China: Capital Markets Reform
British Embassy Beijing
China reopens doors to initial public offerings (IPOs) after a 14 month long suspension. This is the latest of several attempts to improve China’s capital markets. The leadership hope this will lessen China’s disproportionate reliance on bank lending and supply capital to China’s more dynamic growth sectors.
On the last day of November, the China Security Regulatory Commission (CSRC) issued reform guidelines for initial public offerings (IPO). The newly announced guidelines end a 14-month IPO freeze, and try to make the process less bureaucratic (a ‘registration’ system is set to replace the ‘ approval’ system). The CSRC’s announcement echoes China’s overall economic reform plans, unveiled during the 3rd plenum in mid November, where China’s top leaders had promised to increase the proportion of financing supplied by bond and equity markets (as opposed to bank financing).
Approvals for new IPO applications have been suspended since October 2012. The ban was seen as an attempt to boost the weak stock market (limiting supply of new shares pushes up prices), clean up financial fraud of current listed companies and intensify self-review of pending IPO applications. A consequence of this suspension is that nearly 800 companies are queued up to make their IPO. It has also encouraged Chinese firms (e.g. Alibaba) to look to float overseas. The Shanghai stock market dropped 6% on the announcement of the IPO resumption: investors feared the supply of new shares would outpace demand. The market has since stabilised, reflecting the prevailing view that the impact will be limited.
Earlier in 2013, China made several attempts to improve the capital market, in order to clarify the power and responsibility of all parties in the market (e.g. underwriters, lawyers, accountants, companies themselves, etc). In April 2013, Chinese security broker Ping An Securities was fined GBP 5 million and had its underwriting license revoked for three months because it failed to conduct adequate due diligence on a listing – the first ever such punishment for a Chinese broker. In the same month, Wang Qishan ordered a high profile anti corruption investigation into the interbank bond market. Several high profile senior fund and asset managers in China’s biggest banks were questioned by regulators regarding insider trading for personal gain, leading to several arrests. This included "the bond market King" of China’s largest investment Bank, CITIC securities.
Faced with a choice between fast, but uncontrolled equity market development, and a pause for a root-and-branch review, the CSRC has chosen the latter.
The government’s judgement seems to be that there is a lack of trust in China’s equity markets (in particular over transparency of information) which needs to be addressed before equity markets can perform a genuine role as providers of equity. At the same time, China has gradually implemented important reforms – in particular, interest rate liberalisation, which will help the market to build a market-determined pricing mechanism, narrowing the lending margin gap between capital market financing (equity and debt) and bank financing.
China’s policy approach is also an attempt to strengthen the institutions (accountancy, judiciary), while moving away from a bureaucratic ‘permission based’ culture. This institutional-reform approach was also a key element of the Party’s third plenum in November, and is likely to continue.
What does this mean for the UK?
Now allowed to raise equity domestically again, we would expect a lessening of interest in Chinese firms looking to list in London. At the same time, new IPOs represent an opportunity for investment banking in China, though foreign firms have very small market share. The October Economic and Financial Dialogue (EFD) delivered a license (RQFII) for the UK (the first country outside of China to get this), which will enable UK firms to invest RMB directly in these new IPOs.
China’s Capital Market: Background Note
Smaller and less significant than in developed economies…
Compared to developed economies, the capital market (stock and debt) in China is a less significant part in size and share. According to data from the Brookings Institute, of 110 trillion RMB in total credit in 2012, bank loans still accounted for 60% which represented 128% of GDP (compared to less than 50% in the US). By contrast, equities and bonds represent 44% and 41% of China’s GDP respectively, compared to 118% and 240% in the US.
This in part represents the history of China’s financial system’s evolution. In a centrally planned economy, the initial aim was simply to channel funds to preferred State Owned Enterprises, and bank loans were the simplest way to do this. To this day SoEs are key players in the system, accounting for about 80% of market capitalization in China’s stock markets, but the system has been gradually opened out, beginning with treasury and (limited) corporate bonds in the 1980s and the launch of two stock exchanges, in Shanghai and Shenzhen, in the 1990s.
…but with rapid growth.
China capital market now includes two large exchanges in Shanghai and Shenzhen, the inter-bank bond market, market intermediaries (114 security houses by 2012), as well as over 300 local government level exchanges (trading all types of products such as commodities, copper, silver, art works, etc). In terms of market players, over 2400 listed companies in China stock markets generated market capitalization of RMB23 trillion and market turnover of RMB32 trillion.
Along with this development is a clearer division between mainland China’s two leading stock exchanges. In past three years, Shenzhen with its concentration on SME market and innovative start-ups has been able to top Shanghai in terms of both numbers and value of IPOs. Shanghai, after years of SOEs boom, is seeing sharp declining IPOs activities.
SoEs still the main beneficiaries
SOEs and family-run businesses (each on average 37% owned by the largest shareholder) are major players in the market. Among 2400+ companies listed in China’s stock market, 70% of them are SOEs, (especially in the Shanghai market), accounting for 80% of the market capitalization. For the bond market, Government departments, the Central Bank and large financial institutions combined sell over 70% of bond products. Through measures such as high issue price, etc, China’s capital markets act as a cheap funding source for underperforming SOEs as well as large companies with government connections.
On the other hand, even with the Shenzhen Stock Exchange mainly serving SMEs and innovative start-ups, SMEs in China are largely unable to get funds from capital markets. According to one analyst, SMEs in China contribute about 60% of GDP and 80% of employment, while less than 4% of them can receive extra financing, due to: 1) bank’s tight lending policy on back of risk concerns; 2) undeveloped Merger & Acquisition environment; 3) SOE dominated equity market.
A sharp difference between stock and bond investors
Stocks – retail investors / speculation / volatility
Bonds – bank investors / stability / no market liquidity / never default
Individual investors hold about 99% of trading accounts in Shanghai Stock exchange in 2012, contributing 80% of trade volume and 20% of holding value. The nature of retail investors (little investment knowledge and unstable trade pattern) causes the high level of volatility and speculation. One example is Everbright Security’s "fat finger" trade event which happened last August. A trading system error in Everbright Security attracted a large volume of copycat buying, raising The Shanghai Composite Index by 6 percent in two minutes.
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