given the high volatility of Chinese stock prices (see Chapter 4) it is crucial that the settlement period is kept as short as possible. Thus the current T+1 settlement for A shares is well within the Group of Thirty guidelines and is well ahead of many developed countries (eg the US settling at T+5) and emerging market countries (eg, Thailand settling at T+3 and Singapore at T+4).

On the other hand B shares settle at T+3, which exactly meets the Group of Thirty benchmark. this will only likely be reduced if and when Chin~amoves to full convertibility and foreign custodians and clearing banks can accelerate payments to meet a shorter settlement period. Shortening the settlement period itself might require a rationalisation of the whole regional custodian system for B share trades, which can be very cumbersome. Recent proposals to set up a regional 'Asiaclear' for settling trades in Asian equities may be a step in the right direction3 although the payment, political and technological barriers are likely to deter its development for some time especially as a fully fledged 'Asiaclear'would require China and other Asian countries to abandon their local and national CSDS.~

Apparently because of their short settlement period (T+1) settlement risk has not been a major problem on the Chinese exchanges. Moreover, all exchanges have member-funded guarantee schemes to cover defaults. Such funds are crucial because failure to settle by one participant can result - in extreme cases - in the failure of other participants to settle as well. This is a situation of systemic or contagion risk. Because such events are rare it is hard to know how robust these guarantee schemes are likely to be to systemic shocks. Nevertheless, it should be noted that since settlement is effected through limited liability private sector corporations, eg, the Shenzhen Securities Registry Co, with limited access to bank credit and limited guarantee funds, this risk cannot be ignored. Chinese CSDs would find it hard to cover defaults in major shock conditions without implicit or explicit back-up support from the government. Such back-up guarantees have advantages in reducing systemic risk exposure, but also have potentially high costs for the government and its budget deficit. Government guarantees (whether explicit or implicit) to CSDs also raise important social welfare issues as to whether society should subsidise private CSD systems.

The seventh recommendation concerned achieving payment for securities in same day funds. In general where payment for securities is made by settling through deposit accounts held at a settlement bank, as on the Shanghai, Shenzhen and STAQS exchanges, same day payment is not always possible. This is because payment transfer delays from a broker's local bank into the broker's account at the settlement bank may inhibit payments being effected on a timely basis. Indeed, one of the reasons for Shanghai moving from T+O to T+1 in 1995 is because the bank check clearing system for deposits is less efficient than the securities netting settlement system. To achieve better payment performance brokers' may need to gain access to either the national payments system (such as INEPS), or to establish a private wire-transfer system between the brokers' local banks and the settlement bank (such as ICBC). Direct access to NEPS would confer bank-like status on brokers. The eighth recommendation concerned the use of standardised international numbering or coding systems for securities, such as the International Securities Identification Numbers (ISINS)of the International Securities Organisation (ISO). This international coding system aids cross-border trades of international investors and thus the liquidity of B-type shares. Both the Shanghai and Shenzhen Exchanges have adopted internationally recognisable coding systems.

The ninth recommendation concerns . Often trades fail to settle on the settlement day because the seller's securities account is short of the required number of securities on that day. To prevent 'fails' some countries allow for a system of organised securities lending among brokers/investors. Securities lending enhances market liquidity and investor portfolio flexibility, but at the same time it creates an increased ability for investors to take short positions. For the securities lender, additional returns can be earned over and above normal portfolio returns. No organised securities lending system currently exists for Chinese equity markets. However, an organised repurchase agreement (repo) market exists for bonds on a number of exchanges such as Wuhan. The absence of securities lending for equities is partly because of regulatory concerns regarding the destabilising effects of enhanced short-selling opportunities (short-selling is officially prohibited on the Chinese equity markets). Given the high volatility of Chinese equity prices, the benefits of enhanced securities lending are probably outweighed by the costs, at this moment in time. Indeed, of the Asian emerging markets, only Singapore has relatively few restrictions on equities securities lending.

Overall, the major Chinese exchanges have come a long way towards meeting the Group of Thirty recommendations. The two areas of greatest weakness appear to be the absence of a single (national) securities depository for equities and the fact that the payments system lags behind the securities settlement system in terms of efficiency.

Other CSD issues

As China liberalises and reforms its financial markets and instruments of monetary policy it has been proposed that it place greater reliance on open market operations (OMOs).OMOs require an ability of the Central Bank to buy and sell government securities at short notice (eg holding an auction to sell to (or buy from) dealers some pre-determined quantity of bonds). Currently OMOs are hampered in China by the fact that bonds are not dematerialised. Moreover, they are immobilised at different depositories with different standards on registration and transfer. A proposal has been made by the CSTS, the owner of NETS, to establish a government bonds book entry system (GBBS). The advantages of a centralised book-entry system for bonds, apart from making OM0 easier, include enhanced market liquidity and investor safety. In addition it allows the Central Bank to better monitor the demand conditions for new issues of bonds.

The key question is, who should operate and who should own such a system? In many developed countries, such as the US, the book-entry system for government bonds is operated by the Central Bank alongside a fund wire-transfer system. The advantages of a 'nationalised' or government-run wire-transfer system is that the credit risk relating to transactions is eliminated for the private buyers and sellers of bonds. In particular, the Federal Reserve guarantees all transactions made on both the Fed's bond and fund wire-transfer systems. While CSTS has access to the Central Bank's satellite communications system and its wire-transfer system, and is partially-owned by the PBC, it is still a limited liability company. As such its creditability and status must be less than the PBC or a bond CSD directly established by the government. This makes any guarantees regarding settlement and DvP contingent, in part, on the creditstanding of the CSD itself. As noted earlier CSDs are not banks and, in general, they have limited access to funds should material settlement or payment failures occur. This suggests two policy possibilities: either the PBC directly guarantees all transactions on a CSTS operated GBBS, or else it moves towards establishing a fully nationalised, government- owned and operated bond book-entry system, and connecting it to its NEPS wire- transfer system along the same lines as the system operated by the Federal Reserve.

Notes 1 Harrison (1994). 2 Clearance and Settlement in US Securities markets, Federal Reserve Board of Governors Staff Study, March 1992, page 10. 3 Giddy, Saunders and Walter'l 992. 4 Asian Finance ,1990 ANNEX 4.2 TECHNICAL NOTE ON THE ANALYSIS OF EQUITY MARKETS

The underpricing of initial public offerings

IPO data: A shares and B shares The analysis uses all data on new issues of A and B shares on the Shanghai Stock Exchange, from the start of trade to 13 September 1994, as well as all available data on new issues of H shares and N shares, until the end of 1994.

There have been at least three previous studies of underpricing of stocks on the two major Chinese equity markets (Fung and Ho (1 994), Chen (1 993) and Shyy and Ho (1993)). These studies have been based on very small samples and very limited time periods. The present study utilises all available new issue data, over the entire time period since trading began, as long as the required data were available for price changes over six time intervals, defined as:

T+1 price on offer date to opening price on first day of listing T+2 opening price on first day of listing, to closing price on first day of listing T+3 closing price on first day of listing to closing price on trading day T+20 T+4 closing price on trading day T+20 to closing price on trading day T+40 T+5 closing price on trading day T+40 to closing price on trading day T+60 T+6 price on offer date to closing price on trading day T+60

For A shares, 11 4 met these criteria; for 'B' shares the number was 23.

In addition Shanghai 'A' market index and '6' market index prices were collected for periods that matched the offering and trading dates for lPOs denoted above. These indices allowed 'raw' returns on lPOs to be adjusted for market return movements over similar periods, ie., to calculate -adjusted returns on lPOs by taking the difference between raw returns and market returns.

Table 4.3 in Chapter 4 provides data on the risk-adjusted returns for different holding periods different share categories, and over different sample periods. -the mean, standard deviation, minimum and maximum degrees of underpricing of risk-adjusted returns for both A and B shares are given, for the IPO holding time intervals T+l to T+6. This table calculates average risk-adjusted returns for the IPO holding periods, for the entire sample period. Annex 4.2 Table la China's equity markets: underpricing of new share issues Risk-adjusted returns on Initial Public Offerings: Shanghai A shares 7 992 to 1994

------1992 1993 1994

Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max. Dev. Dev. Dev

Rrl : Offer date to opening price on T1 52 12.46 14.34 0.94 58.74 50 2.40 2.22 0.37 12.79 8 1.28 1.12 0.45 . 3.08

Rr2: Opening to closing price on T1 52 0.02 0.11 -0.20 0.35 50 0.02 0.14 -0.20 0.40 8 -0.06 0.11 -0.17 0.14

-4 OI CO Rr3: Closing price TI to T20 52 -0.07 0.36 -1.45 1.17 50 -0.01 0.22 -0.29 0.79 8 -0.08 0.09 -0.24 0.05

Rr4: Closing price on T20 to T40 52 0.21 0.99 -0.38 5.65 50 -0.01 0.13 -0.25 0.35 8 0.1 7 0.31 -0.16 0.71

Rr5: Closing price on T40 to T60 52 -0.04 0.24 -1.20 0.36 50 -0.01 0.11 -0.33 0.48 8 0.06 0.10 -0.06 0.20

Rr6: Offer to T60 52 10.72 17.73 0.13 76.40 50 1.85 1.98 0.12 12.45 8 0.94 0.56 0.11 1.73 The risk-adjusted returns rr3, rr4 and rr5 show, respectively, the aftermarket or seasoned return performance of lPOs for the period from close of trade on first day to close of trade on day T+20 (rr3), close of trade on day T+20 to close of trade on day T+40 (rr4) and close of trade on day T+40 to close of trade on day T+60 (rr5). There are only relatively small declines in the stock's return in the aftermarket. Similar calculations were undertaken for B shares.

The extent to which the market 'matured' is captured in Tables Ia and 1 b, where analogous calculations have been undertaken for new issues of A and B shares, grouped by year of issue.

IPO data: H shares and N shares Raw (ri) and (market) risk-adjusted (rr,) returns are estimated on the 11 H share issues by Chinese companies in 1993 and 1994 up to October 1994. In this case too, both raw and risk-adjusted returns were estimated, and the market risk estimates were calculated on the Hong Kong Hang Seng index.

There have been only two 'China'shares on the New York Stock Exchange where data is available from the Bloomberg screen; China Tire Holdings Ltd and Brilliance China Automotive Holdings Ltd, and the analysis is based on these companies (which are actually 'Bermuda' companies). Since the offer price on the NYSE is usually set (less than) one-day before trading starts on the NYSE, the 'offer to open' raw and risk-adjusted returns (rri) are isomorphic.

Trading of equities and market volatility Returns: raw and risk-adjusted The analysis of return performance first calculates raw returns on the A and B share indices, for both Shanghai and Shenzhen. Returns are estimated for one week holding periods (r,) from the market's opening in December 1990 to the middle of September 1994. Next, risk return trade-offs ('ratios') are estimated by dividing mean weekly returns by the standard deviation of weekly returns on the market index (:,/oA) over the whole sample period.

Risk adjusted returns were also computed using two assumed holding periods - 10 weeks and 20 weeks. Although 10 weeks and 20 weeks are somewhat arbitrary they give an indication of the type of risk-adjusted returns a well diversified investor who bought and held equities for relatively longer horizons might generate. Results are presented in Table 4.5 in Chapter 4. Annex 4.2 Table 1b China's equity markets: underpricing of new share issues Risk-adjusted returns on Initial Public Offerings: Shanghai B shares 7 992 to 7 994

Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max. Obs. Mean Std. Min. Max. Dev. Dev. Dev.

Rrl : Ofier date to opening price on TI 6 10.33 1.39 9.35 13.1 12 0.15 0.13 0.01 0.39 5 0.17 0.22 0.00 0.55

Rr2: Opening to closing price on TI 6 -0.01 0.08 -0.12 0.12 12 0.17 0.17 -0.05 0.44 5 0.00 0.04 -0.04 0.05

Rr3: Closing price TI to T20 6 0.00 0.04 -0.04 0.07 12 0.00 0.15 -0.30 0.25 5 -0.07 0.09 -0.19 0.05

Rr4: Closing price on T20 to T40 6 0.11 0.08 -0.04 0.19 12 0.07 0.07 -0.04 0.18 5 0.00 0.08 -0.11 0.08

Rr5: Closing price on T40 to T60 6 -0.16 0.35 -0.86 0.1 12 0.05 0.13 -0.1'1 0.28 5 0.08 0.04 0.03 0.13

Rr6: Offer to T60 6 6.31 3.22 0.10 9.5 12 0.48 0.34 0.04 1.23 5 0.15 0.28 -0.20 0.57 Returns: autocorrelation Autocorrelations of weekly returns were estimated for the Shanghai A and B markets. The lags potentially allow for autocorrelations of up to lag 48 for A shares and up to 33 lags for B shares (Figure 1). Although the one, two and three week lagged autocorrelations with the current week's return were estimated, only the first lag's autocorrelation coefficient is statistically significant at the 95O/0 confidence level.

Annex 4.2 Figure 1 Autocorrelation of Shanghai and Shenzhen weekly index returns

Autocorrelation 1 coefficient Shanghai

Week

Autocorrelation coefficient Shenzhen

I Week

Source: Calculations based on data provided by the Shanghai and Shenzhen exchanger

Overall, there is evidence of trends in returns in both the Shanghai A and B share markets. Given the greater relative thinness and low trading volume of the B share market, price movements tend to persist in that market longer than in the more liquid A share market.

Shenzhen A share autocorrelations show a much stronger first order autocorrelation than for B shares. Specifically, the first order A share autocorrelation is 0.38 versus 0.026 for B shares. This first order A share autocorrelation coefficient is statistically significant at the 99% level. This evidence may well reflect the greater relative thinness of the Shenzhen A market to the Shanghai A market. Real returns, stock prices, and inflation A final test undertaken on returns seeks to examine the degree to which stock prices reflected fundamental economic values. It has long been argued that stock returns should provide a good hedge against inflation since, unlike fixed coupon bonds, an enterprise's nominal cash flows will tend to move in line with inflation as would its nominal profits and potentially dividends. This has usually been tested by examining the empirical relationship between stock returns and the one period lagged inflation rate (see, for example, Bodie (1976) and Jaffeand Mandel ker (1 976)). If the lagged inflation rate is a good proxy for next period's expected inflation rate such a test is also equivalent to testing whether the Fisher equation holds for stocks ie., there is a one to one positive relationship between stock returns and expected inflation rates such that stock returns fully reflect expected inflation rates.

Chinese inflation rates were collected monthly for the period December 1991 to February 1994. Chinese inflation rates are based on moving annual periods eg., January 1993 to January 1994, February 1993 to February 1994, etc. Matched returns were calculated for A and B shares over the same sample period. For the Fisher equation to hold, the slope coefficient of the regression of the lagged inflation rate on returns should be positive. However, for Shanghai A shares the relationship was found to be -0.36, indicating that the returns on A shares have actually been negatively correlated with inflation. Moreover this relationship is highly significant (at the 99% confidence level). For Shenzhen A shares, measured over the April 1992 to February 1994 period, the relationship was also significantly negative (- 0.28). For B shares, the regression coefficient was close to zero (.00122) for Shanghai and statistically insignificant at meaningful levels. That is, B share returns on the Shanghai Exchange appear to have moved independently of inflation. Moreover the results for Shenzhen also produced a coefficient insignificantly different from zero (0.04).

These results suggest that Chinese investors seeking to hedge their savings against inflation might have been better off investing in government bonds whose coupons have been (partially) indexed to inflation in recent years. In addition, they suggest that foreign investors have not been impounding a (risk) premium for inflation into their required returns on B shares. Volatility The analysis of 10 week standard deviations for Shanghai and Shenzhen A and B shares is presented in the text (Figure 4.6).

Autocorrelation of volatility An examination of the degree to which volatility (like returns) is autocorrelated over time is also undertaken. The question is, does Chinese stock market volatility exhibit some type of autoregressive conditional heteroscedasticity or (ARCH) behaviour or is it largely random on a week by week basis. Weekly volatility is characterised, following Lo and Mackinlay (1 988), Brock (1 994) and others, by looking at the autocorrelations among weekly squared returns. The autocorrelations from lags 1 to 48 for A shares, and from lags 1 to 33 for B shares, on the Shanghai market were estimated (Annex 4.2 Figure 1). As with returns, Shanghai B share volatilities show stronger autocorrelations than A shares. The first, second and third order autocorrelations for A(B) shares are respectively 0.01 4 (-.036), -0.007 (-.080) and -0.0099(-.0806) none of which are statistically significant at meaningful levels. Thus, it appears that both A and B Shanghai share volatilities tend to have been largely random on a week-to-week basis. In particular, there is no evidence of an ARCH type process.

In contrast to the Shanghai market, A share volatilities (squared returns) on Shenzhen show significant autocorrelations at the one and four-week lag level, while B share volatilities show some evidence of a significant autocorrelation at the one-week lag level. Thus B, and especially A shares, on the Shenzhen market appear to show some ARCH-type properties, ie., volatility itself has not been random over time.

Returns and volatility behaviour of H shares The comparative analysis of return and volatility performance of H shares traded in Hong Kong is based on the new Hang Seng Chinese Enterprise Index, overthe period from July 1993 to October 1994.

Returns Returns on H shares in Hong Kong are higher than on B shares in China. Details are given in the text (Table 4.5). Volatility The ten week standard deviation of H shares has varied between a low of 0.03 and a high of 0.09. The level of volatility and the volatility pattern is quite similar to that for Shanghai B shares and Shenzhen B shares over the same period.

Autocorrelations These were estimated from lag one to 15 for weekly H share returns and return volatility - returns squared. Like Shanghai B shares, H share returns have a strong first order autocorrelation (0.281). Also like Shanghai B shares, H share volatilities tended be uncorrelated over time, ie, volatility appears to have followed a random walk on a week by week basis.

Market in fegration Correlation of indices and returns across the major markets The contemporaneous correlation matrix among indices (levels) using all available daily observations up until 14 September 1994 is shown in Table 2 (first table below). As can be seen, the indices on similar classes of share tend to co-move together across exchanges. The high daily correlation of Shanghai Aand Shenzhen A share indices, indicates strong sensitivity to common factors and news. By comparison the correlation of Shanghai Aand B shares has been low, and Shenzhen A and B relatively low. B and H share indices are highly correlated. Table 3 (second table below) recalculates the correlation matrix using weekly returns rather than daily index levels. Although the size of the correlations are lower, the results generally support those found for daily index movements.

Annex 4.2 Table 2 Contemporaneous daily correlations among A, B and H share index levels (All available data December 1990 to September 1994)

Shanghai Shanghai Shenzhen Shenzhen Hong Kong A shares B shares A shares B shares H shares

Shanghai A 0.1 57 0.91 9 0.388 0.399 Shanghai B 0.051 0.746 0.859 Shenzhen A 0.472 0.342 Shenzhen B 0.862 Hong Kong H Annex 4.2 Table 3 Weekly correlations among A, B and H share returns (All available data December 1990 to September 1994)

Shanghai Shanghai Shenzhen Shenzhen Hong Kong A shares B shares A shares B shares H shares

Shanghai A 0.41 08 0.475 0.151 0.207 Shanghai B 0.31 7 0.324 0.527 Shenzhen A 0.256 0.315 Shenzhen B 0.208 Hong Kong H

Price premiums and discounts between A and B shares Stock price data are adjusted for all A and B share stock splits. Comparisons of prices quoted in Rmb, HK$ and US$ were undertaken using daily, end-of-day exchange rates. Calculation results are discussed in Chapter 4.

A and B spreads are described in terms of the B share discount, defined as [(pa-p,)/ p,]. The A and H discount is measured by [(pa-pJ/p,J, or the daily A share price (in Rmb) minus the daily H share price (converted into Rmb, using each end of day HK$/Rmb ). A positive spread indicates that H shares stand at a discount to A shares. H share discounts were estimated over the period 27 August 1993 to 13 September 1994. Given the very limited number of H shares in total, however, and the even more limited number that can be matched with corresponding issues of Aor B shares, the evidence must be viewed as preliminary.

Data on N shares are scarce because of the Chinese ADRs listed in the US. Two, (Shanghai Chlor-Alkali SP and Shanghai Erfang Co. Ltd) have no published or on- screen daily price data, as these are privately traded. Another two (Shandong Huaneng Electric and Huaneng International Power) have no domestic A or B shares (see Chapter 5).

One NY ADR is equal to 100 Hong Kong H shares of this enterprise. In this case the enterprise issued its H shares on the same day as the ADR (26 July1993). This enterprise also issued Ashares later, on 11 August 1993. Using 100 H and 100 A shares as equivalent to 1 ADR, average spreads are calculated between the A and the ADR share prices of the enterprise, and between its H share and ADR prices, in the period until 13 September 1994.

CHAPTER 5

Like other emerging markets, China's securities markets are rapidly developing international links, both as China seeks to augment domestic savings from international resources, and as increasing volumes of private investment flows from overseas seek higher returns in emerging markets. While the augmentation of domestic savings by the resources of international investors is valuable, it also raises questions about the impact such flows may have on the domestic economy, and thus, how to provide for a stable and orderly increase in international participation. China today faces the need to formulate strategies for the opening up of its capital market to foreign participation in terms of appropriate vehicles and instruments, and appropriate terms and conditions.

The present chapter first examines the issue of the 'safe' internationalisation of China's securities markets, and (especially in view of the Mexican crisis of late 1994), the extent to which China is vulnerable to domestic destabilisation through international participation in its securities market. The next section examines equities markets, in terms of international participation in Chinese domestic securities exchanges (B shares) and also, the trading of Chinese securities in overseas exchanges (H shares, N shares and depository receipts). The third section examines debt securities, in terms of the possibilities for overseas participation in China's domestic debt securities, and also, the terms which China is able to obtain for its overseas debt issues. Alternative debt instruments (syndicated loans versus securitised debt) are considered. Finally, the desirability of introducing new derivative instruments is briefly reviewed. The key conclusions of this chapter are first, that China today is not vulnerable to a destabilising domestic backlash, if flows of portfolio investment to China were to be sustained. Indeed, China needs to achieve a better balance of its foreign resource inflows between direct and portfolio investment. Second, in terms of foreign equity investment, greater efficiency could be achieved in the design of China's overseas equity issues, which will be required for sustained and increasing foreign interest. Today the novelty value of Chinese shares has begun to wane and greater emphasis on strengthening fundamentals is necessary. A major difficulty faced by overseas investors in China equities has been the limited liquidity in the thin and segmented markets for overseas shares, especially in the B share market but also elsewhere, for example shares listed exclusively on the New York Stock Exchange. Almost all China shares held by overseas investors trade at a discount to domestic shares. If China were to remove its present distinctions between share categories, this problem would be alleviated, and other efficiency gains would also ensue. While uncontrolled foreign equity inflows are undesirable, many optional safeguards are available. Meanwhile, another option open to China is to increase liquidity through dual listings, and the recently popular GDR or multiple depository receipts mechanism provides a useful vehicle for this. China can explore the more complex options available under such programmes as 'side-by-side' ADRs, or gradual increases in ADR levels. Third, on the issue of taxes on portfolio investment, this is today a lesser fiscal issue than achieving a level playing field between FDI and portfolio investment, and reducing preferential incentives for the former while introducing double taxation treaties for the latter is desirable.

Fourth, China's domestic fixed income securities market is today closed to foreign participation. For the time being, strengthening the domestic market should be the first priority. In the medium term, however, a gradual opening up to foreign investors can be adopted, using a sequenced approach. The fifth conclusion is that China, like other countries, has greatly increased its presence in the international bond market, and to date enjoys favourable terms, relative to most other emerging market economies. China could try to further expand the maturity of its bond issues, in view of domestic needs. Streamlined domestic procedures for issuing international bonds would benefit from greater flexibility. The sixth point is that China has also been able to increase the volume of international syndicated loans it receives, in this case contrary to global experience. Again, the terms so far have been favourable, and initial-launch spreads were steady through to the end of 1994, though maturity appears to be on the decline. Secondary market prices show some weakness. Creative extensions to longer maturity may be possible. The next conclusion is that there are some indications that terms of commercial bank credit to China may grow less favourable if the borrowers credit ratings and guarantee status are not clarified. In overall terms, broadening of overseas funding options should be the strategy for the Chinese authorities to pursue. Finally, China's participation in international derivative markets is inevitable, and the key consideration in increased participation is that it should be orderly and regulated.

The Scope for Safe Participation in International Securities Markets

China has been very successful in attracting large private foreign resource inflows in recent years. Total private flows (on a net basis) jumped to $36 billion in 1993, up from $5 billion in 1990, and are estimated to have reached $40 billion in 1994. The increase in private resource inflows to China parallels a global trend of rapidly increasing private resource inflows to emerging market economies. Yet, the composition of external investment flows to China is strikingly different from comparator countries. While the international experience suggests that foreign portfolio equity investment has been increasing the most rapidly, resource inflows to China have been increasingly skewed towards foreign direct investment (FDI), which accounted for more than two thirds of the total net private investment flows to the country in 1993.

Figure 5.1 Private capital flows to China

US$ million

50.000 r

Foreign direct investment

0 + 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 I Year 1 Source: World Bank The contrast to other major emerging markets, even in absolute terms, is clear from Figure 5.2, which shows China's enormous share of developing country FDI, but its small relative share in terms of securitised flows, such as equities or bonds.

Figure 5.2 China and other emerging markets: Participation in international capital flows

Portfolio equity Bonds

Mexico Mexico

Indonesia Chile 0 2 4 6 8 10 12 14 16 -10123456789 US$ billion (1993) US$ billion (1993)

Foreign direct investment

China

~epiblcof Korea 0 5 10 15 20 25 30 US$ billion (1993)

I Source: WorldBank

Relative to portfolio flows, FDI flows tend to be more stable and long term. A key factor in the Mexican crisis in late 1994 was the predominance of foreign investment in short-maturity government securities linked to the US dollar; the tesobonos. Bondholders in domestic government securities markets tend to be a more volatile group of investors than holders of equities, and this is compounded if the securities held are short term. Moreover, even in the case of portfolio flows, China's segregated share categories, with foreign investment on domestic markets limited to the relatively small B share market and with H shares tradable only outside the country, a 'withdrawal' from China can only mean a decline in share price among foreign investors with no dollar pull-out from China. As Figure 5.3 supports, China, on account of both the composition and maturity of foreign capital inflows, does not appear to be vulnerable to the potential contagion effect of the Mexico crisis.' It is acknowledged that today there are instances where the distinction between portfolio investment and direct investment grows blurred. One example is the emergence of so called 'direct investment funds.' This investment vehicle takes the form of closed-end funds (like portfolio equity investment), but is used to participate in FDI projects (eg, take a minor stake in a new joint venture investment). This new development is attributable to:

international investorsf efforts to take equity positions in Chinese firms, in the face of limited supply of B shares in the local markets and international equity issues pricing inefficiency of public offering, and, tax incentives for FDI.

A second example is offered by overseas investors who undertake FDI in Chinese enterprises today which they hope are likely to be listed some years later, thus providing an opportunity for a one-time gain from share price increases at the

time of the IPO; the so called 'pre-emptive FDIf strategy. Nevertheless, these investments also have stable and long time horizons, and therefore today share these characteristics with FDI. On balance, to the extent that a position can be taken without a sensitivity analysis of macro-economic consequences, China is, rather, in a position to cautiously increase participation in world securitised flows.*

Figure 5.3 China and Mexico inflows

China (US$146 billion) Mexico (US$81 million) ~ I I

7%

Other private flows

Source: World Bank One question which may be raised here is why it is at all desirable for China to seek to diversify its foreign capital inflows, in view of the relative stability and the concomitant (nonfinancial) benefits of FDI. First, the heavily concentrated nature of private capital inflows in FDI (compared with portfolio equity flows) is a source of concern. The FDI boom has been fuelled, at least in part, by preferential treatments (eg, tax incentives), which could distort investment decisions and resource allocation in the long run, and are also costly to the government. Another reason for high FDI levels has been the low availability of equities and limited development of the capital market. Secondly, it is known that at least a part of China's FDI takes the form of 'round-tripping,' to benefit from tax incentives. Thirdly, FDI often generates substantial reflows of remitted profits, making the cost of capital on the part of the host economy quite high.3 Striking a better balance between FDI and portfolio equity investment in local capital markets should serve the national interest in the long run. Ashort-term policy measure for the Government would be to eliminate preferential tax treatments for future FDI.

International Participation in China's Equity Issues

Foreign investment in domestic share markets: B shares

As described in Chapter 4, foreign portfolio investment in Chinese equities was initially made possible through direct purchase of B shares listed at Shanghai and Shenzhen Stock Exchanges (Appendix Table A5.1). By the end of November 1994, the 28 B shares listed on Shanghai and 23 listed on Shenzhen had raised a total of US$1.3 billion equivalent, through new share issues of an average size of US$25 million each. Chinese securities regulators authorised different classes of shares for local listing and sales to foreign investors, primarily to accommodate limits on foreign ownership and Rmb ~onvertibility.~

As documented in Chapter 4, the segmented market structure has yielded a divergent performance between A and B shares, where B shares typically sell at a large discount to A shares. The performance of China's B shares contrasts with the experience of other countries, where stock markets that have Iiberalised foreign investment rules (for example, Argentina, Brazil, Colombia, and Pakistan) have subsequently experienced huge price increases, although followed by significant market corrections. In Chile, Mexico, and the Philippines, price-to-earnings ratios have risen continuously for several years after the market opening. The current system of separation of A and B shares presents problems, of which the first is price distortion across markets. Second, the possibilities for arbitrage lead to illegitimate transactions, such as A share investments by non-residents; reducing market transparency. Third, share segmentation curtails liquidity and reduces efficiency. Fourth, the learning benefits of permitting more experienced and less speculative share market participants are also lost.

These disadvantages would be removed by the synchronisation through merger of the A and 8 share markets. Two arguments are generally offered against this. The first is the limited convertibility today of the Rmb. It should be pointed out that this need not be a necessary condition, provided foreign exchange is freely available for transactions relating to equity investment. Countries such as Korea permitted foreign investment in domestic equities before full convertibility, although the commitment to full convertibility had already been adopted. The second factor is the concern that the merger of A and B shares could leave China vulnerable to the problems of excessive inflows, which could crowd out domestic participation, or excessive outflows, which could destabilise the domestic market. A range of alternative safeguards may be adopted, as the experience of other countries shows:

Ceilings may be imposed on foreign investment, at the enterprise, sectoral, and individual levels. For example, in Korea, foreign investors can own up to 12 per cent (recently increased from the previous ten) of the shares of most listed companies, but an individual investor can only hold three per cent. Lower ceilings are set for sensitive sectors such as power generation, or iron and steel. In Indonesia, foreigners can hold up to 49 per cent of shares. Participation can be restricted to known and approved large investors. In some cases, non-resident participation can be permitted only through approved mutual funds or trust funds or country funds, with pre-approved credentials (Korea, Taiwan, India). Selective secondary equity market transactions with a destabilising potential can be restricted. For example, foreigners can be restricted from buying or selling at the margin (Korea) or short selling (India). In Taiwan, foreigners are allowed to sell one day after purchase; earlier, they were allowed sales only after taking delivery. Restrictions on voting rights or board membership have also been adopted by some countries (Appendix 85.1). In ferna fional financial flows fo developing countries

The pattern of international financial structural changes in global financial flows to developing countries has markets, including increased changed fundamentally in the 1990s. financial integration of developing First, the volume of private capital flows countries, growing international now far exceeds official flows. From less diversification of investment funds, than one third of resource flows till the and easier access by developing late 1980s, private flows today account countries to industrial country capital for three quarters of resource flows to the markets, developing world. Second, the especially for FDI, deregulation of the composition of private flows is strikingly private sector, the growth of different from official flows. regionalism in trade and investment, disintermediation from the banking Equity, rather than debt flows, system since the onset of the debt dominate. Equity investment crisis, and lower costs in accounted for two thirds of private transportation and communication. capital flows in 1993. Securitised, non-bank flows such as In terms of strategies and instruments, 40 bond issues are replacing bank loans. per cent of long-term bond financing In FDI, growth has been strong and received by developing country sustained, facilitated by structural and borrowers went to three Latin American secular developments such as the countries - Argentina, Brazil, and Mexico increasing global integration of (1 989-93). Over 50 per cent of portfolio production. equity flows (including international Recipients are now mainly private equity issues such as ADRs and direct instead of predominantly sovereign. foreign investment in developing country Private-to-private flows now represent stock markets) went to three countries - roughly 70 per cent of net flows to Mexico, Korea, and Brazil. And over 50 developing countries. per cent of total FDI flows went to five Recipients are mainly middle-income developing countries -Argentina, China, countries. China and India are two Hungary, Malaysia, and Mexico over the notable large low-income exceptions. same period. China, with FDI inflows of US$27 billion in 1993, became the The causes of these changes are largely second largest recipient of FDI in the structural. Major contributing factors world, after the United States, and was have been: the leading recipient of aggregate external financing among developing countries, low real interest rates (particularly in accounting for 20 per cent of net flows key source countries - the United to all developing countries. States and Japan), leading to improved developing country Available borrowing strategies reflect a creditworthiness, combination of factors includingcountry macro-economic policy changes creditworthiness, past creditor exposure, within developing countries, country regulations and institutions, and including trade liberalisation, fiscal country/corporate funding strategies consolidation, privatisation, and deregulation, between debt and equity. Between 1991 US$47 billion in 1993, and is estimated and 1993, Chile, China, Indonesia, to have reached US$40 billion in 1994, Korea, and Thailand were able to access with roughly US$20 billion through direct a wide range of private sources of long- purchases by foreigners in the emerging term finance. For both China and Korea, stock markets, and international equity only about 15 per cent of new debt offerings. acquired was short-term. Argentina, Brazil, and Mexico converted foreign Prior to 1990 the bulk of foreign loans to bonds through debt reduction portfolio investment in d'eveloping operations, or to equity, through debt-for- country equities took place through equity swaps. About two thirds of new closed-end country funds. A number borrowing by Mexico was short-term, of developing countries have recently which was a critical factor contributing liberalised their domestic equity to the country's recent financial crisis. markets for direct foreign investment, About half of new debt flows to Argentina and subsequently experienced large (and Malaysia and Thailand) have been investment inflows. For example, since short-term. its market opening in 1992, Korea has received about US$10 billion of net investment up until the end of 1994. Portfolio equity investment Studies (Jun, 1994) show that the flows to developing countries impact of market opening has been Portfolio equity investment flows, either largely beneficial. Improved market in the form of direct purchase by foreign performance contributes to lowering investors in host country's local stock cost of equity capital, although foreign markets, or investment in equities traded portfolio investment was often followed outside the country of issuer, often by increased volatility in host country through closed or open-ended stock markets. Estimates for Korea investments, have been the fastest showed that US$1 billion of foreign growing component of private capital portfolio investment inflows improved flows in the 1990s. From a mere US$3.5 the by 20 per cent, with billion in 1989, portfolio equity only marginally increased market investment in developing countries has volatility and inconsequential macro- increased more than thirteen times to economic disturbances.

.. I Trends In prlvate flow to developing countries Major recipients of private captial flow, 1989-93 1 US$ billion US$ billion 1 250

200

150 I 100

50 On#c#alloans 20

0 1986 1988 1990 1992 1994' 'Pro~ected Such restrictions on equity purchase and equity market participation differ from foreign exchange controls, on the repatriation of capital or dividends. In certain circumstances, holding period limitations may be imposed on capital gains repatriation (Chile, Taiwan), or ceilings may be stipulated above which case by case approval for capital gains repatriation may be required (Thailand). Examples are given in Appendix 85.2.

Special protection is sometimes given to domestih 'financial institutions, for example, ceilings on the foreign acquisitions of domestic banks' shares (Thailand and Indonesia: 49 per cent; Argentina: 30 per cent without special government approval). In some cases, special measures may also be taken to encourage the development of local non-bank financial institutions, such as securities firms or brokerage houses. Thus, Brazil requires the domestic comanagement of foreign investment funds, and Argentina requires investment to be undertaken through authorised domestic stock brokers.

Thus a range of safeguards exist, applied in varying degrees in other countries. China must take care not to impose too many 'safeguards,' which could make entry unduly restrictive. An appropriate balance has to be found, to ensure safe participation in a manner which is beneficial to the domestic market's development.

Tax treatment of foreign equity investment

A question frequently raised by Chinese authorities concerns the desirability of imposing taxes on dividends and capital gains on overseas investors. At present no such taxes are imposed. It is true that these are applied in a number of other emerging markets (Appendix B5.3 has examples of tax policy of emerging markets with regard to portfolio investment). Yet at present, China's chief concern should be to level the playing field between taxes (and tax incentives) for FDI and foreign portfolio investment. At the same time, China would benefit from some form of a capital gains tax, at least on A shares, as this would discourage speculative investment (see Chapter 4). China has a difficult path to tread in this realm, as it is recognised that the imposition of dividend or capital gains taxation may discourage liquidity and further reduce the attractiveness of portfolio flows relative to FDl.5 On balance, it is suggested that although a tax on dividends may be an unnecessary discouragement, a form of capital gains tax could be beneficial. Overseas listing of Chinese equities: H and N shares; depository receipts6

Access of foreign investors to Chinese equities expanded considerably with the introduction of H shares (Appendix TableA5.2).7Averagingaround US350million each, these are considerably higher than the averageof US$25 million for B shares, and thus more significant, as a vehicle for raising capital overseas. Nine of the most internationally well-known Chinese enterprises (including Tsingtao Brewery, Shanghai Petrochemical, and Maanshan Steel) were listed on the Stock Exchange of Hong Kong in the form of H shares by the end of 1994 representing a cumulative total of US$3 billion. By the end of 1994,15 of the total of 31 approved companies had already established a listing on Hong Kong.'

Chinese companies began to go further afield for capital, to the New York market, as early as 1992. Before the regulatory authorities had developed policies for raising capital and listing shares overseas, three joint venture companies established Bermuda-based subsidiaries to issue and sell shares in US public offerings. Meanwhile, encouraged by the success of early H share issues, the authorities permitted selected Chinese companies to officially approach the US market. The first officially recognised and authorised Chinese company listing on New York was the Shanghai Petrochemical Company, in July 1993, for US$170 million. It was decided that the listings in New York would take the form of depository receipts, based on underlying Chinese Rmb shares, rather than being listed as US shares.

By the end of 1994, eight Chinese companies had established Level Ill or Rule 144A ADRs. Six of these were companies that already had H share listings. Shanghai Petrochemicals, the first, had a dual listing of an H share offering in Hong Kong and a registered public offering under a Level Ill ADR, traded on the New York Stock Exchange. The remaining five used privately placed Rule 144A ADRs, not tradable on NYSE or INASDAQ.' Further such ADRs (Level Ill or 144A) are expected from companies approved but not yet listed in Hor~gKong, and some of the H share companies already listed are likely to establish 'side-by-side' Level 1 or I1 ADR programmes to supplement the liquidity of the HKSE listings.1°

Another two companies, Shandong Power and Huaneng Power, launched ADRs which had no corresponding H share listings; the so-called 'N share"ADRs.There have been no simultaneous offerings of B shares and ADRs so far, but four B share companies have subsequently set up Level I ADR programmes to stimulateoverseas Characteristics of Depository Receipts

A Depository Receipt (DR) is a negotiable in this case new capital cannot be certificate evidencing ownership of a fixed raised. Level Ill, with rigorous number of shares, or fractions of a share, in disclosure, allows capital raising and a foreign corporation, based on a ratio set provides access to the broadest US by the issuing company. The underlying investor base and the most liquid US shares remain on deposit in the issuer's securities market. home market. DRs are quoted and traded in the currency of the country in which they Restricted ADRs: Privately traded; trade and are governed by the trading and Exempt from US SEC Registration settlement procedures of that market. Rule 144A ADRs (RADRs): these are DRs pursuant to Rule 144A, which was American Depository Receipts (ADRs) are adopted by the SEC in April, 1990. This the oldest form of DR. ADRs were is a 'safe harbour' rule which allows developed to address concerns of US companies to offer unregistered investors who were interested in investing securities to large institutional investors abroad but were reluctant to purchase known as Qualified Institutional Buyers foreign stocks. ADRs eliminate many of the (QIBs) who can resell these to other disadvantages of holding non-US securities QIBs, but not to US retail or public because they are quoted in US dollars and investors for at least two years. pay dividends in US dollars, thus helping investors avoid currency conversion cost Global Depository Receipts (GDRs): and risk. They trade on major US An offering of DRs that is available in exchanges in accordance with US clearing two or more markets outside the issuer's and settlement conventions. There are home country. several types of ADRs: Combinations and offshoots Unrestricted ADRs (sponsored Level I, 'Side-by-sider ADR programmes: With II and Ill): Publicly traded; US SEC this programme, first introduced in Registered 1991, a company establishes a publicly Sponsored Level I ADRs: These require traded Level one programme as well as minimal SEC procedures, and can only a privately placed RADR or GDR for trade in the over-the-counter (OTC) the same class of stock. This structure markets. A Level I programme cannot allows issuing companies to combine be used to raise capital in the United the benefits of a publicly traded States. After one or two years of Level programme with a RADR or GDR I trading, or when an outstanding ADR programme's usefulness as a capital- reaches 5%, companies typically raising tool. upgrade their ADRs to Levels II or Ill. American Depository Debentures .Level II and Ill ADRs: These ADR (ADDS): This represents debt rather programmes permit listing on an than equity. Since 1993, ADDS were exchange or on NASDAQ, and require offered in conjunction with rights compliance with 5EC registration and issues, which are convertible into exchange requirements. Disclosure ordinary shares or ADRs. requirements are lower for Level II, but Source: Bank of New York; World Bank demand for their shares. By the end of November 1994, the total overseas capital raised over 1991 to 1994 by Chinese companies amounted to US$ 3.73 billion equivalent of which US$1.35 billion was through B shares (36 per cent); US$ 1.13 billion through H shares which had already been listed (30 per cent) and US$ 1.25 billion (33.5 per cent) through ADRs or GDRs."

Table 5.1 Chinese companies with A DR and GDR programmes (December 1994) (and other China stocks traded on New York)

Listing Where Amount Offer 12/30/94 AlDR type date listed raised price Price (US$) (US$) (US$) - - - H shares Shanghai Petrochem 7/93 NY/SE/QI/H K $28 7/8 Level Ill Maanshan 11/93 Portal n.a. Rule 144A Yizheng 3/93 Portal n.a. Rule 144A Harbin Power 11 /94 Portal/HK n.a. Rule 144A Shanghai Hai Xing 11/94 Portal n.a. Rule 144A Qingling Motorsa 6/94 H WQIIPortal n.a. Rule 144A

N shares Shandong Power 6/94 NYSE $9 5/8 L.evel Ill Huaneng Power 8/94 NYSE $14 3/4 Level Ill

B shares Erfangji 12/93 OTC 1.evel I Chlor-Alkali 3/93 OTC Level I Shenzhen SEZ 8/94 OTC Level I Tire & Rubber 12/93 OTC Level I

Other China-related stocks (Bermuda shares) Brilliance China 10/92 NYSE EK-Chor 6/93 NYSE China Tire 7/93 NYSE

Notes : NYSE: New York Stock Exchange

QI:SEAQ International HK: tfong Kong "Chinese ADR. Sources: Bank of New York; World Bank International equity issuance can be beneficial to both issuing companies (and countries) and foreign investors. From the issuer's viewpoint, it expands the investor base, which can lead to a higher stock price and a lower cost of capital. It also provides new markets for raising funds, and enhances visibility of the issuing company and its products in international markets. From the investor's perspective, an international share listing allows share trading and dividend payments in convertible currencies; provides international diversification to institutional investors, which are often prevented by their charters from investing in foreign currencies (since ADRs, for example, are treated as domestic securities in the United States); allows convenient and dependable settlement and custodian services (especially in cases of cross-border settlements with dual listings), and meets standard disclosure requirements.

A potential drawback of heavy dependence on offshore investment, however, is that a concentration of trading in domestic equities abroad could slow the development of local capital markets. Nevertheless, studies have shown that an international share-listing programme (even for small numbers of issues) can produce an economy-wide benefit for the home country.12 This arises from the 'spillover'effect on the pricing of domestically traded securities.

The Performance of China's Overseas Equity Listings

Although H shares had higher average returns and lower volatility than B shares, H shares, like B shares, typically traded at discounts to their A share counterparts. Compared with H shares in the first wave of issues, those in the second batch experienced more difficult market conditions. For example, Luoyang Glass saw prices drop sharply on post-issue trading of its HK$660 million shares, and the issue by Shanghai Haixing Shipping was postponed because of weak demand. An H share offering by Tianjin Bohai , the last of the first batch of H share issues, was subscribed only 1.003 times, the lowest level for any H share offering. Although this is partly due to exogenous factors, the recent experience underscores the importance of solid and stable performance in the home markets.

In terms of shares listed and traded at New York, the early 'Bermuda shares', while successful at raising capital, have performed poorly in secondary trading, with share prices falling, on average, by 38 per cent by the end of 1994. The two N share Level Ill ADRs were also trading at a discount, of 29 per cent. By contrast, the one dual H share Level Ill ADR, Shanghai Petrochemicals, sold at a premium of 42 per cent. The poor performance of the N share ADRs has been attributed to the lack of dual liquidity with a regional Chinese market (such as Hong Kong) where investors have access to company information." The five 144A ADRs have yet to establish 'side-by-side' programmes with Level I or II ADRs, which would help liquidity and enable US investors to buy unrestricted ADRs of the same underlying share class (for example, H shares), thus countering any flowbacks of shares to the underlying (H share) market.

Other options for overseas listing of China's equities

New opportunities for international equity offering are appearing. From 1 January 1995, the Tokyo Stock Exchange (TSE) introduced reforms to its restrictive listing system, aimed at attracting listings by companies from Asian emerging markets, especially China. The liberalisation measures include:

reduction of the existing minimum requirements for shareholders' equity from 100 billion yen to 10 billion yen acceptance of an application for listing from companies that are not listed in their home countries abolition of the required minimum time period for incorporation before listing relaxation of the requirements for dividend payments, minimum number of shareholders, and financial disclosure, and, reduction in initial listing costs and listing appraisal charges.

Most of these deregulation measures are angled towards privatised companies, particularly Chinese infrastructure ventures with no track record as corporate entities.

The Singapore Stock Exchange also offers promise, in view of strong local investment interest in China. At present, no Chinese companies have been officially floated in Singapore, but there is one back-door listing, Cosco Investment, and one fund, Hoare Govett's China North Fund. London Exchange too is stepping up its efforts at attracting emerging market issuers. To this end a special depository receipt programme was set up in August 1994 to provide a less demanding means of raising capital than a traditional listing on SEAQ International (the exchange's computer-traded systems for international equities).14 A key concern with listing in new exchanges will be the degree to which liquidity can be expected (as in the case of the US China ADRs with no cross-listing). Cross-listing programmes may therefore be a good route to begin. Several companies are believed to be considering simultaneous offering of Singapore Depository Receipt programmes and B shares. Another general issue concerns the timing of new share issues, and the 'bunching' that Chinese companies have had to conform to, due to 'batch' government approvals. Greater flexibility in timing would permit better prices wherever the new issues are made.

China investment funds

Closed-end national index funds (or country funds) targeted at emerging capital markets shares have expanded considerably since the mid-1 980s. The value of such indirect investment vehicles, aside from the mobilisation of external resources, is that they also promote pricing efficiency in the originating stock markets.15 Since the introduction in 1992 of the first country fund targeted exclusively at Chinese stocks - the China Fund listed on the Stock Exchange of Hong Kong - a total of 18 China country funds had been launched by end November 1993, attracting some US$3.0 billion of foreign investment.

Like most other closed-end funds, these China funds have traded mostly at a discount to net asset value, with discounts ranging from zero to about 20 per cent over the last few years. Although some China funds initially commanded a premium, boosted by rarity value, the trend has been increasing discounts. The rising trend in discounts could be attributed to the fall-off in rarity value, with the rising supply of Chinese equities, but also, to sluggish performance in the home markets in Shanghai and Shenzhen since late 1993.

Moreover, as Figure 5.4 indicates, the relative performance of China's closed-end funds, initially superior to other emerging markets, deteriorated. This is confirmed by an analysis based on a selected group of China funds, which had average annual returns of 9.4 per cent in the third quarter of 1 994.16 This was considerably lower than many other funds, especially those for Latin American countries, but fared better than the large emerging Asian economies of India (6.5 per cent) and Indonesia (5.7 per cent) during the same period. The deteriorating performance of China funds, like many China equities listed on overseas exchanges, which have traded at discounts to their offer price, re-emphasise the importance of first strengthening the domestic market. China shares are no longer a novelty on the overseas market today, and their attractiveness to overseas investors will depend on the performance and intrinsic value of the companies listed. Table 5.2 China closed-end counfry funds: discounfs/premiums (per cent difference from net asset value to share price)

China - equity funds % Discount/Premium 5/31/92 11/30/92 5/31/93 11/30/93 5/31/94 11/30/94

BOC China Fund Ltd. CH China Investments Ltd. China & Eastern Inv Co. China Fund (HKSE) China Fund Inc. China Invest & Develop Fd China Investment Company China Investment Trust Equity Fund of China Fleming Chinese Inv Trust HSBC China Fund Ltd. Jardine Fleming China Inc Jardine Fleming China Ltd Lloyd George China Shanghai Fund (Cayman) Shanghai Growth Inv. Ltd. Templeton China World Fd Templeton Dragon Fund Inc

Source: World Bank

Figure 5.4 Country funds - average discount

I +China --Emerging global +India +South Korea 1

Source: Lipper Analytical Services; World Bank Opening of Fixed-Income Securities Markets

One of the most notable recent developments in the cross-border flows to developing countries is the growing portfolio investment in local currency- denominated fixed income securities. High real interest rates in some developing countries, often the outcome of external credit constraints or tight monetary policies, have attracted international investors seeking high return alternatives in the emerging domestic debt markets. Latin American countries such as Mexico and Argentina have had high foreign participation in these markets.17

Among emerging Asian markets, Korea, with more than US$100 billion equivalent of local currency bonds outstanding at the end of 1993, has the largest fixed income market, but until recently it had been closed to foreigners. In July 1994 Korea partially opened its bond market, to foreign investment in convertible bonds of small and medium-size companies listed on the Korean Stock Exchange. Other Asian markets are relatively open to foreign investors but have much smaller fixed income securities markets.18

The nature and potential impact of cross-border flows differs between equities and fixed income securities. On the one hand, bond investment raise no sensitive issues of foreign control of domestic industry (an argument raised against the complete opening of stock markets). But on the other hand, foreign investment in fixed income securities tends to be volatile, reflecting the global (as well as host) market situation, and thus undermining the stability of domestic markets and effectiveness of monetary control. In the long term, despite the macro-economic management issues (particularly in monetary control) raised by portfolio inflows, foreign participation in local currency fixed income securities can contribute to the deepening of domestic financial markets and to the reduction in the cost of capital in the recipient economies. For instance, bond yields have declined by some 300 basis points in Malaysia and the Philippines since foreign portfolio investment took off in early 1993. But effective mechanisms for monetary control should be in place first to afford protection.

Compared with other emerging Asian market economies, China's fixed income securities markets are fairly large. Primary money and bond markets reached Rmb300 billion or US$25 billion equivalent at the beginning of 1994. Unlike stock markets, money and bond markets in China remain closed to foreign investment. In view of the large and growing needs of China's real sector, global participation in its financial markets is an important question. But the benefits of increased foreign investment must not be outweighed by the costs of reduced stability and autonomy.

As discussed in Chapter 3, China's fixed income securities markets today require further strengthening in a number of areas. Given the current weak infrastructure in money and bond markets, it would not be advisable to proceed with direct foreign investment in Rmb denominated fixed income securities within the medium term. The financial crisis in Mexico in late 1994 also underscores the importance of an adequate policy framework, in tandem with the liberalisation of short-term capital flows. China must first strengthen its domestic securities markets, dealing with the issues raised in Chapter 3, including the lack of a market-based benchmark, due to irregular government bond issues, administered or below-market rates; illiquid secondary trading, itself partly due to instrument design, interest rate controls, and the absence of institutional investors; and regionally s.egmented bond markets, due to the absence of a central depository or mutual recognition of certificates of ownership.

The first steps are therefore to develop money market instruments to conduct efficient policy actions, such as sterilisation, to deal with large inflows of foreign capital. In parallel, domestic bond markets should be strengthened, and domestic bond instruments expanded, to longer maturities, more sophisticated structures (such as convertibles), and more non-government issuers. As a long-term objective, China may follow a gradual and sequential approach to bond market internationalisation, such as the approach adopted by Japan (1 970s) and Korea (1 990s). Partial and/or indirect opening would be a prudent first step. Specific types of instruments (convertibles, non-guaranteed), maturity ranges (longer end), and eligible sectors could be considered, with additional safety features such as restrictions on resale or holding period conditions during initial phases, to mitigate any adverse impact on the market and economy. A closed-end fund for total currency bonds during initial phases is another possibility for the early phase of market opening.

China's Access to Overseas Securities Markets

International financing activities by developing country borrowers are being increasingly dominated by securitised arrangements, such as bonds, as opposed to loans. This reflects in part the increase in securitisation in global capital markets. Developing countries raised US$53 billion (gross) through bond issues in international capital markets in 1993, more than twice the amount raised in 1992. Low interest rates, particularly dollar rates, and improved creditworthiness in many developing country borrowers contributed to that surge.lg

Overseas bond issues

China's access to international capital markets has expanded substantially in recent years, emulating the global trend. The annual volume of new overseas bond issues has grown remarkably fast, expanding from less than US$200 million a year, on average, over 1989-91, to over US$2 billion per year for 1992-94. In 1994 overseas bond issues reached US$3.5 billion, an all time high. In terms of currencies, China's overseas bond issues have been concentrated in two currencies, the Japanese yen and the US dollar. Currency denomination of new bond issues has recently shifted away from the yen, which was the dominant currency before 1992, to the US dollar, due to the combined effects of the strengthening yen and relatively low dollar interest rates. In terms of rate structure, recent historically low interest rates in major markets led to a concentration of new issues in fixed rates (70 per cent). The average maturity of new bond issues has increased every year since 1991. In 1994, new US dollar bonds had an average maturity of 9.3 years, compared to 5 years in 1 992.20Yen bonds in 1994 averaged close to seven years, compared to around five years in 1992 and 1993. Although growing, these maturities have not yet achieved the levels desirable for long gestation infrastructure projects.

Figure 5.5 International bond issues by Chinese borrowers: currency, type and maturity

US$ million equivalent Years to maturity

Source: Eurornoney Bondware; World Bank (IEC) Interest spreads on new issues, on average, have had some downward trend since 1989 until late 1994. While lower interest rates in the early 1990s partly reflect declining global interest rates, it is interesting that the relative spread on new issues for China, compared to other emerging markets, is low. In 1994 China enjoyed lower spreads than lndia or Thailand, (although not as good as Korea), and also countries outside the region, such as Hungary and Mexico (before its ~risis).~'The favourable terms enjoyed by China until recently reflect in large part its good macro-economic perf~rmance.~~Following the Mexico crisis, developing countries as a whole witnessed some decline in their terms. In the case of China, there was some deterioration in secondary market prices on bonds.23

Table 5.3 Average spread on floating rate medium and long-term bond issues (Basis points)

China Hungary lndia Korea Mexico Thailand

Source: World Bank, lEC

Chinese overseas bond issues

Chinese bond issuers have diversified their currencies and markets. Aside from the new entries to Yankee bond markets and continued Samurai issues, China entered the Dragon bond (Hong Kong dollar denominated) market for the first time in October 1993, with a $300 million ten year issue. China's first Dragon was also the first sovereign issue in this market and the first with a maturity of ten years. With Moody's rating of A3, it was also the lowest investment grade in this market. After a six year hiatus, China returned to the market in September 1993 with a five year Rmb30 billion issue to finance infrastructure projects.

In early February 1994 China launched a $1 billion ten year global bond issue; the largest global dollar bond issue by a developing country so far. It was China's second Yankee bond issue, following CITIC's pioneering ten year issue in 1993. Despite the slack market, due to recent US rate hikes, China's first global issue was well received. The benchmark Chinese offering was priced to yield 85 basis points over the comparable US Treasuries. There have been five international sovereign bond issues up until the end of 1 994:

DM30 million issue in October 1987, which was fully repaid in October 1992 Rmb30 billion five year Euro-yen issue in September 1993, carrying 5.375 per cent coupon; $300 million ten year Dragon issue in August 1993, with 6.125 per cent coupon; $1 billion ten year global issue in February 1994, with 6.5 per cent coupon; and Rmb6O billion Samurai issue in July 1994, in two tranches (Rmb30 billion, five year maturity, and 4.4 per cent coupon, and another of Rmb30 billion, ten year maturity, and a 4.95 per cent coupon).

Within the total borrowing approved in 1994 ($1.5 billion), the choice of specific markets is based on the combined considerations of, relative prevailing rates, listing costs, issue and listing processes (for example, the Euromarket is usually considered to have a simpler listing process), general market recognition and reception (Asian markets are relatively favourable to China), diversification and market liquidity. International bond issues by the state government are conducted and managed by the MOF.

Chinese borrowers remain relatively inactive in convertible bonds and bonds with derivative elements. Only three issues have been launched: China Textile Machinery's $23 million equivalent of SFR-denominated five year , in November 1993, and two separate seven year US dollar bond issues, with a 'put'option, by Shandong Industrial Trust & Investment in July 1994 ($130 million) and September.1994 ($1 50 million).

China's credit rating enjoys an above-investment grade by all major rating agencies. The country's sovereign rating was upgraded to A3 by Moody's in September 1993, thanks to the agency's assessment of its strong potential to attract foreign investment, low external debt burden, and likely 'soft-landing' for a successful transition to a more advanced market economy.24This was followed by a similar upgrade for three major financial institutions; Bank of China, CITIC, and People's Construction Bank (Appendix Table A5.4).

Looking at the domestic organisation of overseas bond issues, these, like other securities issued, still form a part of the annual credit plan, and specifically, part of the foreign borrowing quota. The allocation is carried out in consultation with the People's Bank of China. Priority is usually given to the central government- and 'pre-approved' SPC projects; unallocated portions are then distributed to provincial borrowers, and other Chinese entities. Approvals are also required by the State Administration of Exchange Control for medium to long-term issues. The SAEC imposes stricter controls on bond issues, relative to commercial loans and short-term debt. Convertible securities are regulated by both the SHEC and the CSRC.

China's international bond issues have been carried out by certain financial institutions comprising selected banks and those trust and investment corporations authorised to engage in international operations. By 1993, around ten such institutions had been authorised, referred to as the 'ten windows.' The 'windows' act essentially as intermediaries, who on-lend to domestic end-users (although a portion of their borrowing is for their own use). Among the 'windows,'ClTlC and the Bank of China (BOC) have been the most active. In the late 1980s, these were the only two institutions issuing debt. Gradually, the government's authorisation of additional bond issuers has reduced their share, which in 1994 accounted for 29.7 per cent of all Chinese external bond issues (or 55.6 per cent of non- government bond issues).

These domestic procedures raise certain issues. First, it is difficult to ensure that proceeds from foreign bond issues eventually go to the projects with the highest returns. Allocation of the 'residual' quota among provinces suggests, rather, that distribution criteria and bargaining elements could be introduced. On-lending' terms for overseas loans to eventual domestic borrowers do not appear to be clearly defined and may not be governed by creditworthiness considerations alone.

Second, the merits of 'window-based' overseas borrowing requires careful thought. While this approach may accrue benefits to China, mainly in the form of cost savings due to the higher credit standing of some windows in the international capital markets, the system also has disadvantages. Some windows have weak balance sheets leading to cost ineffectiveness, and market absorption could also be an issue. Exclusive emphasis on the windows can encourage back-door financing activities, such as inducing offshore borrowing by Chinese enterprises through their foreign subsidiaries. Greater direct access by non-windows to overseas funding should therefore be encouraged for more efficient resource mobilisation and allocation. Since 1993, the authorities have been considering a more pragmatic approach, which allows domestic enterprises direct access to overseas bond markets. Yet as Appendix Table A5.6 indicates, this plan has not been actively implemented. Direct bond issues by manufacturing enterprises have been rare, and bond issues linked to specific infrastructure projects are unknown,25 although increased flexibility has been afforded to some institutions (including CITIC) in the execution of individual borrowing programmes within the quota. A limited role has also been conceded to internal credit rating agencies in assessing the financial adequacy of borrowing entities. Increased direct market access would be advisable, with international creditworthiness being the principal criterion for selection.

Role of credit rating for developing country bond issues

Developing countries' desire to gain access to overseas funds has fuelled formal rating activity by international rating agencies. The assignment of investment grade credit ratings to developing countries by international rating agencies such as Moody's and S&Pfs has allowed these countries to raise resources from industrial country institutional investors (including pension funds and insurance companies). Stipulated portfolio allocation guidelines by the trustee of institutional investors often do not permit investment of asset portfolios in less-than-investment-grade securities.

The proliferation of developing country bond issues was supported by the more active participation of rating agencies. In addition to the two above-mentioned agencies, these include Fitch, Duff and Phelps in the United States; Japan Bond Research Institute (JBRI),Japan Credit Rating Agency Limited r:JCR), and Nippon Investor Service (NIS) in Japan; and IBCA, the only cross-border rating agency that is based in Europe and specialises in the rating of financial institutions.

An increasing number of non-sovereign developing country borrowers are also being rated, as established issuers diversify funding sources and access a wider investor base and as new borrowers enter the market. As emerging-market issuers shift from the Eurobond market (where formal rating is not required) to other international bond markets, demand for ratings is rising. For example, issuers entering the Samurai market have all been required to obtain ratings (from Japanese rating agencies). Ratings are not formally required in the Yankee bond market, but because a credit rating provides investors with a standardised benchmark for evaluating bond issues, several developing country borrowers in this market have acquired ratings. In the primary issue market 18 per cent of total bond issues by developing country borrowers were rated by Moody's and S&Pfs in 1993, compared with 15 per cent in 1992, and this shift toward rated issues is continuing. As the first among the international rating agencies, Moody's opened its Hong Kong office during the summer of 1994.

Figure 5.6 China: international syndicated loans

US$ million 7000 Yen

6000 FFR 5000

4000

3000

2000 [3 Lit 1000

0 1990 1992 1992 1993 1994 (end July)

Source: Eurornoney Loanware

Syndicated loans

Syndicated loans to Chinese borrowers rose in tandem with new international bond issues, reaching US$7.3 billion (equivalent) in 1993, compared with less than US$3 billion in 1991. The firming trend was sustained during the first half of 1994, exceeding US$4 billion through to the end of July. The continued buoyancy in international commercial banking flows to China is noteworthy because the global trend has been the slowing of new bank loans. Most commercial banks in major industrial countries have becomeextremely selective, at least during 1993, in extending new credits in the aftermath of the of the early 1980s; their capital adequacy ratio has been under pressure and profit margins squeezed. This certainly bodes well with China's track record (ie, no history of loan rescheduling) and impressive macro-economic performance and thus market creditworthiness.

China's new commercial bank credits have been arranged largely in US dollars, unlike new bond issues which have been more diversified between dollar and yen. Also in contrast with international bond issues, the average maturity of syndicated loans for Chinese borrowers has been progressively shortened during the 1990s: from 8.4 years in 1990 to 5.5 years in 1994. This partly reflects some international banks (especially Japanese)concerns over large Chinese exposures built up during the period.

International syndicated loans to China are increasingly linked to project financing largely in support of infrastructure projects, and this trend will be likely to intensify in the coming years. While estimates vary considerably, infrastructure financing cost for China could amount to hundreds of billions of dollars by the end of the decade. The Three Gorges project for the world's largest hydro dam is a good example, which alone would cost US$24 billion, with as much as 80 per cent of the total cost to be financed by foreign resources. Greater activities in limited recourse project financing such as build-operate-transfer (BOT) schemes are anticipated to be the main vehicle to mobilise funds from commercial banks, which are less willing to engage in long-term financing.26Malaysia is one of the countries more actively implementing BOT schemes by making them a major component of its privatisation programmes. Earlier in 1994, IFC helped launch Peregrine's planned US$1 billion Asian Infrastructure Fund with Chinese projects being the main focus, emulating the AIG-sponsored Asian Infrastructure Fund. Efforts to structure infrastructurefinancings for China have been going on widely: JP Morgan recently arranged an innovative US$80 million syndicated loan deal for a coal-fired plant providing 15-year debt, with the last five-year maturities guaranteed by the World Bank.

Figure 5.7 China: maturities and spreads on international syndicated loans

Years Basis points

6 ...... -. -Am-+- 100 ..- .I.. .-., :.

-&China - -C - -Hungary - -+- -All currencies -US$ - - -A - - HK$ - - -A - - India SKorea

Source: Eumrnoney Loanware and World Bank Staff estimates ~ The State Development Bank (SDB), one of the three newly established policy banks (the others are the Export Import Bank of China and Agricultural Development Bank), has been designated with managing two-thirds of China's infrastructure financing needs. The SDB is therefore expected to play a major role in developing an environment conducive to foreign investment. While the SDB funding will come primarily from the issuance of domestic bonds, the first SDB mandate that involves a foreign currency component is the US$350 million Qinshan nuclear power plant in Zhejiang Province, based largely on OECD export credits.

In summary, the large volume of syndicated loans extended to Chinese borrowers in recent years reflects good credit perceived by risk-conscious international commercial banks, adding to the greater diversification of China's external funding source. And there is nothing inherently wrong with this form of financing to the extent that the fund is used productively and is well managed. In view of a growing need for longer-term financing, overseas financing must be structured adequately to meet this changing need (eg, extending maturities with IF1 guarantees). Mexico's recent problems highlight the need for a prudent macro- level asset-liability management. Viewed from this perspective, more active bond issues, vis-2-vis bank loans, should be considered.

Trading in Derivative Instruments on lnternational Markets

The trend towards global financial integration has been accompanied by an explosive growth is the use of derivative financial products. These financial instruments can be used for risk management, for lowering the cost of capital, or for spe~ulation.~~Developing country involvement in derivatives has so far been modest due to a combination of several factors: regulatory barriers, small and unsophisticated financial markets, and little demand for risk management tools in the presence of implicit government guarantees. Yet this market has been witnessing rapid growth, in unison with the growing integration of developing country financial markets into the global market.

International trade in derivatives of financial securities

While the development of markets in financial derivatives is a vital part of any well-functioning capital market, due to the need for effective risk-management tools, the development of derivatives also gives rise to systemic risk issues. This sometimes prompts regulatory authorities to clamp down on domestic derivatives activity, but the typical consequence is that these markets move off-shore to circumvent legislation. The appropriate approach therefore is not to restrict their emergence, but to create appropriate guidelines for the prudential regulation of derivatives activity.

The prevention of systemic risk is of concern to financial authorities, and also of concern to market participants. One complicating factor is the typically huge size of the OTC market worldwide, which makes supervision and controls difficult because of the off-exchange and bespoke nature of the contracts. International guidelines have evolved to deal with the issue of systemic risk. Since derivatives activity of banks is off-balance sheet, the imposition of the 1988 Basle capital adequacy requirement to account for off-balance sheet positions of banks has been an important step in this direction. Capital has to be set aside to cover credit risks from the risk-adjusted asset positions of banks as they relate to their derivatives exposure. The contracts are marked to market (ie, periodically revalued at current market prices) to determine credit exposures of each bank. Disclosure requirements are also an important element of the evolving regulatory framework, so that market participants realise, and hence limit, their exposures. There is also an effort towards legal recognition of netting procedures to establish exposures between counterparties. (Bilateral netting reduces the replacement value of the positions between two parties to their net, rather than gross, obligations).

At the level of participating firms, regulators suggest imposing strong internal risk control procedures. The recent well-publicised cases of trading losses related to derivatives (such as Codelco, the Chilean copper company, Metallgesellschaft, Proctor and Gamble, Barings) all involved to a lesser or greater extent the lack of proper internal risk control programmes. The management of any firm engaging in derivatives has to enforce limits on aggregate positions, aggregate credit risk and capital at risk. 'this would imply restrictions on the level of autonomy given to the desk traders and the appropriate supervisory infrastructure for the management to effectively monitor the activity of the trading desk.

China's involvement today in the domestic trading of derivatives of financial securities consists mainly of Treasury bond futures, traded on the Shanghai Securities Exchange. The enormous burst of activity in the trading of futures in government treasury bills in February 1995 is detailed in Chapter 3. The government is aware of the need to better regulate derivatives activities; and new regulations on futures trading were published in the same month (see Chapter 2 for details). The need for tightened regulations is particularly acute in view of the plans in 1994 to widen financial futures. The Shanghai Securities Excha~ge planned to start trading financial options, for which government approval had been given.28There are no equity-linked futures (eg, stock index) or foreign exchange futures in China. Foreign investors are currently prohibited from trading commodities and financial derivatives in China.

In the international arena, since several large loss-making incidents by Chinese enterprises through overseas derivatives dealings in 1994, financial operations in international derivatives markets grew more tightly controlled. Financial derivatives are under the jurisdiction of CSRC (Futures Department). Overseas derivatives activities by Chinese entities are usually confined to exchanges acceptable to the CSRC, such as the CBOE (Chicago Board Options Exchange) and clearing members of the exchanges. Large financial institutions are considering the use of overseas derivatives to hedge risks associated with international bond issues. An expansion of involvement in these areas is inevitable, in view of the deepening domestic , and the increasing international integration of China's securities markets, and the government should, with appropriate precautions, encourage its development for risk-management capacity (hedging) rather than speculative trading.

For China, therefore, the appropriate policy stance is one which encourages the development of derivatives markets, but with appropriate risk control procedures in place. This includes compliance with capital adequacy standards, disclosure rules and the recognition of netting procedures. It also requires the adoption by participants of the principles for prudential internal risk reduction programmes, such as limits on positions, credit exposures and capital at risk. Finally, it requires a sound internal risk supervision system which would monitor trading activity in derivatives by these firms. In terms of sequence, however, the development and strengthening of underlying (cash) securities markets should be given first priority.

Endnotes

1 Moreover, from a macro-economic standpoint, the positions are very different. China has a healthy external payments situation, no significant exchange rate distortions, and a current account surplus in 1994. Even when the current account has been in deficit, deficits have rarely exceeded 2 per cent of CDP. An analysis of the range of macro-economic consequences of foreign capital inflows is omitted here. Recent US Department of Commerce studies (Survey ofCurrent Business, various issues) suggest that rate of return on FDI in East Asia (including China) has been consistently large at over 25 per cent, more than double the worldwide returns on FDI. According to sources in China, the introduction of B shares was virtually necessitated by the pressure of demand for Chinese shares from overseas Chinese, and especially, Hong Kong Chinese. The introduction of B shares provided a first safeguard against means of seeking illegitimate investment in the local market. The lack of double-taxation treaties with most source countries further curtails the interest of foreign portfolio investors in China's equities. Data for this section were obtained from the World Bank, and from the Bank of New York, which has been particularly active in launching Chinese ADR programmes. Again, legalisation followed the fact, as backdoor listings on Hong Kong through local subsidiaries, the so called 'red chip'shares, had already begun to occur. A second batch of 22 companies had been approved for listing in 1995, but a series of delays reduced the total number of new listings in 1995 to only five, with a total value of US$60 million. However, the pace resumed in 1996, and in the first six months of the year, around US$450 billion had been raised on the Hong Kong market through ten H share issues by six Chinese companies. One of these, Qingling Motors Company, launched a CDR programme for the first time as a Chinese issuer (July 1994). A step already taken by over 60 major and many medium sized companies listed at Hong Kong. These figures are approximate. For ADRs and CDRs, details of capital raised through the private placement 144AADRs are not all available. For H shares, where data are from the World Bank data base, details are not provided for all 15 companies. For example, Eun, Claessens, and Jun(1 993). It is shown here that to the extent that internationally traded securities' prices are correlated with those of domestically traded securities (which is the case with Chinese shares, although the degree of correlation is not very high), the firms represented by the latter could 'ride free' and benefit in terms of higher securities prices and lower cost of capital. New York specialist firms have complained that trading is too thin to even fix an opening price, and they must wait for matching buy and sell orders, which may take several hours. SEAQ accounts for 60 per cent of all share trading outside home markets, with over 470 companies quoted. Diwan, Errunza and Serbert (1993). Appendix Table A5. 3. A group of 13 'best performing' funds, for China . This was most noticeable in Mexico, where foreign investors held more than US$23 billion in Mexican government securities (one-third of the entire market) by the end of the first half of 1994 (a rapid build-up from US$1.8 billion in 1990). Most holdings by foreigners were in short-term government paper (cetes), dollar-linked securities (tesobonos), or in the medium-term, floating rate Mexican government bonds (ajustobonos). Foreigners have also been active in Argentina's fixed income markets, traditionally favouring bonex (dollar-denominated government debt), although peso-denominated bocones were popular in 1993 because they could be used to buy shares in the newly privatised companies. Brazil's bond market is large, but restrictions on foreign participation have constrained foreign investment. 18 Malaysia's market had outstanding ringgit bonds of about US$27 billion equivalent in 1993, and Thailand had about US$6 billion equivalent of baht-denominated bonds, but with little secondary market activity. Some market sources report US$5 billion of new inflows into the fixed income market in Malaysia and US$1.5 billion in Thailand in 1993. 19 Almost half the total went to issuers in Latin America, with the remainder going in almost equal proportions to borrowers from Europe and East Asia. The bulk of the borrowing has been in the Euromarkets, mainly the Eurodollar market. 20 Looking at major new issues, dollar bond maturities stretched from seven years in November 1992, for the People's Construction Bank of China, to ten years in July 1993, for a ClTlC Yankee issue, and to 20 years in March 1994, for the Bank of China. 21 An adequate set of comparable data for each year and country, in terms of currency of issue and maturity does not exist, and the table is therefore based on a specific bond type, the floating rate bond, for medium and long bonds. 22 A recent study suggests that the price of developing country new bond issues is strongly affected by macro-economic performance (Junand Mahajan; 1994). Four determinants of bond risk premia are statistically significant in this study: reservesldebt ratio (-); variance of reserves (+); inflation rates (+); and real CDP growth rates (-). 23 Since China's overseas bond issues are not traded on the exchanges, but are traded largely over the counter between major international investors, the measurement of the true deterioration in these terms is difficult. 24 At this time, Moody's rated Argentina, Brazil and Mexico, as well as Venezuela, Turkey, Pakistan and Hungary, below investment grade. Chile, Colombia, India and Indonesia were investment grade but below China. However, three Asian emerging economies enjoyed higher ratings; Korea (Al), Malaysia and Thailand (A2). (Appendix Table A5.5) 25 Although Chinese authorities claim that a substantial part of the proceeds from overseas bond issues are used for domestic infrastructure projects, it is difficult to assess the extent to which this occurs (since each bond issue effectively 'bundles' a number of loans to infrastructure projects), or its effective cost to the final borrower. 26 Limited recourse project financing refers to independent project financing where the balance sheet of the sponsor is not exposed (or only exposed in a limited way) to the project's risk. 27 Derivatives enable the underlying (from which they 'derive' their value) to be stripped of various dimensions of risk, which are then packaged and marketed as new instruments. Derivatives can be broadly classified as forward-based (eg, futures, forward rate agreements, swaps) and options-based (eg, options, caps, floors, collars). 28 The Shenzhen Stock Exchange expressed an interest in a currency . There has been a currency market which has received some recent setbacks, and traders had expressed interest in establishing a currency futures market, which has, so far, been resisted by the authorities.

CHAPTER 6

Institutional Investors and Securities Markets

As the, previous chapters illustrated, China's securities markets are characterised by relatively low liquidity and high volatility. The behaviour of investors tends to be speculative and oriented towards short-term returns. Among the factors which give rise to such characteristics is the investor profile, which is biased towards small retail investors. The absence of professional investors in China is notable even relative to other emerging market economies. Increased participation by institutional investors such as insurance companies, pension funds, and mutual funds, would stabilise the market. The focus of the present chapter is an analysis of the reasons for the limited participation of institutional investors in China, and suggestions for how such participation could be increased. '

A first difficulty concerning the participation of institutions for contractual savings in the securities market in China, is that such participation has been limited by restrictive regulations. Appendix B1 discusses investment patterns oi contractual savings institutions in other countries: developed and developing. In China, such institutions have been obliged to invest their resources in a combination of government securities and bank deposits, which have often paid low or sometimes negative rates of returns. Aware of the consequences of such restrictions, the government is considering the gradual lifting of these constraints, with appropriate safeguards against speculative investments that may lead to large-scale losses for individual savers. Yet China's contractual savings institutions today also face a second serious handicap; the problem of low relative levels of contractual savings, of only three per cent of GDP. This is an apparent anomaly in a country with a notably high savings rate. While it is true that China is a low-income country, contractual savings as a proportion of GDP in China are much lower than other developing East Asian countries, such as Korea (1 8 per cent), Malaysia (48 per cent) or Singapore (78 per cent). A primary reason is that under the system of central planning, the state assumed the functions of providing pensions, housing and social security primarily through state enterprises. Services such as domestic How do institutional investors benefit securities markets?

Contractual savings institutions such as modernisation of securities markets. life insurance companies and pension In some countries, institutional funds can: investors have played an important mobilise long-term financial part in facilitating privatisation resources. Their investments can programmes. They can also: increase the demand for long-term help ownership dispersal, and bonds and equities. Mutual funds stimulate greater corporate efficiency mobilise relatively short-term by monitoring the performance of the funds, but they pool the resources companies in which they invest. of many smaller investors. lnstitutional investors with large Institutional investors can increase shares in individual companies can the effective demand for exert control over corporate marketable securities. management. They can provide professional investment and management These beneficial effects will materialise services, and thus higher long terms only if institutional investors face the returns to their clients. right types of incentives. For instance, As professional investors, their their impact on market liquidity will managers may exert pressure for depend on whether institutional better standards for accounting and managers are encouraged to trade auditing as well.as for more actively or to acquire long-term meaningful and timely disclosure of strategic holdings. Their impact on information to investors. corporate performance will depend on They may also encourage improved their ability to collect information brokerage and trading arrangements about corporate performance and then and help establish more efficient and analyse the prospects of individual reliable clearing and settlement companies and sectors. Their facilities. contribution to ownership dispersion lnstitutional investors may further will depend on the extent to which encourage and laws encourage closely-held efficiency. In sum, institutional companies to accept a dilution of investors may stimulate the control.

insurance were not permitted. With the transition towards a market economy, China today has to face the problem of how to build up such institutions. The emphasis of the present chapter is therefore on the second and more structural problem of building up efficient vehicles for contractual savings. This chapter discusses the current situation and future potential and options facing the principal types of contractual savers and potential institutional investors in China; the insurance industry, the pension system, housing funds and mutual funds. The growth of contractual savings in different countries

High income countries with relatively Large accumulated long-term finan- low social pensions: (USA, UK, Canada, cial resources. Australia, New Zealand, as well as some Relatively large contractual savings. European countries, such as Denmark, the Netherlands and Switzerlandl Developing countries with partially funded pension schemes: (Brazil, Indo- These countries rely mostly on funded nesia, the Philippines, lordan and Turkey) occupational schemes for supple- mentary pensions. These countries have partially funded They have experienced a rapid private or public pension schemes, growth of contractual savings. and the size of their assets in relation Institutional investors play a dominant to total financial assets is not very part in these countries' capital mar- large. kets. Developing countries with Pay As You High income countries with relatively Go pension schemes: (Most Latin Ameri- high social pensions (France, Germany, can, Eastern European and Central Asian Italy, Austria). These countries are char- countries) acterised by: Relatively underdeveloped occupa- In contrast, these countries have pay- tional pension schemes. as-you-go pension systems that make Lower contractual savings. little or no contribution to the accu- Limited role of institutional investors. mulation of financial savings.

Developing countries with funded pen- Source: World Bank sion schemes: (Singapore, Malaysia, Egypt, Cyprus, Chile and Zimbabwe)

The principal conclusions of this chapter, regarding the different segments of China's contractual savings are first, that the insurance industry is growing rapidly but is still dominated by the People's Insurance Company of China (PICC). It is still structurally biased towards non-life insurance, which provides relatively shorter-term funds for investment, compared to life insurance. While both the life and non-life business appear relatively well managed, the restrictions on investment, and lack of profitable financial investment opportunities, in the face of the relatively high inflation rate, lower the real financial performance of PICC. Yet, the insurance industry is better poised today to potentially contribute investible funds to China's capital markets in the medium term than pension funds. These may take time to emerge as a reform of the current unfunded pension system and reduction of its high contribution rates may first have to be undertaken. Such a reform programme is unlikely to be implemented in the short run. While the

The three segments of institutional investors: pension funds, life insurance and mutual funds I

Size of life insurance Size of mutual pension funds and pension funds

Growth of pension funds Total assets of life insurance Net assets of mutual funds (% GDP): companies and pension funds (% GDP, 1993) (1990, % GDP) Singapore (1 976-86) 28% to 73% France Malaysia 11980.87) 18% to 41% UK 97% USA Chile (1981-90) 1% to26% USA 75% 1 UK Singapore 78 % lapan 11% Malaysia 48% Korea 21% Chile 30% India 12% Korea 18% Mexico 5%

Factors behind the growth of contractual savings:

coverage contribution rates (wage growth returns to investment. eg Chile: mandatory personal pension plan introduced in 1981 high returns in the 1980s, averaging 13% per year. USA, UK (1980s): Large rise in stock market prices. Switzerland, Netherlands: Expansion to near universal coverage of working population by funded pension schemes.

The slower relative growth of mutual funds is due to their voluntary nature. Pension fund participation, even if not mandated by the government, is usually compulsory at thecompany level. Growth in mutual funds has been stimulated by the development of money market funds, bond funds, and recently, in developed countries, by low deposit interest rates.

Source: World Bank difficulties of China's pension system are sometimes attributed to its enterprise- based nature, the real drawbacks of the system lie with the complete reliance on pay-as-you-go schemes. Today pension funds have negligible accumulated balances to invest in capital markets, and the building up ofthese balances through pension reform must occur before their serious participation in capital markets can begin. Meanwhile, other contractual savings funds are beginning to take shape but are still very small. Housing funds are effectively still forced saving schemes with very low real returns and with little incentive to attract investors' funds. Prospects for mutual funds have been constricted by the lack of an appropriate supervisory framework, and ad hoc changes in the regulations they face, reflecting the government's concerns about their possible effect on diversion of bank deposits. Strengthening the macro-economic environment is a requirement for encouraging their growth. Measures to strengthen the development of the contractual savings industries are discussed in each section.

The Insurance Industry in China

Prior to 1979, the insurance industry in China was limited to only a small volume of foreign insurance, mainly marine cargo and aviation insurance. All types of domestic insurance, including life insurance in particular, had been banned since 1959. A first observation on the development of the industry is that insurance business has experienced phenomenal growth since 1979, driven by the radical transformation of the Chinese economy (Figure 6.1). In 1993, total annual premiums are estimated to have doubled, and life premiums trebled.

Figure 6.1 China: insurance premium growth (1 986 - 1992)

--r inn

1 Source: Niu (1 994) I Yet, the second key observation is that relative to other countries, including countries in Asia, the industry is still poorly developed (Figure 6.2). These countries illustrate that apart from income levels, the development of the insurance sector is also related to factors such the regulation of the industry, especially to permit competition, including foreign entry. Countries which have allowed market forces to play a greater role in their domestic markets and have encouraged greater integration with international markets through freer retention policies and freer entry of foreign companies have experienced high growth of their insurance markets (Appendix Table A6.3).

Figure 6.2 China: infernafional comparison of insurance premiums (1992)

Asia Africa Korea Japan South Africa Taiwan Malaysia Zimbabwe Singapore Philippines Kenya Thailand Morocco China 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 % GDP % GDP I Latin America I Brazil 1 Panama Chile Venezuela Uruguay Colombia Argentina Mexico 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 % GDP

1 Source: Sigma, ce in 1992, Swiss Company, March 7994

Although there are signs of new competition in the insurance industry, it is dominated by the state-owned People's Insurance Company of China (PICC) which in 1992 held over 90 per cent of the market.2 There are a total of 24 companies in China but most of these are regional and are partly owned by PICC. Most were regional branches of PlCC that were transformed into separate subsidiaries with partial ownership by local interests, notably banks, during the 1980s. Two independent domestic companies also exist, which are evolving toward competing and innovative nationwide insurers. China Pacific lnsurance Company (CPIC), which has its headquarters in Shanghai, is owned by the Bank of Communications, and the Ping An lnsurance Company (PAIC) of Shenzhen is jointly owned by a group of banks from Shenzhen and Hong Kong and the Chinese Merchants Group in Shen~hen.~With the opening up of domestic insurance and the growth of competition, PlCC modernised its operations in the 1980s, introducing new products, computerising its data processing and improving overall efficiency. The number of household policies increased from 30,000 in 1 980 to 1 30 mill ion in 1 993, while life insurance contracts, covering three classes (pension insurance, industrial life insurance, and personal accident insurance) grew from 300,000 in 1982 to 300 million in 1993. Motor insurance also registered a large increase, growing from less than 8,000 vehicles insured in 1980 to 20 million in 1993. More specialised lines of business also grew at very high rates. For instance, marine hull insurance reached 11 0,000 ships in 1993 from less than 300 in 1980 and aviation insurance reached 7,400 aircraft in 1993 from just 13 in 1986. Signs of competition are emerging in certain regions (eg, Shanghai) and sectors (aviation insurance) by the aggressive marketing strategies of new companies. So far, the new companies, primarily established by banks, have still to acquire the professional skills which would permit them to seriously compete with PICC.4 In 1993 foreign insurance companies were selectively allowed to enter the market and American International Assurance (AIA) Ltd., a fully-owned subsidiary of American lnsurance Group (AIG), was given a license to operate in Shanghai. AIA can sell non-life insurance to foreign companies and joint ventures and life insurance to individual Chinese, and is reported to be expanding rapidly. Tokyo Marine and Fire has also received a full authorisation license, while more licenses are expected to be granted to foreign or joint venture companies with permission to operate nationwide. Meanwhile, Chinese companies are also developing links to international market^.^

As in most developing countries, the insurance industry in China is strongly tilted d toward non-life business (Figure 6.3), although the rapid growth of life insurance enabled it to account for 30 per cent of the total in 1992. The rapid growth of life insurance is partly explained by rising income levels, but primarily by the growth of group life insurance, for workers in joint ventures, foreign and private companies, and small rural co-operatives, which are not covered by the social pension system but are required to be covered by group policies arranged through insurance companies (Figure 6.4). Figure 6.3 China: comparison of the life and non-life structure of insurance with selected countries r 1 I Africa Latin America I 100% ro 100% .? 90% .-5 90% E 80% E 80% g 70% g 70% = 60% 3 60% 5 50% 5 50% 40% .tj 40% 30% 2 30% 2 20% = $ 20% " 10% 2 0% 9 10% 0% 5 .s 3 X 0 0 .-- G 5 a, 0 .--m .-0 m m N 0 Y X .o .- F E 2 6 m Ki 5 -6 5 S aP East Asia

1 Source: Sigma, Swiss Reinsurance Company, March 1994

Figure 6.4 China: insurance premiums by line (1 992)

1 Source: 1992 PlCC Annual Report The financial performance ofChina's insurance industry An evaluation of the financial performance of China's insurance industry (based on the results reported by PlCC for 1993), shows that non-life insurance in China has relatively high loss ratios, unusually low commission ratios, and modest expense ratios, even compared to typical developing countrie~.~Its profits are modest, ranging from a five per cent loss for motor vehicles to 15 per cent for marine and general insurance (Table 6.1).

Table 6.1 China: underwriting performance of the People's Insurance Company of China (1 992/93)

Fire Motor vehicle Marine & general Total non-life Life 1992 1993 1992 1993 1992 1993 1992 1993 1992 1993

Operating results (Rmb billion) A. Premiums B. Investment income C. Claims 0. Addition to reserves E. Surrenders F. Commissions G. Expenses H. Taxes I. Profit

Ratios (pcr cent of premiums) Loss ratio (C/A) 59 59 66 69 48 52 57 60 24 28 Pay-back ratio [(C+D+E)/Al 6 1 65 75 84 58 63 65 71 107 107 Commissions (F/A) 5 4 2 4 8 4 5 4 3 3 Expenses (G/A) 11 11 13 12 12 12 12 12 8 7 Combined ratio 77 80 90 100 78 79 82 87 118 117 Taxes 5 6 5 5 6 6 5 6 Investment income 1 18 17 Profit 18 14 5 -5 16 15 13 7 - Source: PlCC annual report 7992 PlCCs financial management of life insurance is relatively good. The PICCfs reported loss ratio for life insurance amounted to 28 per cent, but including additions to reserves and policy surrenders, the pay-back ratio amounted to 107 per cent. PICC also reports an investment income equal to 17 per cent of life premiums. This is used to cover commissions, which amount to only three per cent of premiums and expenses of seven per cent of premiums and the rest is credited to policyholders in the form of life funds. These loss and expense ratios compare very favourably with those of other developing countries (Figure 6.5) whilst the commission and expenses ratios are low by the standards of most developing countries.

This assessment, however, masks a rather poor overall financial performance in life insurance, due to low returns on investment income. With Rmb20.3 billion as the estimated value of funds available for investment throughout the year, the investment income of only Rmb 1.6 billion implies a rate of return of only 7.9 per cent. This is a negative rate of return as inflation during 1992 exceeded 13 per cent. It reflects the low nominal returns obtained on the assets of PICC.

Adding its life and non-life business, overall financial performance is weak due to low returns on investments. PICC had total assets of Rmb59 billion in 1993, but of these only Rmb39 billion were income earning (Appendix Table A6.6). IUearly 70 per cent of income earning assets (Rmb22 billion) were placed in cash or bank deposits, while the remainder was mostly invested in government bonds. The mid-year value of income earning assets was Rmb35.5 billion and the total investment income for the year was Rmb3.3 billion, implying a nominal rate of return of 9.3 per cent. The low overall financial returns are a result of the investment rules imposed on PICC, combined with relatively high rates of inflation. The non- availability of financial instruments with positive real returns is forcing insurance companies to emphasise the family protection aspect of their policies and to downplay potential investment returns. Within this financial environment, PICC maintains good control of its financial affairs. At less than three per cent of annual premiums, premiums receivable stand at a very low level by comparison with most developing countries where they often reach or exceed 30 per cent of annual premiums. PICC also has a strong solvency margin, amounting to 26 per cent of premiums and 51 per cent of claims. INSTITUTIONALI NVESTORS

Figure 6.5 China: comparisons of the performance of the insurance industry in selected countries

Non-life insurance: loss ratios and Life insurance: payback ratios and expense ratios expense ratios

~ Source: Munsalem eta/ (1993) and World Bank Staff Estimates

As is clear from the accounts of PICC, insurance companies build up substantial reserves. The reserves of life and annuities policies are of a long-term nature and are available for investment in government, corporate and mortgage bonds as well as in corporate equities and real estate. In the case of PICC, however, the life reserves have been mostly invested in bank deposits and treasury bonds. Even non-life business, which covers relatively short-term risks, can accumulate substantial reserves. Since loss claims facing non-life insurance companies often suffer from processing delays, non-life insurance companies in OECD countries, especially in Anglo-American countries, also tend to place a high proportion of their reserves in equities, which are expected to provide a better hedge against inflation than bonds, while being more liquid than real estate. In China, the non- life reserves of PICC have necessarily been mostly placed in cash and bankdeposits yielding an even lower rate of return than life reserves.

Regulatory reform of the insurance industry and future prospects Until 1995, the insurance industry was regulated by the Interim Regulations Governing lnsurance Enterprises issued in March 1985. These allowed for the demonopolisation of insurance activity and the authorisation of new domestic companies as well as subsidiaries or branches of foreign companies. In October 1991 the drafting of China's first Insurance Law began, and China's lnsurance Law was finally adopted on 30 June 1995, and effective as of 1 October 1995. Measures of insurance efficiency

Efficiency in the insurance industry is and in processing claims as well as difficult to measure because, like all other an uncompetitive distribution system. types of financial services, there is no easy definition of the output of the sector. The combined ratio, which is often Various measures are used for used as a measure of the underwriting comparative purposes. profitability of insurance companies, is the sum of the loss and expense Non-life Insurance. In non-life business, ratios. underwriting performance is measured by four basic ratios: the loss ratio, the The operating ratios, which also takes expense ratio, the combined ratio and the account of the investment income operating ratio. earned on loss reserves. It is obtained by deducting investment income as The loss ratio measures claims paid a ratio of retained premiumsfrom the (and provisions for losses incurred but combined ratio. not settled) as a proportion of retained premiums, ie., gross premiums Traditionally, non-life insurance received less premiums ceded to companies aimed to operate with a reinsurers. It shows the percentage of combined ratio of 95% and earn a 5% premiums that are paid back to the profit on their premiums without taking insured; a high ratio normally account of investment income. With an indicates an efficient and competitive average ratio of premiums over equity of industry. Differences in reserving 3, this resulted in a satisfactory return on policies and manipulation of reserves equity of 15%. But high inflation and high for tax and other purposes reduce the nominal rates of investment returns as usefulness of the loss ratio. well as a growing level of reserves in relation to premiums forced insurance The expense ratio is computed as companies to take account of investment general expenses and net com- income on reserves and to engage in what missions paid (ie., commissions paid has become known as cash flow to agents less commissions received underwriting from reinsurers) as a proportion of gross premiums. It provides a measure When investment income is high as a of the acquisition costs of insurance proportion of premiums, insurance business. A high expense ratio would companies may lower premiums in suggest low operating efficiency in relation to expected losses and the marketing and product innovation combined ratio may exceed loo%, giving rise to an underwriting loss. This is made subsidisation by regulation. up from the investment income earned on reserves. This explains the use of the Life Insurance. In life insurance, the operating ratio. concept of the loss ratio has less meaning, as it would include only claims paid due International comparisons of non-life to death or maturity of contract. For a insurance results are complicated by growing industry, the loss ratiso would be differences in accounting conventions, quite low because a substantial part of market structure, business mix, inflation premiums is placed in reserves to cover rates, and data coverage. Differences in the long-term liabilities inherent in life business or product mix are particularly policies. If benefits and dividends paid important because both acquisition costs to policyholders and additions to and loss claims vary significantly across technical reserves are treated as different lines. In most countries, representing the premiums paid back to automobile insurance operates with very policyholders in the long run, then this high combined ratios, because premiums pay-back ratio could be a better measure tend to be regulated, whileexpenses and of efficiency for life insurance business losses are high. In contrast, the fire than the loss ratio. contract is almost everywhere associated Source: World Bank with low loss ratios, due to cross-

The new insurance law is a good start in implementing an internationally acceptable standard of insurance regulation, with management accountability, a strong focus on contract law, emphasising a balance in protecting the rights of the insured and the insurer, and a strong emphasis on defining the role of the regulator. On the other hand, it vests considerable authority in the supervisory body and its capacities. For example, until the passage of the new law, insurance premiums were subject to a controlled tariff but with a wide range of variation of 30 per cent above or below the approved premiums. The new law states that all basic insurance premium rates shall be formulated by the supervisory body while other rates shall be filed with the supervisory body. This may reduce the discretion permitted to insurance companies to determine premia. In terms of capital market development, the law is cautious; more so than its previous draft versions. the application of funds are limited to bank deposits, government bonds, and other forms of fund application specified by the State Council. Investment in enterprises (presumably including the holding of equity shares) is explicitly precluded. If the law is to be successfully implemented in China today, a considerable amount of training of actuaries and other insurance specialists including specialists at the supervisory authority, is required.

Future prospects On the whole, the prospects for the insurance industry are bright. Continuing high economic growth is likely to stimulate the demand for non-life insurance, while the high rate of saving and the need to cope with the ageing population will stimulate the demand for life insurance. On the supply side, the ongoing regulatory reform, the modernisation of the operations of PICC, the creation of new domestic companies and the entry of foreign insurers are all pointing to higher efficiency and an expansion of the insurance habit among Chinese firms and households. The government could also undertake supplementary measures to stimulate the growth of the insurance industry and enable it to achieve its potential and contribute to the development of ttfe socialist market economy, including: completion of the passage of the implementing regulations for the new insurance law; providing for the training of regulators and insurance examiners; establishing an effective new supervisory authority; increasing the contestability of the insurance market by encouraging new domestic companies; authorising more foreign and joint venture insurance companies to stimulate competition; improving accounting and information disclosure standards to facilitate the solvency monitoring of the industry and protect the interests of policyholders; and taking measures to strengthen links with international insurance and financial markets, especially by opening up the reinsurance market to foreign companies. In the medium term, China should consider undertaking revisions to the recent insurance law to provide more flexibility to insurance companies in terms of (a) setting premia and (b) determining their own investments, while encouraging them to invest prudently and profitably, to permit them to contribute to the further development of the capital market and the real economy. China's draft insurance law

Coverage: The new law consists of 152 Investment rules: With regard to the articles in eight sections. It focuses investment of accumulated funds, the primarily on the contractual relationships law is conservative. The application of between insurer and insured and the funds is limited to bank deposits and supervision of the insurance industry. It government bonds. lnvestment income does not cover social insurance and will therefore be limited, combined with employee welfare benefits or some the solvency tests, lack of profitability specialised forms of insurance could restrict growth, and paradoxically encourage foreign insurers to provide Authorisation criteria: Two types of needed capital. domestic insurance companies may be established: a shareholding company Premium and product controls: Basic with limited liability, or a wholly state- premia are to be set by the Financial owned enterprise. lnsurance companies Supervision Authority. Other premia must can engage in life or non-life insurance be submitted to this Authority for record. only. The minimum capital for creating The law also requires insurers to cede at insurance companies is Rmb 200 least 20 per cent of each contract to a million. Twenty per cent of the capital reinsurance company. The law also must be deposited as guarantee with the provides for the creation of a fund to Financial Supervision Authority. cover catastrophic risks and a guarantee fund to cover the liabilities of insolvent Prudential norms and solvency companies. requirements: lnsurance companies are required to maintain an unearned Supervision: The law provides for an premium of 5 0 per cent, as well as IBNR industrywide Financial Supervision (incurred-but-not-reported) and RBU Regulatory Authority, under the State (reported-but-unpaid) claim reserves, and Council, with considerable powers of to make contributions towards an surveillance, on-site inspection, and accumulated fund reserve. To avoid intervention and sanctioning. This could concentration of risks, no individual risk be within the Peoples Bank of China, as can exceed 10 per cent of net assets. at present, or could be an independent ' lnsurance companies are also required body. It will be responsible for issuing all to maintain a solvency margin. Retained detailed regulations. 1 premiums cannot exceed four times net assets. The Pension System

Currenf sfrucfure

Chinese pension funds are even less developed than the insurance sect~r.~A major reason why pension funds have grown so slowly in China is the prevalence of unfunded pension schemes. Second, the population coverage of the current schemes is very small and excludes the large rural population of China. With the urban population representing 30 per cent of the total population and a coverage ratio of urban workers of about 60 per cent, the overall coverage of the pension system is probably only about 18 per cent of the economically active population. The current system also suffers from a very uneven burden among enterprises and provinces, reflecting large differences in demographic structures and dependency ratios. A further problem confronting the system is the rapid ageing of the population, which makes future pension reform of critical importance. But the system also has three mitigating factors that enhance the potential for reform: the current low level of pension spending (which makes pension reform and the transition to a new system easier and less costly); the high rate of economic growth; and the very high rate of household saving.

The enterprise-based character of China's pension system has often been held to be a factor responsible for its inadequacy. But this feature is far from unique to China and is found in many high and low income countries. Enterprise or company-based schemes suffer from portability, vesting, funding and labour mobility problems in all countries. What is uniquetochina and its current pension problems is a combination of three additional features: the absence of a social safety net or public pillar covering all workers; the complete reliance on 'pay-as- you-go' rather than even partially funded pension financing systems; and the economic problems of many state-owned enterprises.

To assess the efficiency of the present system, we first look at the national efficiency ratios for pension schemes. The general finding is that while costs are relatively low, so is coverage, and the volume of contributions in terms of pension funds available for investment is very low. Thus, in 1993, the overall system dependency ratio was 23 per cent, which is not much higher than the demographic dependency ratio, of 18 per cent.9 The average replacement ratio is 65 per cent.I0 Though lower than the targeted rate of 70 per cent to 80 per cent, it is quite high in view of prevailing inflation." Table 6.2 shows the required contribution rate for break even in China (1 5 per cent) and the implied share of covered wages in GDP (only 10 per cent). A comparison with other countries shows that the cost of pensions in China is currently quite low, both because of the low dependency ratio and because of the low share of covered wages in CDP.

Table 6.2 China and other countries: basic equation of social pension system (%)

Average System Required Labour IPensions replacement dependency contribution income YO rate ratio rate share CDP - - China (1993) 65 2 3 15 10 1.5 Hungary (1 992) 49 59 2 9 37 10.6 Czech Republic (1 992) 49 49 24 42 10.2 Poland (1992) 74 49 3 6 4 1 14.8 Russia (1 992) 3 4 46 16 29 4.6

Note: Administration costs and investment income are not taken into account. Source: Vittas and Michelitsch (1994)

Annual contributions are low, amounting to only Rmb50 billion, or around 1.5 per cent of CDP. In Eastern Europe, pensions correspond to 10 per cent or more of CDP. Annual pension expenditures are around Rmb45 billion, leaving a very small investible surplus per year, of only Rmb5 billion. By 1993, the total accumulated capital amounted to Rmb27 billion, of which Rmb7 billion was invested in specially issued non-marketable treasury bonds and the rest mostly in bank deposits. The rate of return has been well below the rate of inflation in recent years and has eroded the real value of accumulated balances.

Uneven burden of pension funds: Shanghai, Beijing and the railways indust ry

Provinces such as Shanghai, Beijing and Tianjin, with many loss-making enterprises and aged labour forces, bear a greater burden from pensions than new cities like Shenzhen, which have profitable firms and young labour forces. The difficulty of transferring pension and other employee benefits is impeding the restructuring and downsizing of state enterprises. To cope with this problem, a programme of 'socialising social security' has been under implementation since 1986. This involves the 'pooling' of the social responsibilities of enterprises, either along geographical lines, or on a sectoral basis. A limited number of industrial sectors pool enterprises on a national scale: electricity, water, power engineering, railways, airlines and transportation, post and telecommunications, banking, coal mining, petroleum and natural gas, and construction. All other enterprises are pooled either at a province or city level. Under this programme, enterprises continue to be primarily responsible for collecting contributions and paying pensions but those with deficits receive transfers from those with surplus funds through provincial agencies. However, as the pools are not connected across provincial or industrial lines, pools with heavier burdens are forced to increase their contribution rates. As the illustrations from three cities and one industry show, there is currently considerable variation in contribution rates across different regions or industries, while benefits are still not transferable across different pools.

In Shanghai, the system dependency ratio, at nearly 35 per cent, is 50 per cent higher than the national average.12 The replacement rate of 57 per cent is below the national average, of 65 per cent, and even further below the promised replacement rate of 70 to 80 per cent.13 Contribution rates, of 54 per cent of aggregate benefits, or 28.5 per cent for pensions alone, are very high by international standards, especially for a country with the level of income of China and pension reform should aim to lower contribution rates. Maintaining current pension payments requires a lower (20 per cent) contribution rate for break even. A small surplus has thus accumulated, amounting to Rmb 450 million in 1993, and projected to reach Rmbl.2 billion by the end of 1994. The management of these funds is relatively innovative; as they are entrusted to the Pudong Development Bank (PDB), which invests the funds in local firms and projects. The returns of the PDB are higher than those obtainable on bank deposits and treasury bonds, and the permission to allow a diversification of investments away from an exclusive reliance on these is broadly speaking to be welcomed. Yet, in the present instance, a note of caution should also be interjected, as the PDB is effectively under the aegis of the Shanghai Municipal government, and funds invested are thus prone to be utilised for municipal government priority investments. Some investments of such new financial institutions may also be highly risky and speculative, with large reliance on real estate investments (in the recent past). Safeguarding the savings of pensioners must not be forgotten. The eventual aim should be to permit pension funds to invest in a diversified portfolio of publicly traded securities. 1 China: pooled pension funds

Shanghai municipality Beijing Municipality Number of active workers: 4.9m Number of enterprises in pool 10,000 Number of retired workers 1.7m Number of active workers 2 m Dependency ratio: 35.0% Number of retirees 740,000 Average monthly pension 265Rmb Dependency ratio: 3 7% Average monthly wage 465Rmb Effective contribution rates

Replacement rate 57% (Oh payroll) Pension contribution rates: 28.5% State enterprises 19% Employees: 25.5% Foreign cos and joint ventures 17% Employees: 3.0% Collectives 27% (New employees rate: 8.0% Contract workers 17% Break-even contributions 20.0% Coverage Other employer contributions: Pensions Medical 1 5 .O% Living allowance for staple foods Unempt. insurance 0.5% Health insurance Housing costs 5 .O% (Foreign and JV cos.) Other employee contributions Average monthly pension Housing costs 5.0% (similar to Shanghai) Total benefit contribution 54% Average replacement rate 60% (Employers 46%) Additional savings plans (Employees 8%) (Beijing municipality)

0 Individual accounts: Employer contributions 2% 1. Actual Employee contributions 5 % (full employers cont: 3 '10) individual accounts: 2. Notional (less experimentation (half employers cont: 13%) than Shanghai) Accumulations (end 1993): Rmb 450m Projected accum. (end 1994): Rmb 1.2b Tianjin municipality Average monthly wage Rmb 310 Railways industry (Including benefits) Active workers (1993) 3.4m Average monthly pension Rmb 260 Retired workers (1993) 900,000 Replacement rate 84% Dependency ratio 26.5% Dependency ratio 33% Average monthly wage Rm b 400 Required breakeven Average monthly pension Rrnb 320 contribution 28% Replacement rate 80% Actual average contribution 26%

Breakeven contribution 21 O/O SOE employers 20% (per cent of payroll) SOE employees 4% of which, employee Foreign enterprises and JVs 30% contribution 2% (of which medical 18% Employees: 25.5% pensions 1 8% Employees: 3 .oO/a employee 4%) (New employees rate: 8.0% Accumulated reserves Break-even contributions 20.0% (end 1993) Rmb 340m Reserves as total spending on pensions (1993) 3 3 '10 Another innovation was recently introduced by Shanghai in the management of retirement funds (early 1993). The retirement and medical insurance contributions of foreign companies and joint ventures, hitherto paid to PICC, will now be made to the Retirement Insurance Management Centre of the Shanghai Municipality.14 These can then be placed in PICC, AIA, or other competitive domestic or foreign insurance companies. Such investments may be safer than deposits with financial institutions such as Trust and Investment companies which have large exposures in securities markets.

The situation in Beijing is not very different from that of Shanghai, although experimentation with individual accounts is less advanced. The average monthly pension and average replacement rates are similar, and the pension system should be running a small surplus. But many loss-making companies are unable to pay their contributions and thus the system suffers from a small deficit. Meanwhile the Beijing Municipality has introduced additional savings plans, involving a two per cent contribution from employers and five per cent from employees.

In Tianjin, the level of both wages and pensions is lower than in the other two municipalities, but the average replacement rate is much higher at 84 per cent. Average contributions are about 26 per cent, compared to a break-even contribution rate of 28 per cent, leaving a small deficit for the system. The accumulated reserves of the fund for the Tianjin Municipality amounted to only Rmb 340 million, which corresponded to just over one third of the total spending on pensions in 1993. The situation in terms of funding is thus worse than Beijing or Shanghai.

The railways industry is one of the sectors where pooling is based on industrial rather than geographical lines. The system dependency ratio of 26.5 per cent is lower than that of Beijing or Shanghai, but higher than the national average. The current average replacement rate of 80 per cent implies a required contribution rate for break even at just over 21 per cent of payroll. Of this, two per cent was contributed by workers and the rest by the employer. The railways industry is currently restructuring. Some units have high dependency ratios, are unable to make adequate contributions and rely on transfers from surplus units for meeting their pension obligations. Reform options and policy recommendation15 The Chinese authorities at the Ministry of Finance, Ministry of Labour and the State Commission for Restructuring Economic Systems are fully aware of the problems facing the pension system from its uneven burden and the rapid ageing of the population, and are considering a range of reform options. The reform that appears to command widest support involves the creation of a dual public-pillar structure, with the option of additional pillars to be provided by company schemes or personal pension plans.16

Pension reform policy options: funded and unfunded pillars

Many options are available. For instance, taken to ensure that the resources the unfunded pillar could be financed accumulated in the funded pillar are from payroll taxes or from general tax invested prudently and wisely, with the revenue, although given the low coverage objective of maximising the returns for of the formal pension system the latter their members subject to a reasonably approach would not be advisable. The low degree of risk. benefit from the unfunded pillar could be a flat pension paid to all workers Over time the funded pillar would irrespective of their career earnings and become a major source of institutional years of contributions, or it could follow funds and would complement the the structure of the Swiss public pillar and operations of the insurance companies divide the public pension into two in modernising the capital markets. components; one based on years of Initially, its investments would be tilted service and the other on career earnings toward marketable government bonds with a clear ceiling on the public pension. and other lower risk instruments, but later on as the equity market gets better Similarly, the funded pillar could be organised and accounting standards and based on centralised management by a information disclosure considerably public agency analogous to the Central improve, a growing proportion of funds Provident Fund in Singapore or it could could be invested in corporate equities. be operated by competitive fund At that stage, a move away from management companies as in Chile or centralised management would be by employers as in Switzerland. The advisable, both in order to ensure a funded pillar could also cover the competitive and efficient fund housing accounts that have been management industry, and in order to established in many provinces, as well avoid undue state influence in corporate as saving for other uses such as education affairs. and medical care. Care should also be The drawback of the present proposal is that the two public pillars would not be funded and would require a rising contribution rate to break even.17 While the practical difficulties of mobilising resources for funded pension schemes are recognised, it must be seriously considered that a largely unfunded pension system would be difficult to sustain in the long run, given the projected rapid ageing of the Chinese population. Given the low cost of current pensions, China today has a golden opportunity to introduce a fully funded, fully vested and fully portable second pillar that would be based on individual capitalisation accounts supplementing a first, unfunded pub1ic pillar, in a two-pillar or multi- pillar system. Combined with a gradual raising of the normal retirement age, such a system would not only be sustainable in the very long run but would then be able to generate long-term funds that would be available for investment.16 A combined unfunded/funded structure would also in the long run reduce contribution rates and thus lower the burden on labour costs.

An unreformed pension system will face major pressures in the future. Projections carried out by Chinese researchers show that the system dependency ratio may exceed 50 per cent and the required contribution rate may reach over 30 per cent by the year 2050 if no reforms are carried out (Table 6.3). A reform of the system, based on the forms suggested above, suitably adapted to any special features in China, and offering adequate but affordable and therefore sustainable benefits should be undertaken as soon as practically possible. The benefits from an effective and sound reform and from the creation of a new multi-pillar structure will be very large not only for the pension system itself but also for the labour and capital markets and thus for the national economy.

Table 6.3 China projected basic equation of social pension system (Without major reform) (Percentages)

- -- - Year Average System Required Labour Pensions replacement rate dependency ratio contribution rate income share % of CDP

2020 63 35 22.1 18 4.0 2050 63t 5 3 33.4 22 7.3

- - - Note: Administration costs and investment income are not taken into account. Source: Pension projections and simulations prepared by the 710 Agency. Research institute affiliated to China's Aerospace Ministry Housing Funds

Since 1992, most municipal authorities have established compulsory individual housing savings schemes where both employers and employees are required to contribute, generally five per cent from each party for a total ten per cent of wages. These funds are intended for housing purchase. They are operated by banks under terms and conditions considerably influenced by municipal authorities. The accounts purport to help workers accumulate the required downpayment for purchasing a home. However, the rates of interest paid on these accounts are very low and have been highly negative in real terms since their inception. The housing accounts are effectively forced saving schemes subject to heavy taxation. A large number of accounts appear to have been established, but in some cases they represent little more than payroll entries, maintained at the enterprises concerned, rather than individual and separate bank account^.'^

In the Shanghai Municipality, 4.6 million such 'accounts' had been opened by the end of 1993 and the balances accumulated on these accounts reached about Rmb 5 billion by end 1994. These funds are placed with the PCBC rather than the Pudong Development Bank. The rate of interest offered in these accounts has been set at the interbank, yearly fixed deposit rate, which amounted in mid-I 994 to close to 11 per cent per year.

The business of housing accounts is dominated by the PCBC, with ICBC taking a growing, but still small, share. The choice of bank is made by the employer. The rate of interest paid is largely determined by the municipal authorities, subject to PBC administered guidelines. Accumulated funds in housing accounts are used by banks for loans to municipalities for land development and to enterprises and housing developers as well as for loans back to employees to enable them to buy their houses. The money saved on housing accounts can be withdrawn on retirement or when it accumulates 30 per cent of the value of the house. On rare occasions, a 15-year bank loan can be obtained, at generally negative interest rates. Under current terms, the average worker needs to save for around nine years to accumulate 30 per cent of the value of a standard house. With the negative interest rate earned on housing accounts, this period is likely to increase to the point where the likelihood of housing purchase grows low.

Housing funds may have some potential to contribute to institutional investment funds, but only if accounts at banks are genuine in character, and if their operation was streamlined and their rate of return raised to a reasonably positive level in real terms. At present, however, realistic levels of contributions to contractual savings are low. To the extent that funds accumulate, they are used by municipal authorities for low-return financing schemes, reinforcing low returns to savers. In future, if genuine housing accounts are created, they could be linked with individual accountsfor retirement, which have already been introduced in several provinces. Administrative problems of opening individual accounts for millions of workers can be overcome, if the implementing institutions make considerable progress in computerising their operations.

Mutual Funds

Mutual funds, the third pillar of contractual savings, can play a very important part in the development of Chinese capital markets. It already comprises many providers, is potentially highly competitive, is free from the legacy of non- performing loans and bad investments that afflict the banking sector, and shows a high degree of financial sophistication. Mutual funds facilitate pooling to benefit from economies of scale, risk diversification and professional management. They can provide an attractive vehicle for financial saving, especially for less wealthy

investors. *O

Mutual funds come in three main bond funds, which compete with varieties: long-term bank deposits and life insurance policies, and, money market mutual funds, which equity funds, which compete with invest in short-term financial investments in other real assets, such instruments, such as treasury bills, as land and housing. commercial paper and large bank certificates of deposit and thus Mutual funds have the potential to offer compete directly with short-term a better combination of return, liquidity bank deposits and risk than alternative instruments if well managed and regulated.

Banks and other financial institutions were permitted to set up mutual funds for equity and bond investments in 1991 as it was appreciated that they could become a big factor in reducing the high volatility of the Chinese stock markets and could also help individual investors participate more easily to invest in corporate bonds and equities. Following this authorisation, 50 funds had been set up by mid- 1993, raising nearly Rmb5 billion. In September 1993, the PBC imposed a temporary freeze on all new authorisations as it was concerned that their apparent high success rate and rapid growth could divert large funds from the banking sector.

Most are closed-end funds that invest either in bonds or in equities. Very few have been established as open-ended funds. In the absence of national regulations, the various stock exchanges have issued provisional rules for the operations of mutual funds. Under these rules, funds are defined as trust-type businesses in which specialised investment management companies invest in securities or other assets after collecting funds from the public. Closed-end funds may be traded both over the counter and through stock exchanges, while shares or units in open- end funds may be redeemed by the manager at any time. The parties involved in a fund, ie., the manager, the trustee and the investors, have a contractual relationship through a contract that sets out the rights and duties of the respective parties and defines the method of calculating the net asset value of the fund.

Limitations have been imposed on the managers and trustees in order to contain conflicts of interest and minimise the occurrence of related-party transactions and self-dealing. For instance, the manager and the trustee may not own more than 10 per cent of the shares of any listed company, nor act as manager or director of a listed company. Neither the trustee nor the manager may engage in the distribution of securities or act as guarantor for loans. In addition, no more than 10 per cent of the fund's assets may be invested in a single company, while a reserve for trading losses must also be set up. The trustee must be approved by the PBC and either belong to a state-owned financial institution or have capital (net assets) of at least of Rmbl00 million. The trustee'sduties include the clearance and transfer of transacted securities, protection of the rights of fund investors, and supervision of the manager. The fund manager must also be an approved institution with a minimum capital of at least Rmb20 million and appropriate qualifications and skills. One third of its employees must be graduates in economic disciplines with two years' experience in securities markets. The manager's duties include managing the fund, redeeming shares, commissioning securities brokers to handle fund's investments (with a limit of not more than 25 per cent to any one broker), and reporting to the trustee and investors. Potential role and benefit

The high potential of the mutual fund industry has been held back by:

the absence of a supportive legislative and regulatory framework concerns of the monetary authorities that growth of the mutual fund industry may divert resources away from the banking sector, with potentially adverse effects for the financing of loss-making state-owned enterprises erratic macro-economic performance with a significant rate of inflation.*'

On the other hand, their growth has been stimulated by the controlled rates of interest on bank deposits, frequently set at negative real levels.

The future prospects for mutual funds would be improved by a clearer definition of their regulatory framework. They would also benefit from the restructuring of the pension system and the setting up of a fully funded pillar as well as by the future growth of life insurance and annuity business, which will itself be linked to the reform of the pension system. Pension funds and insurance companies are major investors in mutual funds in several high income countries. This has been associated with the growth of variable (or unit-linked) insurance and annuity policies and with the pursuit of specialised investment vehicles by both insurance companies and pension funds.

Endnotes

1 A glossary on technical terms for institutional investors may be found in Annex 6.1. 2 Because of the creation of many regional companies in which PlCC has a controlling stake, the share of insurance business attributable to PlCC seems to have fallen to around 60 per cent in 1993 (Rmb31 billion out of a total of Rmb54 billion for the market as a whole). But PlCC may still effectively control 90 per cent of the market. 3 There is also an agricultural insurance company in Xinjiang province and the China Reinsurance Company, an independent subsidiary of PlCC responsible for reinsurance both within China and in foreign markets. 4 PlCC officials have been able to acquire considerable knowledge and expertise over the years, in large part through their regular contacts with the Hong Kong and international reinsurance markets. 5 Such as Ming An (a PlCC subsidiary), China Re (Hong Kong), (a subsidiary of the PRC China Reinsurance Company), Guandong Asia Insurance Company, and Bank of China Group Insurance (Hong Kong), China lnsurance Co (a PlCC subsidiary) in London, the Chinese American Insurance Company (CAIC - a joint subsidiary of PlCC and AIC) in New York and Ping An lnsurance (USA) in Delaware. Interests from China are reported to control 35 per cent of the insurance capacity of the large Hong Kong market. 6 Additions to reserves absorbed between two and ten per cent of premiums. PlCC does not report any investment income for its non-life business. 7 Many training programmes are under way, through close co-operation with overseas professional bodies such as the US Society of Actuaries and the UK Institute of Actuaries. 8 The comments made here are preliminary. Two further World Bank studies on this issue were completed in 1996; a study on Pension Reform by the World Bank Beijing Office, and a study on State Enterprise Reform. 9 The system dependency ratio is derived from the ratio of retired workers receiving pensions (19 million), toactivecontributing workers (83 million). In many developingcountries in Latin America and Eastern Europe, there is a much greater gap between the system and demographic dependency ratios. 10 Estimated as the ratio of the average pension (Rmb2,400 per year) to the average wage (Rmb3,650 per year). 11 Pensions are not fully indexed to inflation but are adjusted on an ad hoc basis. 12 The system dependency ratio is likely to grow, and the Shanghai Municipality expects it to peak at 50 per cent in the year 2020. It does not anticipate any need for a further increase in contribution rates. However, estimates suggest that there is no reason why the system dependency ratio will not go higher than 50 per cent. 13 This is partly because pension payments were not indexed until 1993 although adjustments were made on an ad hoc basis. The indexing of pensions and the expected growth of real wages however imply that the average replacement rate will continue to be low. 14 Workers will be required to contribute 3 percentto their individual accounts, while both employers and employees will also be required to contribute 5 per cent of wages to housing accounts. These contributions are subject to ceilings that are set at twice the average level of wages in Shanghai for the pension contributions and equal to the average wage for the housing accounts. 15 For a comprehensive worldwide review of pension reform issues, see World Bank (1994). See also Davis (1993), Diamond and Valdes-Prieto (19941, Queissar (1991 ), Vittas (1 993a) and (1993b), Vittas and Skully (1 991), Vittas and lglesias (1 992), and Vittas and Michelitsch (1 994). 16 The first public pillar would pay a flat benefit to all full career workers equal to 25 per cent of the average economy-wide wage and a second public pillar would pay earnings-related pensions at an accrual rate of one per cent for every year of service (after the fifth year) up to a maximum 35 per cent of average indexed lifetime earnings. This would give a total replacement rate for a full career average-wage worker of 60 per cent. These two pillars would be unified national schemes covering all urban wage-earners. Rural workers would be covered by a mutual assistance and co-operation system. 17 To keep the contribution rate from reaching too high a level, an extension of the normal retirement age is contemplated, although such a move would be complicated by the growing need to provide employment opportunities to younger workers and to workers who might be displaced by the restructuring of state and collectively owned enterprises. Currently the normal retirement age is 50 years for women and 60 years for men. These may be raised gradually to equality first and then to 65 years. 18 Such long-term funds could be valuable sources of finance for infrastructure; managers of such funds could provide demand for longer maturity bonds. 19 Two other sources of funds that are far less important are city or provincial funds initiated by municipal authorities and funded from real estate taxes and the proceeds of land sales to developers and enterprise funds which are funded from rent income, sale proceeds, and sometimes a profit allocation. 20 A description of mutual funds in Hong Kong may be found in Annex 6.2. 21 International experience shows that, faced with high inflation and instability, wealthy investors find ways to engage in capital flight and invest in overseas markets, while less wealthy investors respond by investing in real assets, such as land and housing, or by increasing their consumption and lowering their rate of saving.

ANNEX 6.1 GLOSSARY ON CONTRACTUAL SAVINGS INSTITUTIONS

Actuary A professional expert who calculates insurance premiums, reserves and dividends. Bancassurance A regulatory framework in which banks and insurance companies are allowed to operate in each other's field and to combine their operations to lower marketing cost. Benefits A payment provided for under an annuity, pension plan or insurance policy. Commission A fee paid to agents in compensation for selling insurance. Controlled tariff A schedule of premium rates set by a governmental body or an insurance association. Expense ratio Ratio of expenses incurred to premiums written. Fire insurance An insurance which covers damages caused by fire to real property. Group insurance A form of life insurance in which a master policy is issued to an employerto cover all employees in the plan. Household property An insurance which covers damages to insurance household goods. Industrial life insurance A life insurance issued in small amounts, usually under US$1000, with premiums collected door to door on a weekly or monthly basis. Life fund An account representing the stake of policyholders of a life insurance which is to be distributed later in the form of benefit, cash surrender or dividends. Life insurance A contract which provides a certain sum of money to a designated party upon the insured's death. Loss claim Demand for payment for a damage suffered from an event covered by an insurance policy. Loss ratio Ratio of claims incurred to premiums written. Marine insurance An insurance covering property damage due to sea perils. Motor (vehicle) insurance An insurance which covers losses associated with a car accident. It consists of two broad classes; physical damage insurance which reimburses automobile owner for damages to own vehicle and liability insurance which provides payment to third parties who are injured by a negligent policyholder. Operating ratio Ratio of losses and expenses incurred to premiums written. Pension A contract which provides retirement income. Personal accident An insurance covering medical costs due to an Insurance accident; purchased on individual basis. Personal pension plan A private contract of providing retirement income: purchased on an individual basis. Policyholder The owner of an insurance policy. Premium The consideration paid for a contract of insurance. Reinsurance The shifting of risk by a primary insurer (known as the ceding company) to another insurer ( known as the reinsurer). Reserve A fund set aside to meet claims that are expected to (Technical reserve) arise in the future. Retention ratio Ratio of retained premium (after subtracting the premium ceded to a reinsurer) to the whole premium. Social pension A government sponsored plan which provides income after retirement. Solvency margin A minimum level of net worth to be maintained by an insurance company to secure financial stability of the business. The level depends on the size and the type of risks underwritten by each insurer. ANNEX 6.2 INSTITUTIONAL INVESTORS IN HONG KONG

Hong Kong has a highly developed financial system and well established institutional investors. Considerable expertise has been accumulated in operating insurance companies, in creating pension schemes, and in fund management. Such expertise draws on the presence of a large number of financial groups with high international reputations. Its availability in Hong Kong could make a very significant contribution to the development of Chinese institutional investors and capital markets. Such contribution could take the form of new operations and joint ventures in different regions of China or it could involve the provision of training and other technical services, such as marketing, system design, and fund management.

Insurance companies

The insurance industry of Hong Kong comprises 228 companies (September 1994), of which 40 specialise in long-term business (life insurance) and 169 in general insurance, while 19 companies are composites. One hundred and three companies are registered in Hong Kong, although most of them are owned by foreign interests. Of the remaining companies, 29 are from the UK, 17 from other EU countries, 21 from the US, eight from Japan, seven from Switzerland and four from China. The split of business, based on gross premiums in 1992, was 52 per cent in general or non-life insurance and 48 per cent in long-term or life insurance.

The Hong Kong insurance market is governed by regulations that emphasise solvency monitoring and prudential norms. The regulations lay down minimum capital and solvency margin requirements as well as 'fit and proper'standards for insurer directors and controllers. For general insurance, a 20 per cent solvency margin in relation to net premiums is required, while for life business the EU approach that relates solvency margins to technical reserves and liabilities to policy holders is likely to be adopted. The Insurance Authority also has powers of investigation and intervention.

Companies are required to appoint an auditor and to submit annual audited accounts, while long-term insurers must also appoint an actuary. General insurance, but not life, companies are required to maintain assets in Hong Kong of not less than 80 per cent of their liabilities and solvency margins arising from their general business in Hong Kong. The motivation for this requirement is to protect legally assets pertaining to local companies in cases of . Insurance intermediaries are subject to self-regulation arrangements administered by the Hong Kong Federation of Insurers in the case of insurance agents and the Hong Kong Confederation of Insurance Brokers in the case of brokers. The insurance industry employs a total of 50,000 people, including agen.ts and brokers. There is also a strong actuarial society with over 250 members, 70 of which are qualified fellows of US, UK or Australian societies.

Total gross premiums in general insurance amounted in 1992 to HK$14.2 billion or about 1.85 per cent of GDP. Property damage accounted for 28 per cent of the business, 26 per cent for motor insurance, 14 per cent for general liability and ten per cent for accident and health. About six per cent of the business represents premiums for active reinsurance, ie., inward reinsurance business accepted from other primary insurers. Passive reinsurance varied from 80 per cent in the case of ships to 50 per cent in the case of property damage to only 15 per cent in the case of accidents and health insurance. Over all lines, the retention ratio stood at 64 per cent. The total net premiums (after subtracting premiums ceded to reinsurers) amounted to HK$9.1 billion and the net earned premiums (ie., after deduction of the provision for unearned premiums) to HK$8.4 billion.

The loss ratio, based on net claims incurred as a proportion of net earned premiums, amounted to 55 per cent. Among the big lines, property damage had a loss ratio of 41 per cent and motor vehicle business of 58 per cent. Some of the smaller lines, like aviation and ships, had much higher loss ratios. Management expenses amounted to 15 per cent of net earned premiums and net commissions payable to 30 per cent, resulting in a very small underwriting loss. Technical reserves for non-life business stood at HK$7.8 billion, corresponding to only about one per cent of GDP or 86 per cent of net premiums.

Long-term business covers life insurance and retirement schemes. Total premiums amounted to HK$13.0 billion or 1.7 per cent of GDP. Individual life business accounted for 63 per cent of total premiums and retirement schemes for 30 per cent. More than 60 per cent of individual life business is in the form of participating with profits policies, with the remainder in non-participating policies. Unit linked business represents only a small part of total business.

Reserves of long-term business, representing the net liability to policyholders, amounted to HK$32.1 billion or 4.2 per cent of GDP. Thus, despite the presence of a large number of companies, life insurance business has not accumulated large financial resources, probably because of the existence of occupational pension schemes. No information is available on the investment allocation of reserves, though Hong Kong companies are expected to follow the 'prudent man' rule and are not subject to any specific guidelines regarding their investment policies.

Hong Kong has two insurance guarantee funds that cover compulsory business, relating to motor insurance and workers compensation. The Motor Insurers Bureau, set up in 1980 and covering all car insurance companies operating in Hong Kong, operates two schemes. One is funded by a 0.5 per cent surcharge on motor insurance premiums and covers against uninsured or untraced drivers, while the other is funded by a 2.5 per cent levy on premiums and protects claimants against the insolvency of insurers. The Employees' Compensation Assistance Scheme was established in 1991. It is financed through a two per cent levy on work accident insurance premiums and protects workers who are otherwise uncovered (failure of employer to arrange insurance policy or insurer insolvency). It also covers employers against insurer insolvency.

Pension funds

Hong Kong has a large number of occupational pension funds. There are over 15,000 such schemes, covering over 30 per cent of the local workforce. Ninety per cent of the schemes are set up as defined contribution plans where benefits depend on the contributions made by employers and employees and investment income. Ten per cent of schemes are organised as defined benefit plans where the benefit is based on final salary and years of service. However, defined benefit schemes cover more than half the labour force. There is also a civil service scheme that covers 5 per cent of the labour force.

Defined contribution schemes typically involve a ten per cent contribution rate, split equally between employers and employees. Defined benefit schemes are non-contributory and they typically offer 1.5 per cent of final salary for every year of service. Most schemes make lump sum payments on retirement or termination. Although there is no standard age for retirement, most workers retire at 65. The civil service scheme pays a monthly pension, but otherwise very few schemes pay benefits in the form of periodic pension payments. It is claimed that this is because there is littledemand for annuities while lump sum benefits are not subject to tax. Employees leaving before retirement have a right to their vested accrued benefits, subject to a vesting scale. For defined benefit schemes, the typical vesting scale is 0.25 per cent per year of service, rising by an additional 0.25 per cent for every three years of service, until it reaches 1.25 per cent which is the typical accrual factor until retirement, when it rises to 1.5 per cent. In defined contribution schemes terminating employees are entitled to their own contributions plus a rising share of the employer's contributions. The typical vesting scale is zero for less than three years and then jumps to 30 per cent after three years of service, rising subsequently by ten per cent for every additional year of service. Employer contributions up to 15 per cent of payroll are tax deductible (and not included as part of employees' salaries for income tax purposes) and lump sum benefits are not subject to tax, but employee contributions are not tax deductible. Investment income is not subject to tax but pensions, when they are paid, are taxed.

There are no data on the total size of pension funds because until recently no registration was required other than for tax purposes. A new law requires registration with the Registrar of Occupational Retirement Schemes from December 1995. Estimates by research institutes and consulting firms put the total assets at between HK$100-120 billion and growing fast. This corresponds to between 13 per cent and 16 per cent of GDP. Surveys conducted by consulting firms show that the typical pension fund places 77 per cent of assets in equities, 17 per cent in bonds and 6 per cent in cash. Hong Kong equities represent 28 per cent of the total portfolio, US equities 11 per cent and other equities 38 per cent. All in all, foreign assets account for 57 per cent of total assets, of which 20 per cent are in US instruments and 37 per cent in others. The average rate of return over the five years ending in 1993 for the typical pension fund amounted to 16.9 per cent. This exceeded the growth rate of salaries of 13.4 per cent and the rate of inflation of 10.1 per cent over the same period.

There are a few detailed investment rules, and these aim to safeguard the interests of members. Thus, pension funds assets are subject to a ten per cent limit for investments in securities of the sponsoring employer, while no investments are allowed in unlisted equities or in equities listed in non-recognised exchanges (this limit is likely to be relaxed to permit such investments up to 15 per cent of total assets). Otherwise, pension fund assets must be separated from those of the sponsoring employer and cannot be mortgaged or leveraged. Pension schemes must be audited and subject to regular actuarial review and funding recommendation (if based on defined benefit plans), while adequate information on benefits and the financial standing of the pension scheme must be disclosed to its members on a regular basis.

The Hong Kong authorities have considered two major changes in the pension system over the past few years. First, a consultative paper was prepared recommending the adoption of a community-wide retirement protection system. This would have made mandatory the provision of employment-related pensions with minimum benefits stipulated by law and based on defined contribution schemes with individual capitalisation accounts. The aim of the scheme was to expand coverage to the large number of workers who were not covered by the existing occupational retirement schemes. The proposed system would have followed the precedents set by Switzerland and Australia. The committee that prepared this study rejected the alternatives of having either a centralised national provident fund or a totally decentralised non-employment-linked Chilean pension system. The committee expected an increase in coverage with better retirement protection for all covered workers but without any large macro-effects since the proposed contribution rate of ten per cent was rather low compared to the 28 per cent rate of saving of Hong Kong households.

However, the recommendation of this consultative paper was not adopted by the authorities, mainly on the grounds that the protection benefits of the system would take too long to be felt by the currently uncovered workforce. Instead, a proposal was put forward to introduce a 'pay-as-you-go' public pillar. Currently, Hong Kong pays an old age allowance that consists of two parts: a non-means tested payment of HK$510 to people over 70 and a lower means-tested allowance of HK$450 to people aged between 65 and 69. But elderly people who are in financial need can apply for assistance under the Comprehensive Social Security Assistance Scheme. A single elderly person will receive HK$1,510 per month plus other supplements and benefits, such as reimbursement of rent, free medical treatment and a special diet allowance.

The proposed pay-as-you-go pillar would pay a pension of HK$2,300 to all residents who were 65 years or older. This pension would equal about 30 per cent of the average wage, but as it would be linked to prices, its relation to the average wage would decline over time (assuming rising real wages). Acontribution rate of three per cent, equally divided between employers and employees, was envisaged, while the government was to make an initial contribution of HK$10 billion to cover the cost of the first generation of beneficiaries. The scheme came under strong attack because it assumed very high rates of real wage growth and implied very low real rates of return on younger participants. The need for a pay- as-you-go scheme paying a universal benefit was also questioned, especially for a society with a generally high rate of saving. The proposed public pillar seems unlikely to be adopted.

Mutual funds

In 1993 there were over 900 mutual funds in Hong Kong with total net assets amounting to HK$200billion. Mutual funds are both closed-end and open-ended funds. The former may be listed on the Hong Kong Stock Exchange, although most trading is done over the counter with minimal trading on the exchange. The latter are operated by fund management groups, who stand ready to redeem individual units or shares at any time. Hong Kong has a large presence of foreign banks, fund managers, stockbrokers, securities dealers, and investment advisers. Many of them engage in business with non-residents, especially high net worth individuals from the Asian region, making Hong Kong Asia's largest offshore fund management centre. In all, there are over 900 securities dealers as well as stock exchange members and over 500 investment advisers. Most of these are registered with the Securities and Futures Commission, though some are exempt from registration because they deal exclusively either with non-residents or with professional investors.

The vast majority of mutual funds are established in foreign jurisdictions. Only about 80 mutual funds are local ones, authorised by the Securities and Futures Commission. Mutual funds authorised in a number of recognised jurisdictions, such as Luxembourg, the UK, Jersey, Guernsey, the Republic of Ireland, and the Isle of Man can operate in Hong Kong without obtaining local authorisation. Such mutual funds may be sold in Hong Kong but are not allowed to be advertised or actively marketed to the public. They must comply with local regulations regarding fees, reporting and public announcements in Hong Kong, and their management companies must obtain approval from the local regulators.

Local mutual funds must comply with the Hong Kong Code on Unit Trusts and Mutual Funds. The code was first issued in 1 978 and was revised in 1991 . It provides that offer documents must be printed in both Chinese and English, and that the fund must be subject to the jurisdiction of Hong Kong. It applies investmen? rules that include limits of no more than ten per cent of net assets invested in one company's securities, no more than 15 per cent in unquoted securities, no more than 15 per cent in warrants and options not held for hedging purposes, and no more than 20 per cent in physical commodities.

The trustee of a mutual fund must be a licensed bank or trust subsidiary, a trust company, or an overseas bank or trust company acceptable to the SFC. The minimum capital of trustees must be HK$IO million, although lower requirements are imposed on subsidiaries of large financial institutions. The trustee acts as custodian for the securities of the mutual fund and has significant responsibility for supervising their management, ensuring that prices are properly calculated and other rules are complied with. The trustee must be independent of the management company and is required to report annually to investors on the conduct of the management company.

Managers of mutual funds must comply with local regulations as well as with a code of conduct issued by the Hong Kong Investment Funds Association. The code requires members of the Association to preserve client confidentiality, give priority to the interests of investors, and avoid the issuance of misleading advertising material. CHAPTER 7

As the preceding chapters show, China's capital market is still evolving, and at a rapid pace, with frequent dramatic new developments. Is it possible, in the context of such trends, to draw any longer term and more enduring conclusions about this market?The answer is yes. Many features of the present market are symptoms of a common thread of underlying causes. Most of these causes are embedded in policy decisions and options, and as such, lend themselves to actions which can certainly improve market functioning. The emphasis here is therefore on recommendations that are appropriate regardless of day-to-day events on the market.

The preceding chapters have summarised the conclusions and recommendations appropriate for improving the functioning of each segment of the market. The purpose of the present chapter is not to reiterate these, but to synthesise findings across all segments of China's securities markets and point out underlying links between problems observed in individual market segments. The following section draws together the ten most important broad areas of concern raised by this study, and the final section provides priorities for action.

Capital market development in China is still embedded within the framework of an economy in transition, where many of the features of the former planning system remain. Specifically, capital market expansion and development is contained within the framework of the aggregate credit plan, and state investment plans. Capital markets are therefore viewed primarily as a route, and one among alternative routes, for raising funds for investment. The extent to which capital markets grow, either in terms of debt issues or stocks, is determined essentially by the credit plan, ratherthan by agents issuing securities. In addition to the continued existence of the aggregate credit and investment plans, the economy still retains other basic pillars of a non-market regime; the regulation of interest rates, a banking system which lends largely on the basis of the credit plan and is unaccustomed to the management of interest rate risks, liquidity risks, or asset liability management, and the widespread state ownership of enterprises which de facto face limited financial risks, as they can access credit, provided this is allocated within the credit plan.

-In a mature market economy, while capital markets are indeed intended to mobilise resources, this is only one of their aims. Price discovery, risk management and efficient resource allocation are key capital marketfunctions. Resource mobilisation can also be undertaken by other means, such as bank deposits. The value added of well-functioning capital markets lies in their ability to act not as primary vehicles of resource mobilisation, but in the channelling of large volumes of savings, at short notice, and in a flexible fashion, between alternative uses. The first finding of this book is that, as capital market growth and development is embedded in an environment which still retains many elements of a non-market economy, and indeed, the extent to which capital markets develop depends on the role assigned to them under the credit plan, capital markets in China today are unable to realise their fundamental functions of increasing the efficiency of resource allocation, aiding the pricing of risks and returns, and providing a vehicle for risk management. The approach to capital market development in China has been cautious and experimental. The problem with this approach is that eventually its internal contradictions will distort capital market development.

Second, these problems today most acutely affect primary markets. In secondary markets, transactions are sophisticated, with screen-based, satellite-linked trading systems, continuous order matching and the capacity for T+O settlement. The form of the markets is advanced, compared to other developing countries and even relative to the standards of advanced economies. But the closer one gets to primary markets, the more apparent are the conflicts due to controls imposed under the remnants of the former system, and the less efficient the securitiesmarkets are. Apart from controlling the volume of issues and selecting the issuer, the government today also regulates coupon rates on debt securities, in tandem with its controls on deposit and lending rates. It can also intervene, through local government security offices, in the pricing of initial offerings of equities, and sets margins on coupon rates on corporate bonds, relative to government securities coupon rates. The government is in a position to also change the relative rates of return on different securities, for example by boosting returns to equity through announcement effects, if it is felt that the equity market is in need of support, or by raising coupon rates on bonds, when large new government securities issues are due to be made. And reform in primary markets will be difficult without parallel reforms in other basic features of China's transitional economy.

Third, controls on the growth of China's securities markets under the credit plan imply that the extent to which they are able to support the investment requirements of the real sector is also predicated upon the limits imposed under the credit plan. As such, whether China's capital markets will lend support to the financing of infrastructure investment, or to the raising of equity capital for enterprises, depends today on whether these investments are approved under the credit plan, and whether capital markets are the chosen vehicle for the financing of these investments. In the case of bonds, the problems of illiquidity of the bond market additionally make investors reluctant to hold instruments of long maturity, and this effect is compounded by the relatively high levels of inflation China has experienced in recent years. In terms of equities, new issues are again rationed under quotas embedded in the credit plan. Outstanding (and non-negotiable) state owned shares remain the dominant stock in most enterprises, and as such, secondary benefits of participation in equities markets, such as exposure to shareholder scrutiny, are not being significantly realised. Moreover, the formulation of an appropriate balance between debt and equity, essential for the implementation of modern corporate finance techniques in a market economy, is difficult to realise with the aid of China's capital markets today.

Fourth, the contribution of capital markets to the financing of the government's deficit, and their potential aid to macro-economic management is not being realised to the extent desirable. The government's targeting of retail investors, and extensive use until recently of administrative placement techniques when voluntary purchase is not forthcoming, has its limitations, which the government realised after the mid-I 980s, when it was obliged to shorten maturities and permit the development of secondary markets, to prevent the illicit sales of bonds at heavy discounts. Another solution, sought more recently, has been the raising of coupon rates on government issues. Coupon rates on government securities have been set with reference to, and at a relative premium to, deposit rates of comparable maturities, rather than with reference to secondary market yields (and problems in the money market compound the difficulties of such pricing, due to an ill defined yield curve). The difficulty with this strategy is that it could prove very expensive in the long run, as the stock of outstanding debt cumulates. For example, secondary market yields are shown to have been low in the latter half of 1994 (around 8 per cent), but the government had issued its new debt for the year in the first half of 1994, at rates varying between 10 and 14 per cent. The implication is that the government may be adopting an unduly expensive financing strategy. With increased reliance on government debt issues to finance the deficit due to restrictions imposed since 1994 on treasury borrowing from the central bank, the problem will become more important over time. A fortiori, should the invisible (quasi-fiscal) deficit currently covered through PBC lending to the financial system be transferred to the visible budget, costs of government borrowing will be an increasingly serious issue.

The high volatility and highly speculative nature of China's capital markets has drawn much attention, and much of the blame has been laid at the door of the inexperienced retail investors in the market.' A fifth basic conclusion of this report is that there are many other inbuilt mechanisms in the market which contribute to instability, some of which stem from the primary issue process. These are at least as important as investors' inexperience. Limited disclosure, which could permit decisions to be based more on underlying fundamentals, is a pervasive problem. In the equity and corporate bond markets, this refers to corporate fundamentals; in government bond markets it refers to features such as the inflation indexing of most long (three to five year) issues to an unpublished index (with the resulting extreme speculatign documented in Chapter 3). Other market features have also encouraged speculation; for example, the 'lottery system' assignment, of bunched IPOs, in the equities market, (described in Chapter 4); and the limited role allowed to competitive forces (for example the circumscribed role of underwriters and primary dealers, both in the equities and bond markets).The design of securities (with non-payment of cash dividends on equities and non- payment of period interest on bonds) have also implied that purchasers tend to seek capital gains from securities rather than investment incomes. Finally, government announcement effects and sudden changes in interest rate differentials themselves lead to increased volatility.

The sixth broad conclusion is that the market distortions of today are also due to the limited participation of wholesale and institutional purchasers of securities. This refers not only to the limited development of contractual savings institutions (see Chapter 6) but also, to the limited (voluntary) participation by large financial

, . - , ------_/. '*->.-^-I I.. mi------institutions such as banks in the wholesale market for government securities (see Chapter 3). The causes lie deep in the evolution of the financial system. Insurance was banned at the outset of reform in 1979, and has since been largely the monopoly of a single institution. Yet its accumulations are growing faster today than pension funds or social security systems, which have suffered primarily from largely unfunded pension schemes. The growth of significant funds here for investments in securities could take time. Meanwhile, participation in wholesale securities markets by financial institutions has not developed because of their limited active liquidity management; itself partly the outcome of branch-level liquidity management and difficulties in intra-bank transactions. Neither has the design of securities issues by the government, with typically Iimited transferability and administrative placement, facilitated the participation by financial institutions.

A seventh broad area of concern is regional market segmentation. The regional participation of China's provinces in the emerging securities market is still Iimited. The primary market for equities is still regionally distributed by quota. This returns to the issue of the difficulties of reconciling the credit and investment plans and the growth of capital markets. From the point of view of market growth, it can limit the access of enterprises, especially enterprises in regions which do not have recognised trading centres, and are relatively unknown at a national level, to the market. The regional primary market for bonds is also driven by a combination of quotas (for corporate bond issues) and administrative placement (for government securities). In terms of secondary markets, restrictions against the cross-listings of equities impedes the growth of a national market, although the inter-linkages of satellite centres of the Shanghai Exchange permit dealers in many regions to access its quotations. From a regulatory point of view, the principal central regulator has no regional offices at trading sites and moreover no authority whatever in informal trading centres. Secondary market integration in the bond markets has been facilitated by the growth of the automated electronic quotation systems; STAQS and NETS, which have greatly helped reduce regional price differentials. However the national integration of the debt market is impeded by the multiple independent depositories, and the lack of mutual recognition of bond certificates issued by different centres.

The eighth major issue also concerns market segmentation - by investor type. Although this problem has been virtually eliminated in debt securities (where formerly the coupons payable to individual and enterprise investors differed for the same security), it is a major problem in the equities market. China is virtually unique in having different categories of investors for the same class of ordinary share. Among domestic securities, the persistence of non-traded state shares, and thinly traded C (legal person) shares, reduces market liquidity (acutely, in the case of C shares). Looking at foreign investors, the distinction between A and B share classes, as well as other shares, has led to wide price differentials and a consequent inducement to illegally benefit from arbitrage (see Chapter 4). China is also unique in that shares held by overseas investors have traded consistently at a discount to domestic shares. One reason is that the small B share markets are highly illiquid, and as a consequence, overseas investment in this market is being discouraged.

Ninth, looking at China's participation in international securities markets, the report shows that despite the alarm caused by the recent Mexico crisis, China faces no dangers of macro-economic destabilisation due to foreign portfolio investment inflows. Indeed, in China today, the mix of foreign resource flows may be too heavily skewed towards foreign direct investment, which may be unnecessarily expensive in the medium term, especially in view of the preferential tax treatment currently enjoyed by FDI investors. China can cautiously encourage an increase in foreign portfolio capital inflows and should curtail the preferential treatment accorded to FDI. The problem may lie in the opposite direction. International investors' early eagerness to buy any Chinese securities due to their novelty value has passed. Foreign investment in China is increasingly being driven by fundamentals, and in this context the problems in the B share market are of concern. Meanwhile, China's present strategy of broadening its access to a variety of overseas markets is an appropriate one.

Another issue concerns China's access to international securities markets. While the high international ratings enjoyed by China until the end of 1994 are commendable, China is likely to face deteriorating terms in the future, on two counts: the general reduction in international enthusiasm for emerging markets following the Mexico crisis and the rise in developed country and especially US interest rates, and also, persistent symptoms of macro-economic imbalance, particularly concerning inflation, in China. Chinese overseas bond issues have begun to trade at a discount in secondary markets.

Finally, on the subject of securities market regulation, the government correctly points out that regulation per se is not the issue. Details of many securities regulations, particular1y concerning equities, are basically in accordance with international principles. Rather, the problem here primarily concerns government oversight, both functional and institutional. At present, oversight is splintered in both these senses, and also regionally scattered between municipal and central authorities. One consequence of this is that some areas of regulation tend to 'fall between the cracks' and certain segments of the market have little de facto regulation; notably, securities dealers and institutional participants in securities markets. The regulation of corporate bonds (trading, rather than issues) is another grey area.

All the above issues suggest that there is a need for intervention, and the adoption of revised policies, if future development of China's capital markets is to proceed in a healthy direction.

Suggested Policy Changes

First of all, the government has to determine whether it is prepared to launch upon reforms on a broad front, in terms of those features of the economic system that impede capital markets from performing efficiently: financial sector reforms which allow a greater role for the interest rate as a pricing mechanism; a reduced role to credit and investment plans for capital allocation, the transformation of banks into entities which lend on the basis of risk evaluations and creditworthiness of clients rather than their credit plan quotas, and reforms of state enterprise which permit them to face a real environment of risks and returns; ie, a 'binding budget constraint'. Such major decisions can perhaps not be taken solely on the basis of the future development of capital markets alone, but it is necessary to recognise that these affect and apply to all segments of the financial system.

The question which follows is, how, in the context of capital market development, are such changes to be implemented?It is recognised atthe outset that abandoning the credit plan in the absence of indirect instruments of monetary control, or the simultaneous decontrol of all interest rates, will lead at least initially to chaotic conditions, and the more germane question therefore is, what are the next incremental steps that can be taken towards realising these objectives? While questions of time-phasing of overall reform are beyond the scope of this book, three broad suggestions are proposed here, before interest rate deregulation, and reduced reliance on the credit plan, are embarked upon.* The government must better co-ordinate its monetary and . If the government intends to exercise monetary control through debt sales, it needs to be certain, in a deregulated environment, that the volume of debt sold will not cause interest rates to rise to levels which damage both the real economy and the developing capital market. So far, this has not been a problem, but as the volume of treasury debt outstanding escalates, it will be an increasingly important concern. In parallel, the government must establish better knowledge of its cash flow requirements, so that debt issues can be better co-ordinated with its spending requirements.

In terms of the banking sector, the speedy implementation of the separation of 'policy' and commercial lending is required, so that banks grow more aware of the need for risk management. In parallel, banks must begin to acquire the capacity to manage interest rate risk, and also attend to the current mismatch between their assets and liabilities.

Interest rate deregulation could begin in the areas which most affect primary markets; short-term rates and money market rates. Liberalising interest rates in these areas would help establish a better defined short-term yield curve and thus help the pricing of new short and medium-term government securities issues.

Second turning to securities markets themselves, the most important area for attention, where the greatest problems lie, is the primary market. Any remaining administrative placement of bonds should be curtailed, and all bond issues should be tradable. In the bond market, the government must:

Clearly distinguish between wholesale and retail investors, and increase the relative emphasis on the former category. Focus on a wholesale investor base will permit the offer period to be reduced, and will permit the eventual adoption of an auction system. The present distribution system, parcel sizes and title transfer systems are poorly suited to a wholesale market, or to the development of a liquid secondary market. An effort should be made to gauge wholesale investors' demands for bonds, and their preferences in maturities. Bonds should then be targeted for sale to this group, and retail investors should be treated as a residual. The government must also assess its own short and long-term financing requirements, and its cash flows. For its term financing requirements, the government should have a pre- announced issue calendar for the year for its debt issues, spread over the year. This will also help to improve liquidity management at the level of the wholesale buyers, and assist the development of a ben~hmark.~ Government and institutional liquidity management would be further assisted by regular issues of short-term debt (one to twelve months maturity), to meet short-term liquidity needs. In addition, the central bank (PBC) can issue short-term paper, on an as-required basis, to help liquidity management. Electronic registration and transfer of title should be adopted as the standard for wholesale issues. The yield at issue should be related to current secondary market yields, rather than to deposit rates. The government can then move gradually to an auction system, auctioning a part of its bills, and selling the rest on a non-competitive auction or average price bid basis.

For retail investors, a savings bond issue should be designed, available on demand at any time of the year, which would have the effect of spreading retail sales over the year. The interest rate offered could be altered to stimulate or dampen retail demand. Since such an 'on demand' issue will be difficult to trade because of the variety of maturity dates, it should be possible to redeem them early at a penalty. For corporate bonds, the determination of capacity to issue has been based more on evaluations from credit rating agencies than quota-driven decisions by local authorities.

For equities, attention to primary markets also implies a greater role for market forces:

The decision to issue new equities should be left more in the hands of risk- taking enterprises, subject to compliance with rules established by the exchanges, and the central regulatory authority. The large role of local governments in the selection of such enterprises (in accordance with prevailing policy priorities) must be reduced, and the frequently continuing role of local authorities in the pricing of new issues must also be curtailed. Any remnants of the lottery-based system of share allotment must be phased out, preferably in favour of a discriminating price auction. The selection of underwriters should be left to issuing enterprises, and underwriters should be allowed to competitively bid for terms. The present 'firm commitment' underwriting system should be gradually abandoned in favour of systems where the enterprise and underwriter are better able to share risks, such as the 'best effort' or auction methods. The length of time from offer to opening should be reduced. The bunching of new issues should be avoided, and, Fees for application forms should be done away with.

The third area for action is secondary market development. Many of the problems here stem from underlying primary market problems. In the bond market, the problem of poor liquidity impedes price discovery and is reflected in the ill-defined present yield curve. China has still to develop a benchmark issue to enable more efficient securities pricing: These problems will be assuaged by the measures recommended above, for the primary market, especially with the introduction of issues more evenly spaced out over the year, on a pre-announced schedule, targeted primarily towards wholesale investors. Additionally (although detailed recommendations are beyond the scope of this book), constraints on the operation of the money market must be addressed.

Regional market segmentation in the bond market, and regional price differentials, have greatly improved, but will not be eliminated unless the government either:

sets up a centralised depository for all government bond issues, or requires the adoption of mutual recognition of share certificates from different trading centres. The former is the route adopted by most mature economies, including large economies such as the US.

In the secondary market for equities, the key problem of volatility also stems in part from features of the pririary market, and the measures described above (reduced reliance on lottery-style IPOs, competitive underwriting, etc.), will help address this problem. Additional measures which can be taken include:

Reintroduction of daily price limits. Introduction of (an ideally short-term) capital gains tax on share trading. If it is not administratively feasible to implement this, a share turnover tax can be imposed as a second best alternative. Payment of cash dividends. In February 1995 the government announced its intention to introduce this, and the intention should be implemented and monitored. Improved disclosure, in terms of both quality and timeliness. An emphasis on press responsibility. A more proactive stand against front-running and market manipulation.

Most of all, the government must be more aware of its own 'announcement effects', which demonstrably have the capacity to send markets soaring or plummeting. Some government interventions undertaken in the market, such as sudden announcements of bans on new share issues, would be regarded as market manipulation in mature economies.

Apart from the problem of volatility, the issue of regional market segmentation remains a large issue in the equities market. It is recommended that:

dual listings on the presently recognised exchanges be permitted new trading centres be allowed to open, provided they can comply with all requirements laid down by the central authority, and provided, the establishment of regional offices of the CSRC be permitted, and the present conflicts between central and regional regulations be removed, with a single, centrally-based regulatory authority.

The problem of different share classes is also an issue, and the present distinction between state, legal person, and individual shares should be done away with. It is encouraging that the new Companies Law (unlike the former Standard Opinions) makes no reference to such distinctions.

Fourth, all parts of the market would benefit from the development of an institutional investor base, and here the government should further encourage flexibility in the uses of funds for contractual savings institutions (the new insurance law already goes some way towards this and encourage further competition in insurance by more clearly separating the spun-off subsidiaries of PlCC from the parent. The greatest challenge in this area lies in augmenting the sources of funds, through pension and social security reform, where the mobilisation of funds is limited, due to the prevalence of pay-as-you-go pension systems. China today is well situated to take a major step forward here, by introducing a multi-pillar, funded social insurance and pension system. Housing funds should be permitted to offer more attractive returns. In addition, the present ill defined regulatory framework for mutual funds needs clarification, and ad hoc government interventions in mutual fund regulation should be discouraged. Fifth, regarding the participation of foreign investors in China's securities markets:

China can afford to, and should, encourage foreign portfolio equity investment today, vis-2-vis foreign direct investment; and should reduce the fiscal incentive bias in favour of FDI. The present uniquely Chinese distinction between A and B shares should be removed. The requirement of a freely convertible currency in this regard is not critical; there are countries which have restrictions on convertibility which do not impose such restrictions (eg Bangladesh). The few countries which used to maintain such distinctions (the Philippines, Finland), have now abolished them. While the aim of controlling foreign participation in the domestic equity market (and consequently capital inflows and outflows) is understandable, this aim can be realised by other means (see Chapter 5). China should continue to broaden its base in overseas listings, on a variety of exchanges, but should also try to encourage dual listings (eg, with Hong Kong), to ensure adequate liquidity. Present restrictions against foreign participation in the domestic debt securities market should be maintained, until the domestic bond market is considerably strengthened.

Sixth, in the area of regulation, it is recognised that the details of regulations are not in themselves a problem, and most are sound by international standards. The first key issue here is the fragmentation of oversight; horizontal, vertical, and functional. To address these problems, it is recommended that:

The present dual regulatory regimes maintained by the centre and by local authorities should be removed, and the CSRC should be given jurisdiction, through its own regional offices, over regional trading centres (both the present two officially recognised exchanges and any others that may be established and recognised in the future). Present overlap in jurisdictional oversight between the PBC and CSRC must be addressed, and consolidated under a single authority. While the role of the PBC in this area is recognised to be the outcome of the historical evolution of the market, its continued and overlapping authority impedes efficient oversight. The problems of more clearly defining certain areas of oversight are particularly acute for certain types of securities; (bonds are more affected than equities, and corporate bonds are the least clearly defined), as well as for certain market participants; notably, securities dealers and intermediaries, and for institutional investors such as mutual funds. In these areas, the underlying laws themselves need to be clarified.

A key legal issue to be addressed is the clarification of the separation of bank and non-bank activities. So far this appears to have been handled by administrative regulations under the PBC, but in view of the close institutional ties between deposit taking institutions and securities dealers, as well as the rapid growth of the latter, a clarification and strengthening of these laws is required. This has been addressed in the Commercial Bank Law of 1995, but the implementation of the separation is still incomplete.

Finally, if the new framework of regulations and recommendations is to be effectively implemented, the government must strengthen the CSRC, which at present, with its single Beijing-based office of some 120 staff, is not adequately equipped to effectively discharge its responsibilities.

The last issue discussed here is, what structure of priorities should the government adopt in implementing these recommendations? First of all, it is recommended that the government address the fundamental questions regarding the enabling environment. Next it should address the problems of the domestic primary markets, and third, examine issues pertaining to secondary markets and international investors. The development of institutional investors and strengthening of the framework of regulation and oversight should proceed in parallel.

Endnotes

1 While volatility has been most apparent in the equities market, there was a spectacular recent (February 1995) escalation of bond futures trading, due to a speculative bubble in a single futures contract (see Chapter 2). Trading in the underlying spot markets for bonds also grew as a consequence. 2 Some World Bank studies shed more detailed Iighton some of these issues concerning the 'enabling environment' including an informal study on interest rate liberalisation (April 1994); a study on state enterprise reform (August 1994), as well as a study on Public lnvestment (which includes an evaluation of the State lnvestment Plan and State Credit Plan) (November 1995). 3 To avoid a large number of issues of different maturity dates, and hence improve liquidity, some countries have adopted an 'on-the-run' issue system, in which bonds issued at different dates in the year all mature on the same date.

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- 1988a, Indonesia: Rural Credit Sector Review, Report No 691 7-IND, April.

- 198813, Philippines: Financial Sector Study, Report No 71 77-PH, August.

- 1988c, Asia: Regional Financial Sector Report: Lessons from Financial Liberalization in Asia+A Comparative Study, Report No 751 2-AEP, November.

- 1990a, China: Financial Sector Policies and Institutional Development, A World Bank Country Study Washington, DC, The World Bank.

- 1990b, Indonesia: Financial Sector Report, Report No 81 59-IND, May.

- 1990c, Thailand: Financial Sector Study, Report No 8403-TH, May.

- 1990d, 'China - Financial Sector Review: Financial Policies and Institutional Development', Report No 841 5-CHA, 29 June.

- 1991, Viet Nam: Transforming a State Owned Financial System, A Financial Sector Study of Viet Nam, Report No 9223-VN, April.

- 1992a, Philippines: Capital Market Study, Report No 10053-PH, February.

- 1992b, Philippines - Capital Market Study, Report No 10053 2 vols, February 24.

- 1993a, CHINA - Financial Sector Development Strategy Paper Draft Washington DC.

- 1993a, India: Capital Markets Review, Discussion Paper, IFC Washington DC.

- 199313, Korea Financial Sector Study, Report No 11 373-KO, 15 July.

- 1994a, China: Internal Market Development and Regulation.

- 199413, Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth, Oxford University Press, New York.

- 1994c, Argentina: Capital Markets Study, Report No 12963AR, 29 June.

- 1994d, China: Financial Sector Reforms: Current Status and Issues, Draft, Confidential Report No 13492-CHA, September.

- 'Financial Flows and the Developing Countries', World Bank, Quarterly Publication, Debt and International Finance Department.

- 1995, 'China: Macroeconomic Stability in a Decentralized Economy' Wuhan Securities Exchange Centre 1994, 'A Brief Introduction to the Wuhan Securities Exchange', Wuhan, China.

Yi-Chen Zhang and Yu Da, 1994, 'China's Emerging Securities Market', Columbia Journal of World Business, Vol XXIX, Summer 11 3-21

Yisun, Ying 1994, 'The Development of China's Stockholding Companies and Stock Market' Hong Kong Stock Market Research Team, Research Report Series 1994, (WP-94-05), People's Bank of China, Zhejiang Branch.

Yongzhi, Chen 1994, 'The Transformation of China's SOEs to the Stockholding System and an Inquiry into the Prospects for Development of the Stock Market', Stock Market Research Team, Research Report Series 1994, (WP-94-08), Industrial Finance Trade Research Institute, Sichuan.

Zhongfang, Chen 1994, 'China and Foreign Securities and Financial Capital - Comparison of Observations on the Macroeconomy' Stock Market Research Team, Research Report Series 1994, (WP-94-01), Zhejiang Zhongsheng Futures Brokerage. Appendix Table Al.l China: debt securities issued and outstamding (Rmb100 million)

Treasury bonds lssued Redeemed Outstanding Treasury bills lssued Redeemed Outstanding Fiscal bonds lssued Redeemed Outstanding National construction bonds lssued Redeemed Outstanding National key project con- struction bonds lssued Redeemed Outstanding Special national bonds lssued Redeemed Outstanding Appendix Table Al.l China: debt securities issued and outstanding (Continued)

Inflation-proof bonds lssued Redeemed Outstanding

National investment bonds lssued Redeemed Outstanding

National investment corporation bonds lssued Redeemed Outstanding

Government-owned enterprise bonds lssued Redeemed Outstanding

Financial institutions debt lssued Redeemed Outstanding Financial bonds lssued Redeemed Outstanding Trust fund securities lssued Redeemed Outstanding Appendix Table A1 .I China: debt securities issued and outstanding (Continued)

Investment fund securities lssued Redeemed Outstanding

Enterprise bonds lssued Redeemed Outstanding Local enterprise bonds lssued Redeemed Outstanding Short-term paper lssued Redeemed Outstanding Domestic bonds lssued Redeemed Outstanding Housing construction bonds lssued Redeemed Outstanding Local investment corporation bonds Issued 4.37 Redeemed Outstanding 4.37' Subtotal Issued 48.66 43.83 41.58 42.53 65.61 192.51 236.87 419.18 382.36 394.15 695.41 1,197.67 381.31 Redeemed 0.00 0.00 0.00 0.00 0.00 27.88 75.83 108.38 127.27 203.58 260.41 465.09 123.29 Outstanding 48.66 92.49 134.07 176.60 242.21 406.84 567.88 878.68 1,133.77 1,324.34 1,759.34 2,491.82 2,749.84 Appendix Table Al.l China: debt securities issued and outstanding (Continued)

Stocks Total of which: A shares B shares H shares

Large sum negotiable CDs Issued Redeemed Outstanding

Note: "The balance outstanding for treasury bonds cited here does not equal last year's balance plus net new issues, because of a difference between the redemption amount and settlement amount, owing to a split year adjustment. 1994, Rmb75.11 billion of bonds were issued by the newly established State Development Bank, to other financial institutions. The bonds are non-tradable, are of three and five-year maturities, and have coupon rates of 12.5 per cent and 14.0 per cent, respectively. Source: State Council Securities Committee, circular dated August 1994 Appendix Table A1.2 China: trade in securities (Rmb100 million)

Treasury bonds Treasury bills Fiscal bonds National construction bonds National key project construction Special national bonds Inflation-proof bonds

National investment bonds

National investment corporation bonds Key enterprise bonds Capital construction bonds

Financial bonds

Local enterprise bonds

Short-term enterprise negotiable certificates

Subtotal debt securitiesa

Enterprise stockb

Jumbo CDs

Total all securities

Note: "Bond trading is estimated on a gross basis. bEnterprisestock trading includes officially recognised centres only. Source: State Council Securities Committee, circular dated August 1994 Appendix Table A1.3 China: securities trading on the Shanghai Exchange in 1994 (January 1994 to January 1995) (Turnover, Rmb million)

Equities Treasury bonds Funds Total

A shares B shares Spot Repurchase Futures

Source: Shanghai Securities Exchange: Monthly Market Statistics Appendix Table A1.4 China: Securities markets and the financial sector (Rmb billion ) (1 989-1 994)

Assets Financial institutions Specialised and universal banks: total assets of which, loans Credit co-operatives: assets of which, loans Nun-monetary financial institutions

TICS:assets a lnsurance companies Non-monetary financial institutionsc NMFl Assets 1%) Liabilities Deposits at financial institutions Specialised and universal banks Credit co-operatives Securities (annual issues) of which, debt securities Securities outstanding of which, debt securities Securities issued /Total deposits (%I Securities outstanding /Total deposits (%) CDP at market prices Securities outstanding1 CDP (%)

Notes: "Data are available specifically for finance companies, securities companies and leasing companies only for 1992, when their assets were Rmb 19 billion. bData for 1993 are estimated. 'Data for 1995 are reclassified in a new format, for all 'non-monetary financial institutions'taken together. Sources: (1990 to 1994) bank and credit co-operative's assets and liabilities: IMF 1995 Article IVstatistical tables. 1994 data are from the end of September. 1994 data on non-monetary financial institutions are hrom the same source. (1989) Bank and credit co-operative's assets and liabilities: IMF 1994 Article IV report. lnsurance company data: Almanac of China's Banking and Finance; P/CC annual reports. Securities data are from the State Council Securities Committee (see Appendix Tables A 1.1 and A 1.2) Appendix Table A1.5 Financing of the Government deficit: contribution of bond issues (1988 -1 994) (Rmb billion)

Year 1988 1989

Government budget deficit Budgetary revenue (Rmb billion) Budgetary expenditure Visible deficit Financing of the visible deficit ~omestic: Gross PBC borrowing " Change in treasury deposits Purchases of Government bonds by state banks Other domestic financing Other domestic financing not elsewhere-classified Foreign Consolidated deficit PBC Lending to financial system (a)Policy loans, lower bound % GDP (b)Policy loans, upper bound '% GDP Consolidated deficit: lower bound Consolidated deficit: upper bound Government debt securities issues Treasury bond issuesd Redemptions Net treasury bond issues Net issues of treasury bills Treasury bond net issues % of visible deficit % of consolidated deficite Treasury bill net issues % of visible deficit -21 .O -11.5 % of consolidated deficite -9.3 -4.9 Overseas sovereign bond issues (Rrnb billion) (US$ billion) % of foreign financing of visible deficit Memo item: GDP (Rmb billion) 1407.4 1599.8 Exchange Rate (Rmb per US$) 3.722 3.765

Notes: a Figures for 1993 and 1994 are estimates.

b,c Defined as 60 and 80 per cent of PBC lending to financial system. Treasury bonds include treasury bills special national bonds (and include inflation indexed bonds), as well as bonds issued to financial institutions (fiscal bonds) and bonds earmarked for specific investments (National Construction Bonds and National Key Project Construction bonds). 'Lower bound. Sources: Data pertaining to the government deficit and its financing are based on IMF (7 995 and earlier years) Article IV; estimates of the consolidated deficit are based on World Bank, CEM, 1994 (both using CFS definitions). Data on securities issues are from the State Council Securities Policy Committee Appendix Table A1.6 China: contribution of securities markets to investment (Rmb million) (1 987-1 993)

lnvestment Total investment in state owned units Capital const. inv. in state owned units lnvestment in key state projects lnvestment financing through securities 1. Treasury bondsa of which, earmarked investment bondsb 2. Investment bondsc 3. Enterprise bondsd % Treasury bonds in total SOU inv. % Tbonds+investment bonds in total SOU inv % Enterprise bonds in total SOU inv. Total contribution of bonds to SOU investment (YO)' Equity: annual new issues Total contribution of equity to SOU investment (%) Memo items: financing of SOU investment State budget % Domestic loans % Foreign investment % Self-raised funds and other %

Notes: "These include bonds used for general financing, such as treasury bills, fiscal bonds, inflation-proof bonds, as well as some bonds earmarked for construction projects (see b below). See Appendix Table A 1. 1. bNational Construction bonds and National Key Project Construction bonds. 'Earmarked investment bonds issued by provincial governments to aid regional development, as well as bonds issued by the now largely defunct State lnvestment Corporations. dThese include bonds issued by central enterprises (Government-owned enterprise bonds in Appendix Table Al. 1)as well as local enterprise bonds, commercial paper, housing construction bonds, and also, i'ocal investment corporation bonds (see Appendix Table A 1.1). eThis is the upper bound, assuming all government bond issues are used to finance investment. The actual proportion of bond issues used for investment financing is clearly likely to be lower. Sources: Data provided by the State Council Securities Committee and the State Planning Commission Appendix Table A1.7 China: overseas debt and capital markets (1 987- 1993) (US$ billion and O/O)

1987 1988 1989 1990 1991 1992 1993

% 70 Yo Yo Yo Yo 70 ANRF ANRF ANRF ANRF ANRF ANRF ANRF

Aggregate net resource flows (ANRF) 8,575 10,272 9,685 10,047 9,777 23,785 41,235

LT debt 6,052 6,773 6,047 6,312 Disbursements 8,044 9,092 8,431 9,649 O/Wbonds 1,064 12.4 782 7.6 450 4.6 277 commercial banks 4,605 53.7 4,470 43.5 2,014 20.8 3,244 Repayments 1,992 2,319 2,384 3,337 O/Wbonds 0 0 11 0.1 33 0.3 325 commercialbanks 468 5.5 754 7.3 867 9.0 808 Net flows 6,052 6,773 6,047 6,312 bonds 1,064 12.4 771 7.5 417 4.3 -48 commercial banks 4,137 48.2 3,716 36.2 1,147 11.8 2,436

Direct FI 2,314 27.0 3,194 31.1 3,393 35.0 3,487 34.7 4,366 44.7 11,156 46.9 25,800 62.6 Portfolio equity foreign in vestment 0 0 0 0 0 0 0 0 653 6.7 1,194 5.0 2,278 5.5

Grants excl. TA 209 304 245 249 242 327 360

Aggregate net resource flows (ANRF)" 8,575 10,271 9,685 10,048 9,777 23,785 41,236

Commitments 10,335 10,149.7 8,338.2 9,979.2 8,286.7 16,830.8 21,798.8 bonds (%commitments) 993.5 (9.6) 781.8 (7.7) 727.0 (8.7) 0.0 (0) 260.4(3.14) 894.2 (5.3) 2,656.9(12.2)

Note: "Aggregate net resource flows = long-term debt+direct foreign investment + portfolio equity foreign investment + grants excluding technical assistance. Source: Calculations based on data from the World Bank, IEC Appendix Table A2.1 China: structure of securities regulation

I STATE COUNCIL I

(0 final approval of new exchanges and overseas listings ) ilJC F1 -7 FI FI

.supervision of markets securities licensing and regulating accountants einvestment funds and

- CSRC National I companies I, I regulation listings I I Accountants I securities companies I I I I supervision (but licensing) I I I I I 1-1 ~awyers I

I l~hanghai I Shenzhen 1 - 4- - I 1 u

regional enterprise bonds issued by regional enterprise companies

Shanghai Shenzhen Local stock trading centres I I Appendix Table A2.2 Structures of regulation in Asian securities markets

Regulator Bangladesh Hong Kong India Indonesia Korea Malaysia

Government Controller of BAPEPAM MOF MOF capital issues (for SE and MOF Governance)

Other agency SFC SEBl SEC SC (exec.body is SSB)

9 persons of Board of regulator The office of 10 persons of 6 persons whom 6 are 9 persons controller of whom 5 are including appointed by the including 4 capital issues staff and the representatives present from the others are non- from the (recommended by government government Ministry of the Ministry of and 4 Finance, Finance], 3 are appointed by Ministry of full time. the Ministry of Law, Justice The appointees Finance and Company include the Affairs, the Governor of the Reserve Bank Bank of Korea, the of India, and Chairman and 2 government CEO of the appointments Korean Stock Exchange and the Vice Minister of the Ministry of Finance

Power to prosecute MOF No To whom the No regulator reports MOF MOF Exco MOF securities bureau MOF Industry bodies concerned with KSDA self- regulation No No No No Stock Brokers' Association Appendix Table A2.2 Structures of regulation in Asian securities markets (Continued)

~~~~~ Regulator Pakistan Philippines Singapore Sri Lanka Taiwan Thailland

Government Corporate law authority

Other agency SEC MAS SEC SEC SEC and office

Board of 4 persons, the 5 persons. All Controlled 10 persons. 7 14 persons, of Upto11 regulator Chairman is a appointments are wholly by the appointments whom 7 to 9 are persons. The civil servant. 3 made by the government. including one full time. They Chairman is from persons president. All The Chairman is Deputy include persons the Ministry of appointed by the appointments are the Minister of Governor of the from the Finance. Other Ministry of full time. Finance. Central Bank. Ministries of institutions Finance. 3 are ex officio; Finance, represented are the Deputy Economic the Central Bank Secretary of the Affairs, Justice, and Ministry of Treasury, the the Central Bank, Commerce. 4-6 Registrar of the Planning appointments are Companies and Council and the by the the President of Economic government. the Institute of Council. Chartered Accountants.

No Yes Power to No Yes prosecute MOF Dept. of Finance MOF To whom the MOF MOF regulator reports PASBD (rather AMSET Industry bodies inactive) TSDA concerned with No self- regulation

Source: International Securities Consultancv Appendix Table A2.3 Minimum listing requirements of major stock markets

Market Trading record Profits record Minimum market capitalisation Minimum net assets

Hong Kong 3 yrs Yrs 1 and 2: Aggregate US$12.8 million (with at least N/A profits attributable to US$6.4 million public shares) shareholders lie, after tax) of at least US$3.8 million Yr 3: Profits attributable to shareholders (ie, after tax) of at least US$2.6 million

Aggregate Profits before tax for past 3 financial Australia 3 yrs years of US$0.7 million US$1.423 million with at least US$0.3 million profit before tax in latest financial year

Singapore Cumulative consolidated

SES 5 yrs Profit before tax of Capital*: US$2.6 million US$4.858 million for the US$67 million = greater of US$lOm or 10% N/A

3 yrs

Tokyoa Stocks are assigned to 1 st section the 1 st section from the 2nd section based on their trading levels and dividend record

-

Note: *Percentage of shares in hands of holders with between 500 and 10,000 shares Appendix Table A2.3 Minimum listing requirements of major stock markets (Continued) - Market Trading record Profits record Minimum market capitalisation Minimum net assets

2nd section 5 yrs Profit before tax US$10 million N/A Yr 3:US$2.0 Min shareholder's equity Yr 4:US$3.0 million Yr 5:US$4.0 million

5 yrs Profit before tax in each US$100 million of last 3 years Min shareholder's equity of at least US$20 million

US$1.0 per share OTC 1 vrs 12.5% of shares to be offered to US$2 million the public

United Kingdom N/A London Stock 3 yrs US$1.035 million Exchange (can have made losses) Unlisted securities 2 yrs N/A (can have made N/A market losses)

Either USA 3 yrs Profit before taxYr 1: US$18 million NYSE US$2 million, Yr 2: US$2 million ,Yr 3: US2.5 million Or: aggregate profit before tax in the last 3 years of US$6.5 million and at least US$4.5 million in Yr 3 (all three years must be profitable)

Note: *Percentage of shares in hands of holders with between 500 and 10,000 shares

283 Appendix Table A2.3 Minimum listing requirements of major stock markets (Continued)

Market Trading record Profits record Minimum market capitalisation Minimum net assets

AMEX 3 yrs Profit before tax of US$3 million US$4 million US$750,000 in last FY or in 2 of last 3 years

NASDAQ 3 yrs Profit before tax of US$3 million US$4 million US$750,000 in last FY or in 2 of last 3 vears

Canada Toronto NIA Profit before tax for industrial companies in last FY of either: (a) US$72,186 with a (a) Public shares of at least (a) USS0.722 million pre-tax cash flow of US51.449 million Or US$0.285 million Or (b) N/A (b) Public shares of at least (b) US$3.493 million Or US$1.527 million Or (c) US$0.142 million (c) Public shares of at least (c) NIA with a pre-tax cash US$1.449 million flow of US$0.362 million

Note: "October 1994. Source: International Securities Consultancy Appendix Table A3.1 China: Securities trading by region Trading value (1 992) (Rmb million)

------National investment Local Local Large-sum Treasury corporation enterprise Financial enterprise Enterprise Itime-deposit bills bonds bonds bonds bonds Total Percent stocks certificates

Beijing Tianjin Hebei Shanxi Inner Mongolia Liaoning Shenyang Dalian Jilin Changchun Heilongjiang Harbin Shanghai Nanjing Zhejiang Ningbo Anhui Fujian Xiamen Jiangxi Shandong Qingdao Henan Hubei Wuhan Hunan Guangdong Guangzhou Shenzhen Guangxi Hainan Sichuan Chengdu Chongqing Cuizhou Yunnan Ti bet Shaanxi Xian Cansu Qinghai Ningxia Xinjiang Total

Note: Estimated on a net basis. Source: Almanac of China's Finance and Banking (1993) Appendix Table A3.2 Monthly transaction volume in the interbank market (Rmb bill ion)

Non-bankd financial All financial M bc Year Month State banks % Other banks O/O institutions % institutions

Total 1990 Total 1991 1992 January February March April May June July August September October November December Total 1992 1993 January February March April May June July August September October November December Total 1993 1994 January February March April May June July August September October Total 1994'

Notes: "State banks include lndustrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, People's Construction Bank of China, Bank of Communications and ClTlC lndustrial Bank. banks include non-state-owned commercial hanks and regional banks. 'Data on other banks and non-bank financial institutions available from 1993. dNon-bank financial institutions include rural and urban co-operative credit agencies, trust and investment companies and accounting firms. 'January to October only. Source: SEEC, 1995 Appendix Table A3.3 Assets of financial institutions engaged in the interbank market (Rmb billion)

State bank Other bank NBFIC Year Quarter assets YO assets YO assets YO Total"

Total 1991

Total 1992

Total 1993

Total 1994

Total

Notes: "Totals for 1990-1 992 include only state bank assets and non-bank financial institutions assets. bJanuary-Septernberonly. 'Non-bank financial institutions Source: SEEC, 1995. Appendix Table A4.1 China: Key characteristics of the equities markets of Shanghai and Shenzhen

Shanghai Shenzhen 1991 1992 1993 1994 1991 1992 1993 1993 1994

A. Quantitative indicators Number of listed companies (Nos) Number of listed stocks (Nos) of which A of which B Market capitalisation (Rmb billion) of which A of which B Value of trades (Rmb billion) of which A of which B Number of shares traded (million) of which A of which B Members of exchange (Nos) of which members outside exchange city

B. Trading rules and characteristics Year founded 1990 1991 Hours M-F 9:30-ll:30 M-F 9:OO-l l:00 1 :30-3:30 2:OO-3:30 Quoteslclearance A shares Rmb Rmb B shares US dollars HK dollars Typical type of listed company Large industrial (State-owned) Small/export oriented Listing criteria Minimum value of issues Rmb 50 million Rmb 20 million Operating performance 3 years of profits 3 years operating record Individual share of equity ( mini 25% Settlement A shares T + 1 A-shares T + 1 A-shares B shares T + 3 B-shares T + 3 B-shares Clearing Book-entry Book-entry Round lot 100 shares 2,000 shares Registration Beneficial Ownership Broker's Name (Nominee) Total dealing costs (two-sided) 1.52% t 2.1% + Short-selling Prohibited Prohibited Capital gains tax 20% " 20% Dividends tax 0% 0%

Source: Shanghai and Shenzhen Stock Exchange.

288 Appendix Table A4.2 China: Size and growth of China's equities markets (1 991 -1 994)

Shanghai Shanghai Shenzhen Shenzhen Hong Kong Year A shares B shares A shares B shares Total H shares Total

1. Number of listed stocks (Nos) 1991 Q1 Q2 Q3 Q4 1992 Q1 Q2 Q3 Q4 1993 Q1 Q2 43 Q4 1994 Q1 Q2 Q3

2. Total market capitalisation (Rmb million) 1992 1993 1994

~ - pp

Source: Calculations based on data provided by the Shenzhen and Shanghai securities exchanges Appendix Table A4.3 Trading value of equities (1991 -94) (Rmb million)

Total Trading Value Per Quarter Average Daily Trading Value Shanghai Total Shenzhen Total Total Hong Kong Shanghai Shenzhen Hong Kong Year A shares 1 B shares Shanghai A shares 1 B shares Shenzhen China shares Total A shares 1 B shares A shares ( B shares shares Total

------

Source: Calculations based on data from the Shanghai and Shenzhen securities exchanges Appendix Table A4.4 China: Trading volume of securities per day (1991 -94)

Average number of daily transactions Year Shanghai A shares Shanghai B shares Shenzhen A Shenzhen B Hong Kong Trlday Shlday Trlday Shlday Shlday Shlday Shlday (000) (000) (000) (000) (000) (000) (000)

Source: Calculations based on data from the Shanghai and Shenzhen Stock Exchanges Appendix Table A4.5 Trading value of inter-linked trading centres (Linked to Shanghai) (January 1995)

Stocks Funds Bonds T-bond futures Trading trading value trading value trading value trading value centre (Rmb million) % (Rmb million) % (Rmb million) % (Rmb million) %

Beijing Sichuan Fujian Jiangsu Zhejiang Qingdao Nanfang Shenyang Hunan Anhui STAQ Harbin Xian Shenzhen Guangxi Henan Shandong Hubei Hainan Chongqing Ningbo Total Shanghai

Source: Shanghai Stock Exchange: Monthly Market Statistics, January, 1995 -- -

Appendix Table A4.6 China: Stock trading centres

Name Founded Approved by No. of listed instruments Number of members

1. Tianjin Securities 8 August1992 Municipal government Trading Centre Tianjin branch of PBC 2. Shenyang Securities 28 April 1992 Municipal government Trading Centre Shenyang branch of PBC 3. Dalian Securities May 1992 Dalian branih of PBC Trading Centre 4. Wuhan Securities April 1992 Hubei provincial branch and Trading Centre Wuhan City branch of PBC 5. Hainan Securities 20 December 1991 Hainan provincial Branch Centre (operating from of PBC 20 January 1992) 6. Hunan Securities 28 October 1993 Hunan provincial branch 5 Trading Centre of PBC 7. Fujian Securities December 1992 Fujian provincial branch None Trading Centre of PBC 8. Zhenang Securities 8 November1 992 Provincial branch 4 Trading Centre of PBC 9. Chongqing Securities 9 October 1992 Chongqing city branch ? Trading Centre of PBC 10. Harbin Securities 18 March 1993 Heilong Jianprovincial branch T-Bonds (no trading) Trading Centre of PBC (Jointlyoperated by provincial branch, with the city branch playing the main role) 11. Xi'an Securities 8 July 1993 Shanxi provincial branch of PBC None Trading Centre (not operating yet) 12. Tai Yuan Securities Prepared in 1992 Shanxi provincial branch of PBC None Trading Centre (not operating yet) 13. Zi Bo Securities 18 August 1993 Zibo Municipal Stocks = 12 Automated Trial operating government Quotation Systems September 27, 1993 (founded) 14. Quingdao Securities 25 December1993 Qingdao municipal government None Trading Centre (not operating yet) and Qingdao city branch of PBC 15. Sichuan Financial Market September, 1991 Provincial government (According 20 Securities Trading Centre (founded) to the opinion on trail opening on 26 November 1991 securities trading market jointly (started operation) signed by provincial restructuring committee and provincial branch of PBC) 16. Southern Securities 1 June 1993 Cuangdong provincial branch Centre (founded) of PBC 18 August 1993 (trial operation) 17. Beijing Securities At preparatory stage Beijing branch of PBC Trading Centre

Source: International Securities Consultancy (Hong Kong)

293 Appendix Table A4.7 Shanghai Securities Exchange: trading summary of sectoral stocks

Turnover Turnover Turnover No. of shares No. of listings (%) value (Rmb m) (%) per listing (No. of shares) (%)

January-December,1994 Industrial 119 58.62 279,195 48.68 2346.2 39,883.6 60.73 Commercial 35 17.24 89,862 15.67 2567.5 9,953.7 15.1 6 Real estate 12 5.91 68,413 11.93 5701.1 3,887.6 5.92 Utilities 13 6.40 48,626 8.48 3740.4 4,393.2 6.69 Misc. 24 11.82 87,412 15.24 3642.2 7,557.8 11.51 Total 203 100 573,507 100 65,676 100

January, 1995 Industrial Commercial Real estate Utilities Misc. Total

Source: Shanghai Stock Exchange: Monthly Market Statistics, January, 7995 Appendix Table A4.8 Initial public offering quotas (1993) Regional utilisation of provincial and municipal quotas (end 1993)

1. Hunan 28. Wuhan 2. Hubel 29. Cuangzhou 3. Cuangdong 30. Dalian 4. Anhui 31. Shenyang 5. Fujian 32. Tianjin 6. Henan 33. Qingdao 7. Liaoning 34. Nanjing 8. Hebei 35. Ningbo 9. jilin 36. Xiamen 10. Shandong 37. Chengdu 11. Cuizhou 38. Beijing" 12. Canshu 39. Xi'an" 13. Shanxi 40. Harbina 14. Yunnan 41. Chongging 15. Cuangxi 42. Shanghai 16. Heilongjiang 43. Shenzhen 17. Ningxia 44. Changchun 18. Zhejiang Total 19. Jiangsu 20. Neimenggu" II. A share quotas used by H share companies (at ) 21. Hainan" 22. Sichuana 1. Shanghai Petrochemical 150 23. Qinghaia 2. Qingdao Brewery 100 24. Xizhanga 3. Maanshan Steel & Iron 600 25. Xinjiang 4. Cuangzhou Shipyard 126.48 26. Shaanxi 5. Kunming Machinery 60 27. Jiangxi Total 1,036.48

- - - pppp

Note: There have been no public offerings in these provinces and independent municipalities. Source: China Securities Regulatory Commission Appendix Table A4.9 China and other emerging equity markets: relative size and market liquidity (1 994)"

Number Market No. Average Market Value of capital shares Value daily Turn- capitalisation/ traded/ Market listed isation Traded traded Traded trading valued over GDPe GDPe name stocks (US $ million) ratio (US $million) (US $ million) (US $ million) ratio (per cent) (per cent)

China 247

Other Asian emerging economies Indonesia 186 Korea 696 Malaysia 427 Philippines 184 Taiwan 292 Thailand 361 India 3,734

Latin America Argentina 168 264.1 408 Brazil 544 242.3 1,087,778 Chile 281 185.8 N.A. Mexico 195 986.8 2,381

Europe Greece 161 Portugal 186 Turkey 160 Hungary 32 Poland 2 7

Notes: "Average of 12 monthly observations, November 1993-October 1994. bDefined as (price per share) x (total outstanding shares). 'Defined as market capitalisation/listed shares. dDefined as value traded/number of trading days in the period. '1993 end of year data. Source: Calculations based on data from the IFC Emerging Markets Database and data from the IEC, World Bank Appendix Table A4.10 China and other emerging equity markets: growth (1 989-1 993)

Number of listed shares Value tradedb Market capitaliisation (Nos)" (US$ million) (US$ million) 1989 1991 1993 1989 1991 1993 1989 1991 1993

China

Other Asian emerging economies Indonesia Korea Malaysia Philippines Taiwan Thailand India

Latin America Argentina Brazil Chile Mexico

Europe Greece Portugal Turkey Hungary Poland

------

Notes: dAsof the end of the period. bT~talvalue of shares traded during the period. 'Defined as [price per share) x (total outstanding shares), as of the end of the period. Source: Calculations based on data from the IFC Emerging Markets Database Appendix Table A4.11 China and other emerging equity markets: volatility (1 993-1 994)

------Co-efficients of variation Sharp Mean COV Daily ratio Mean COV market market trading Turnover return on PIE PIE dividend dividend value ratio index ratio ratio yield yield

China 1 .06 0.92 0.03 203.73 0.75 4.20 0.43

Other Asian economies Indonesia 0.38 0.32 0.42 17.09 0.11 17.09 0.11 Korea 0.36 0.32 0.47 12.90 0.05 1.48 0.05 Malaysia 0.60 0.54 0.34 34.19 18.98 1.37 0.1 7 Philippines 0.61 0.32 0.43 40.58 0.07 0.90 0.08 Taiwan 0.56 0.44 0.31 3.47 28.73 0.56 0.36 Thailand 0.62 0.53 0.25 15.19 0.06 3.24 0.1 1 India 0.57 0.42 0.35 27.83 0.1 3 1.41 0.20

Latin America Argentina Brazil Chile Mexico

Europe Greece Portugal Turkey Hungary Poland

Source: Calculations based on data from the IFC Emerging Markets Database Appendix Table A5.1 International B and H share offerings by Chinese issuers

Issuer Announcement date Listings Value (Rmb) US$ equivalent

1. B shares: Shenzhen and Shanghai China Southern Glass Co Shenzhen Properties & Resources Development (Group) Ltd Shenzhen Petrochemical (Group) Shareholding Co Ltd Victor Onward Textile industrial Co Ltd Shenzhen Zhongchu Co Ltd Shenzhen Shenbao Industrial Co Ltd Chiwan Wharf Holdings Ltd. Shenzhen Fiyta Holdings Ltd. Shenzhen Tellus Machinery & Electronics Co Ltd China Merchants Shekou Port Service Co Ltd Shenzhen Vanke Co Ltd. Shenzhen Gintian Industry Co Ltd Tsann Kuen (China) Enterprise Co Ltd. Zhuhai Special Economic Zone Lizhu Pharmaceutical Group inc Shenzhen Lionda Holdings Co Ltd. Shenzhen Special Economic Zone Real Estate & Properties Ltd Subtotal for Shenzen Exchange

Shanghai Tyre & Rubber Co Ltd. China Textile Machinery Stock Ltd. Shanghai Refrigerator Compressor Co Ltd. Shanghai Jinqiao Export Processing Zone Development Co Ltd. Shanghai Outer Gaoqiao Free Trade Zone Development Co Ltd. Shanghai Dazhong Taxi Co Ltd. Shanghai Lian Hua Fibre Corp Shanghai JinJiang Tower Co Ltd Shanghai Forever Bicycle Co Ltd Shanghai Phoenix Bicycle Co Ltd Shanghai Haixin Co Ltd Shanghai Yaohua Pilkington Glass Co Ltd Shanghai Dajiang (Group) Stock Co Ltd Appendix Table A5.1 International B and H share offerings by Chinese issuers (Continued)

Issuer Announcement date Listings Value (Rmb) US$ equivalent

Shanghai Hero Co Ltd Shanghai Diesel Engine Co Ltd Shanghai Friendship & Overseas Chinese Co Ltd Shanghai Industrial Sewing Machine Co Ltd China First Pencil Co Ltd Shanghai Shangling Electric Appliances Co Ltd Shanghai Steel Tube Co Ltd Shanghai Material Trading Centre Co Ltd Shanghai Automation Instrumentation Co Ltd Shanghai Posts & Telecommunications Equipment Co Ltd Shanghai Lujiazui Finance & Trade Zone Development Co Ltd Huaxin Cement Co Ltd

Subtotal for Shanghai 7,627.681 920.922

2. H Shares: Hong Kong Yizheng Chemical Fibre Co Ltd Tianjin Bohai Chemical Industry (Croup) Co Ltd Dongfang Electrical Machinery Co Ltd Dongfang Electrical Machinery Co Ltd Luoyang Glass Co Ltd Luoyang Class Co Ltd Zhenhai Refining & Chemical Co Ltd Shanghai Hai Xing Shipping Co Ltd Shanghai Hai Xing Shipping Co Ltd Harbin Power Equipment Co Ltd Harbin Power Equipment Co Ltd Zhenhai Refining & Chemical Co Ltd Chengdu Telecommunications Cable Co Ltd Chengdu Telecommunications Cable Co Ltd

Subtotal for Hong Kong 8,756.700 1,132.975

Notes: Listings : HK : Hong Kong H : Shanghai SZ : Shenzhen Source: World Bank. IEC Appendix Table A5.2 China's overseas share listings (Hong Kong and New York) - Company Amount Listing

China Southern Airlines (One of China's three largest airline groups based in Shanghai) China Eastern Airways (A core enterprise of the China Eastern Airlines group based in Shanghai) Datang Joint Stock Power Company (A power supply company incorporated in Hebei province) Huaneng International Joint Stock Company (A Beijing-incorporated power supply company, Sino-foreign joint-venture) Shandong Huaneng Electricity Joint Stock (Sister company to above. Beijing-incorporated) Shandong lnternational Power Development Co. (Power supply company incorporated in Jian, Shandong Province) Dongfeng Motor Corp. (Ranked the eighth largest Chinese industrial enterprise in 1993, with a staff of over 90,000) Qingling Automobiles (A Sino-foreign joint-venture between Chongqing Autonlotive Corp and Japan's lsuzu Motors and United Capital of Japan) Wuhan Iron and Steel (Ranked China's fifth largest enterprise in 1992 and the country's largest producer of steel sheets) Tianjin Steel Tube Company (A manufacturer of steel pipesfor use in oil drilling, less than two years in operation) Cuangzhou-Shenzhen Railway (The most profitable railway line under the auspices of the Ministry of Railways) Xian Aircraft lnternational (An alrcraft industrial company incorporated in Beijing, with plans to inject the assets of ten more aircraft enterprises into the listed vehicle) Zhenhai Petrochemical (Under the auspices of the state refiner China Petrochemical (Sincopec). 47th largest company ranked in 1992) JilinChemical Industrial Co. (The 13th largest Chinese industrial company incorporated in JilinProvince) North East Electric Transmission (A transformer manufacturer incorporated in Liaoning Province) China Harbin Power Plant Equip Joint Stock Co. (Based in the northeastern province of Heilongjiang. Makes oil boilers, steam turbines generators and hydroelectric equipment) Appendix Table A5.2 China's overseas share listings (Hong Kong and New York) (Continued)

Company Amount Listing

lingwei Textile Machinery Plant (Produces textile machinery for garment manufacture. Based in Shanxi Province) Shanghai Hui Zing Shipping Company (One of a dozen companies under Shanghai Shipping Group. Provides ships and freight forwarding for the domestic market) Chengdu Cable Plant (Produces telecommunications cable. Located in Chengdu, Sichuan Province) Luoyang Glassworks (One of China's three largest glass makers) Guangdong Foshan Ceramics JointStock Co. (A construction materials producer incorporated in Foshan, Guangdong Province) Nanjing Panda Electronics Joint Stock Co. (A manufacturer of televisions, videos and telecommunications equipment incorporated in Nanjing)

-- - Source: Euroweek, 13 May 1994 Appendix Table A5.3 Country funds: trends in total returns Developing countries' best performing closed-end funds

(O/O average total return)

1992Q4 199341 1993Q2 199343 1993Q4 1994Q1 1994Q2 1994Q3

Asia 5.29 0.33 -1.68 4.03 19.75 -4.51 2.23 10.74 Brazil -1 0.55 3.21 3.43 4.92 1.03 34.61 -18.36 57.95 Chile 6.8 -6.21 7.56 1.81 13.64 3.05 13.08 1 3.45 China 3.04 -1.63 -5.5 2.48 15.51 -23.03 -5.12 9.41 Emerging global -0.2 -1 .82 3.21 2.52 14.8 -7.1 5 -3.92 17.28 India -8.22 -9.26 -1.62 3.94 10.21 10.66 7.23 6.45 Indonesia -0.05 2.89 4.98 2.89 12.65 -14.57 -7.97 5.66 Korea, Republic. of 8.1 3 0.73 0.11 6.09 9.04 0.2 6.08 9.76 Latin America 0.33 5.31 5.95 2.87 11.5 2.82 -7.5 22.61 MalaysiaISingapore 5.29 1.76 -4.64 5.2 20.8 -25.08 2.86 20.66 Mexico 11.73 6.99 2.93 -4.85 15.04 -9.76 -5.96 16.81 Pakistan 0.71 -6.81 7.02 3.08 16.38 12.25 -4.36 nia Philippines -0.97 -2.7 -1.86 5.1 1 40.62 -20.3 8.52 12.79 Thailand 8.65 -7.02 3.32 1.8 28.07 -20.08 4.39 16.1 9

Source: Lipper International Closed-End Funds Service Appendix Table A5.4 Credit ratings of Chinese borrowers

Ratings Announcement date Issuer full name Listing Standard and Poors Moodys

Bank of China A3 Bank of China Baal ClTlC Baal ClTlC Baal

ClTlC BBB Baal ' People's Republic of China A3 GlTlC BBB Baal People's Republic of China BBB A3 Bank of China BBB Bank of China BBB CITIC BBB Bank of Communications BBB

Notes: TO : Tokyo LX : Luxembourg LN : London UQ: Unquoted NY : New York 51 : Singapore H : Hong Kong Appendix Table A5.5 Sovereign ratings of selected developing countries Sovereign foreign currency debt (1994)

Moodys Standard and Pators

Investment grade Chile Baa2 BBB+ (1) China A3 BBB (2) Colombia Bal BBB- (2) Cyprus n.a. AA- (1) Czech Republic Baa2 BBB+ (2) Greece Baa3 BBB- (1) Indonesia Baa3 EBB- (2) Korea, Republic of A1 A+ (3) Malaysia A2 A (2)

Malta A2 ' A (1) Portugal A1 AA- (1 ) South Africa Baa3 BB (2) Thailand A2 A- (1

Below investment grade Argentina B1 BB- (2) Brazil B2 n.a. Hungary Bal BB+ (1) India Ba2 BB+ (1) Mexico Ba2 BB+ (2) Philippines Ba3 BB- (1) Slovakia n.a. BB- (1) Trinidad & Tobago Ba2 Turkey Ba3 Uruguay Bal Venezuela Ba2

Notes: (I) Stable outlook (2) Positive outlook (3) Negative outlook woo 00 29"0 0 82 mho mol NLOONn0- m NoJ LD 0 Nw-N-'O - LO N

P--.99 2 2 2 0 nw"0 3 0 -- - LON- -f 01hLOCO m n i~ a- ?g"- 2 2 V! 1 ?- LON m N -~~nm hNN LO 03 --- * N - m Appendix 85.1 Limits on equity participation by foreign investors

Korea Taiwan (i) General restrictions (i) General restrictions Foreign investment is limited to a Foreign portfolio investment is permitted maximum of 12% of the outstanding only through authorised trust funds. shares, except for some special cases. Overseas investors must enjoy foreign Foreign portfolio investment is allowed institutional investor status and should for up to 30% of convertible issues of be: among the world's 1000 largest smaller and medium-size companies foreign banks; insurance firms with 5 listed on the Korean stock exchange. years in business; or fund managers with Foreign shareholders are not allowed to minimum assets of $300 million and 3 buy or sell stocks on the margin or serve years in business. on the board of directors. (ii) Approval regulations (ii) Approval regulations All foreign institutional investors must Non-residents can participate only apply for prior approval from the SEC to through approved mutual funds. Foreign be allowed to invest in Taiwan. investors must register with the Korean (iii) Equity Participation Limit Securities Settlement Board and appoint Foreign institutional investors may hold either the Korean Securities Settlement a maximum of 5 % in any listed Corporation, a Korean bank, a Korean company and the total foreign holdings broker or the Korean branch of a foreign of each quoted company may never rise securities company as custodian. above 1 0%. (iii) Equity participation limit (iv) Other restrictions Since January 1992, foreign investors In 1993, the maximum investment have been allowed to own up to 10% of allowed per single foreign institution was the shares of most listed Korean raised from US$50 million to US$200 companies but a single foreign investor million and requirementsfor investment is limited to 3% of the foreign institutions were also relaxed. (except in Korea Electric Power Foreign investors are allowed to sell Corporation and Pohang Iron and Steel stocks one day after purchase, a change Corporation where the foreign and single from the earlier rule of allowing sales ownership limits are 8% and 1% only after physically taking delivery. respective1y). (iv) Other restrictions The Securities and Exchange Commission has the powers to impose specific restrictions. Appendix B5.1 Limits on equity participation by foreign investors (Continued)

India (iv) Other restrictions (i) General Restrictions A proposed future change in structure India's equity market opened up to would not allow foreign investors to overseas institutional investors in enjoy voting rights. September 1992. Foreign portfolio investors were allowed to invest directly Indonesia in listed Indian securities. Foreign (i) Approval regulations investors are not permitted to short sell Foreign portfolio investment is possible in the market. without prior approval. (ii) Approval regulations (ii) Equity participation limit Investment in securities is possible only The limit on foreign ownership is 49% through investment trust funds estab- of the listed share capital. lished in India, authorised by the Central (iii) Other restrictions Bank and registered with the Securities The articles of association of some listed and Exchange Board of India. companies contain further restrictions. (iii) Equity participation limit Gradual transfer of equily by the foreign Maximum of 5% per foreign investor for investor to an Indonesian party is any individual company. Total per required. company may not exceed 24% of the company's issued capital. Argentina (iv) Other restrictions (i) General restrictions Normally, 40%. Higher ceilings can be There are no restrictions on foreign possible in priority industries. acquisition of shares in existing local companies quoted on the stock market. Thailand (ii)Approval regulations (i) General Restrictions lnvestment in Argentina is no longer Foreign brokers must channel subject to the approval of the Argentine transactions through Stock Exchange of government. But prior approval is Thailand member firms. needed for the purchase of unquoted (ii) Approval regulations shares. Registration of foreign portfolio (iii) Equity participation limit investment is required. There are no limits on the amount of (iii) Equity participation limit foreign investment or on the percentage Foreign lnvestment is restricted to no of capital that may be acquired. more than 49% of any individual (iv) Other restrictions company's equity, with the limit lowered Mass media is the only sector that is to 25% for commercial banks and entirely off-limits to foreign investment. finance companies. S0urc.e: World Bank data Appendix 85.2 Foreign exchange controls on portfolio investment capital gains and dividends

Korea India (i) Capital (i) Capital Free repatriation of capital is guaranteed Repatriation of capital is permissible and is permitted on a dollar for dollar except when specifically precluded basis regardless of the exchange rate. under the original investment approval.. (ii) Capital gains, dividends and interest (ii) Capital gains, dividends and interest Guaranteed unlimited transfer of profits Provided that investment in securities is at the prevailing exchange rate. shown to have originated in an inward (iii) Currency and others transfer of foreign exchange, duly No foreign exchange controls unless the registered with the Central Bank, country is havingdifficulty in maintaining permission for repatriation is given once the balance of payments, there is a tax and reserve requirements have been sudden change in the exchange rate or met. the repatriation of funds is detrimental to (iii) Currency and others the domestic financial market. Each remittance of redemption proceeds to foreign investors requires central bank Argentina approval. (i) Capital Repatriation of capital is freely allowed. Thailand (ii)Capital gains, dividends and interest (i) Capital Remittances of dividends and capital are Free repatriation made via dollar denominated bonds (ii) Capital gains, dividends and interest purchased from the Central Bank. In Guarantee of annual dividend general there are now no restrictions on remittances of a maximum of the the movement of funds in and out of equivalent of 15% of paid up foreign Argentina, nor are there any constraints capital. on the repatriation of income and capital (iii) Currency and others gains. Prior approval of the Central Bank is (iii)Currency and others needed for outward transfer of foreign Official exchange rates apply to all currency for any purpose. Transfer up to transactions. There is no minimum time $500,000 in capital gains and dividends limit for foreign investment in Argentina per transaction may be done without and free currency conversion through the central bank approval. foreign exchange markets exists. Appendix B5.2 Foreign exchange controls on portfolio investment capital gains and dividends (Continued)

Taiwan convertible. Proceeds are remitted at the (i) Capital exchange rate at the time of transfer Repatriation of capital can be effected unless the firm's investment agreement one year after the capital has been specifies another rate. remitted to Taiwan. (ii)Capital gains, dividends and interest Chile For approved investments, investors can (i) Capital freely remit capital gains and dividends Capital may be repatriated one year after without restrictions. its entrance in Chile since December (iii)Currency and others 1992. As of November 1994, Central Bank; (ii) Capital gains, dividends and interest authorisation is necessary for overseas Dividends and net realised capital gains remittance of proceeds from securities can be remitted any time. There is no transactions in foreign currency in excess restriction on the remittance of profits. of $1 million. (iii) Currency and others Remittances are made at official Indonesia exchange rate via the Central Bank. (i)Capital Foreign exchange controls require all Repatriation of capital is permitted only foreign investments to be registered in after tax concessions given to the foreign order to secure the remittance investment company have expired, of income and capital. Investors are unless the funds remitted are derived from guaranteed access to foreign exchange the sale of shares to an Indonesian citizen. markets but there are no guarantees for Guaranteed repatriation of capital. variations in fiscal regulations. (ii) Capital gains, dividends and interest Repatriation of profits by the foreign Mexico (till November 1994) investor is permitted at any time. Foreign Currency and others investors repatriation of profits is Foreign investments are subject to the free guaranteed under the terms of the Foreign market exchange rate and no particular Capital Investment Law of 1967, as exchange control regulations are amended. applicable. (iii)Currency and others No restrictions on foreign exchange Source: World Bank data which would restrict remittances in or out of the country. Currency freely Appendix B5.3 Taxation of dividends and capital gains of foreigners investing in emerging markets

Korea (iii) Dividends and interest without tax (i)Capital gains tax without tax treaty treaty Those from countries without tax treaties Withholding tax on dividends is 35% if are subject to a tax of 26.875% on capital paid from untaxed profits, otherwise zero. gains, or of 10.75% of the value of (iv)Dividends and interest with tax treaty transactions, whichever is lower. No withholding tax on dividends. (ii) Capital gains tax with tax treaty (v) Fees and other taxes Investors from countries with tax treaties Sales through the Mexico Stock Exchange pay no tax or a lower tax. of shares considered as available to the (iii) Dividends and interest without tax general investing public are exempt of treaty withholding tax. 25% withholding tax on dividends. (iv) Dividends and interest with tax treaty Thailand Withholding tax may be reduced to 10 - (i) Capital gains tax without tax treaty 15% when a tax treaty is in force Retail investors are exempt from payment (v) Fees and other taxes of capital gains taxes arising from No fees. All investors subject to 0.2% tax transactions on the Stock Exchange of on the value of their stock sales Thailand. Local companies are taxed at the corporate tax rate of 30% while Taiwan overseas institutions pay a 15% (i) Capital gains tax without tax treaty withholding tax on capital gains. No capital gains taxes are levied (ii) Capital gains tax with tax treaty (ii) Capital gains tax with tax treaty 25% for non-residents. Residents of a No capital gains tax country which has a double taxation (iii) Dividends and interest without tax treaty with Thailand (26 countries), may treaty be eligible for exemption or lower rates. For approved investments, there is a 25% (iii) Dividends and interest without fax withholding tax on dividends and treaty interest. For unapproved, the tax is 35%. Foreign investors are subject to a 10% (iv) Dividends and interest with tax treaty withholding tax on dividends and 15% There is a withholding tax on dividends on interest and interest of 20%. (iv)Dividends and interest with tax treaty (v) Fees and other taxes Withholding tax on dividends is lo%, Transfer of shares is subject to a securities intcrest 3-15%. transaction tax of 0.1 %-0.3%. (v) Fees and other taxes VAT. Mexico (i) Capital gains tax without tax treaty Indonesia No capital gains tax. (i)Capital gains tax without tax treaty (ii)Capital gains tax with tax treaty Capital gains on the sale of Indonesian No capital gains tax. Appendix 85.3 Taxation of dividends and capital gains of foreigners investing in emerging markets (Continued)

securities by non-residents are not Decree 2284191 and Decree 114193 presently subject to withholding tax. respectively. (ii) Capital gains tax with tax treaty No capital gains tax. Chile (iii) Dividends and interest without tax (i) Capitalgains tax without tax treaty treaty There is no withholding tax on net The withholding tax on dividends or realised capital gains that are reinvested interest is 20% for residents of countries in Chile. For those that are not reinvested, which do not have tax treaty with the tax is 15%. Indonesia. (ii) Capital gains tax with tax treaty (iv) Dividends and interest with tax treaty No withholding tax. 10-20% withholding on dividends and (iii) Dividends and interest without tax interest. treaty (v) Fees and other taxes No withholding tax on dividends that are Average VAT of 10% applies to transfers. reinvested in Chile. For those that are not reinvested, the tax is 10% on interest and Argentina 20% on dividends. (i) Capital gains tax without tax treaty (iv) Dividends andinterest with tax treaty Income derived from the sale and No withholding tax. exchangeof securities are income exempt (v) Fees and other taxes for Argentine individuals and foreign No fees. FClF Law subjects foreign beneficiaries per Decree 2284191. investors to only 10% withholding tax at (ii) Capital gains tax with tax treaty the moment of remitting profit. No capital gains tax. (iii) Dividends and interest without tax India treaty (i) Capital gains tax without tax treaty Dividends are no longer subject to Long term capital gains (where stock has income tax per Law 24073 as of 1 April been held for a year or more) attract a 1992. Withholding tax on interest is 12%. tax of 10%. The 1993-94 budget reduced (iv) Dividends and interest with tax treaty the short term capital gains tax for the No withholding tax on dividends. foreign investor from 65% to 30%. Withholding tax on interest is 10-12%. (ii) Capital gains tax with tax treaty (v) Fees and other taxes Dividend and interest income taxed at Dividends and capital gains can be 20%. remitted up to 12% of the investment per (iii) Dividends and interest with tax treaty annum. Excess profits tax of 15 - 25% is Withholding tax on dividends 10% and levied on remittances exceeding the limit. interest 25%. Transfer of securities tax and stamp tax (iv) Dividends and interest with tax treaty within the jurisdiction of the city of Withholding tax on dividends 0-25% Buenos Aires has been abrogated by interest 7.525%. I Source: World Bank data I Appendix Table A6.1 China: lnsurance premium growth (1 986-92)

Year Premiums (Rmb billion) Growth rate (per annum) % GDP

Source: Niu (1994)

Appendix Table A6.2 China: International comparison of insurance premiums ( 1992) (per cent of GDP)

Asia Latin America Africa

China 1 .O Brazil 4.3 South Africa Korea 12.3 Panama 3.3 Zimbabwe Japan 8.6 Chile 3.0 Kenya Taiwan 4.8 Venezuela 2.2 Morocco Malaysia 3.8 Uruguay 2.0 Singapore 3.7 Colombia 1.8 Philippines 2.3 Argentina 1.6 Thailand 2.0 Mexico 1.5

Source: Sigma, World Insurance in 1992, Swiss Reinsurance Company, March 1994 Appendix Table A6.3 China: Comparisons of growth of insurance penetration (1 970-92) (annual premiums as per cent of GDP)

East Asia South Korea Taiwan (China) Malaysia Singapore Philippines Thailand Indonesia China

Latin America Brazil Chile Colombia Argentina Mexico

- - - - - Source: Sigma, Swiss Reinsurance Company, April 1992, June 1992 and March 7 994 Appendix Table A6.4 China: Comparisons of the structure of life and non-life insurance (1 992) (per cent of total premiums)

Life ( per cent) Non-life ( per cent)

East Asia South Korea Taiwan (China) Singapore Philippines Thailand Malaysia Indonesia China

Latin America Chile Mexico Colombia Argentina Brazil

Africa South Africa Zimbabwe Kenya Morocco

Source: Sigma, Swiss Reinsurance Company, March 1994 Appendix Table A6.5 China: Comparisons of the performance of the insurance industry in selected countries

Expense ratio Combined ratio

Non-life (Loss ratio) China (1 992) 65 Argentina (1 992) 53 Canada (1 987-89) 76 Mexico (1985-89) 80 United States, (1984-88) 83

Life (Payback ratio) China (1 992) 107 Argentina (1 992) 68 Canada (1 987-89) 128 Mexico (1 985-89) 78 United States (1 985-89) 119

Source: World Bank Staff Estimates

Appendix Table A6.6 China: Assets and liabilities of the People's Insurance Company (1 992/93)

Assets Liabilities Rmb billion YO Rmb billion YO 1992 1993 1992 1993 1992 1993 1992 1993

Liquid assets 22.2 23.1 46.2 39.5 Equity 8.2 8.0 17.1 13.7 Investments 10.1 15.6 21.0 26.7 Policyholders 28.4 36.0 59.1 61.5 Fixed 5.8 7.8 12.1 13.3 Reinsurers 2.8 1.5 5.8 2.6 Premiums receivable 0.9 0.7 1.9 1.2 Sundry creditors 8.6 13.0 17.9 22.2 Interest receivable 2.5 2.9 5.2 5.0 Reinsurers 1.6 1.8 3.3 3.1 Sundry debtors 5.0 6.6 10.4 11.3 Total 48.0 58.5 100.0 100.0 Total 48.0 58.5 100.0 100.0

Source: PlCC Annual Report 1992 Appendix B6.1 Investment patterns of contractual savings institutions

1. Pension funds and insurance companies and pension funds place companies. The role of institutional between 60% and 70% of assets in these investors in the securities markets differs instruments. Investments in foreign considerably from country to country, securities are affected by regulations such reflecting historical traditions and as foreign exchange controls or differences in regulation. prudential controls. Following the United Kingdom: Fund managers have removal of exchange controls and the been subject to the 'prudent man' rule relaxation of investment rules, pension without detailed investment regulations. funds in several countries have built up A preference for equity investments has substantial holdings of foreign equities developed, mainly in response to the high and bonds. rates of inflation of the 1960s and 1970s. Pension funds invest over 66% and life Percentage foreign securities held by insurance companies over 50% of their institutional investors ofdifferent countries assets in corporate equities. Pension funds and life insurance companies Hong Kong 55% Netherlands 22% accounted in 1988 for 60% of corporate United Kingdom 26% Japan 17% equities. Australia 25% Canada 13% United States: Fund managers are also New Zealand 23% United States 11% subject to the 'prudent man' rule but (i) pension fund regulations impose stricter 2. Mutual funds. The composition of funding and accounting obligations on mutual funds also reflects diversity in sponsoring companies and (ii) insurance regulations and traditions. regulations impose tighter limits on United States: Mutual funds are equally investments. As a result, pension funds divided between money market mutual invest less than 45% of assets in corporate funds, bond funds and equity funds. equities. Insurance companies invest less United Kingdom: Nearly all the mutual than 10% of their assets in equities. funds are equity funds. Contractual savings institutions hold only Germany: Bond funds account for 8O0/0 about 25% of corporate equities in the of mutual funds. US, though they account for well over France: Money market mutual funds 50% of corporate bonds. represent nearly 60% of mutual funds, European countries: Similar to US life mainly because of the continuing insurance companies, the largest part of imposition of ceilings on retail deposits funds are placed in government, with banks. corporate and mortgage bonds, as well as long-term loans. In Switzerland, the Netherlands and Germany, insurance Appendix B6.1 Investment patterns of contractual savings institutions

3. Insurance and pension funds in provident funds in African countries developing countries. Their role is (Ghana, Nigeria, Kenya and Zambia) and shaped more forcefully by regulation and nearly all the partially funded pension government direction. In certain systems of developing countries have countries, the funds ofcontractual savings invested their resources almost institutions have been used for exclusively in government bonds and low development purposes. interest loans to members. Real returns Singapore and Malaysia: National on accumulated funds have been highly provident funds invested over 90% of negative and in some cases the real value their funds in government securities, of balances has been completely wiped although these earned a barely positive out. real rate of return. However the Central Provident Fund of Singapore has also 4. Mutual Funds in Developing operated as a compulsory national Countries. These are mostly invested in mutual fund, investing in foreign assets. equities. Bond and money market mutual Individual members of the CPF have long funds have developed more slowly, had the right to withdraw funds in order mainly because of the absence of to purchase a home or finance education enabling legislation and the hostility or medical expenses. In recent years, they toward their authorisation by the banking have also been allowed to invest directly sector. The latter continues to hold a in approved domestic and foreign dominant position in the financial securities. systems of most developing countries and Malaysia: The successfuI implementation is concerned about the loss of deposits of economic growth policies has ensured to bond and money market mutual funds a reasonable real rate of return on the that would not be subject to reserve balances of the Employees Provident requirements, interest rate controls and Fund, especially in the 1980s. More other regulations and would thus be able recently, with the decline in the to offer higher returns than those offered borrowing needs of the Malaysian state, by banks. Monetary authorities have also the EPF has diversified its assets into been reluctant to authorise bond and corporate bonds and equities as well as money market mutual funds because of mortgage instruments. concern about the potential loss of Egypt:The resources of the social security monetary and credit control and a feared system have been placed with the higher volatility and instability of interest National lnvestment Bank, the rates and government bond prices. investments of which have generally suffered from negative returns. The Source: Vittas (1992) and Davis (1993)

CHINA'S EMERGING CAPITAL MARKETS Authoritative analysis ofperformance and prospects

There has been exceptional growth and regulators in Beijing, as well as from market di\w-sification in China's capital markets participants, local a~~thoritit.~,exchanges in the 1990s. Yet the fundamental and trading centres at Shangl~ai,Shenzl~cn, determinants of market structure or Wuhan, Tianjin and Hong Kong. It presents bchaviourarepoorly~lnderstood.Market cr)mprehensi\rc data and statistics to analysts, financial institutions and other illustrate and support its analysis and potential investors, policy advisors and conclusions. observers of China's economy are thwartcd by insufficient information and inadequate This book clearly explains the context of analysis upon which to base thcir recent capital market develnpments in judgements and strategic decisions. China and e\~aluatesthe effect of regulatory changes on the performance of the securities Q What factors affect the efficiency and market and the key players in each sector. It growth of China's capital markets? makes clear recommendations to the government, to investors and to financial What is the potential for foreign Q institutions, suggesting how strategies can investors in China's equity and bond be formulated to strengthen the markets? fundamentals of the capital market and Q Which government agencies regulate open it up to wider, and mare profitable, this sector and how do their actions domestic and international participation. control the degree and direction of securities markets growth?

China's Emerging Capital Markets is the result of a joint investigation by the staff of FINANCIAL TIMES the World Bank, its consultants, and the Firlurtcilri Publblisl~in~ China Securities Regulatory Commission Aiu P~~t-ifit into China's securities markets. It draws on Providing essential information and objective primary data from the government and analysis for the global finance industry.