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Essay Number 12
November 1998  

Exploring the Alphabet Soup of Chinese Financial Markets

thin rule
By Satya J. Gabriel

After more than seven years, China's stock exchanges in Shanghai and Shenzhen are still considered an experiment by the Chinese authorities. They remain uncertain whether or not these stock markets will serve a useful long-term purpose. The primary reason for creating the stock markets was to allow state-owned enterprises (SOEs) to raise capital from Chinese households and from foreign entities by initial public offerings (IPOs) of unseasoned (never before traded) shares as a substitute for continued central government funding of such capital investment. But it hasn't exactly worked out as planned. Despite the fact that the Chinese government began the process of converting SOEs to joint stock corporations in 1984, only a few firms have been allowed to issue publicly traded securities (with the hope that those favored firms would be able to raise more money in an environment where the supply of new stock was limited) and those firms have raised far less capital (particularly capital denominated in U.S. and Hong Kong dollars) than had been anticipated. The lack of enthusiasm for these initial public offerings is influenced by a wide range of factors which will be discussed in this essay.

First of all, who knows what the government plans to do with these state-owned enterprises? The government retains control over them, both in terms of ownership (approximately three fourths of the total shares of listed companies remains under the control of the central government and related holders of legal-person shares) and in terms of the political power to change the rules of corporate governance. This gives the government extraordinary power to set the rules governing residual claims to the cash flow of state-owned enterprises, as well as the rules for the deployment of investable funds. Minority shareholders who have purchased shares on stock exchanges have virtually no power to influence the political outcome of struggles over corporate governance in China, to influence the determination of residual claims, or to push corporate managers to take shareholder wealth maximization into consideration when developing capital budgets.

This is a version of capitalism where the minority owners are incredibly weak and the single majority owner has almost god-like powers. In other words, in the legislation and adjudication of corporate governance in China, there is no rule of law autonomous from the executive authorities within the central government. There is no independent judiciary. There is an innate conflict of interest when the entity solely responsible for creating, changing, and enforcing the rules of corporate governance is the ultimate owner of corporate assets and primary claimant to the cash flow generated by those assets, particularly in the context of minority claimants. This creates a serious political risk to portfolio investors in China. If the government decides to change corporate governance in a manner detrimental to the minority shareholders, there is no way for the minority shareholders to take effective legal action in order to redress their grievances or block the action taken by the government. Thus, minority ownership of shares in a Chinese firm carry virtually no elements of control and, therefore, such ownership is worth less than it might be in an alternative environment where some degree of control comes along with the ownership of shares. This is no minor matter, in modern capitalism rentiers (owners of liquid shares of capitalist corporations) have significantly reduced their overall risk by diversification. The modern capitalist owner (of publicly traded capitalist firms) does not typically place all of their accumulated wealth in a single corporation or industry, but spreads ownership shares over a range of firms and industries. This implies that it is not typical, in most contemporary versions of capitalism, for individual owners in publicly traded firms to have an absolute majority of ownership shares in any given firm. Capitalist owners give up absolute control for diversification, but still expect to have significant influence over the enterprises where they have ownership stakes. This influence can be critical in pushing firms to take actions in the interest of shareholder wealth maximization or, at least, to avoid taking actions that destroy shareholder wealth. In the Chinese version of capitalism, minority owners have extremely limited channels of influence over those publicly traded state-owned firms with which they have ownership stakes. This defect in Chinese capitalism can only be partly compensated for by publicly traded firms paying a relatively large and regular dividend. The reforms that will satisfy private shareowners and dramatically improve the market valuation of Chinese firms are those that break the central government's monopoly over majority ownership and the determination of proper corporate governance. We will have to keep attentive to the changes in enterprise laws that come out of the Party Congress meeting in March of 1999.

Secondly, the experimental nature of the Chinese stock exchanges is, in and of itself, an impediment to raising more capital through initial public offerings on those exchanges. Who wants to buy Chinese stocks if they feel uncertain about the future of the stock exchanges where these stocks are bought and sold? Since portfolio investors don't know if this game will be allowed to continue into the indefinite future, there will be fewer takers and those who do get involved in the stock market are less interested in evaluating their stock purchases on the basis of the long-term cash flow generating ability of companies, but instead take an attitude akin to that of internet investors in the U.S. --- buying on momentum and whim. Technical analysis is very popular in China, in part, because stock buying and selling is seen as a complicated gambling exercise in which money is made by correctly predicting the waves of optimism and pessimism of other buyers. Of course, these waves of optimism and pessimism of the other buyers and sellers is also based on their perception of what the rest of the crowd is about to do. The absence of long-term investors (and restrictions on institutional trading, which will be discussed below) creates more volatility in the Chinese exchanges.

Thirdly, the Chinese government has created an alphabet soup of different types of shares that trade in different ways, by different economic agents, and sometimes in different locations. This financial market segregation has created firewalls between certain types of portfolio investors and reduced the liquidity of all the shares traded. There are officially four classes of shares that can be issued by Chinese firms: Chinese public or A shares, foreign-person or B shares, legal-person or C shares, and Hong Kong listed or H shares. Chinese citizens are restricted legally to buying A shares, although sometimes Chinese citizens will illegally purchase B shares through a proxy (a foreigner acting for the Chinese citizen and buying the shares in U.S. dollars, if the shares are bought in Shanghai, or Hong Kong dollars, if the shares are bought in Shenzhen). Provinces, government agencies, official organizations, and other such institutions can hold the misnamed legal-person or C shares. The central government also holds shares, although these shares do not have a special letter designation. The H shares are similar to the B shares in that they are designed for purchase by foreigners. However, H shares do not trade inside China.

In addition, H shares are sometimes bought by non Chinese investment banks for the purpose of selling these shares off-shore in the United States or Great Britain. The banks do not physically move these shares to the U.S. or Britain, but instead issue depositary receipts that represent a certain number of these shares. The shares remain in Hong Kong, so that it is easy to buy and sell them. The bank then attempts to get the depositary receipts listed (in a manner similar to the listing of a stock) on exchanges in the U.S. or on the London Exchange. Holders of the depositary receipts have virtually the same rights as a holder of the shares. This is part of the implied contract between the issuing bank and the purchaser of the depositary receipts. The bank is obligated to act for the purchaser in Hong Kong, collecting dividends and passing them along to the receipt holder, collecting voting proxies and passing these along to the receipt holder, etc. Depositary shares that trade in the U.S. are called American depositary receipts or ADRs and those that trade in London are called global depositary receipts or GDRs. For example, Shanghai Petrochemical H shares are bundled in groups of 100 and then depositary receipts are issued for each bundle and traded as stock on the New York Stock Exchange under the ticker symbol SHI. These shares traded as ADRs are sometimes called N shares, although they are not technically shares but derivatives, and the designation N shares is not official. If the board of directors of a Chinese firm is granted permission by the central government to do so it may sell new shares directly to a bank for listing as ADRs or GDRs or both.

The National Association of Securities Dealers (NASD) is actively seeking to list shares of more Chinese firms on the automated NASDAQ system and, if permission is granted by the Beijing authorities, may even list primary shares, rather than depositary receipts. NASD hopes to list shares of "growth" oriented Chinese firms, rather than be restricted to the traditional state-owned behemoths that may or may not (typically not) exhibit growth characteristics (such as annual rates of revenue and/or earnings growth in excess of 20%). This would be an important signal of further financial market liberalization. However, under the current rather complicated arrangement for trading shares in Chinese firms and the alphabet soup of different types of shares there is probably a good deal less interest in owning such shares than might be the case under some alternative, and less confusing, arrangement. Rentiers are simply not sure what they are buying when they buy a share of a Chinese firm. The lack of clarity about what a share of a Chinese publicly traded firm represents results in less interest by portfolio investors in such shares. This makes it very difficult to use the stock market as a tool for raising capital, particularly hard currency capital.

Fourthly, the Chinese government has maintained strict controls over which firms can list shares on either the B-share market or in Hong Kong as H-shares (and therefore of which firms can be purchased as ADRs or GDRs). As I mentioned earlier, SOEs have been favored in this process of raising foreign capital. The Chinese government has tried to use the financial markets as a mechanism for weaning the SOEs from dependence on state financing. It is the opposite strategy to that used by Mexico, for example. Mexican firms have relative freedom in deciding whether or not to engage in an initial public offering (IPO). This has resulted in a veritable explosion of stock listings in Mexico City, as well as a wide range of Mexican equities available as ADRs or GDRs in the U.S. and London. Despite the peso crisis of 1994-1996, Mexican firms have been relatively successful in raising capital, including hard currency capital. In China, on the other hand, the favored firms that have been able to raise funds in IPOs have, for the most part, squandered those funds and then returned to the central government for further financial support. That was not what the IPOs were supposed to be all about. If the competition among firms for IPOs was determined outside of the government, then better managed firms might be more likely to get the support of merchant banks in IPOs and portfolio investors would be in a position to cast their monetary votes for which firms are deserving of capitalization. This more decentralized process of determining success in the IPO market might act as a disciplinary mechanism in pushing firm managers to come up with better plans for how to use the funds raised in IPOs. Better plans might result in relatively better deployment of the capital raised. And better deployment of capital by Chinese firms might attract more interest from both domestic and, particularly, international portfolio investors.

Fifthly, unlike most privatizations in other countries (where shares are issued as secondary offerings with the proceeds going into the government treasury), the Chinese central government does not sell its own shares to the public. When a Chinese SOE engages in an IPO, it does so by issuing new unseasoned shares (a primary offering) that are additive to the already existing shares held by the state. The proceeds go to the issuing firm, providing valuable funds for investments. The central government dilutes its ownership only modestly and the presence of these untraded shares acts as a depressant on the overall market. If the state was willing to trade its own shares, this might add more liquidity to the market and create the potential for more valuation driven trading in general. I would advocate that the state act as a professional portfolio manager, creating an agency that buys shares when they are deemed undervalued and sells them when they are deemed overvalued. The state should make clear that it is abandoning forever the role of fundamental appropriator of capitalist surplus value and henceforth will only act in the capacity of a recipient of subsumed class payments, either as tax collector or as an owner. The state should then be willing to completely give up controlling interest in firms when it would be in the financial interest of the state to do so. Other social objectives, including the minimization of so-called externalities or encouraging employment growth, should be achieved through alternative mechanisms to the current overdependence on maintaining a controlling interest in SOEs. This would encourage other portfolio investors to take their role as owner more seriously.

Finally, the government has placed severe restrictions on institutional trading. Institutions can play an important role in raising capital in financial markets, as well as in raising standards of transparency and accountability of listed firms. The Chinese government should allow other institutions into the stock markets as active traders. At present, the government has sought to isolate domestic individual portfolio investors from competition with both foreign portfolio investors and institutions. This is because the government believes these institutions to have an advantage over individual investors, both in terms of their ability to move markets by trading large blocks of stock and by a superior ability to gather and use information. While this assumption is correct, it is also true that these large institutions can add liquidity to markets and make it easier for individual portfolio investors to buy and sell stock, reducing volatility and creating more opportunity to engage in long-term investment. In addition, the government has had only limited success in restricting access of institutions, such as the trust and investment companies (TICs), from participation in the markets. These TICs simply limit the size of their trades to avoid drawing the attention of the regulatory authorities. It would make more sense to allow the TICs to openly trade and simply require strict disclosure of their transactions. Over time, higher volume trading would most likely encourage the growth of an industry that would make more information available to individual portfolio investors, as well as institutions. This would encourage even greater participation and liquidity in the markets.

The Chinese stock markets have so far proven only modestly effective in providing investment capital to firms and relatively ineffective in disciplining the management of listed firms. These are both considered important roles of financial markets. These markets provide a mechanism by which owners and creditors can send signals to both each other and to firm management, generating changes in behavior. In China, the government has created so many restrictions and firewalls that slow down and diminish the strength of such signals that the financial markets have become little more than gambling casinos for day traders. While there is always an element of this in any stock market, the Chinese market has become devoid of almost every stock ownership motivation except for this trading motivation. Indeed, for the most part, the management in listed Chinese firms doesn't really care whether or not the stock price rises or fall. When they do care, the reaction is often perverse. For example, I've been told that many SOE managers have been trying to drive down the price of their firm's stock under the belief that the government may eventually follow the trend in Eastern Europe and many other parts of the world and fully privatize these SOEs. The managers hope to buy shares cheaply if this privatization occurs, perhaps even arranging to buy a majority stake in the firm.

The administration of Premier Zhu Rongji is pushing a new Securities Law that is supported by the new financial industry in China. The hope is that many of the above described problems will be solved as the Zhu administration pushes to make the Chinese financial markets more "modern." The hope is to ultimately make these financial markets the real testing ground for the ability of firm management to develop effective competitive strategies, including improving the technological foundation of the firm's productive activities. In other words, the Zhu administration believes the market mechanism can be a tool in the overall "modernization" of the Chinese economy, particularly in motivating the stodgy, conservative management in place in the SOEs to develop new, more market competitive management practices (that is, practices that result in more surplus value being generated by the SOE workforce). The Chinese leadership has been relatively patient in their development of the financial sector. Many of the graduate students in my corporate finance seminar at Nanjing University were optimistic that these financial markets would continue to play an important role in the future and that the government would not roll back financial sector reforms but would, instead, continue extending those reforms. The construction of the new stock exchange building in Shanghai, a beautiful glass and steel structure built in the shape of the Chinese symbol for rice, is reflective of this commitment.  And at the Fifteenth National Congress in October of last year the Communist Party of China reaffirmed its commitment to the shareholding corporate structure (gufenzhi jingji) as the model for separating corporate management responsibilities and ownership rights.

One last point. There is one significant reform already written into the Commercial Bank Law that demonstrates that the Chinese leadership recognizes some of the mistakes others have made in developing the linkages between the financial markets and the industrial sector. Unlike banks in Germany, Japan, and many other nations, Chinese commercial banks will not be allowed to become majority owners of industrial enterprises. Despite fears that China will try to reproduce the Japanese keiretsu (or South Korean chaebol) model, China wants to avoid wedding banks too closely with industrial firms. The current Chinese administration is keen on keeping some degree of separation between the financial and industrial sectors. This should reduce the possibility of the development of a capitalist oligarchy with control over both the financial and industrial sectors, using the one to support their monopolization of the other. I, for one, think that's a good idea.

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Copyright © 1999 Satya J. Gabriel, Mount Holyoke College.  
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