Exploring the Alphabet Soup of Chinese
Financial Markets

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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