World Bank Document · 2016. 7. 17. · DTC Depository Trust Company ... GATT General Agreement on...

Report No. 14501-CHA

ChinaThe Emerging Capital Market(In Two Volunies) Volume l: Main Report Strateo,ic Issuies and Options

November 3, 1995

East Asia and Pacific Region

China and Mongolia DepartmentCountry Opterations Division

:~~~~~~~~~~~~~~~~~~~~~~~K

i~~~~~~~~~~~~~~~~~~~

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

ACRONYMS AND ABBREVIATIONS

ABC Agricultural Bank of ChinaADD American Depository DebenturesADR American Depository ReceiptsAIA American International AssuranceAIG American Insurance GroupAMEX American Stock ExchangeAMSET Association of Members of the Stock Exchange of ThailandBAPEPAM Badan Pelaksana Pasar Modal (Capital Market Executive Agency) (Indonesia)BOC Bank of ChinaBOCOM Bank of CommunicationsBOT Build-Operate-TransferCAIC Chinese American Insurance CompanyCBOE Chicago Board Options ExchangeCD Certificate of DepositCIB China Investment BankCITIC China International Trust and Investment Corporat ionCPA Certified Public AccountantCPF Central Provident FundCPIC China Pacific Insurance CompanyCSRC China Security Regulatory CommissionCSTS China Securities Trading System Corporation LtdDR Depository ReceiptDTC Depository Trust CompanyFDI Foreign Direct InvestmentFIBV Federation Internationale des Bourses de ValeursGATT General Agreement on Trade and TariffsGDP Gross Domestic ProductGDRs Global Depository ReceiptsGITIC Guangdong Industrial Trust and Investment CorporationGNP Gross National ProductIBCA International Banks Credit Agency (originally; today officially IBCA.

An international credit rating agency headquartered in London).ICBC Industrial and Commercial Bank of ChinaIFC International Finance CorporationIFI International Financial InstitutionIMF International Monetary FundIOSCO International Organization of Securities CommissionsIPO Initial Public OfferingISC International Securities ConsultancyITIC Investment and Trust CorporationITS Intermarket Trading SystemJCR Japan Credit Rating Agency LimitedKSDA Korean Securities Dealers AssociationLTS Local Tax ServiceMAS Monetary Authority of SingaporeMICEX Moscow Interbank Currency ExchangeMOF Ministry of FinanceMOFTEC Ministry of Foreign Trade and Economic RelationsMOU Memorandum of Understanding

NASDAQ National Association of Securities Dealers Automated Quotation SystemNETS National Electronic Trading SystemNBFI Nonbank Financial InstitutionNIS Nippon Investor ServiceNSCC National Securities Clearing CorporationNYSE New York Stock ExchangeOECD Organization for Economic Cooperation and DevelopmentOTC Over-the-CounterPAIC Ping An Insurance CompanyPASBD Philippine Association of Stockbrokers and DealersPBC People's Bank of ChinaPCBC People's Construction Bank of ChinaPDB Pudong Development BankPICC People's Insurance Company of ChinaPortal An OTC cross-border clearing systemPRC People's Republic of ChinaQIB Qualified Institutional BuyersRADRs Restricted American Depository ReceiptsS&P Standard and PoorsSAEC State Administration for Exchange ControlSC Securities Commission (Malaysia)SCRES State Commission for Restructuring the Economic SystemSCSC State Council Securities Policy CommitteeSDB State Development Bank of ChinaSEAQ Stock Exchange Automatic Quotation SystemSEBI Securities Exchange Board of IndiaSEC Securities Exchange CommissionSEEC Securities Exchange Executive CouncilSES Stock Exchange of SingaporeSESDAQ SES Dealing and Automated Quotation System MarketSETC State Economic and Trade CorporationSEZs Special Economic ZonesSFC Securities and Futures Commission (Hongkong)SHSE Shanghai Securities ExchangeSITICO Shanghai International Trust and Investment CorporationSOEs State-Owned EnterprisesSOUs State-Owned UnitsSPC State Planning CommissionSRC System Reform Commission (abbrev. for SCRES)SSB Securities Supervisory Board (Korea)STAQS Securities Trading Automated Quotations SystemSZSE Shenzhen Stock ExchangeT BILL Treasury BillT BOND Treasury BondTICs Trust and Investment CorporationsTSDA Taipei Securities Dealers AssociationTSE Tokyo Stock ExchangeUCC Urban Credit CooperativeYTM Yield to Maturity

CONTENTS

Contributors .................................................................. HiiExecutive Summary and Recommendations ....................... ............................. iv

1. THE CONTEXT OF CAPITAL MARKET DEVELOPMENT ........................... 1A. The Context of Capital Markets in China's Financial Sector ....................... 2B. Capital Markets and the Financing of Government Borrowing Requirements .. .3C. Capital Markets and the Financing of Real Sector Investment Requirements .... 4

2. THE REGULATORY FRAMEWORK ........................................................ 6A. Introduction .................................................................. 6B. The National and Regional Regulatory Framework .................................. 8C. The Regulation of Bonds ................................................................. 9D. Banking Laws and Securities Laws ................................................... 10E. Distribution Of Oversight Within The Government .......... ...................... 11

Comparisons With Other Countries ............... .............................. 11

3. DOMESTIC BOND MARKETS .............................................................. 12A. The Primary Market .................................................................. 13B. Secondary Markets in Debt Securities .................. .............................. 17

Secondary Market Efficiency: (i) Trading Volumes and Liquidity ........ 18Secondary Market Pricing Efficiency: (ii) Price Unity ........ .............. 21Secondary Market Issues: (iii) Benchmark Issues and the Yield Curve ... 22

4. EQUITY MARKET PERFORMANCE ...................................................... 25A. Introduction: Issues to be Examined .................................................. 25B. The New Issue Process And Public Offerings ....................................... 25

The Efficiency of the New Issue Process ............ .......................... 26Comparisons with Other Countries ................ ............................. 28

C. Stock Price Volatility and Returns to Investors ............ ......................... 29D. Market Integration: Current And Potential .............. ............................ 33

5. INTERNATIONALIZATION OF CHINA'S SECURITIES MARKETS ............. 37A. The Scope for Safe Participation in International Securities Markets ...... ..... 37B. Foreign Investment in Domestic Share Markets: B Shares ........ ............... 38

Tax Treatment of Foreign Equity Investment .......... ....................... 39C. Overseas Listing of Chinese Equities: H and N Shares; DepositoryReceipts .................................................................. 40

The Performance of China's Overseas Equity Listings ........ ............. 41China Investment Funds . ......................................................... 42

D. Fixed Income Securities ................................................................ 42

- ii -

6. INSTITUTIONAL INVESTORS ............................................... 45A. Institutional Investors and Securities Markets ........................... ............ 45B. The Insurance Industry in China ................................................ 47C. The Pension System ............................................... 49

Current Structure ............................................... 49Reform Options and Policy Recommendation ................ ................. 51

Figures in Text

Figure 1.1 Securities Markets In China's Financial Sector ...................................... 3Figure 1.2 Central Government Budgetary Deficit

And Treasury Bond Issues ............................................. 4Figure 1.3 Contribution Of China's Capital Markets To

Investment In The Real Sector ............................................. 5

Figure 3.1 China: Composition Of Outstanding Debt Issues ................. ................ 13Figure 3.2 Outstanding Debt Composition Disaggregated ......................... ............ 14Figure 3.3 China: Trading Value Of Bonds ............................................... 18Figure 3.4 Ratios Of Trading Volume Of Debt To Debt Stock

And To GDP .............................................. 19Figure 3.5 Ratios Of Debt Stock Outstanding To GDP: China

And Other Countries .............................................. 19Figure 3.6 Regional Bond Yield Differentials (1990) .......................................... 21Figure 3.7 Yield Differentials Between Treasury Bills On

Principal Markets: 1994 (Shanghai, Wuhan And Shenzhen) .......... .................. 22Figure 3.8 China: Secondary Market Yield Curve ............................................. 23Figure 3.9 China: Bond Yield, Deposit Rate And Inflation ................... ............... 24Figure 3.10 Equity Index And Average Bond Yield ............................................. 24

Figure 4.1 Initial Public Offerings Of ShanghaiA And B Shares .............................................. 27

Figure 4.2 Risk-Adjusted Returns To Ipos At Shanghai ............................. .......... 28Figure 4.3 China: Shanghai And Shenzhen Share Indices And

Volume Of Trade .............................................. 30Figure 4.4 Shanghai And Shenzhen: Share Price Variance .................... ............... 31Figure 4.5 Spreads Between Shanghai And Shenzhen

A And B Shares .............................................. 34Figure 4.6 Discounts On Shares Listed In Overseas Exchanges .............. ................ 35

Figure 5.1 China And Other Emerging Markets: ParticipationIn International Capital Flows ...................................... 38

Figure 5.2 Country Funds - Average Discount .............................................. 42Figure 5.3 International Bond Issues By Chinese Borrowers:

Currency, Type And Maturity ..................... ......................... 43

Figure 6.1 China: International Comparison Of InsurancePremiums (1992) .............................................. 47

Figure 6.2 China: Comparisons Of The Performance Of TheInsurance Industry In Selected Countries .............................................. 48

CONTRIBUTORS

This report is the outcome of a joint investigative study undertaken by the World Bank and the ChinaSecurities Regulatory Commission. Its results are based on the findings of a preparatory visit to China inAugust 1994, followed by a full-fledged investigative study in October 1994. In addition to discussions inBeijing, the team visited securities trading centers and market participants at Shanghai, Shenzhen, Wuhan,Tianjin and Hong Kong.

Numerous persons have contributed to this report. The World Bank team consisted of Anjali Kumar(team leader and task manager); David Wilton, FSD, (bond markets); Dimitri Vittas, FSD, (contractualsavings); Kwang Jun, IEC, (international aspects); and consultants Professor Anthony Saunders (SalomonCenter, New York University; equities markets), Susan Selwyn (International Securities Consultancy, HongKong; securities regulation); and Sun Yan, (Columbia University; equity market data analysis). EdgardoBarandiaran and others at the World Bank's Beijing office organized the work in China, and Vikram Nehruparticipated in the mission. Julia Li provided major inputs to the report (on the marco framework and onequity markets) in Washington. Yan Wang provided comparative contributions. The report also benefitedfrom the generous information and comments provided by the IMF (notably Marc Quintyn and MichaelSpencer) 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 coordinating technicalassistance and investigative studies.

The Chinese team was led by Fu Feng Xiang, (Vice Chairman, CSRC), and Bei Duo Guang, DeputyDirector of the International Department, and principal counterpart to the World Bank. Numerous otherpersons 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 organized and accompanied all themission's meetings. Particularly valuable insights to the study were provided by Ma Zhong Zhi (SCSC) andGao Jian, (Ministry of Finance). Particular thanks must also be extended to Liu Bo, executive vice presidentof the Shanghai Securities Exchange and Cavin Xue of its data department; Zhang Ning, of the ShanghaiMunicipal Government Securities Administration Office; Xia Bin, president of the Shenzhen SecuritiesExchange, Lian Quan Kun, president of the Wuhan Securities Trading Center, and Vivian Gu, also of theWuhan Securities Trading Center; and Hu Li Yun, of the Tianjin Securities Trading Center. Officials frommany 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 WanGuo, and the Chengxin securities rating agency. Background papers for the report were contributed byZhang Bing Xun of the Securities Exchange Executive Council (SEEC), and Mr He Dexu, of the ChineseAcademy of Social Sciences. The team extends its gratitude and appreciation to all the officials from thevarious government agencies and securities companies with whom it met.

In Hong Kong, particular thanks must be extended to Andrew Sheng of the Hong Kong MonetaryAuthority, Iris Leung and Iris Cheung of the Hong Kong Securities Exchange, Jane Tamn of the Hong KongSecurities and Futures Commision, and many executives at Jardine Fleming, JP Morgan, Merrill Lynch,Peregrine, Sassoon UBS, and other securities dealers.

Preparation for the missions would have been difficult without the assistance of Cathy Song, and itsproduction would not have been possible without the excellent support of Adelma Bowrin.

- iv -

EXECUTIVE SUMMARY AND RECOMMENDATIONS

A. Capital Markets and China's Economic Development

1. China's capital markets have evolved in parallel to China's move towards the establishment ofa market economy. Economic liberalization began from 1979, and was signaled in the financial sectorby the breakup of the monobank system. With the emergence of a budget deficit in 1981, Chinaresumed the issue of government securities, after a twenty year hiatus, to help finance the deficit. In1984, parallel to the diversification elsewhere in the financial system, and establishment of commercialbanks, informal issues of enterprise stocks also began, while annual bond issues increased in volume,variety and issuing institution.

2. The development of markets in securities in China are relatively more recent in origin.Limited trading of bonds was first permitted in 1988; and it was only from 1990, with theestablishment of the first electronic automated quotation system, and the opening of the Shanghaisecurities exchange, that China witnessed the emergence of officially recognized markets in securities.In the four years since then, securities outstanding, and the volume of trade, have grown exponentiallyto the point where China's securities markets rank, in size, in the middle league of emerging markets,albeit the much longer existence of many emerging markets. Meanwhile, over the same period,diversification of the financial sector has accelerated, taking the form of hundreds of new non-bankfinancial institutions: rural and urban credit cooperatives, trust and investment companies, securitiesfirms and insurance companies. Many of these are major participants in China's securities markets.Financial deepening has accompanied institutional change. The ratio of financial assets to GDP grewfrom 127 percent in 1987 to 170 percent in 1993.

3. China today is making efforts to accord a greater role to financial markets for resourceallocation, and move away from the central allocation of credit. Yet at present the Credit Plan (thegovernment's plan for the allocation of credit via financial institutions towards approved end uses)remains the primary vehicle for resource allocation. Rapid financial innovation has eroded theeffectiveness of older instruments, but new instruments and institutions are as yet not sufficientlydeveloped to ensure the stability of the macroeconomy. This has led to periodic cycles of liberalizingreform followed by partial reversions to old instruments and market contraction. It has also led to theimposition of conflicting government objectives on financial institutions. While the central bank istheoretically endowed with the ability to undertake monetary policy through the use of indirect instrumentssuch as the interest rate, reserve requirements and a discounting facility, its use of such instruments hasbeen restricted as its capacity to make independent decisions has been limited. Approval from the StateCouncil has been required for most decisions, including interest rate adjustment. The role of the interestrate mechanism is marginal as adjustments are infrequent and relatively small. The ability of the People'sBank of China (PBC) to control money creation has been hampered by the rapid growth of the relativelyunregulated interbank market, and transfers of funds out of the banking sector to nonbank financialinstitutions (often for the purpose of participation in securities markets) via the illicit participation of thelatter in the interbank market. With the recent passage of a Central Bank law (March 1995), the role ofthe central bank is expected to be strengthened.

- v -

4. The role of capital markets in China's financial sector is small relative to the banking system,but has been growing. Total assets of non-monetary financial institutions grew from 6 percent in 1989to a high of 8 percent of the financial sector's assets in 1992, declining once again to 5 percent by1994. The pattern reflects the growth of enthusiasm for securities with the legalization of exchangesand high returns to equities from end 1990 to mid-1993. With the introduction of a major program forcontrolling the 'overheating' of the Chinese economy in July 1993 (the '16-point program'), and thesqueeze 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. Both sets ofestimates clearly reinforce the officially expressed position, that the Chinese government's approach tothe growth of capital markets has been 'experimental' and is still an experiment on a small scale. Thecontribution of securities markets to the investment needs of the real sectors of the economy has alsoconsequently been small. The volume of bond issues, relative to the volume of total state investment,has been around 10 percent over the period 1987 to 1992, while the contribution of new equity issuedto total state unit investment has been lower still, peaking at around 2 percent of such investment in1992. Finally, the contribution of securities issues to the financing of the government deficit has alsobeen limited. Taking account of quasi-fiscal operations of transfers to state enterprises, which shouldin a conventional accounting framework be financed through the budget (but which have instead beenfinanced through PBC lending to the banking system), and subject to assumptions on the volume ofsuch quasi-fiscal operations, the annual volume of net treasury bonds issued over 1989 to 1993 hasvaried between 11 and 23 percent of the consolidated deficit, while the annual volume of treasury billsalone has varied between 5 and 23 percent of the consolidated deficit.

5. Despite the current, relatively small role of capital markets, their role in the financial sectorand the real economy is important, and this importance is growing. First, there are strong behaviorallinks between the various segments of the financial sectors, as pointed out above, through suchmechanisms as the Credit Plan and interest rates, so that actions cannot be taken in isolation indifferent segments of the financial system. Thus the free determination of returns to securities throughsecondary trading affects ceilings and floors for bank deposit rates, as well as coupons on treasurysecurities issues. Second, the government is increasingly relying on markets in debt securities for itsown financing requirements. In 1994, the objective of issuing government debt to finance the budgetdeficit took on new significance, due to the decisions to (i) cease to resort to deficit financing throughloans from the central bank; and (ii) gradually transfer subsidies to state enterprises, hitherto funneledlargely through commercial bank lending, to the budget. The threefold increase of new issues oftreasury bonds in 1994 over the previous year, to Y 113.2 billion, is particularly large in view of thefact that the total stock of outstanding treasury bonds at the end of 1993 amounted to only Y 167billion. New issues in 1995 are estimated to be Y 150 billion. Third, for the maintenance of sustainedgrowth of the Chinese economy, it will be important to ensure that resources continue to flow to thosesegments of the real sector which are becoming bottlenecks to expansion, such as infrastructureinvestments. The aim of the present report is to identify the extent to which capital markets in Chinatoday are able to efficiently allocate and channel resources to where they are most required.

6. The present report represents a part of a broader program of economic work on China at theWorld Bank. A separate study on China's banking sector has been prepared in 1995, and a separateexamination of China's non-bank financial institutions is planned for 1996. In view of these, the focusof the present study is behavioral rather than institutional, concentrating on how markets functiontoday and how this performance can be improved. Also in view of these related tasks, the presentstudy concentrates on capital market issues in depth, and does not tackle in detail questions concerningthe links between the banking and non-bank elements of the financial sector. In addition, a selectiveapproach has been adopted towards certain securities market issues, in cases where these are likely tobe addressed elsewhere in greater depth. Thus, in view of a forthcoming study on China's state

- vi -

enterprises, the present discussion on equities markets does not address the issue of the extent to whichsuch markets serve as vehicles for influencing corporate governance. Similarly, the discussion oncontractual savings institutions and the extent to which these can serve as investors in China's capitalmarkets does not examine the options for pension reforms in detail. Pension reforms are to be dealtwith in greater detail in a separate study on China, planned for 1996.

B. Conclusions

7. First, despite remarkably rapid growth by any standards, capital markets in China today arestill struggling to realize their fundamental functions of increasing the efficiency of resourceallocation, aiding the pricing of risks and returns, and providing a vehicle for risk management. 7his isbecause capital market growth and development is embedded in an environment which still retainsmany elements of a non-market economy, notably the Credit Plan, interest rate controls and a risklessenvironment for state enterprises. Because of the present quotas for issues of both debt and equitiessecurities, the extent to which capital markets can grow depends essentially on the role assigned tothem under the Credit Plan. The value added of well-functioning capital markets lies in their ability toact not as primary vehicles of resource mobilization, but in the channeling of large volumes ofsavings, at short notice, and in a flexible fashion, between alternative uses. The approach to capitalmarket development in China has been cautious and experimental. A potential problem with thisapproach is that the internal contradictions between quantitatively administered and quota drivenelements of the financial sector, such as quotas for credit, investment or securities issues, and the needfor market driven price discovery and market driven benchmark interest rates, for healthy capitalmarket growth, could eventually distort capital market development.

8. Second, these problem.s today most acutely affect the primary markets. Secondary markets arerelatively sophisticated, but the closer one gets to primary markets, the more apparent are the conflictsdue to controls imposed by the government. For example, the government today regulates couponrates 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 setsmargins on coupon rates on corporate bonds, relative to government securities coupon rates. Thegovernment is in a position to also change the relative rates of return on different securities, forexample by boosting returns to equity through announcement effects, or by raising coupon rates onbonds, when large new government securities issues are due to be made. And reform in primarymarkets will be difficult without parallel reforms in other areas of China's transitional financialsystem.

9. Third, the extent to which China's securities markets are able to support the investmentrequirements of the real sector is also predicated upon the limits proposed under the Credit Plan. Assuch, 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 areapproved under the Credit Plan, and whether capital markets are the chosen vehicle for the financingof these investments. In the case of bonds, the problems of illiquidity of the bond market additionallymake investors reluctant to hold instruments of long maturity, and this effect is compounded byrelatively high levels of inflation. In terms of equities, new issues are again rationed under quotasembedded in the Credit Plan. Outstanding (and non-negotiable) state owned shares remain thedominant stock in most enterprises, and benefits of participation in equities markets, such as exposureto shareholder scrutiny, are not being significantly realized. Using capital markets for theimplementation of modern corporate finance techniques (ie, appropriate gearing ratios) is difficult toachieve today.

- vii -

10. Fourth, the contribution of capital markets to the financing of the government's deficit, andtheir potential aid to macroeconomic management has yet to realize its potential. Targeting of retailinvestors and raising coupon rates above market yields could prove very expensive in the long run, asthe stock of outstanding debt accumulates. With increased reliance on government debt issues tofinance the deficit due to restrictions imposed since 1994 on treasury borrowing from the central bank,the issue will become more important over time. A fortiori, should the invisible (quasi-fiscal) deficitcurrently covered through PBC lending to the financial system be transferred to the visible budget,costs of government borrowing will be an increasingly serious issue.

11. A fifth basic conclusion of this report is the high volatility and highly speculative nature ofChina's capital markets is due to a series of inbuilt mechanisms, some of vhich stem from the primaryissue process. These are at least as important as investors' inexperience. One such reason is limiteddisclosure, which constrains the ability to base decisions more on underlying fundamentals. In theequity and corporate bond markets, this refers to corporate fundamentals; in government bondmarkets, it refers to features such as the inflation indexing of most long (three to five year) issues toan unpublished index (with the resulting extreme speculation documented in Chapter 3). Other marketfeatures have also encouraged speculation; for example (especially in the early years of theestablishment of the exchanges and issuance of shares), the 'lottery system' assignment, of bunchedinitial public offerings in the equities market, (described in Chapter 4); and the circumscribed role ofcompetitive underwriting or primary dealership, both in the equities and bond markets. The design ofsecurities (with non-payment of cash dividends on equities and non-payment of period interest onbonds) have also implied that purchasers tend to seek capital gains from securities rather thaninvestment incomes. Finally, government announcement effects and sudden changes in interest ratedifferentials themselves lead to increased volatility.

12. The sixth broad conclusion is that market distortions today are also due to the limitedparticipation of wholesale and institutional purchasers of securities. This refers not only to thelimited development of contractual savings institutions (see Chapter 6) but also to the limited(voluntary) participation by large financial institutions such as banks in the wholesale market forgovernment 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 asingle institution. Yet its accumulations are growing faster today than pension funds or social securitysystems, which have suffered primarily from largely unfunded pension schemes. The growth ofsignificant funds here for investments in securities could take time.

13. A seventh broad area of concern is regional market segmentation. The regional participationof China 's provinces in the emerging securities market is still limited. The primary market for equitiesis still regionally distributed by quota. This can limit the access of enterprises to the capital market,especially enterprises in regions which do not have recognized trading centers, and are relativelyunknown at a national level. The regional primary market for bonds is also driven by provincial quotas(for corporate bond issues) and bank branch distribution quotas (for government securities). In termsof secondary markets, restrictions against the cross-listings of equities impedes the growth of anational market. In terms of the regulatory framework, the principal central regulator has no regionaloffices at trading sites, and until July 1995, had no authority in informal trading centers. Secondarymarket integration in bond markets has been facilitated by the growth of the automated electronicquotation 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 independentdepositories, and the lack of mutual recognition of bond certificates issued by different centers.

- viii -

14. The eighth major issue also concerns market segmentation, by investor type. Although thisproblem has been virtually eliminated in debt securities (where formerly the coupons payable toindividual and enterprise investors differed for the same security), it is a major problem in the equitiesmarket. China is virtually unique in having different categories of investors for the same class ofordinary share. Among domestic securities, the persistence of non-traded state shares, and thinlytraded C (legal person) shares, reduces market liquidity (acutely, in the case of C shares). Looking atforeign investors, the distinction between A and B share classes, as well as other shares, has led towide price differentials and a consequent inducement to illegally benefit from arbitrage (see Chapter4). China is also unique in that shares held by overseas investors have traded consistently at a discountto domestic shares. One reason is that the small B share markets are highly illiquid, and as aconsequence, overseas investment in this market is being discouraged.

15. Ninth, despite the alarm caused by the recent Mexico crisis, China can cautiously afford toencourage an increase in foreign portfolio capital inflows and should curtail the preferentialtreatment accorded to foreign direct investment. Foreign investment in China is increasingly beingdriven by fundamentals, and the novelty value of China investments has passed. In this context theproblems in the B share market are of concern. While the high international ratings enjoyed by Chinauntil end 1994 are conmmendable, China may face deteriorating terms in the future, on two counts: anyreduction in international enthusiasm for emerging markets which could occur as a consequence of theMexico crisis and the rise in developed country, and especially US interest rates, and second,symptoms of macroeconomic imbalance, if they persist, particularly concerning inflation, in China.Chinese overseas bond issues have begun to trade at a discount in secondary markets.

16. Tenth, on the subject of securities market regulation, the government correctly points out thatregulation per se is not the issue. Details of many securities regulations, particularly concerningequities, are basically in accordance with international principles. Rather, the problem here primarilyconcerns government oversight, both functional and institutional. At present, oversight is splintered inboth these senses, and also regionally scattered between municipal and central authorities. Oneconsequence of this is that some areas of regulation tend to 'fall between the cracks' and certainsegments of the market have little de facto regulation, notably, securities dealers and institutionalparticipants in securities' markets. The regulation of corporate bonds (trading, rather than issues) isanother gray area.

17. The above issues suggest that there is a need for the adoption of revised policies, if futuredevelopment of China's capital markets is to proceed in a healthy direction. It is encouraging that thegovernment is aware of the need for improved performance and in many areas has begun to initiatechanges. Despite the problems today, credit is due for progress achieved over the early 1990s.

C. Recommendations

18. The recommendations made here, and summarized in a table at the end of this section, arenecessarily interdependent. In many cases, these objectives can only be achieved if there is adequateprogress in other spheres. Thus progress along the suggested axes is necessarily contingent on thedirections adopted by the government in the financial sector and macroeconomy and the time phasingindicated is tentative, in relative terms. Thus, first of all, the government has to determine whether itis prepared to launch upon reformns on a broad front, in terms of those features of the economicsystem that impede capital markets from performing efficiently: financial sector reforms which allow agreater role for interest rates as a pricing mechanism, a reduced role to credit and investment plans forcapital allocation, the transformation of banks into entities which lend on the basis of risk evaluationsand creditworthiness of clients rather than their Credit Plan quotas, and reforms of state enterprise

- Ix -

which pernit them to face a real environment of risks and returns, ie, a 'binding budget constraint'.The real issue is the implementation of these goals. Abandoning the Credit Plan in the absence ofindirect instruments of monetary control, or the simultaneous decontrol of all interest rates, will leadat least initially to chaotic conditions. The more germane question therefore is, what is the modusoperandi, in terms of the next incremental steps, that can be taken towards realizing these objectives?Three broad suggestions are proposed here before interest rate deregulation, and reduced reliance onthe Credit Plan, are embarked upon.

19. First, to exercise monetary control through debt sales, the government must better coordinateits monetary and fiscal policy, to ensure that the volume of debt sold will not cause interest rates torise to levels which damage both the real economy and the developing capital market. The importanceof this will rise as the volume of treasury debt outstanding escalates. The government must alsoestimate cash flow requirements and projections, to coordinate debt issues with spending requirements.Second, in the banking sector, the speedy implementation of the separation of 'policy' and commerciallending is required. Despite the establishment of new policy banks, existing commercial bankscontinue to provide directed credit. Banks must begin to acquire the capacity to manage liquidity andinterest rate risk, and attend to the current mismatch between their assets and liabilities. Third,regarding interest rates, deregulation could begin with short term rates and money market rates. Sucha move would help establish a better defined short term yield curve.

20. Recommendations specific to securities markets fall into the following five broad areas ofaction:

21. The first and most important area for attention is the primary market, both for bonds and forequities. In the bond market, the government must (i) clearly distinguish between wholesale and retailinvestors, and increase the relative emphasis on the former category. Focus on a wholesale investorbase will permit the offer period to be reduced, and will facilitate the eventual adoption of an auctionsystem. (ii) An effort should be made to gauge wholesale investors' demands for bonds, and theirpreferences in maturities. (iii) Bonds should then be targeted for sale to this group, and retail investorsshould be treated as a residual. (iv) The government must also assess its own short and long termfinancing requirements, and its cash flows. (v) For its term financing requirements, the governmentshould have a preannounced issue calendar for the year for its debt issues, spread over the year. Thiswill also help to improve liquidity management at the level of the wholesale buyers, and assist thedevelopment of a benchmark.' (vi) Government and institutional liquidity management would befurther assisted by regular issues of short term debt (one to twelve months maturity), to meet shortterm liquidity needs. (vii) In addition, the PBC could issue short term paper, on an as-required basis,to help liquidity management. (viii) Electronic registration and transfer of title should be adopted asthe standard for wholesale issues. (ix) The yield at issue should be related to current secondary marketyields, rather than to deposit rates. (x) The government could then move gradually to an auctionsystem, auctioning a part of its bills, and selling the rest on a non-competitive auction or average pricebid basis.

22. For retail investors, a savings bond issue should be designed, available on demand at any timeof the year, which would have the effect of spreading retail sales over the year. The interest rateoffered could be altered to stimulate or dampen retail demand. Since such an 'on demand' issue will bedifficult to trade because of the variety of maturity dates, it should be possible to redeem them early at

To improve liquidity, the government should avoid a large number of issues of different maturity dates. Somecountries have adopted an 'on-the-run' issue system, in which bonds issued at different dates in the year all mature onthe same date.

- x -

a penalty. For corporate bonds, the determination of capacity to issue should be based more onevaluations from credit rating agencies than quota-driven decisions by local authorities.

23. For equities, attention to primary markets implies: (i) transferring the decision to issue newequities to risk-bearing enterprises, subject to compliance with rules established by the exchanges andthe central regulatory authority; (ii) doing away with any remnants of the lottery-based system of shareallotment and substituting this universally with discriminating price auctions; (iii) in all cases, ensuringthat the selection of underwriters is left to issuing enterprises, and allowing underwriters tocompetitively bid for terms; (iv) the present 'firm commitment' underwriting system should begradually abandoned in favor of systems where the enterprise and underwriter are better able to sharerisks, such as the 'best effort' or auction methods; (v) the length of time from offer to opening shouldbe reduced; (vi) avoiding the bunching of new issues (already improved since 1994); and (vii) doingaway with fees for application forms and transferring the costs of producing forms to existing or newshareholders, if necessary.

24. The second area for action is secondary market development. In the bond market, the problemof poor liquidity requires greater standardization, targeting issues primarily towards wholesaleinvestors, more evenly spacing these out over the year, on a preannounced schedule. Additionally(although detailed recommendations are beyond the scope of this study), constraints on the operationof the money market must be addressed. Next, regional segmentation in the bond market requires thatthe government either (i) sets up a centralized depository for all government bond issues, or (ii)requires the adoption of mutual recognition of share certificates from different trading centers. Thegovernment plans to establish a centralized depository and is aware of these issues.

25. In the secondary market for equities, the key problem of volatility also stems in part fromfeatures of the primary market, and the measures described above (a further reduction in reliance onlottery-style IPOs, competitive underwriting, etc.), will help address this problem. Additionalmeasures which can be taken include: (i) reintroduction of daily price limits; (ii) introduction of someform of (an ideally short-term) capital gains or turnover tax on share trading; (iii) emphasis on thepayment of cash dividends; (iv) improved disclosure, in terms of both quality and timeliness; (v) newguidelines for press responsibility; (vi) regulations against front-running and market manipulation;(vii) most of all, the govermnent must be more aware of the its own 'announcement effects', whichdemonstrably have the capacity to send markets soaring or plummeting. Some governmentinterventions undertaken in the market, such as sudden announcements of bans on new share issues,would be regarded as market manipulation in mature economies.

26. A second key issue in the secondary market for equities, is regional market segmentation. It isrecommended that (i) dual listings on the presently recognized exchanges be permitted; and (ii) newtrading centers be allowed to open in the medium term. A single central regulatory authority hasrecently (July 20, 1995) been recognized by the government in the form of the CSRC. The CSRC stillneeds, as a precondition, its own regional offices, to supervise such exchanges. A second precondiitonfor establishing new exchanges is that existing exchanges and their institutions must be officiallyregistered, and a third is that new exchanges must comply with all requirements laid down by thecentral authority. A third key issue concerns the different share categories, classified by investor. It isrecommended that the present distinction between state, legal person, and individual shares should beeliminated.

27. Third, to encourage the development of an institutional investor base, the government should(i) further encourage flexibility in the uses of funds for contractual savings institutions (the newinsurance law is a step forward); (ii) encourage competition in insurance by separating the spun-off

- xi -

subsidiaries of the People's Insurance Company of China from the parent. To augment the sources offunds, China should take major steps towards (i) introducing a multipillar, at least partially fundedsocial insurance and pension system; (ii) permitting housing funds to offer more attractive returns; and(iii) clarifying the regulatory framework for mutual funds.

28. Fourth, regarding the opening up of China's securities markets, China should (i) cautiouslyencourage foreign portfolio equity investment and reduce the fiscal incentive bias in favor of FDI; (ii)remove the present distinction between A and B shares, and at the same time (iii) introduce othersafeguards, as discussed, against volatile capital inflows or outflows; (iv) continue to broaden overseaslistings, encouraging dual listings (eg, with Hong Kong), to ensure adequate liquidity; and finally (v)maintain present restrictions against foreign participation in the domestic debt securities market, untilthe domestic bond market is considerably strengthened.

29. Fifth, in the area of regulation, the first key is the fragmentation of oversight; horizontal,vertical, and functional. It is recommended that China (i) remove the present dual regulatory regimesmaintained by the center and by local authorities, and give the China Securities RegulatoryCommission (CSRC) jurisdiction, through its own branch offices, over regional trading centers (boththe present two officially recognized exchanges and others that may be established and recognized inthe future). (ii) Consolidate the present overlap in jurisdictional oversight between the PBC and CSRCunder a single authority. (iii) Define the regulatory framework more clearly for certain types ofsecurities (bonds are more affected than equities, and corporate bonds are the least clearly defined), aswell as for certain market participants, notably, securities dealers and intermediaries, and forinstitutional investors such as mutual funds. (iv) Address the clarification of the separation of bank andnon-bank activities, in view of the close institutional ties between deposit taking institutions andsecurities dealers, as well as the rapid growth of the latter. The recently promulgated CommercialBanking Law has taken important steps towards this objective. (v) Strengthen the CSRC, which atpresent, with its single Beijing-based office of some 120 staff, is not adequately equipped to effectivelydischarge its responsibilities.

30. Finally, what structure of priorities and what sequencing should the government adopt inimplementing these recommendations? First, it is recommended that the government should begin toaddress the fundamental questions regarding the enabling environment. Second, issues regardingcapital markets themselves should be addressed in parallel, with emphasis on the problems of thedomestic primary markets. Third, the government should plan a time bound program ofimplementation of the measures it chooses to adopt, based on the recommendations presented here. Amatrix suggesting an implementation timetable is presented in the following section.

China: Capital Market Development Matrix of Key RecommendationsShort term Medium-term Long term

1(a) Primary Markets: * Assess demands of wholesale investors for bonds in * Initiate the selling of a part of debt at * Sell the majority of government debt

Treasury Bonds terms of maturity structure, etc. secondary market yields, to wholesale through regular and preannounced

* Determine the government's present cash flows, investors. auctions to wholesale investors.

and its spending requirements. * Reduce differential between yields and * Sell a limited part of government debt

* For government term financing requirements, coupon rates on the rest of debt issues. in the form of readily available

introduce a pre-announced annual issue calendar * Initiate auctions of a part of the debt savings instruments to retail investors.

for medium and long term government debt sold to wholesale investors

(tradable), to wholesale investors. * Introduce regular (periodic) interest

* To improve market liquidity, introduce short term payment mechanisms for wholesale(1-12 month, tradable) government debt issues on a issues.regular basis. * Introduce electronic registration and

* To supplement the above, introduce PBC issue of transfer of title for all wholesale buyers.

short term paper on an as-required basis forliquidity management.

* For retail investors, introduce a new savings bondavailable on demand throughout the year (non-tradable but with early redemption).

* Introduce compounding for interest paymentcalculations.

* Publish the price index on the basis of whichinflation adjustments are made.

l(b) Primary Markets: * Introduce requirements for evaluations of issuing * Reduce the role of the Credit Plan in * Remove the role of local governments

Corporate Bonds companies by (approved) independent credit rating determining corporate bond issues by in approving corporate bond issues

agencies. substituting a global (national) quota for * Remove global ceilings on corporateregional or sectoral quotas. bond issues and permit both issue

* Reduce the role of local authorities in volume and rate to be market-approving issues to a no-objection determined.(rather than detailed approval).

* Remove linking of coupons oncorporate bonds to deposit rates or totreasury bond coupons. Permit couponsto be market determined.


I(c) Primary Markets: * Restrict government announcements to ban issues * Reduce the role of provincial quotas for * Remove all share issue quotas,

Equities - of new shares, etc., if companies are approved and share issue. Set an annual or multi-year provided enterprises operate in a

The IPO Process other criteria are met. global national quota, to be filled commercial environment. Allow risk-* Reduce lag between share offer and opening of subject to criteria enforced at the bearing enterprises to determine

share trading. exchanges, rather than at the local whether or not to issue new shares

* Require underwriters and enterprises to undertake government level. based on market conditions.an examination of the appropriate prices for new * Abandon lottery based systems of IPOshare issues. allocation. Require the use of

* Remove fees for application forms for share issues discriminating auction systems for shareissue.

a Reduce bunching of IPOs. Allowenterprises to determine IPO dates, withunderwriters.

* Enforce better disclosure at time ofprospectus issue.

I(d) Primary Markets: * Underwriters: Reduce the role of local * Encourage the diversification of * Sponsor and encourage the

Market governments in the selection of underwriters for underwriting techniques; encouraging, establishment of credit rating agencies. _:

Infrastructure share issues, leaving this entirely to the in addition to the present 'firm * Encourage primary dealers inunderwriters and the enterprises concerned. commitment' method, 'best effort' and government bonds to exercise their

* Permit and encourage underwriters to bid for auction systems that allow risks to be options of establishing bond funds.business on a competitive basis. shared between the enterprises and the

* Primary Dealers: Encourage primary dealers in underwriters.the government bond market to participate in the * Permit foreign underwriters todetermination of terms of issuance with the participate on equal terms with domesticgovernment. underwriters.

* Credit Rating Agencies: Require establishment * Encourage primary dealers inof standards of approval for credit rating agencies government securities to assume theirby PBC.. market making responsibilities


2. Secondary Market * Bond markets: Establish codes for mutual * Bonds: Evaluate study on national * Implement standards for pressDevelopment: recognition of bond certificates at major centers of depository for bonds and launch responsibility.

Shanghai, Shenzhen and Wuhan. implementation. * Launch public education campaign on* Launch a study to examine viability of a national * Shares: Introduce a tax to reduce share holding.

depository for government bonds. speculation, in the form of a short-term * Complete the conversion of all* Equities Markets: Reintroduce daily price limits capital gains tax, or a share turnover multiple share categories to a single

to reduce volatility. tax. ordinary A share.* Enforce payment of cash dividends * Enforce ongoing disclosure of * Permit dual / multiple listing of shares* Undertake a study on the phasing out of performance. at exchanges other than Shanghai and

distinctions between (domestic) A and C share * Prepare standards for press Shenzhen, subject to approval of thecategories. responsibility. concerned exchanges ' requirements.

* Draw up standards for the recognition of regional * Initiate phased conversion of C sharestrading centers as exchanges. into A shares.

* Initiate study on introduction of dual listings on the * Initiate the dual listing of shares atShanghai and Shenzhen exchanges. Shanghai and Shenzhen.

a Evaluate applications of regionaltrading centers to be recognized as x

exchanges.

3. Institutional Investors * Insurance funds: Encourage more competition in * Mutual funds: Clarify the regulatory * Standardize the adoption of fundedthe insurance industry by more clearly separating regime for mutual funds. pension and social security systems onthe newly-created spin-offs of PICC from their * Finalize the choices concerning a widespread scale.parent. appropriate funded schemes for social

* Insurance and pension funds: Investigate with security and pension funds and startdetailed studies the possibilities for introducing a implementation on a pilot basis.multipillar funded social insurance and pensionsystem.

* Housing funds: Allow housing funds to offerreturns closer to prevailing market rates

* Allow greater flexibility to housing funds, socialsecurity funds and pension funds in the selection oftheir investments.


4. Foreign Investors/ * Draw up a phased program for the reduction of * Introduce the participation of approved * Complete the conversion of B andOverseas Securities fiscal incentives for foreign direct investment. overseas mutual funds to participate in other overseas shares into A shares.Issues Undertake a study on alternative safeguards to be the domestic A share market.

adopted for reducing portfolio capital volatility, if * Initiate the conversion of B shares andA and B share distinctions are reduced (eg, other shares into A shares, drawing upsectoral/ global /company specific foreign share conditions and a time table forinvestment limits, Iimitations to approved investors conversion.only, limitation to approved funds only, etc. * Streamline and simplify the procedure

* Explore the possibilities of overseas listings in new for overseas bond issue approvals, andexchanges, subject to dual listing with Hong Kong. permit these to be undertaken by

corporate entities subject toperformance criteria.

5. Regulatory * Securities Law: Pass the draft securities law. * Establish regional offices of the CSRCFramework * Enlarge the CSRC and strengthen its supervision at trading centers and exchanges.

capacity. * Absorb present regional regulatory* Clarify the overlapping jurisdictions of the PBC authorities into a single national

and CSRC especially in the areas of securities umbrella. xdealer licensing and supervision. As far aspossible, consolidate supervision under a singleauthority.

* Clarify the nature of the links between banks andnon-bank financial institutions which are securitiesdealers and ensure against systemic risk, and infavor of depositor protection (possibly through thedraft commercial bank law).

1. THE CONTEXT OF CAPITAL MARKET DEVELOPMENT

Introduction

1.1 China first resumed the issue of domestic securities in 1981, shortly after thelaunching of its economic reform program, after a twenty year hiatus. The motivation at thetime was the emergence of a budget deficit, and the need to raise financing for the deficit.Accordingly, treasury bond issues were introduced, essentially as a vehicle for the purpose ofgovernment resource mobilization. Early bond issues bore a strong resemblance to taxes;subscription to bonds was obligatory, and quotas for bond placement had to be fulfilled byenterprise and by administrative district, in parallel to tax contracts under the fiscal contractingsystem. Bonds were non-negotiable and non-transferable. Early share issues, which began in1984, had similar restrictions. Enterprises sometimes issued shares to employees in lieu ofwage or bonus payments, and shares were not tradable. The ownership rights, especiallyvoting rights, normally conferred on shareholders were not encouraged to be exercised. 1

1.2 Today, fifteen years later, the capital market in China is still viewed essentially as avehicle for resource mobilization. The seeking of listing for an enterprise is synonymous withthe raising of capital through an IPO. A large part of bond issues are still distributed thoughquota allocations, and are non-tradable. But while the ,nobilization of resources is one of thefunctions of a capital market in a market economy, capital markets also have other functions:aiding the efficient allocation of resources, by increasing the transparency of pricing, of risksand returns, and assisting investors with risk-management. The function of resourcemobilization is in fact subordinated to the effective channeling of large volumes of resources,which can be mobilized by a variety of means, to specific ends, and in short periods of time.The central question to be examined in the present study is, to what extent do China'scapital markets fulfill these manifold functions of efficient resource allocation, efficientrisk and return pricing, and risk management, and how can their efficiency be enhanced?How can capital markets help allocate resources efficiently to the real sector, and how can ithelp establish the efficient pricing of risks and returns across different investment alternatives?

1.3 Of great concern to the authorities today is the question of the extent to which thegovernment can successfully implement its proposed major reforms of eliminating reliance onPBC borrowing for the financing of its deficit, and at the same time, reducing quasi-fiscaloperations and transferring 'policy lending' to the budget. If these aims are to be realized, itis critical that the government secures stable and additional sources of financing, and in thiscontext, the report explores the extent to which the bond market can be developed toprovide financing for the government. The extent to which securities markets can providesupport for the adoption of indirect instruments of monetary control, although highly relevant,is however omitted from the scope of the present study, apart from an investigation of theextent to which the bond market can presently provide support to this process through the

Indeed, China was unique, in the 1980s, in the issuing of shares in the absence of any legal framework forshareholding companies, or securities. A description of the characteristics of early securities issues in China isavailable in Bowles and White (1993).

establishment of a benchmark issues which would assist the process of pricing of governmentsecurities issues. The issues investigated are, to what extent do current difficulties in thedevelopment of China's bond market stem from factors related to the primary issueprocess (issue size, pricing, placement methods, timing) and to what extent are problemsobserved in the operation of secondar-' markets. Markets for debt securities (althoughcurrently dominated hy government issues in China) are also important for providingappropriate leverage for enlerprlse flinancinig. and financing for infrastructure. The constraintson the overall developmiienit of debt securities are investigated.

1.4 Equities markets are as inportanit as markets for corporate debt for China's newshareholding companies, wihere the notioni of the appropriate composition of balance sheetswill have to be faced as soon as thie possibility of financial failure (bankruptcy) becomes real.The report investigates the present functioning of China's equity markets at the primaryoffer stage, and in terms of secondary trading. One feature of China's capital marketswhich has disquieteo' both local authorities and investors is thie high degree of volatilityobserved in secondary markets. This is particularly acute in the A share market, for domesticinvestors. Although the bond market has not normally displayed such volatility, there was aremarkable episode of greatly escalated trade in China's bond futures in February 1995,accompanied by a mairked coniraction Of equitV markets. The report examines the issue ofwhy secondary markets have exhibited such instability. The report also examines the effectsof the unique market sepgmenitationi ot the ordinary share market due to multiple sharecategories, and the extent to which regional segmentation may exist due to the nature of thepresent exchanges.

1.5 A major reason frequenitly cited in China, is the nature of the investor base, composedlargely of small individual retailers with a tendency to speculate. The issue explored by thereport is to what extent is the nature of the investor base, relative to other factors, thereason for secondary market instability, and what are the present constraints on thedevelopment of large scale institutional investors, specifically, insurance companies, andsocial securities and pension tunlcds

1.6 The report also exaniiiies the extent to which China's securities markets have openedup to foreign participation, and also the extent to which China itself is a participant in overseasequity markets The issue investigate(d is, on what terms and conditions has foreign capitalentered China, and what alternative methods are available for safely increasing China'scapacity to participate. as an investor and as a recipient, in international securities markets.

1.7 An understanding of Jie regulatory framework of the securities market in China isessential for understanding issues specific to the operation of different segments of the market,not only in terms of types ,f securities but also in terms of market participants, regionalstructure, and oversighit. Ilhe report therefore details the present regulatory environment,and also explores the extent to wvhich the present framework, and in particular the role ofgovernment oversight, slup[Orts ihe stable and efficient development of the market .

A. The C ontext of Capital Miarkets in China's Financial Sector

1.8 The role of .apital n-iarkets in the finanicial sector today is small, but has beengrowing. Total assets of 'wi-iinonletary finanicial insttiutions grew from 6 percent in 1989 to ahigh of 8 percent in i992. .'i tle f;u3nLiall sectorCs assets, declining once again to 5 percent by

- 3 -

1994. The pattern reflects the growth of enthusiasm for securities with the legalization ofexchanges and high returns to equities from end 1990 to mid-1993. With the introduction ofthe 16-point program in the latter half of 1993, and the squeeze of credit to the non-bankfinancial institutions, their levels of activity declined. By early 1994, the decline wasexacerbated by the increase in deposit rates offered on the banking sector. Data on the annualissue of securities, compared to the liabilities of the financial sector, indicate a similar patternand similar relative size: (a 4 percent share in 1989, rising to 6 percent by 1992, and decliningto 2 percent in 1993). Note however that the cumulative share of securities on issue has beenincreasing. Both sets of estimates however clearly reinforce the officially expressed position,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 doubtdominates resource flows to the real sectors

Figure 1.1 Secuities Markets in China's Financial Sector (Y billion)

Assets Uailities

Source: World Bank and IM F data.

1.9 The role of capital markets in the financial sector is more important than these 'stock'estimates of relative size suggest, because of the dynamic or 'flow' considerations which arisefrom the strong institutional links between banks and securities dealers. Many of the latter areoffshoots of banks and in many cases banks have a significant ownership stake in securitiestrading institutions. This leads to the questions of (i) 'leakages' of funds from banks to non-bank financial institutions (NBFIs), and (ii) issues of systemic risk. Leakages from banks toNBFIs were very lage in 1993, mainly through the interbank market . Although theparticipation of NBFIs on this market has been reduced since the 16-point program designed toslow down the 'overheating' of the economy, in July 1993, their share of outstandinginterbank loans is still estimated to be about 25 percent. The issue of systemic risks stillremains.

B. Capital Markets and the Financing of Governmnent Borrowing Requirements

1. 10 The contribution of bond issues to the financing of the budget deficit in the past hasnot been very large, but again, is gaining new significance with the 1994 decision to curtailgovernment borrowing from the central bank. Looking first at the visible budget deficit, netissues of treasury bonds (gross new issues less annual redemptions) have had a highly variablevolume, relative to the size of the overall deficit; over 50 percent as early as 1988 and 1989,when net annual issues were Y 17 and 21 billion respectively. In 1990 and 1992, the relativesize of bond issues fell to around a third. But in 1994, the estimated end-of-year visible deficitwas Y 85 billion, and (gross) new issues of treasury bonds amounted to Y 113.2 billion; or

- 4 -

around 133 percent of the current year's deficit. Taking account of quasi-fiscal operations, therole of bond financing of the estimated consolidated central government budget deficitdeclines.2 The annual volume of net treasury bonds issued over 1989 to 1993 has variedbetween 11 and 23 percent of the consolidated deficit, while the annual volume of treasurybills alone has varied between 5 and 23 percent of the consolidated deficit. If quasi-fiscaloperations are 'fiscalized', an increase in the scale of bond issues is likely to be required.

1.11 The government has recently augmented the contribution of securities markets to itsfinancing, by enhancing its external bond issues. Following a long hiatus in overseassovereign bond issues after 1987, the government made a comeback in overseas bond marketsin 1993, with issues of around US$600 million (Y 3.4 billion), and a huge increase in 1994,with issues of US$1.6 billion (Y 13.6 billion). If these are added to the measures of therelative size of government bond issues and the budget deficit, the role of securities marketsincreases; to around 38 percent in 1993 (33 percent from domestic bond issues, and another 5percent from overseas issues).

Figure 1.2 Central Government Budgetary Deficit and Treasury Bond Issues

30 - -

10 -- -

70

0

-20 -_-- -

-30

-40 - - - - --___

-50- _ _

-60

-70

r [ Vsible Deficit * Net treasury bond issues* Net issues of treasury bills 0 Overseas Bond lssues

Source: World Bank and IMF data.

C. Capital Markets and the Financing of Real Sector Investment Requirements

1.12 The contribution of China's capital markets to the investment needs of the real sectorsof the economy so far has clearly been small. Looking at treasury bond issues alone, thevolume of issues, relative to the volume of investments, was 5 percent in 1987, increasing to 9percent in 1989, and fluctuating between 7 percent and 9 percent between 1990 ad 1992.Adding 'investment bonds' (issued both by the treasury and by the erstwhile state investmentcorporations) to this, the upper limit for both categories rises to 10 percent over the period1987 to 1992. If 'enterprise bonds' are included in this estimate, the maximal possiblecontribution of debt securities to investment finance grew from 8 percent in 1987 to 21 percentin 1992.

2 World Bank Country Economic Memorandum on China (1994).

- 5 -

Figure 13 Contribution of Capital Markets to Real Sector Investment

800 _ __-

700

600

500 n Total I nvestmeni.° State Owned Units

i 400 * Treasury bonds issues

3 Investment bond300 i ssue s

200 _ _ _ _ O° Enterprise bond issue200 V Equity issues

100

0 -__

1987 1988 1989 1990 1991 1992 1993

Source: State Planning Commission and State Council Securities Committee.

1.13 Parallel to this issue is the question of the extent to which the equity market hascontributed to enterprise investment. The answer is, to a very limited extent. New (domestic)issues of equities contributed only around 2 percent to total SOU investment in 1992, and lessthan that in 1993. The cumulative value of new equity issues has been around Y 30 billion sofar. Around midway through 1994, approved new issues of equities were banned from goingto market by the government. Chinese enterprises have also raised equity capital overseas,through the issue of overseas shares, and the amounts raised through such issues are estimatedto have reached US$3.7 billion by the end of 1994; a significant amount compared to amountsraised through domestic markets. Chinese enterprises have also approached the internationalbond markets for resources. Yet international securities issues still account for a small share ofChina's total external debt. Portfolio equity only constituted 5.5 percent of aggregate netresource flows to China in 1993, and bonds accounted for only 2.7 percent of new borrowingcommitments in 1993.

1.14 The contribution of capital markets to resource inflows to the real sectors of theeconomy is controlled by the government, and embedded within the mechanisms of theinvestment and credit plans. Thus quotas are determined for the issue of domestic debt andequity securities, as well as for overseas bond issues, by a combination of the SPC, PBC, andin the case of overseas issues, the SAEC. Thus the extent to which the capital marketscontribute is largely determined by the extent to which the government permits them tocontribute, and the issuers of securities are determined by the distribution of quotas for each ofthese heads by the central and regional offices of the authorities cited.

2. THE REGULATORY FRAMEWORK

A. Introduction

2.1 An understanding of the regulatory framework for China's capital markets is an essentialprelude to the issues discussed in this report. The purpose of this chapter is to describe the presentregulatory framework, and evaluate its impact on capital market performance. It must be pointed outthat the CSRC and other regulatory agencies are highly knowledgeable and are aware of many of thematters raised here.

2.2 A first general finding is that the provisions of existing regulations for domestic securities arebasically sound in terms of international comparisons, and fairly well defined, especially for equities.While the provisions sometimes have unusual features, and sometimes are in unorthodox places, thesedifferences are generally dictated by pragmatic considerations. For example, in the absence of anational securities law, the Companies Law has a series of provisions which would usually be found ina securities law. Most of these provisions are valuable and offer investor protection in the absence ofa securities law. The chief difficulties in the fabric of China's securities regulations appear to be,first, the substantial role and sometimes ad hoc intervention of the governmnent, especially in primaryissues, and second, the difficulties of ensuring compliance and enforcement. The absence of a nationalsecurities law makes the regulatory framework sometimes confusing, and its passage would aidregulatory transparency.

The Framework for Securities Laws: International Standards and Practice and Relevance for China

There is no one set of international standards for securities regulation and legislation (as there is, for example, for theaccounting profession). It is possible to distill an overall set of good standards, derived from forums such as IOSCO(International Organization of Securities Commissions), FIBV (Federation Internationale des Bourses de Valeurs), and theGroup of Thirty. IOSCO attempts to set standards such as in the area of capital adequacy of intermediaries but they are notalways successful in encouraging implementation of their recommendations on a worldwide scale. It is difficult to getuniform standards in a line of business where regulatory arbitrage can be commercially beneficial. National exchanges maywish to lower their standards to attract particularly interesting overseas companies to list on their exchanges. Equallyimportant are certain accepted modern practices, which ensure service to and protection of the investor and the overallminimization of risk. The principles of 'full, fair and timely disclosure', 'transparency' of dealing information and 'minorityprotection' are all accepted as making a market attractive to investors. The existence of efficient trading, settlement andclearing systems can also add to a market's attractiveness.

Types of securities laws adopted depend on the nature of the underlying legal structure, eg, whether there is a framework ofcommon law, the nature of the prevailing companies law, etc. The necessity to take into account 'Chinese characteristics' isindeed important. Securities laws are less than a hundred years old; the oldest are those of the US, and the newest in a majordeveloped market are those of the UK, which had no law until 1986. Developing markets can adapt what suits them from theexperience of overseas markets, based on the form of their overall regulatory infrastructure. History has shaped the securitieslaws of different countries in different ways. Economic, political and social realities have to be considered. Regulationcannot be considered separately from these issues especially in a developing market.

2.3 Second, a major present issue is the form of government oversight. In the present regulatoryapproach to capital markets in China, this is fragmented in three ways: (i) vertically, by the splitbetween national and local regulation, (ii) horizontally, for example, the regulation of securities

- 7 -

dealers is split between the PBC (licensing) and the CSRC (secondary market activities); and (iii)functionally, since approvals for different types of security are split between various governmentdepartments, and multiple approvals are required. The distinction between national and regionalregulators of securities, the multiple institutions involved, and the CSRC's lack of regional officeshave weakened its authority, already limited by its lack of adequate staff.

2.4 Third, for equities, an official framework of secondary market regulation so far has beengeographically 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 arerecognized, and dual listing is not pennitted. The development of OTC and informal markets has not

Securities Market Regulation in the US

Through a combination of competition and direction from these exchanges are linked electronically so that athe SEC, the US securities market has developed a national securities dealer can see on which exchange the best bidmarket framework. This framework comprises three or offer price for a particular security is available. Thenational markets; namely the New York Stock Exchange ITS system then directs the dealer's order to the(NYSE), the American Stock Exchange (AMEX) and the exchange where he can get the best price at that momentOTC market operated by the National Association of in time.Securities Dealers, called NASDAQ.

The national trading market is supported by a nationalThe NYSE is America's largest exchange and acts as the settlement system. A Depository Trust Company (DTC)Big (or Main) Board. AMEX plays a more specialist role and a National Securities Clearing Corporation (NSCC)for medium size companies and equity options and the have been set up by the NYSE, AMEX and NASDNASDAQ market has specialised in providing development (amongst others). Other exchanges like Chicago havecapital for small and innovative companies. In addition, their own depository companies but with links to thethere are several regional exchanges such as Chicago (in the DTC. The DTC and NSCC provide the mechanisms toMid-west) and the Pacific (on the West coast). The SEC has clear trades made on any of these exchanges and thesought to ensure that there is a national market framework DTC immobilises securities and enables those trades tothrough the Intermarket Trading System (ITS). Under ITS, be settled between participants by book-entry transfers,

on a nationwide basis.

been coordinated, leading to problems with the synthesis of the centers into a cohesive nationalsystem. Moreover, the electronic markets have been restricted to bonds and C shares. There is no realnational market and opportunities to participate in the development of the markets vary across thecountry. Given that the main role of a securities market is to mobilize domestic capital, the lack of anationally regulated market is a serious limitation. I Although the present arrangement may bejustifiable at an early stage on the ground of experimentation, in the longer run it will impedecapitalization. The split between national and regional regulation for equities should be eliminatedand any duplication removed. The regional regulators should be branches of the central regulator .

2.5 Fourth, the present fragmentation of regulation particularly aJtJ u ts the bond market. Thiscould contribute to a situation where (like some other Asian markets) tne bond market is less welldeveloped than the equities market, which will eventually limit the financing options and financialstructure of enterprises. Although the present structure arose by historical circumstance, it should bereviewed. At this stage of market development, a single regulator may be enieficial

2.6 Fifth, the regulation of dealers in securities, and particularly, the role of the PBC in thelicensing 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 factoregulation is exercised.

I Although some A Share issues in 1994 were also offered outside the region in which the company is based.

2.7 Sixth, the links between securities dealers, non-bank financial institutions, and the bankingsector although greatly clarified by the new Commercial Banking law, for new financial institutions,have still to be spelled out for existing institutions.

2.8 Finally, the CSRC needs to be considerably strengthened to exercise its present mandateeffectively.

B. The National and Regional Regulatory Framework

2.9 China today has no national securities law. Its securities markets are governed by a series ofregulations, currently split between those that apply nationally and those that are set at local level. Thefirst national regulations on securities issuing and trading (the 'Interim Regulations on Share Issuingand Trading') were issued in May 1993 by the State Council Securities Committee (SCSC). This setof more than twenty regulations forms the framework within which the present regulators of securitiesmarkets, the SCSC and China Securities Regulatory Commission (CSRC) operate. A draft nationalsecurities law has been under preparation since 1993, and was put before the People's Congress inOctober 1994, but has still to be enacted. Meanwhile, a major step forward for securities marketregulation was the new national Companies Law, which came into effect on July 1, 1994. In theabsence of a Securities Law, the Companies Law contains 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 newlayer into the existing legal framework.

2.10 The new two tier national regulatory structure has a first arm which consists of the StateCouncil Securities Policy Committee (SCSC). The SCSC is responsible for macro policy issuesrelating to the securities markets. Such matters include the approval for the establishment of newstock exchanges and the approval of new securities legislation and regulations. It is also the bodyresponsible for setting the level of securities issues over a given period both for bonds and shares atthe national and provincial level, in conjunction with the SPC. The second tier is the executive arm ofthe SCSC, the China Securities Regulatory Commission (CSRC). The CSRC has been established tooperate as an independent legal entity. As such, it has taken over most of the functions previouslyperformed by the Financial Administration Department of the PBC. Although most of the PBC'sregulatory functions were transferred to two these new bodies from December 1992, the PBC remainsresponsible for the licensing of all financial institutions including securities intermediaries. Thisoccurred for historical reasons, since over 90 percent of brokers originated as subsidiaries of banks.The implication is that the role of licensing intermediaries and their on-going supervision is splitbetween two bodies.

2.11 The national regulatory authorities have no regional offices, and regional regulatoryauthorities in the form of the Shanghai and Shenzhen securities exchange commissions, set up prior tothe CSRC, continue to have authority at the exchanges. The regional regulators (i) do not have authorityin any area wvhere there is a national regulation. If, however, national regulations are silent on a point,their regulations can be enforced. (ii) In terms of links between the regional and national regulators, theShanghai and Shenzhen securities exchange commissions still report on a day to day basis to theShanghai and Shenzhen Governments and not the SCSC or CSRC. Yet it is responsible to the CSRCfor the proper administration of the national regulations and is required to bring to the attention of theCSRC any observed breaches or problems within the CSRC's jurisdiction. (iii) In terms of three-waylinks between the central and regional regulators and the PBC, the position is complex, especially withrespect to securities dealers. Although the PBC is responsible for the licensing of securities dealers,

-9-

and their ongoing financial soundness, the Shanghai securities exchange commission also feels someresponsibility for their business performance. At the same time, the direct operation of the secondarymarket is overseen by the SCSC/CSRC, and if a broker is in violation of the regulations, the CSRC isresponsible for investigation and penalties. In the most serious situations it can suspend a broker fromtrading. On the other hand, it is only the PBC that can revoke the license of the broker, and only theauthorities of the exchange that can remove the broker from the exchange floor.

2.12 The implication of the present regional and institutional division of responsibilities is that thosewho are actually in and near the exchanges and who know what is going on have no authority toinvestigate or penalize. The CSRC has the theoretical power but no branches nor has it delegated anyauthority to the regions. Effectively, the power is geographically separated from the action, and thiscan lead to inefficiency and duplication. On the other hand it avoids an overfamiliar relationship fromdeveloping between the regulator and the regulated.

C. The Regulation of Bonds

2.13 The SCSC has the broad role of guiding the direction of capital market development and'supervising the supervisor'. The CSRC is essentially responsible for the supervision of equitymarkets, including equity options. The regulation of debt securities is less well defined and morefragmented than the regulation of equities. (i) The MOF is in charge of the issue of state treasury bonds;(ii) the PBC is in charge of the approval of bonds issued by financial institutions and the securities ofinvestment funds; (iii) The SPC is in charge of the inspection and approval of state investment bonds andbonds issued by state investment companies; (iv) the PBC and the SPC are together in charge of theapproval of central enterprise (corporate) bonds; and (v) provincial or municipal governments are incharge of the approval of regional enterprise (corporate) bonds. This division of responsibilities coversregulation only the primary market, and its fragmentation reflects the great variety of government debtissued in China until 1993. The PBC is responsible for bond trading activities only to the extent that itapproves securities trading centers. Monitoring bond trading on a daily basis, to the extent that thisoccurs on the two officially recognized exchanges, is within the realm of the CSRC, which is meant tosupervise the activities of the exchanges. But monitoring the actual trading of bonds, especiallygovernment bonds, has been a gray area. The PBC, while responsible for the trading of governmentsecurities, has not had the capacity for regular monitoring, and has tended to control by the issue of adhoc regulations as problems are manifest. Even at the official exchanges, the CSRC has hesitated tointervene, as this could be regarded as an encroachment on the PBC. Outside the two officialexchanges, the CSRC does not have any rights of intervention. The government was recently madeaware of the lacunae by the government bond futures trading debacle on the Shanghai exchange inFebruary 1995, and it is now drafting a Government Bond Law, which is expected to cover thesupervision of bond trading activities.

2.14 Corporate Bond Issues. The Company Law requires that all bond issues must be approved bythe Securities Administration Department of the State Council which will grant or withhold approvalwithin limits prescribed by the State Council. It also provides that corporate bonds can be listed tofacilitate transfer by, and among, existing and new bondholders (although this is not compulsory)2However, 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 outprovisions relating to its contents, and also relating to approval documents which must be delivered tothe Securities Administration Department; and the form and contents of the bond certificatesthemselves. The issuer is also obliged to maintain a Register of Bondholders. Bonds may be issued by

2 Para. 170 of the Company Law.

- 10-

all limited liability shareholding companies (with at least two shareholders which are state-ownedentities) or by wholly state owned companies (Para. 159 of the Company Law). The Company Lawprovides that a company may only issue bonds if it satisfies conditions on (i) minimum net asset value;(ii) a maximum ratio of bonds issued to net assets; (iii) the ratio of distributable profits to interestpayments; (iv) the use of funds raised, which must be invested in industries which comply with thepolicies of the state, and nay not be used to cover losses or non-productive expenditures; (v) the interestrate, which may not exceed the limit set by the State Council; and (vi) any other conditions which may beimposed by the State Council. A company will not be permitted to issue bonds if: (vii) on the lastoccasion when it issued bonds, the company failed to raise the full amount required; or (viii) thecompany has defaulted in payment of principal or interest on bonds already issued. The State Council isalso empowered to set limits on the scale of all company bond issues and the CSRC as one of theorgans of the State Council designated for this purpose, may only approve bond issues within thisoverall limit. A company can also issue convertible notes if it satisfies the conditions applicable toboth a bond issue and a public share issue. The Company Law does not envisage companies issuingunlisted securities such as short-term floating rate notes issued to a syndicate of banks. Some of theseprovisions are unusual (eg, (iv), (v) and (vi)), and also the provision that the state council is empoweredto set limits on the scale of company bond issues. They reflect the coexistence of central planning andthe emerging market economy

D. Banking Laws and Securities Laws

2.15 The role of the central bank, the PBC, in securities regulation is at present defined in thesecurities legislation described above; primarily Document No. 68, and the Interim Regulations. Akey issue of importance for China is the extent to which specialized or commercial banks should beallowed to participate directly, or through their subsidiaries, in securities markets. Links betweenbanks or other financial institutions, and securities dealerships have very recently been spelled out inthe new Commercial Bank Law, declared effective from July 1, 1995. For the first time, the new lawconsiderably clarifies in legal terms the degree of separation between banks and non-bank financialinstitutions. 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 isexpressly forbidden. Commercial banks are also forbidden to invest in trust and investment businessesor real estate, and are also forbidden from indirectly investing in non-bank financial institutions. Stiffpenalties are detailed in case of contravention. However, the new law does not deal with existinginvestments of existing banks in non-bank financial institutions. These are to be covered, according tothe law, by separate implementing procedures, to be prepared by the State Council. Given that thelarge banks in China have a substantial or majority stake in many of the most important and largestsecurities dealers, this is an important remaining lacuna and it is hoped that this area too will soon beclarified.

2.16 In the context of China today, here are several advantages in keeping the securities activities inseparate subsidiaries: (i) the securities firm can more easily be regulated by the CSRC, withoutjurisdictional conflicts with the PBC; (ii) the securities firm can be required to meet the usual capitaladequacy requirements for brokers, with separate capital from the bank; and (iii) the traditional deposittaking functions of banks can be protected from potential losses in the securities business.3

3 The proper relationship between banking and securities broking is a contentious issue and the trend today in manydeveloped countries is towards 'universal banking'. However the US Glass-Steagal Act still seeks to keep the traditionalbanking operations of deposit taking and loan separate from all securities business, although there have been calls for theremoval 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.

- 11--

E. Distribution Of Oversight Within The Governument

2.17 A key concern in the regulatory structure for securities markets in China today is thefragmentation of oversight, both functionally, for different segments of the securities markets, (and fordifferent parts of the market for each security, ie, primarv a;id secondary markets), and regionally,between central and regional authorities. The CSRC and SC' C are the principal central authorities.The PBC's role in securities regulation is largely effected through its branch offices. Additionally, theMOF has begun to assume a role in this area, and regiona! governments have powerful bodies ofsecurities legislation.

2.18 The different levels of legislation creates an environment where national regulations may seemto conflict with regional rules, making interpretation difficult. In addition to inter-organizationalfragmentation, there are also problems within regulatory agencies, notably the CSRC, which issignificantly understaffed and has lacked adequate authority to impose its regulations, especially at aregional level. There is clear duplication between the CSRC and the municipal securities regulatoryauthorities. The current division of regulatory responsibilities between the CSRC and the PBC leadsto instances where defacto there is little regulation (for example. in the monitoring and regulation ofthe activities of securities dealers). This has also led to probjeins of coordination. A recent exampleis the CSRC's market support package announcement of end July 1994, which included provisions fora 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.

Comparisons With Other Countries

2.19 Most countries have a single principal securities regulamrr who then comes under the authorityof the MOF, the Central Bank or an independent oversight body. Thus, the single regulator is theSecurities and Exchange Commission in Korea, the Philippines, Taiwan and Sri Lanka; the SEBI(Securities and Exchanges Board of India) in India; and the SFC (Securities and Futures Commission)in Hong Kong. The regulator is usually responsible fhr licensing and supervising securitiesintermediaries. A key question here concerns the regulatior. .-f debt securities, which in China, likemany other Asian countries, have been generally underdevelcped. compared to equities. The easiestway to ensure that inequalities do not develop between Chinia debt and equity markets is to consolidatetheir governance under one regulatory authoritv. Both markets should evolve in tandem. Anomalies inthis regard are already apparent. In theory debt financing n China should be more welcomed thanequity. Not only is debt a cheaper source of financing, i does not dilute the ownership structure. Todate, the amount of corporate debt issued has been very small. While there are other problems thatconstrict the development of the debt market, regulation can also distort the issuing costs for debt andequity. Slight variations are to be expected, but radical ev acions can cause problems. If a situationevolves that is radically different from capital markets mn market economies, PRC issuers would be ata disadvantage in global markets and also would nor be able to adequately implement moderncorporate finance techniques. A sole regulator prnvidees the most pragmatic approach for thedeveloping securities market in China.

3. DOMESTIC BOND MARKETS

3.1 A first broad conclusion of this study is that China's bond market today is a market intransition, and is confronting critical conflicts between the requirements of efficiently functioningcapital markets, and features inherited from the former planning system; (i) the credit plan, (ii)administratively determined interest rates, and (iii) the absence of market pricing of risk. Bondissuance is still essentially regarded as an alternative revenue mobilizing system, and an extension ofthe budgetary process, in terms of financing options under the Credit Plan. Coupon rates are set withregard to the administratively determined deposit rate and do not reflect secondary market yields.Since the default risk of enterprises is still relatively low, bond pricing has not adequately reflectedrisk differentials. In these circumstances, the link between bond market activity and underlying realsector developments, in terms of raising or pricing capital, is constrained, and the bond market cannotact as an efficient allocation mechanism for capital, or pricing mechanism for risk.

3.2 As a result, many of the market's features are contradictory: a secondary market in bondsusing relatively sophisticated trading technology, futures contracts and repurchase agreements coexistswith interest rate regulation in the primary market and the money market; a system of underwritersand primary dealers has been established, but these entities continue to use a retail distribution systemthat was originally used for forced placements of bonds; there are many credit rating agencies andgovernment bonds are liquid enough to begin to provide an indicative benchmark interest rate, but thequantity 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 blurreddistinctions of credit quality.

3.3 The second broad set of conclusions is that the primary process of bond issue in China stillretains many features which arose from its historic origins as an obligatory tax mechanism. Thesefeatures would require modification if bonds are to function as a capital market instrument. Inparticular, the lack of effective competition between underwriters, the large and infrequent nature ofgovernment bill issues, instead of issues based on a preannounced year-round schedule, the targetingof the retail investor base rather than recognizing and differentiating between wholesale and retailinvestors, the system of coupon determination, based on deposit rates rather than market yields, thelack of coupon payments and the method of determination of redemption amounts, and the continueduse of quasi-administered placement (through bank distribution quotas, at above-market interestrates), are issues to be addressed to improve the efficiency of the primary issue process.

3.4 In terms of the development of secondary markets, China has made considerable progresssince 1990. Yet, there are still improvements to be made. The third set of conclusions is that themarket needs to increase its liquidity and to achieve greater price unit. Key factors in improvingmarket liquidity are the primary issue design features referred to above. In addition, presentconstraints on the operation of the money market need to be addressed, to provide funding for bondportfolios and a reliable short-term yield benchmark. Greater price unity across different regions todayrequires the creation of a centralized depository (or existing depositories will be required to agree ona common set of operating standards). Fourth, to reduce speculative tendencies, the volume and

- 13 -

quality of information in the market should be increased. This applies particularly to enterprise andfinancial bonds. This entails the improvement of disclosure requirements and the standardization oflisting requirements. Another element of this concerns the development of credit rating agencies. Italso requires the development of a class of informed institutional investors. Finally, bond marketsneed an appropriate environment in terms of a regulatory framework. Although this has already beendealt with in Chapter 2, it is reiterated here, as it is in the area of bond trading that the presentregulatory framework still requires fortification. The proposed new government Bond Law, to beissued in 1995, and the recently issued regulations on futures trading in bonds are welcome steps inthis direction.

A. The Primary Market

3.5 Volume and Composition of Debt Issues. China's primary markets for bonds have beencharacterized by a huge variety of instruments. Since 1984, the volume and variety of debt issue inChina has grown rapidly. Total debt issues increased from Y 48.7 million in 1981 to Y 65.6 millionin 1985, and to Y 113.3 billion in 1994. New issues planned for 1995 are Y 150 billion. As illustratedin 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. State financialinstitutions and state enterprises have also been authorized to issue debt since the mid-1980s. From1994, there has been a significant increase in the value of treasury bills issued, primarily due togovernment's decision to cease to finance its deficit through borrowing from the PBC. Governmentdebt issues, at over Y 113 billion, increased threefold over 1993. Planned issues for 1995 are higherstill, at Y 150 billion.

Figure 3.1 China: Composition of Outstanding Debt Issues

percent Y 100100% million90% 3500 ___ __

80% - _ 300070% C0 Ds 2500

60% a Corporate 200050% - oFinancial Institution 150

40% ~~~~~~~~~~~~~~~1030% N Government Agency 1000

200/o LL Other Government 500 __EIIiiit

10% - - _ .+\,_TBills

- N 0~~ -a, 00 00 00 0000 00 00 00 00 Qs

YtearsSource. Data provided by the State Council Securities Committee.

3.6 Until 1992, the two major categories of debt in addition to treasury bills were certificates ofdeposit and corporate debt. The growth in corporate debt (comprising local enterprise bonds and shortterm enterprise bills) and financial bonds, issued by banks, is illustrated in Figure 3.2. The growth inthe supply of non-government paper reflected (i) the increased liquidity of capital markets from 1990and therefore the increased likelihood of using debt issues as financing instruments; (ii) increases inbond prices, due to increased liquidity, which further raised their attractiveness for enterprises; (iii)the desire of banks for funds to finance their own capital market activities, or those of their TICsubsidiaries; and (iv) the use of debt issues to tap local sources of finance.

- 14 -

Figure 3.2 Outstanding Debt Composition Disaggregated

Gowrnment Bond

1600

1400 0 Inflation-proof Bond

1200 0 Special National Bonds

0 1000 * Constrtction Bonds

| 800 1 Fiscal Bonds

600 E Tbills

400

200

1981 1983 1985 1987 1989 1991 1993

Corporate Debt Financial Debt900 - 900 ___

800 800

700 700

c 600 0 State Enterprise Bonds ; 600 0 Investment Fund Bondsa 500 * Inter-enterprise debt U Trutst Income Securities

ci0 M Short Tern Paper O E CDs400 a Local Enterprise Bonds 400 a Finance Bonds

300 300

200 l 200100 miI1000 I0 --

- r'o fo 0 - v ) m ts N 0 -oo 00 oooo 00 00 00 00 00 00 00 000% 0% 0% 0% 0% 0% 0% 0 0%~ 0% 0% 0

Source: Data prvided by the State Council Securities Committee.

3.7 Issue Method: Treasury Bills. Despite the fact that methods used to issue government debthave evolved over the past decade, reflecting moves away from administered placement, towardsmore market-based methods, China is still a long distance from more sophisticated bond issuetechniques, such as auctions. In 1991, an underwriting syndicate was entrusted for the first time withthe issue of Y 2.5 billion, out of a total of Y 19.9 billion of the treasury bond quota issue for that year.Underwriting was used again in 1992, to distribute Y 3.6 billion of treasury bills in combination withthe traditional administrative allocation for the balance (Y 36.7 billion) of the years issue. But in thefollowing year, 1993, underwriting failed to sell the desired quantity of treasury bills and thegovernment reverted to mandatory administrative allocation.

3.8 With some revival in the bond market in 1994, the government ventured to experiment withfour different methods of issue for treasury bills, representing a compromise between those whodesired more market-oriented issuing procedures and those who doubted the effectiveness of theunderwriting system in China. (i) Y 13 billion of six month and one year paperless treasury bills wereissued via underwriting agreements. (ii) Y 28 billion of two year bearer treasury bills were sold vialocal financial departments, which applied for allocations. (iii) Y 2 billion of five year bearer treasurybills were placed directly with institutions; but (iv) the largest part of the year's issue, Y 70 billion,three years maturity, was issued in the form of certificates, allocated by PBC to the headquarters of

- 15 -

the specialized banks which in turn allocated them to branches to sell to individuals. These certificateswere redeemable at the bank of issue after six months, although their listing and trading was notpermitted. Of the four distribution channels used in 1994 the Y 13.2 billion placed via underwriting isthe furthest removed from the old administered distribution channels. The difficulty in movingtowards new issue methods is that entirely abandoning administrative placement systems, within theframework of the credit plan, would imply that the fulfillment of 'placement' quotas could no longerbe assured. Another major difficulty with the transition is the administered interest rate, andconsequently bond coupon rate, which effectively removes a major plank of price competition forunderwriters or primary dealers. Third, for reasons discussed further below, institutional buyers arenot at present accustomed to government bond purchase.

3.9 Issue Size, Frequency and Issue Period. Treasury bills typically have been offered in asmall 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 paperlesstreasury bills aimed at wholesale investors in 1994 was an innovation which permitted a much shorterissue period. The current practice has several undesirable implications. First, in the absence ofregular maintenance of a sufficient volume of short term debt on issue, the development of a liquidsecondary 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 methodsof monetary control. Second, the absence of a regular supply of debt of any maturity to the marketimplies that there is no 'current' issue to provide a 'benchmark', either long or short term. Third,since issues are made in the first half of the year, there is little scope for synchronizing the timing of

the sales with the State's cash flow requirements. This raises the cost of funds to the government.Fourth, investors cannot plan orderly acquisitions of new issues over the year in line with their cashflows. A one-off issue period puts considerable strain on the liquidity management and riskmanagement capabilities of banks and institutions. In a market economy such an issue pattern wouldlimit the number of bidders and cause a liquidity squeeze, both of which would operate to raise interestrates and the government's cost of funds.

3.10 On account of these reasons, it would be more desirable for the government (Ministry ofFinance) to (i) 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, (ii) undertake regularissues of shorter term debt (one to twelve months maturity) to meet short term liquidity needs. (iii) Inaddition, the central bank (PBC) should issue short term paper as required, to meet short term liquiditymanagement needs.

3.11 Maturity. Maturities on treasury bills have been progressively shortened from ten to five, andthen to three years. The 1994 treasury bill issue included six month and one year maturities for thefirst time. Today, there is a need to widen the range of maturities offered to satisfy a wider range ofreal sector requirements and investor preferences. On the shorter end, extending the range of shortterm maturities to include 30 and 90 day paper and increasing the volume of short term offeringswould assist financial institutions with liquidity management and encourage the development of a shortterm yield curve. On the longer end, in view of the central and local governments accelerating needfor financing infrastructure investment, there would certainly be an interest on the part of theseauthorities in the issue of long maturity bonds. However, from the perspective of the investor, there isa lack of enthusiasm for debt of long maturity today due to a number of reasons: (i) the lack ofpayment of coupons, and the long intervals to redemption; (ii) high and uncertain rates of inflation,which make the real value of the redemption amount difficult to predict, and usually (in the experienceover the last few years) less attractive than the nominal value, (iii) due to the low incidence of default

- 16 -

on most forms of investment within the framework of a planned economy, investor perception of, andallowances 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 attractiveelsewhere carries little premium in China today. (iv) Liquidity in the bond market is still low. Ifliquidity 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 wouldfind these difficult to sell, and would have to resort again to administrative placement.

3.12 The Investor Base for Primary Sales. Historically and currently the tmajor target market ofdebt sales is individuals. This stands in contrast to developed debt markets, or even markets in Asiancountries such as Malaysia, Thailand or Singapore, where the major target market of primary issuesconsists of wholesale investors such as banks, insurance companies and mutual funds. There is nosystematic trend reduction in the proportion of debt issued to households, over time. The PBC hasrecently begun to encourage institutions to hold treasury bills as it is examining its ability to controlbank liquidity via secondary market treasury bill transactions. But before secondary market treasurybill transactions can be used as a policy tool, the relevant institutions must hold a stock of treasurybills and a liquid secondary market needs to exist.

3.13 Issue Price and Coupon. Government bonds are issued at par and the majority carry apredetermined 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, withoutreference to the secondary market yield oni issues of comparable maturity. The lack of reference tosecondary market yields reflects the administratively determined interest rate structure, and the rolethat debt issues continue to play in the Credit Plan. Most government issues of three years or more inmaturity, 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 proposed fiveyear issue of Y 100 billion for 1995.1 Only two treasury bills pay an annual coupon; the five year1993 issue and the scripless issue of 1994. All other bonds pay a redemption amount consisting ofprincipal plus accumulated simple interest estimated on the basis of the coupon at issue. Oneexplanation may be that since most bonds are held by individuals in the form of bearer certificates,there are no easy channels for periodic coupon payment.

3.14 In 1994 both the two and three year issues, aimed at retail investors, were issued at yieldsabove those in the secondary market. The fact that they were sold at above secondary market yieldsindicates that there are potential benefits to the governmnent from targeting wholesale investors (whodominate secondary market trading) and from taking account of secondary market rates. Had the twoand three year issues been sold at secondary market yields the cost saving would have been in theregion of Y 3 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 byauction.

The inflation adjustment is published on the 20th of each month; adjusted according to the inflation adjustments on thedeposit rate, and a price index used by the PBC. In March 1995, the adjustment amounted to 11.87 percent. The PBCindex differs from the index prepared by the State Statistical Bureau: the former includes goods and services while thelatter is based only on goods. Moreover, the PBC index is not published. The formula used for the inflation adjustmentsis as follows:

Adjustment = [{(w, /w,) - I} - r x n] x I 00 where

w, = the monthly price index, at time of maturitywo = the monthly price index, at time of issuer = annual interest raten = years to maturity

- 17 -

3.15 Tradability. Another feature of bond design in China is that much of it has been non-tradable by regulation. 2 The tradability of government bonds is partly due to the evolving nature ofdebt issues which has resulted in lack of homogeneity in the outstanding stock of treasury bills. Evenin recent years the treasury bill issue has not been homogenous. The 1994 issue of Y 113 billion wasthe largest issue to date but the bulk of this issue is not tradable. Trade in other issues, such asenterprise bonds, is often hindered by lack of issue volume for individual issues ( Figure 3.4).

3.16 Bearer and Scripless Issues. The majority of debt securities are in bearer form. Theexceptions to this norm are the 1994 experimental treasury bill issue (Y 13 billion) and non-tradabledebt issued by mandatory placement to institutions. Bearer issues have contributed to the lack ofliquidity in the secondary market. While depositories exist to record holdings in book entry form, lackof regularized registration procedures between localities cause friction in inter-regional trade. Thedifficulty of aggregating retail parcels has been exacerbated by the need to gather physical scrip.

3.17 Credit Rating Agencies. Although the development of credit rating agencies has beenencouraged since 1991, and an estimated 82 credit rating agencies operate, at present their role is ofmarginal importance to the government and investors. The PBC's headquarters have approved onlytwo agencies so far, although some other agencies have been approved by PBC at a local level.Among acceptable companies the right to issue debt is not determined solely, or even primarily, on thebasis 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 excesssupply of investible funds and because enterprises rarely fail due to state ownership.

B. Secondary Markets in Debt Securities

3.18 The secondary market for China's debt securities has progressed rapidly, with the initiallegalization of trade in 1988, followed by the legalization of inter-regional trading, the creation of theSTAQS and the formal opening of the Shanghai stock exchange, in 1990. The market has improvedimmeasurably since, in terms of increased liquidity, greater geographic price unity and moresophisticated trading. But in comparison to debt markets in other countries the market remainsilliquid; liquidity is not sufficiently to meet the transaction needs of larger participants, and uniformpricing 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 bedriven largely by the weight of liquidity available.

2 Trade in Fiscal Bonds is not permitted, and Special State Bonds cannot be listed, and most of the 1994 and 1995 treasurybill issues are not tradable.

- 18 -

Figure 3.3 China: Trading Value of Bonds

Annual Trading Value: All China Trading Value: Shanghai Stock1400 (1987-93) 120 Exchange (1991-94)1200 0 TBilIs 100

i 1000 - Short Term Enterprise Debt _ o 80 l TBillso E Financial Bonds 8

800 - Local Enterprise Bonds 60 * Total600 g Other 40

>. 400 2

200~~~~~I2

00 X Ch g O - n - ,* - te - C\0% 0 0 C - .o.r- 00 0% 0 % 0 % 0 % 0-0 _ . _ - - - 0' 0 0% 0 0 % _ _

Source: Data provided by the PBC, the State Council's Securitites Committee, Almanac of China's Finace and Bankingand the Shanghai Stock Exchange.

Secondary Market Efficiency: (i) Trading Volumes and Liquidity

3.19 The first aspect of secondary market efficiency examined here is the extent to which secondarymarkets have been able to achieve reasonable volumes of turnover, ie, the degree of market liquidity.As shown in Figure 3.3, annual treasury bill trading volume rose steeply from Y 10.5 billion in 1990to a peak of Y 105 billion in 1992. Although individuals hold the majority of bonds, institutionsaccount for the majority of trading. 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. The improvement in market liquidity since 1987 isillustrated 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 percent ofoutstanding stock and almost 6 percent of GDP, in 1992.

3.20 In addition to the cash (spot) market in bonds, China has bond futures markets, and a marketin repurchase agreements. Futures contracts based on treasury bills trade mainly on the Shanghai(since 1993) and Shenzhen (since 1994) stock exchanges. Individuals have used the futures contract tospeculate against the amount of the inflation top-up and the expectation of the top-up has a largeinfluence on futures trading., The apparent large increase in bond trading in early 1995 was virtuallyentirely driven by futures contracts, which also enhanced the liquidity of the underlying spot market.

3 Speculation on the inflation indexation of a treasury bond led to the recent tremendous increase in futures trading on theShanghai exchange, which had rapidly outstripped spot trading by January 1995. On February 23rd, 1995, the volume offutures trading on the bond market was nearly US$100 billion in a single day. Traders who had taken illicit shortpositions defaulted, leading to widespread disorder and temporary market closure. The implications appear to be that inChina's present inflationary environment, index-linking, with a lack of transparency in the redemption amount, may notbe advisable, and also, that trading in derivatives requires tighter regulation as well as supervision. Tighter regulationswere drawn up rapidly after the incident, with the publication of a 'Regulation on Bond Futures Trading,' within days ofthe incident.

- 19 -

Figure 3.4 Ratios of Trading Volume of Debt to Debt Stock and to GDP

Percentage of Stock Outstanding Percentage of Nominal GDP

140 -6 -...-* TBills-w 120 ~ ~ ~~~~~~~~5 -4-Tradingasa%

- 1 B - -Local Enterprise Bonds f GdP100 o D

80 ~ Financial Bonds

X 60 --- m-Short term Enterprise ' . C

Debt 2040

a 20 1

x00 o0 o -oo co 00 0 0 0 o x 00 0s 0 - r c

Source: Data provided by the State Council Securities Conmmittee, World Bank.

3.21 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 abid and offer price is always available, large cash trades can take time to complete. Other debt issuesare much less liquid. Figure 3.5 compares the ratio of trading volume, as a percentage of GNP, withmore mature markets. Debt on issue as a percentage of GDP exceeded 13 percent 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 120percent in the US, between 1987 and 1993, and 60 to 80 percent in Japan over the same period.Comparing the traded volume of debt to outstanding stock, the results are similar, even if developingcountries are included.

Figure 3.5 Ratios of Debt Stock Outstanding to GDP: China and Other Countries(Percentage of GDP)

percent China percent Other Countries14 .. - . 120

12100

10 --- -... Total debt on -8

8 ~~~issue 4'80

6 +e----- Total trading - 60volume4 .-- 40 -- USA

2 e 20 -- O-Japan

0 0 i

1981 1983 1985 1987 1989 1991 1993 1987 1988 1989 1990 1991 1992 1993

Source: State Council Securities Committee, Salomon Brothers and IMF.

3.22 A first group of the causes of the lack of liquidity stem from primary market practices.First, the lack of homogeneity in the stock of debt reduces the amount of any one type of debt which isavailable to trade. Second, the focus on retail investors as the primary target market for debt issues

- 20 -

reduces liquidity, because while households hold the majority of debt securities, they do not trade asmuch as institutions. Treasury bills are sold in small parcels of Y 100 to Y 1,000 to suit this market,and securities firms have a major problem in accumulating sufficient bonds from individuals to form awholesale parcel. Third, the yield at issue is not related to secondary market yield. Estimatescomparing the coupon rate, effective yield at issue, secondary market yield and deposit rates for the1994 treasury bill issues show that in each case the coupon was greater than deposit rates ofcomparable maturity. However, the effective yield at issue was less than the secondary market yieldfor certain issues; (the 6 month and one year issues) and greater for others (the two and three yearissues).

3.23 Fourth, the primary issue not distributed over the year. The lack of a regular issue calendarinhibits liquidity in two ways. (i) Without a regular issue program, there cannot be a continual supplyof short dated money market paper (maturity under a year) from which a short-end yield curve candevelop. This inhibits money market development, reducing the supporting role the money marketplays to the bond market. (ii) There are no new issues to provide a 'trading' issue to act as a marketbenchmark. Typically as debt issues age, an increasing proportion is held by end-holder investmentportfolios rather than trading portfolios. Fifth, the limited range of maturities of primary issues alsoinhibits 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 shortterm liabilities and an absence of long term paper. A greater variety of maturities would stimulatetrading by providing investors with the opportunity to acquire assets of different maturities, ie, changethe duration of their portfolios, as their view of future risks changed. For example, an investoranticipating a rise in inflation would want to sell longer dated debt and buy shorter maturities. Withan inadequate range of maturities available such transactions will occur less frequently. The frequencyof transactions for risk management purposes is also limited at present by the low level of developmentof treasury risk management functions in financial institutions .

3.24 Another feature of bond design which limits liquidity is the method of coupon payment. Thefirst cause of uncertainty is the correct basis on which to quote bond yields: payment of accumulatedsimple interest on maturity has led to bond prices being quoted on a current yield basis rather than ayield to maturity basis. The second and more important cause of uncertainty, for many recent issues,is the inflation subsidy. While inflation-like bonds may be easier to place in the primary market insome circumstances, the future payout on an inflation adjusted bond will always be open to differingexpectations, 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 extentto which pricing difficulties inhibit trading in China, and in fact increased trading volume over late1994 and early 1995. But this short-lived burst of liquidity does not negate the generally less liquidnature of indexed bonds.

3.25 The second group of causes concerns the money market, which does not function in a mannerwhich assists bond market liquidity. Normally, the money market plays an important role in assistingbond market liquidity through the provision of funding for bond portfolios via either loans orrepurchase agreements. The core deficiencies of the money market, in terms of its potential supportto the bond market are (i) its geographic segmentation, which implies that funds in the provinces areunlikely to be available to finance bond transactions on one of the major exchanges; (ii) its institutionalsegmentation. Regulations control the parties permitted to transact and the maturities that can beoffered. Moreover, bank sub-branches manage their own liquidity on the basis of their allocatedcapital and credit. (iii) Interest rate ceilings, on both loans and repos, preventing the development of ashort term yield curve, as there is no regular supply of short dated treasury bills to provide a liquid

- 21 -

low risk instrument to act as a short term benchmark. (iv) The treasury risk management capability ofbanks and other financial institutions is very thin due to a lack of incentives to manage risk.

3.26 A third difficulty hampering the achievement of secondary market liquidity concerns the lackof a common depository, which reduces inter-regional trade. Since the bulk of debt issues are inbearer form and of small denominations, depositories are vital to aggregate these into wholesaleparcels 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 enablethem to recognize each others depository receipts as good proof of title. This inhibits inter-regionaltrading. 4

Figure 3.6 Regional Bond Yield Differentials (1990)High/Low (1986 5 year Thill)

Basis Points800 - _ _ . ... .-.

700600 _ 10 markets incling500 Shanghai & Wuhan400 U Shanghai & Wuhan300200100

0 J1990 Jan April July Oct

Source: Based on data from Bi (1993).

Secondary Market Pricing Efficiency: (ii) Price Unity

3.27 The second major aspect of secondary market efficiency in China's bond markets examinedhere is the question of a specific aspect of price efficiency; regional price segmentation. The blackmarkets prior to 1988 and the Govermment sponsored markets which followed them were characterizedby significant price differences, especially between regions and between rural and urban areas, due to(i) the lack of information and (ii) the difficulty of transporting large amounts of physical scrip andcash between markets. Local prices thus reflected local liquidity conditions.

3.28 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 developmentsgreatly assisted price convergence. Prices on the Shanghai stock exchange began to act as abenchmark for regional markets. Figure 3.6 indicates the size of the arbitrage opportunities thatexisted in 1990. By the end of that year, there were signs of price convergence between the largermarkets (Shanghai and Wuhan), although looking at a spectrum of ten regional markets, includingsmaller markets, overall price convergence was slower. Regional price differences at the end of 1990could exceed 700 basis points.

4 By August 1995, the Shanghai exchange had around 60 regional depositories and the Shenzhen exchange had its ownnumerous separate depositories. The government of China is aware of the drawbacks of the present management and istrying to establish a Depository Trust Corporation with help from the Central Bank. The new institution will also offercustodial and settlement services to its members and will be affiliated to the present exchanges.

- 22 -

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

Figure 3.7 Yield Differentials between Treasury Bills on Principal Markets: 1994Shanghai, Wuhan and Shenzhen

Basis Shanghai and WuhanPoints Shanghai & Shenzen

600 500

400] 92 3year l 30°0i ff 92 1 yearX ll iii

500- 1 F1 411 1 1g1 00 __

300 L 92er j iIyea30200 .~~~~~~~~~~fl~~0

200 fn~-.,~ 0

100 0

-100 January 1994 September 1994 -100 March April May June

-200 -200

m '0~ - < (4 N e4 a ~) au a) 0) o> 0s 0)a- ~ - - -s -. - -_ - a (

C') ~~~ ~ LO fLO (0 (0

Source: Calculations based on data provided by the Shanghai, and Shenzhen exchanges and Wuhan Trading Center.

3.30 In May 1994, the Shanghai authorities grew concerned that depositories outside its systemwere permitting short selling, and consequently the Shanghai exchange ceased to recognize otherdepositories' receipts. This increased regional market segmentation. The effect of this event on yielddifferences is also shown in Figure 3.7. Between January and September, the yield differencebetween Shanghai and Wuhan widened from around 100 to around 500 basis points. A similarincrease appeared in yield differences between Shanghai and Shenzhen. Problems associated withmultiple depositories could be solved if the existing networks agreed on a common code of practice, oralternatively by the creation of a centralized depository. Ideally, depository practices for all classes ofdebt securities should be standardized.

Secondary Market Issues: (iii) Benchmark Issues and the Yield Curve

3.31 The concept of a benchrnark issue in relation to new debt issues is not operative in Chinatoday, due to (i) the administered setting of yields in the primary market. The operative benchmark inChina today is the interest rate on bank deposits, which is administratively determined. (ii) The pricingof credit risk is poorly determined. It is hard to distinguish between the credit risk of a governmentowned 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 beforebenchmark issues can play a significant role in pricing debt. In terms of the design of debtinstruments, developing the role of benchmark issues in defining the secondary market yield curve

- 23 -

requires (i) a greater range of maturities; (ii) a more regular issue calendar so that fresh issues cometo market throughout the year; and (iii) a greater focus on developing a wholesale market to enhanceliquidity. Due to the lack of a broad spectrum of maturities in the market, a yield curve has beendiscernible only since late 1992. The changing shape and position of the yield curve (YTM basis) isshown in Figure 3.8. Secondary market yields rose from June 1992 to June 1993 and thenprogressively declined; first at the long end of the curve (beyond 1.5 years) and finally at the shortend. The unusual shape of the curve, rising at the long end, reflects the lower liquidity in the treasurybill with the longest maturity. The lower liquidity itself suggests a preference for short maturities, dueto inflation.

Figure 3.8 China: Secondary Market Yield Curve

20

15 .-- 1.2.3.95Dec-92Jun-93

10

- - ~--- u--.- Jun-94

--A- - - Sep-94

0 6 months 1.5 2.5 3.5 4.5

Years

Soure: Calculations based on data provided by the Shanghai Stock Exhanx.

3.32 The trends in secondary market bond yields and inflation are shown in Figure 3.9, whichsuggests that the money market regulations of June 1993 resulted in a diversion of funds, away fromthe equity market towards the bond market. Rising demand for bonds led to increased bond prices andconsequently lower yields. Second, banks themselves were for the first time given clearance to investdirectly in bonds. Bonds are a relatively attractive investment for banks, compared to loans to favoredindustries, as they offer higher returns. This suggests that the market from mid-1994 to mid-1995 hasbeen dominated by actions based on regulatory change. A third influence on bond prices whichbecame more relevant in late 1994 was the high announced level of the inflation subsidy and thespeculative fever attached to anticipating its final value on a specific bond; the three year bondmaturing in June 1995. Evidence for the diversion of funds from equities to bonds is shown in Figure3.10 which plots average yield and the Shanghai stock exchange A share index. The decline in equityprices is accompanied by a fall in yields.

- 24 -

Figure 3.9 China: Bond Yield, Deposit Rate and Inflation30

25

20 -0- Average Yield: YTM

0 15I^ " 'd: -1 year deposit rate

2 - -. - -Average Yield: Simple

10 4 5 /, 5 Retail Price Index

5

0o ~~ o o- o ' - D

0% % % % 0 0 0 0% %0 % 0 %0 0 0%

Source: Calculations based on data provided by the Shanghai Stock Exchange, PBC and the World Bank.

Figure 3.10 China: Equity Index and Average Bond Yield

index percent1600 181400 161200 04

200 12

- 0 _ - .< - o i < 0 o - < A

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

3.33 Many of the problems faced by the bond market in China today are the problems faced by aneconomy in transition. China must face the question of the need for simultaneous action on a broadfront which is required for raising financial market efficiency.

4. EQUITY MARKET PERFORMANCE

A. Introduction: Issues to be Examined

4.1 In many respects, equity markets in China spontaneously evolved more rapidly than thegovernment had foreseen, as enterprises sought new ways to raise capital. Government recognition,and the drawing up of appropriate regulations for the activities of the market, evolved ex post facto.Officially, the stock exchanges of Shanghai and Shenzhen have been authorised by the State Council tooperate strictly 'on an experimental basis', and equity markets are regarded as a controlledexperiment. The government has retained a high degree of control on the listing of new enterprises, interms of enterprise choice and the value of new stock issued, as part of the credit plan. Thegovernment is now closely monitoring the authorization of new exchanges, and the overall the degreeand direction of growth permitted to the fledgling market.

4.2 The issue and trading of shares in China still has some special characteristics. The primary aimof listing is therefore the raising of capital for investment. The propoportion of shares held by privateinvestors is typically small (although the new Companies Law requires at least 25 percent of assetvalue for a new listing), and therefore the extent to which shareholders can be expected to influencegovernance is very limited. Using the stockmarket as a mechanism for merger or takeover threats israre. The sale of existing government shares to private shareholders is still not permitted.

4.3 The aim of the present chapter is to point out key issues which affect the efficiency of China'sequity markets, focussing on three principal areas; (i) the primary issue process for new equity; (ii) thetrading process or operation of secondary markets; and (iii) the issue of market segmentation, in thecontext of China's multiple share categories for ordinary shares, and multiple exchanges.

B. The New Issue Process And Public Offerings

4.4 Virtually all new issues in China have been first time offerings or initial public offerings(IPOs). The efficiency of new issue pricing (ie, pricing at levels close to what the market would bewilling to pay) is crucial for any emerging market economy for the following reasons: First, an ill-designed new issue mechanism that results in significant underpricing implies that there is a largedifferential between the (administered) offer price and the market price, determiined after tradingbegins. This limits the effiiciency of the resource allocative function of these new markets. Second, ifnew issues are underpriced this raises false and unrealistic expectations among investors. Suchexpectations lead to herd-like behavior, speculative bubbles and excessive price volatility. Third, to theextent that bank credit is used to fund the purchase of new issues, it can distort the allocation of creditas well as the money supply. 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 privateindividuals. Fifth, the cost of capital to thefirm is increased.

4.5 In China, all the above problems have been observed in varying degrees. As the analysisbelow shows, there is strong evidence of a high degree of initial underpricing, which is much greaterthan in comparator countries, developed and developing. There have also been instances of severe

- 26 -

speculative bubbles as a consequence., In terms of credit allocation, although in China, margin creditand bank credit for the purpose of stock purchases are prohibited, there appear to be many indirectchannels through which credit and loans have been used to finance new issue purchase.2 It is also clearthat a major consequence of IPO underpricing is the increase in cost of capital to the enterprisesissuing new stock. The implication is that there is considerable scope for improving efficiency at bothpre-offer, or the initial selection mechanism, and the post offer, or the method by which the listing isundertaken, once an enterprise has been selected for listing.

4.6 The principal difficulty at the pre-offer stage is that enterprises are selected for listing basedon national and local priorities, determined by government authorities. The process of selection ofenterprises for listing differs considerably from a more mature market economy, where the decision tolist an enterprise would usually be determined largely by the exchange where it seeks a listing. Thecriteria adopted by the exchange would typically include size, performance, and the extent to whichcompliance with the rules of the exchange could be expected. As a result, enterprises selected forlisting, though perhaps more successful than the average state enterprise, are unlikely to be the sameas the ones which would have been selected by the market. While the establishment of independentreview panels at some government offices, such as the Shanghai Securities Administration Office,attempts to reduce the arbitrariness of the selection process, it also leaves the system open toinfluence.

4.7 The main difficulties at the post-offer stage are (i) approval delays. Once an issue is selected,a filing is made with the CSRC. Although approvals are meant to be made within 20 days (similar tothe US SEC) delays and refilings may stretch the filing period to 2 months or even longer, eventhough eventual listing is virtually ensured. As of October 1994, the CSRC had eventually approvedall 190 of its 190 filings. That is, the screening out of new applicants always occurs at the MunicipalSecurities Administration level rather than the CSRC level. (ii) Many further administrative steps arerequired before an offer starts trading. These include (a) the selection of underwriters, which in theearly part of the period examined, was largely at the discretion of the local securities authority.(b) The payment of a fee for obtaining application forms from banks or brokers. In some cases the feehad been divided between the brokers (who retained around a third) and the state securities authorities.In other cases, brokers' fees were separately determined. (c) Conducting a lottery (since the IPO isusually oversubscribed by a large multiple) to determine the final allocation of available shares toinvestors. (iii) A large speculative element introduced through the lottery process. The lotteriestypically determine both whether an investor is eligible to apply at all, and which enterprise's shareshe or she can buy. (iv) New issues have tended to be made in 'lumps' or 'tranches'. The histograms ofnew offering frequency on the Shanghai Exchange show considerable bunching around July 1992 andOctober 1993 (Figure 4.1). (v) As a consequence of the above, there are long delays between offerand opening of trade. The average IPO underwriting/new issue process has commonly taken as long as1 l/2 months.

The Efficiency of the New Issue Process

4.8 The specific questions investigated here are, (i) how large has underpricing been in theChinese equity markets vis a vis other emerging market countries? (ii) Do we see differences inunderpricing among A and B shares, in view of the fact that B shares are purchased by supposedly

The Shenzhen riots of August 1992 were the consequence of an inefficient new issue process, which resulted inoversubscription by a multiple exceeding 600 times

2 For example, evidence from Hong-Kong and Singapore has shown money supply increases of 30 percent or more aroundthe time of major new issues.

- 27 -

more diversified and sophisticated foreign investors? (iii) Is underpricing evident only on the openingof trading? In particular, does underpricing decline as the issue gets seasoned in the aftermarket? (iv)As equity markets have matured, and local participants have become more experienced, has theabsolute degree of underpricing declined? (v) What has been the underpricing experience of new issuesby Chinese enterprises in Hong Kong (H-shares) or in New York (N-shares)? Specifically, has therelative degree of underpricing been less and if so why?

Figure 4.1 Initial Offerings of Shanghai A and B Shares

Number of new A Sharesfirms listed

0i.etf6~ l5f+ 111+ 25t

20

… - - - -o c, o-

Number of new BSaefirms listed BSae

1ei o

Source: Calculations based on data from the Shanghai and Shenzhen exc:hanges.

4.9 The answers to these questions, obtained through an analysis of data on the pricing of publicofferings on the Shanghai exchange, can be summarized as follows. First, the average degree ofunderpricing of A shares has been extraordinarily high, at 732 percent. That is, the opening price ontrading has been more than seven times higher than the offer price. Second, an analysis of theunderpricing results for B shares shows that the absolute degree of underpricing for B shares has beenless than that for A shares, but is still extraordinarily large by international standards. Third, theundervalued pricing is not only to due to speculation at open of trading, but persists for long periodsafter trading begins, and thus represents a real rather than speculative phenomenon. Fourth,underpricing has indeed declined as the market has matured. The degree of underpricing was far moresevere in 1991 than in 1993. Indeed, the underpricing performnance of B share issues in 1992-3 is notvery dissimilar from that experienced on many mature equity markets. Fifth, underpricing is arelatively modest problem in the more mature H share mnarket .

- 28 -

4.10 The results of analysis also show that, on average over the period examined, brokers anddealers who legally abided by restrictions prohibiting them from acquiring IPOs in the lottery wouldhave 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 obtain forms in advance and the smallreturns to those who wait till trading begins would suggest that there are huge incentives to brokersand dealers to circumvent the regulations and acquire shares before trading begins. These large initialgains have declined markedly since late-1994.

4.11 A diagram of risk-adjusted returns to investors who are able to 'win the lottery' is presented inFigure 4.2. Mean returns for A and B shares are shown on the X axis and relative expectedfrequencies on the Y axis. Mean returns to both are positive, to A are higher than to B, and in bothcases, and especially for A shares, returns are widely dispersed. I

Figure 4.2 Risk-Adjusted Returns to lPOs at Shanghai(Offer to Opening Price)

12%

>. 10%

8%

| 6%

4% re Shanghai B Shares

0 Shanghai A 9are2% SianghaiA Sare

0%o 0> C <~"I 00 X o' 0 0 ao " 00 0

Mean ReturnsSource: Calculations based on data from the Shanghai and Shenzhen exchanges.

Comparisons with Other Countries

4.12 China is not alone in having its new issues underpriced. There is world-wide evidence ofunderpricing. Underpricing exists even in more mature economies (between 9 and 16 percent inCanada, Germany, Japan and the US; lower in France (4 percent) and the UK (for offers by tender; 2percent). Underpricing is relatively high in emerging Asian countries (eg, a lottery process) such asHong Kong (18 percent), Singapore (27 percent), Taiwan (45 percent) and Thailand (58 percent). Yetthe degree of underpricing in China over the entire period examed (732 percent for Shanghai A sharesand 218 percent for Shanghai B shares) far exceeded these countries. The problem remains today,although markedly less severe.

4.13 What policy reforms to the new issue process might be considered to improve the proceedsraised by enterprises and the allocation of new issue gains among investors? Recommendations tostrengthen the IPO process in China first require an understanding of the factors leading tounderpricing. First, underpricing in other countries has been associated with a relatively long elapsedtime lag between the public offer and issue date (exceeding one month). Thus the elapsed time lag in

3 Note that in the diagram (Figure 4.2), a normal distribution of returns around the mean has been assumed.

- 29 -

France, the US and UK (tender offers) is zero to one days only, while the time lag in Hong Kong,Singapore, and Taiwan, has been a month or longer. Second, a relatively high degree of investoruncertainty regarding the true quality of the firm going public, due to weakness in disclosure andauditing standards. Third, the allocation mechanism adopted for the new share issue affects the degreeof underpricing. Non-discretionary allocation of shares, by mechanisms such as a lottery, exacerbatethe tendency to underprice. Fourth, the underwriting proceduires and process significantly affect theefficiency of pricing for new offerings.

4.14 Options available to China for improving efficiency in this area are therefore (i) with regard totime lags, reduce the elapsed institutional time lags between the announcement of an offering and thelottery), with regard to the lottery system and non-discretionary share allocation, (ii) ensure that thereis nio more bunching of new issues, (already reduced), which has created classic conditions forinformation leakages and herding behavior, ie, classic conditionis for large-scale oversubscriptions andunderpricing; (iii) ensure th(at each new offer is backed by wviidelv-available and reliable informationabout the funadamentals of the enterprise; (iv) discourage the c-harging a price or fee for application 4

With regard to the underwriting process, it is recommended that China should (v) encourage morecotmpetition in the underwriting process, and reduce thie role of state authorities in recommendingunderwriters. It is recognized that if this process is pushed too far there is the risk of overpricing andbankruptcies among the least experienced local underwriters. To protect against this, (vi) appropriatecriteria for pernmittinig participation in the underwriting process should be developed. It is alsorecommended that (vii) foreign uinderwriters might be allowed to become members in A shareundenvriting synd(icattes. Foreigin underwriters are already allowed to participate in B shareunderwriting, and this overseas experience may account for the lower degree of underpricing on the Bshare market., (viii) The present 'firm comnmnitment' undentriting mechanism uisually adopted in Chinacould be switched to the French sYsteem of allocation; the discriminating price auction. This is similarto the system used in maniy government bond markets. France has the lowest average degree ofunderpriciing (4 percent). and also enjoys an institutional lag of less than a day. Finally, (ix)maonitoring the leakage of credit to retail investors seekinig to invest in new issues should bestrengthened. Legally, banks cannot provide credit for stock purchase nor can brokers (implying animplicit l00 percent margin requirement for stock purchase). Reportedly there have been manyindirect ways in which bank loans have been channeled into stock purchase and in which brokers haveprovided credit to favored customiiers, althouglh to a greater extent in secondary rather than primarymarkets.

C. Stock Price Volatility and Returns to Investors

4.15 The second issue examined is the efficiency of trading on China's equity markets, andspecifically, (i) the low levels of returns to investors, and the efficiency of the pricing mechanism,and (ii) the high degree of variability of these returns, as evidenced by their volatility. An empiricalexamination of the behavior of prices and returns on the Shanghai and Shenzhen A and B marketsshows that, due to the differenit investmenit clienteles in the A and B markets (small local retailinvestors for A shares and foreign institutional and wealthy investors for B shares); there aresignificant differences in the return and volatility characteristics of the two share categories. The moststriking findings are that (i) returns (risk-adjusted) have. on average, been very low, on both share

4 To the extent that fees are charged to cover processing costs, these can instead be charged to winners of the lotteryafterwards, or to other costs recoverable from new or existing shareholders..

5 It is recognized that unrestricted participation by foreign underwriters may discourage the development of the infantdomestic financial service sector. Cautious and limited models tor collaboration with overseas underwriters could belaunched in an initial phase.

- 30 -

categories and on both exchanges. (ii) Returns are similar on the two exchanges, on A shares. (iii)There is a significant difference between returns to B shares and A shares, and returns on B shares atboth exchanges have been relatively poor.

4.16 Looking at market behavior in terms of volatility, the problem of extreme price volatilitywhich the Shanghai and Shenzhen markets have exhibited since opening is illustrated in Figure 4.3.For example, the Shanghai A share index more than doubled in a single day, from 617 on May 20,1992, to 1266, on May 21. By November 17th 1992 the Shanghai A share index had fallen back to athird of this level, to 393. More recently, this index was trading at the 400 level in July 1994 but bySeptember 1994 it had risen above 900.6

Figure 4.3 China: Shanghai and Shenzhen Share Indices and Volume ofTrade

Shanghai A Shares Shenzhen A SharesDaily Daily

__ __ __ Turnover Turnover

L A Shares Index (No of A (No. ofSAares) Snares)

Index > _ Daily Tumover (bn) Index _ Daily Turnover (mn)

1800 r 1.80 400 X ___. _

1600 t 1.601400 1.40 3004 8001200 t 1.20 O1000 10600

8004 0.8020

600 0.60 4040 ~~~~~~~0.20 100 200

90 91 92 93 94 91 92 93 94

Shanghai B Shares Shenzhen B SharesDaily Daily

Turnover Turnover

B Shares Index (No of -- (No. oft - ----ares Index 4 hae) B Shares Index Shares)

Index a _ Daily Turnover (mn) Index Daily Turnover (000)

140 _ _ -35 200 - 25,000

120 ~ ~~~~j30 2000too0 25 150 t-20,000801 20 o \- '' 15,000

604 15 100 1 0

40 10 50 1,0

92 93 94 92 93 94

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

4.17 More detailed analysis of the behavior of the markets in this regard shows (i) that A sharemarkets in both Shanghai and Shenzhen have exhibited far greater volatility than B share markets. (ii)

6 Early indications are that the introduction of the T+ 1 settlement system in January 1995 has helped reduce volatility.

- 31 -

The absolute sizes of volatility 'jumps' in the Shenzhen A market have generally been less than thosein the Shanghai A market. Both (i) and (ii) are illustrated by an examination of the standard deviationsof share prices on both exchanges (Figure 4.4). (iii) Volatility patterns in Shenzhen, in both the A andthe B share markets, like the behavior of returns, suggest that markets are thin and inefficient, and thatinformation is dispersed slowly to investors. (iv) Particularly large daily jumps in volatility have beennoted on a few specific dates.

4.18 Persistent and high levels of volatility can discourage a market's growth. More risk-averseinvestors are likely to seek alternative outlets for their savings. Excessive volatility, where 10 percentdaily rises and falls in the market index are seen as 'normal,' has been common in other Asian equitymarkets at similar stages of development. For example, Hong Kong went through a period ofconsiderable volatility in the early 1970s, while the Korean and Taiwanese markets also exhibitedconsiderable volatility in the 1960s and 1970s. But again, the volatility observed in China exceedsthese comparators. From a policy perspective, the important questions to address are: (i) what factorsgive rise to the poor efficiency and high volatility of equity trading in the case of China; and (ii) whataction can regulators take to bring volatility under control?

Figure 4.4 Shanghai and She nzhe n: Share Price Variance(Ten-week Standard Deviations)

Shanghai ShenzhenStandard Standard

Deviation Deviation

0.45 0 -. 16 - a 0.40 A Shares 0o4 1----A shares1

0.35 1 i l X B Shares 1 L - - B shares 0.301

0.25i 10.20 .. 0.8-

1 I .061 i \liI

0.10 D~~~~~~~~~~~~~~~~.024~' 0.05 0.020

_N O_ O N ON es N O ON ON ON ON ON ON ON ON ON ON ON ON v0.00 --0'~ O ,. 0 - --- -0

r]~~~~~a v :> = m oer- I oe>*o s4t m 0e


4.19 The short-term horizons and speculative behavior of poorly informed retail investors arefrequently offered explanantions for volatility. But this short-term behavior itself is encouraged by anumber of other factors, including (i) as discussed in the previous section, the IPO process, includinglimited disclosure and the 'lottery process' associated with the bunching together of IPOs. This isexacerbated by (ii) the tendency of wealthy investors and brokers to engage in front-running behaviorthat is nothing less than overt market manipulation; itself the outcome of relatively limited supervisionof intermediaries in the securities markets.7 (iii) The absence of an enforced capital gains tax, whichwould encourage shareholding for longer periods of time, also encourages short term speculation, and

7 'Front-running' refers to market manipulation by brokers who float rumors that are likely to sway the market, when theymay be in a position to take advantage of such market movements. A classic case was a week in October when rumorsabout the health of Deng Xiaoping resulted in a fall of 40 percent in the Shanghai A share index on one day, followed bya jump of 36 percent in two hours the next day when the rumor was denied. By buying and selling 'in front of' suchnews leaks large investors and brokers can make huge potential gains at the expense of small retail investors.

- 32 -

(iv) the typical non-payment of cash dividends implies that the only way of realizing cash gains is bycapital gains rather than by the dividend income flow. (v) The absence of large, stable institutionalinvestors is certainly a factor, but as pointed out above, not a sufficient explanantion for marketbehavior.

4.20 In addition to these factors, a major contributant to market volatility has been the succession ofregulatory 'events' generated by the government. Specific instances of very big jumps in A shareprice volatility: such as May 1992 (with the abolition of daily price limits) and July 1994 (with theannouncement of the 'support' package), are clearly attributable to government policy decisions.,While many of these announcements were ironically made with the intention of 'improving' marketfunctioning, and reducing volatility, in practice, such policy announcements have enhanced volatility.

4.21 The policy actions for the reduction of volatility suggested here are: (i) the reintroduction ofdaily price lirmits. (ii) the introductioni of appropriately structured taxes on capital gains. In developedeconomies, where taxes are relatively easy to collect, a two-tier short vs. long-term capital gains taxcould 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 up until 1986.However, in view of the potential difficulties of tax collection in China, such a tax might requiresimplification." A transactions tax inversely linked to the time a stock was held (speed of turnover)would penalize those investors who take a short rather than long-term view. A flat turnover tax (suchas recently implemented in Israel) would probably not create sufficient incentives to deter gainstrading. However, arguably, the information systems needed to accurately track and historically recordthe buy and sell orders of individual investors are not in place in China nor will they be for some time.(iii) A more pro-active stand on insider trading and fronit-running must be adopted by the CSRC, thePBC and the Exchanges.

4.22 The above policies are largely short term. Afourth, more secular policy to reduce volatility, isto create a market environment in which investors are encouraged to take a long-term view. This maybe achieved by at least three different routes. (a) First, cash dividend paying by firms must beenouraged.' Currently, dividends appear to be very much a residual after a firm is required to makeallocations from profits to various 'pools' including investment, bonus and staff welfare. To makedividends more prominent, enterprises must be given more discretion on dividend payments (especiallycash rather than stock dividends) and dividend annlouncements should be made at least annually. (b)Second, foreign securities firnms such as Merrill Lynch and Morgan Stanley should be allowed to tradeA shares (as well as B shares). Such firms with their relatively sophisticated analytical tools and advicewould likely add some degree of stability to the A share mnarket at least in the long-run. (c) Third, thedevelopment of longer-term private pension and mutualfunds should be encouraged.

The first jump followed the removal of the 5 percent daily price change limits tor individual stocks on May 20, 1992,which led to a one-day doubling of the Shanghai A share index. The July 1994 jump reflects the 'market support' policiesannounced at the time by the CSRC; including (a) a moratorium on new A share issues (to raise prices by restrictingsupply), (b) easier credit availability for brokers in Shanghai through a special line of credit, and (c) stimulating theestablishment of mutual funds, though the establishment of new funds and possible foreign participation in this industry.

9 It is also recognized that policies towards the taxation of capital gains in stock trading cannot be adopted in isolation frompolicies towards capital gains elsewhere in the economy. In the short run a turnover tax may be the solution; in the longerterm an integrated approach is required.

'° Policies introduced in 1995 to (i) only permit stock dividends if cash dividends have been paid. (ii) allow stock dividendsto be paid only once in 12 months, and (iii) only up to one-third of total dividend payments, are a move in the rightdirection.

- 33 -

D. Market Integration: Current And Potential

4.23 The third key policy issue confronting the development of China's equity markets concernsmarket segmentation, both across different exchange (geographical segmentation), and different sharecategories (segmentation by investor type). Today, cross-listing of shares at the two officialexchanges of Shanghai and Shenzhen is not permitted. The listing of enterprises at the other exchange-style trading centers is not recognized under national law. The multiple share categories in China,which separate shares according to whether their holders are resident or non-resident, individual orinstitutional, and whether the shares in question are traded in domestic or overseas exchanges (Ashares, B shares, C shares, H shares and N shares) have been described in detail elsewhere.,Segmentation by domestic and overseas investors have arisen because of fears, which have legitimateprecedent, of the possibly destabilizing impact of volatile capital inflows and outflows. Geographicalsegmentation in China arose due to the fact that 'exchanges' were established independently atdifferent locations, in the absence, initially, of a uniform national framework. The costs of marketsegmentation are (i) a decrease in liquidity; (ii) a likely decline in the pricing efficiency of themarkets due to thinness of trading; (iii) reduction of access to available investor bases, and (iv) likelyillegal transactions, with 'leakages' arising due to the possibility of arbitrage across markets.

4.24 The analysis first shows that (i) A type share index movements are closely integrated acrossexchanges as are B index movements; however (ii) the integration been A and B share indexmovements is low. (iii) B and H share indices are highly correlated, indicating that internationalinvestors tend to look at similar economic factors in making investment and pricing decisions aboutthese two share classes. The slightly higher correlation of B and H for Shenzhen may reflect the factthat both are traded in terms of Hong Kong dollars (Shanghai B stocks are quoted in US dollars).

4.25 Although A and B shares only weakly move together over time, both classes have potentiallythe same dividend and voting rights. The important question which follows is, are their prices similar,and if not, what is the price premium or discount between A and B shares? In most emergingmarkets, foreign-owned shares have normally traded at a premium to domestically-owned shares.Spreads between the price premiums and discounts between individual enterprise A and B shares onthe Shanghai and Shenzhen exchanges are shown in Figure 4.5. As can be seen, (i) on averageChinese B shares trade at a considerable discount to A shares. In fact, the daily average discount of Bshares relative to A shares over the period analyzed was 213 percent. (ii) Spreads have been lower inShenzhen than Shanghai, by approximately half.

" Vol. II of the present report, IMF (1994), or Bei Duoguang et. al, (1992).

- 34 -

Figure 4.5 Spreads between Shanghai and Shenzhen A and B Shares(Discounts of B Shares to A Shares)

% Discount of B Shanghaishares to A shares

4 % Discount of B

400 f shares to A shares

200 16 T.." 4

l50 r I lY100 50 , - - -

Q2 Q3 Q4 Ql Q2 Q3 Q4 QI Q2 Q392 93 94

% Discount of B Shenzhenshares to A shares _

250-1250 E--a % Discout of B

200 shares to A shares

150 rU-___

100 I- .

50

0 - ---- - _- _ _ _ _ ~- ,_- _~ __

Q2 Q3 Q4 Ql Q2 Q393 93 93 94 94 94


4.26 The analysis of premiums and discounts can be similarly calculated between A, B, H and Nshares, in cases where a given firm issues or trades shares both domestically and internationally.Figure 4.6 shows the discounts on Hong Kong H shares relative to A shares issued by the sameenterprise. For six matched H and A stocks, all H shares stood at discounts to their respective Ashares. The daily average discount was 47.6 percent. Figure 4.6 also illustrates price differentials fora New York listed enterprise, Shanghai Petrochemicals, relative to both its domestic and Hong Kongmarket price. For the H shares, the daily discount averaged only 0.2 percent. For the A shares, thedaily discount averaged 15.3 percent. Indeed, while the discount started high, it has fallen over timeand for a short while was negative (ie, the A share traded at a discount). As will be discussed inChapter 5, this enterprise presents a special case in some respects, and is considered to have a goodperformance relative to other New York listings. Since even in this case, the New York listing tradedat a discount, it reinforces the finding that shares held by overseas investors trade at a discount todomestically held shares.

- 35 -

Figure 4.6 Discounts on Shares Listed in Overseas Exchanges

% Discount of H Shares to A Shares % Discount of Shanghai Petrochemicals ADR to A Shares200 120

100 -- % Discount of

150 80 ADRstoA shares

% Discount of H shares 60 % Discount oft00o A shares 40 ADRs to H shares

50 -~ y 20-

0~~~~~~~~~~~~~~~~~~~~~0

O N D J F M A M JJA S m - v-50L 1993 1994 40

-60

Source: Calculations based on data from the Shanghai and Shenzhen exchan,s and the New York Stock Exchange.

4.27 What can explain the reason for the discount on Chinese B and H shares while foreign heldshares in other Asian emerging markets tend to trade at a premium? First, the high differentials inliquidity. Foreign-owned and domestic-owned shares can be traded back and forth among investors inThailand, Singapore and Korea, while China is relatively unique in having district classes of shares,and B shares have a relatively low capitalization compared to A shares. Second, foreign investorsrequire higher risk premiums to hold Chinese shares, due to economic uncertainties and political risk.

4.28 What are the policy implications of these findings? First, the data on the correlation of returnsshows that Shanghai A and Shenzhen A stock price indexes and returns have tended to move togetherover time, and thus, they appear to respond to common news and economic factors. This raises thequestion of the potential for a fully national market for enterprises' shares. At the moment A shareslisted in Shanghai are heavily associated with enterprises located in the Shanghai 'region' whileShenzhen and Guangdong enterprises are heavily represented on the Shenzhen exchange. These arethus largely regional exchanges, reacting to some common factors and news. To create a more nationalmarket for shares the government and regulatory authorities should encourage cross-listing of A shareson the two major exchanges. Arguably, cross-listing competition among exchanges would likelyproduce a slower path to a full national market, but (i) such a process is potentially more beneficial, toboth investors and enterprises, if the exchanges compete for business and national market share thoughlowering fees and commissions, and improving the efficiency of their trading services. (ii) Someenterprises due to the nature of their business may only serve a regional area. Such enterprises thenhave the option of listing on a local exchange, possibly at a lower fee or with less onerous listingrequirements.

4.29 Currently, there are barriers, of varying degrees of severity, to the cross-listing of A or Bshares on the Shanghai and Shenzhen exchanges, at at least four levels. The first set of barriers is atthe issuer level. Here the problem is the regional equity quota allocation system, to the extent thatenterprises may be 'persuaded' by state securities authorities, to enlist in a specific exchange. Thiseffect can only be ameliorated, eventually, by eliminating the national quota system. The second set ofbarriers are at the investor level. Today, shares on the Shanghai market are registered in the individualshareholder'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 atdepositories on the other exchange. This would allow them to trade and settle any given share on both

- 36 -

exchanges, inhibiting price discrepancies and arbitrage possibilities."2 The third set of barriers exist atthe member or broker level. Membership of an exchange gives a broker quasi-monopoly power (withother members) over trade in shares on that exchange. The fourth barrier is technological. For aneffective national market to develop, screen and other information technologies would need to beavailable to give investors speedy access to price and volume information on the same share in bothmarkets. Not only would such information have to be available it would have to be widely availableacross a large set of investors (both wholesale and retail) at relatively low cost. The failure to developthe technology to make information widely available could result in considerable inefficiencies, withthe same stock trading at widely different prices on the two major exchanges. Given the current qualityof Chinese equity information technology it may be a number of years before a fully 'price' integratednational market becomes feasible for all but the very largest sized A share issues.

4.30 Some of these problems today may be losing significance. The CSRC has pointed out that thenew registration system for investors may not be a technological necessity and also that barriers at themember level are weakening with increased cross-membership at the two exchanges-currentlyestimated at 80 percent of the members of each exchange.

4.31 Finally, the results also suggest that markets should be integrated across different sharecategories, between domestic and foreign investors. The implementation of this recommendation isdiscussed in the following chapter, which deals with the internationalization of China's capitalmarkets.

12 For example, Shanghai investors could open accounts with Shenzhen brokers (who settle on their behalf), while Shenzhenbrokers could open direct accounts at the Shanghai depository. Interviews with depository officials suggested that at thetechnical level, the ability to undertake this exists already.

5. INTERNATIONALIZATION OF CHINA'S SECURITIES MARKETS

5.1 The key conclusions of this chapter are, first, that China today is not vulnerable to adestabilizing domestic backlash, ifflowvs 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 portfolioinvestment. Second, in terms of foreign equity investment, greater efficiencv could be achieved in thedesign of China's overseas equity issues, which will be required for sustained and increasing foreigninterest. Today the novelty value of Chinese shares has begun to wane and greater emphasis onstrengthening fundamentals is necessary. A major difficulty faced by overseas investors in Chinaequities has been the limited liquidity in the thin and segmented markets for overseas shares, especiallyin the B share market but also elsewhere, for example shares listed exclusively on New York. Almostall China shares held by overseas investors trade at a discount to domestic shares. If China were toremove its present distinctions between share categories, this problem would be alleviated, and otherefficiency gains would also ensue. Meanwhile, another option open to China is to increase liquiditythrough dual listings, and the recently popular GDR or multiple depository receipts mechanismprovides a useful vehicle for this. China can explore the more complex options available under suchprograrns as 'side-by-side' ADRs, or gradual increases in ADR levels. Third, on the issue of taxes onportfolio investment, this is today a lesser fiscal issue than achieving a level playing field betveen FDIand portfolio investment, and reducing preferential incentives for the former while introducing doubletaxation treaties for the latter are desirable.

5.2 Fourth, China's domestic fixed income securities market is today closed to foreignparticipation. For the time being, strengthening the domestic market should be the first priority. Inthe medium term, however, a gradual opening up to foreign investors can be adopted, using asequenced approach. Fifth, China, like other countries, has greatly increased its presence in theinternational bond market, and to date enjoys favorable terms, relative to most other emerging marketeconomies. China could try to further expand the maturity of its bond issues, in view of domesticneeds. Streamlined domestic procedures for issuing international bonds would benefit from greaterflexibility. Sixth, China has also been able to increase the volume of international syndicated loans itreceives, in this case contrary to global experience. Again, the terms so far have been favorable, andinitial-launch spreads were steady through end 1994, though maturity appears to be on the decline.Secondary market prices show some weakness. Creative extensions to longer maturity may bepossible. Seventh, there are some indications that terms of commercial bank credit to China may growless favorable if the borrowers credit ratings and guarantee status are not clarified. In overall terms,broadeninig of overseas fundinig optiorns should be the strategy for the Chinese authorities to pursue.

A. The Scope for Safe Participation in International Securities Markets

5.3 China has been very successful in attracting large private foreign resource inflows in recentyears. 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. Yet, the composition of external investmentflows to China is strikingly different from comparator countries, as illustrated in Figure 5.1, which

- 38 -

shows China's enormous share of developing country FDI, but its small relative share in terms ofsecuritized flows, such as equities or bonds.

Figure 5.1 China and Other Emerging Markets: Participation in InternationalCapital Flows

Portfolio Equity Bonds_ = China

China |.Mexico_ :: :MMexicoexico Argentina

Republic of Korea Brazil

*_ Malaysia __-_.Republic of Koreagentina Thailand

Thailand Phillippines

~ Indonesia MalsnsiaPhillippines

Chile '- , - -| Ch it I _

0 2 4 6 8 10 12 14 16 -1 0 1 2 3 4 5 6 7 8 9

US$ b (1993) US$ b (1993)

Foreign Direct Investment

ri 2 .. * ~~~~~ChinaArgentina

MexicoMalaysia

ThailandIndonesia

ChileBrazil

Phillippines

Republic of Korea

0 5 10 15 20 25 30

USS b (1993)

Source: World Bank.

5.4 On balance, given the low present levels of portfolio investment, and in view of its healthyreserves, current account surplus, and fairly stable exchange rate, China is in a position to cautiouslyincrease portfolio investment inflows. While acknowledging the relative stability and the concomittant(nonfinancial) benefits of FDI, such a strategy would have the following advantages: First, the FDIboom has been fueled, at least in part, by preferential treatments (eg, tax incentives), which coulddistort investment decision and resource allocation in the long run and are also costly to thegovernment. Second, it is known that at least a part of China's FDI takes the form of 'round-tripping,'to benefit from tax incentives. Third, FDI often generates substantial reflows of remitted profits,making the cost of capital on the part of host economy quite high. A short-term policy measure for theGovernment would be to eliminate preferential tax treatments for future FDI.

B. Foreign Investment in Domestic Share Markets: B Shares

5.5 Foreign portfolio investment in Chinese equities was initially made possible through directpurchase of B shares listed at Shanghai and Shenzhen stock exchanges. 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 billionequivalent, through new share issues of an average size of US$25 million each. As documented inChapter 4, the segmented market structure has yielded a divergent performance between A and Bshares, where B shares typically sell at a large discount to A shares. The performance of China's B

- 39 -

shares contrasts with the experience of other countries, where stock markets that have liberalizedforeign investment rules (for example, Argentina, Brazil, Colombia, and Pakistan) have subsequentlyexperienced 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 afterthe market opening. The current system of separation of A and B shares presents problems, of whichthe first is price distortion across markets. Second, the possibilities for arbitrage lead to illegitimatetransactions, such as A share investments by non-residents; reducing market transparency. Third,share segmentation curtails liquidity and reduces efficiency. Fourth, the learning benefits ofpermitting more experienced and less speculative share market participants are also lost.

5.6 These disadvantages would be removed by the synchronization through merger of the A and Bshare markets. Two arguments generally offered against this are first, the limited convertibility todayof the RMB. This need not be a necessary condition, provided foreign exchange is freely available fortransactions relating to equity investment. Countries such as Korea permitted foreign investment indomestic equities before full convertibility, although the commitment to full convertibility had alreadybeen adopted. Second, there are concerns that the merger of A and B shares could leave Chinavulnerable to the problems of excessive inflows, which could crowd out domestic participation, orexcessive outflows, which could destabilize the domestic market. A range of alternative safeguardsmay be adopted, as the experience of other countries shows. First, ceilings may be imposed on foreigninvestment, at (i) the enterprise level, (ii) sectoral, and (iii) individual levels. For example, in Korea,foreign investors can own up to 12 percent (recently increased from the previous 10) of the shares ofmost listed companies, but an individual investor can only hold 3 percent. Lower ceilings are set forsensitive sectors such as power generation, or iron and steel. In Indonesia, foreigners can hold up to49 percent of shares. Second, restrict participation to known and approved large investors. In somecases, non-resident participation can be permitted only through approved mutual funds or trust fundsor country funds, with pre-approved credentials (Korea, Taiwan, India). Third, selective secondaryequity market transactions with a destabilizing potential can be restricted. For example, foreigners canbe 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 takingdelivery. Fourth, restrictions on voting rights or board membership have also been adopted by somecountries. Such restrictions on equity purchase and equity market participation differ from foreignexchange controls, on the repatriation of capital or dividends. In certain circumstances, holding periodlimitations may be imposed on capital gains repatriation (Chile, Taiwan), or ceilings may be stipulatedabove which case by case approval for capital gains repatriation may be required (Thailand).

5.7 Special protection is sometimes given to domestic financial institutions, for example, ceilingson the foreign acquisitions of domestic banks' shares (Thailand and Indonesia: 49 percent; Argentina:30 percent without special government approval). In some cases, special measures may also be takento encourage the development of local non-bank financial institutions, such as securities forms orbrokerage houses. Thus, Brazil requires the domestic comanagement of foreign investment funds, andArgentina requires investment to be undertaken through authorized domestic stock brokers.

Tax Treatment of Foreign Equity Investment

5.8 A question frequently raised by Chinese authorities concerns the desirability of imposing taxeson dividends and capital gains on overseas investors. At present no such taxes are levied. It is truethat these are applied in a number of other emerging markets. For example, Korea has both capitalgains taxes and witholding taxes on dividends for overseas investors; Taiwan, Mexico, Indonesia andChina have provisions for dividend taxation but not for capital gains taxes. In Chile, dividend taxation

- 40 -

is exempt if proceeds are reinvested. But many of these countries have reduced tax rates or exemptionsfor countries with whom the government has tax treaties. China at present lacks such double taxationtreaties, which is a disincentive for foreign investors. China has a difficult path to tread in this realm,as it is recognized that the imposition of dividend or capital gains taxation may discourage liquidityand further reduce the attractiveness of portfolio flows relative to FDI. At present, China's chiefconcern should be to level the playing field between taxes (and tax incentives) for FDI and foreignportfolio investment. At the same time, China would benefit from some form of a capital gains tax, atleast on A shares, as this would discourage speculative investment (see Chapter 4). On balance, it issuggested that although a tax on dividends may be an unnecessary discouragement, a form of capitalgains tax could be beneficial.

C. Overseas Listing of Chinese Equities: H and N Shares; Depository Receipts

5.9 Access of foreign investors to Chinese equities expanded considerably with the introduction ofH shares. Averaging around US$350 million each, these are considerably higher than the average ofUS$25 million for B shares, and thus more significant, as a vehicle for raising capital overseas. Nineof the most internationally well-known Chinese enterprises (including Tsingtao Brewery, ShanghaiPetrochemical, and Maanshan Steel) representing a total of $3 billion in value were listed on the stockexchange of Hong Kong in the form of H shares through early 1994, and another 22 companies wereauthorized for H share issues to be launched by the end of 1995 as a second batch. The second batchof H shares are expected to generate about $8 billion of additional foreign equity capital. By the endof 1994, 15 of the total of 31 approved companies had already established a listing on Hong Kong.

5.10 Chinese companies began to go further afield for capital, to the New York market, as early as1992. Before the regulatory authorities had developed policies for raising capital and listing sharesoverseas, three joint venture companies established Bermuda-based subsidiaries to issue and sell sharesin US public offerings. Meanwhile, encouraged by the success of early H share issues, the authoritiespermitted selected Chinese companies to officially approach the US market. The first officiallyrecognized and authorized Chinese company listing on New York was the Shanghai PetrochemicalCompany, in July 1993, for $170 million. It was decided that the listings in New York would take theform of depository receipts, based on underlying Chinese RMB shares, rather than being listed as USshares. By the end of 1994, eight Chinese companies had established Level III or Rule 144A ADRs.Six of these were companies that already had H share listings. Shanghai Petrochemicals, the first, hada dual listing of an H share offering in Hong Kong and a registered public offering under a Level IIIADR, traded on the New York stock exchange. The remaining five used privately placed Rule 144AADRs, not tradable on NYSE or NASDAQ. Further such (Level III or 144A) ADRs are expected fromthe companies approved to be listed in Hong Kong which are not already listed, and some of the Hshare companies already listed are likely to establish 'side-by-side' Level I or II ADR programs tosupplement the liquidity of the HKSE listings. Another two companies, Shandong Power andHuaneng Power, launched ADRs which had no corresponding H share listings; the so-called 'N share'ADRs. There have been no simultaneous offerings of B shares and ADRs so far, but four B sharecompanies have subsequently set up Level I ADR programs to stimulate overseas demand for theirshares. By the end of November 1994, the total overseas capital raised over 1991 to 1994 by Chinesecompanies amounted to US$ 3.73 billion equivalent of which $1.35 billion was through B shares (36percent); US$ 1.13 billion through H shares which had already been listed (30 percent) and US$ 1.25billion (33.5 percent) through ADRs or GDRs.

5.11 International equity issuance can be beneficial to both issuing companies (and countries) andforeign investors. From the issuer's viewpoint, it expands the investor base, which can lead to a

- 41 -

higher stock price and a lower cost of capital; provides new markets for raising funds; enhancesvisibility of the issuing company and its products in international markets. From the investor'sperspective, an international share listing allows share trading and dividend payments in convertiblecurrencies; provides international diversification to institutional investors, which are often preventedby their charters from investing in foreign currencies (since ADRs, for example, are treated asdomestic securities in the United States); allows convenient and dependable settlement and custodianservices (especiaally in cases of cross-border settlements with dual listings), and meets standarddisclosure 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 oflocal capital markets. Nevertheless, studies have shown that an international share-listing programs(even for small numbers of issues) can produce an economy-wide benefit for the home country. Thisarises from the 'spillover' effect on the pricing of domestically traded securities .

The Performance of China's Overseas Equity Listings

5.12 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 inthe first wave of issues, those in the second batch experiences more difficult market conditions. Forexample, 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 shareoffering by Tianjin Bohai Chemical Industry, the last of the first batch of H share issues, wassubscribed only 1.003 times, the lowest level for any H share offering. Although this is partly due toexogenous factors, the recent experience underscores the importance of solid and stable performancein the home markets.

5.13 In terms of shares listed and traded at New York, the early 'Bermuda shares,' while successfulat raising capital, have performed poorly in secondary trading, with share prices falling, on average,by 38 percent by the end of 1994. The two N share Level III ADRs were also trading at a discount, of29 percent. By contrast, the one dual H share Level III ADR, Shanghai Petrochemichals, sold at apremium of 42 percent. The poor performance of the N share ADRs has been attributed to the lack ofdual liquidity with a regional Chinese market (such as Hong Kong) where investors have access tocompany information., The five 144A ADRs have yet to establish 'side-by-side' programs with Level Ior II ADRs, which would help liquidity and enable US investors to buy unrestricted ADRs of the sameunderlying share class (for example, H shares), thus countering any flowbacks of shares to theunderlying (H share) market.

5.14 New opportunities for international equity offering are appearing, especially on the exchangesof Tokyo and Singapore. A key concern with listing in new exchanges will be the degree to whichliquidity can be expected (as in the case of the US China ADRs with no cross-listing). Cross-listingprograms may therefore be a good route to begin. Several companies are believed to be consideringsimultaneous offering of Singapore Depository Receipt programs and B shares. Another general issueconcerns the timing of new share issues, and the 'bunching' that Chinese companies have had toconform to, due to 'batch' government approvals. Greater flexibility in timing would permit betterprices wherever the new issues are made.

New York specialist firms have complained that trading is too thin to even fix an opening price, and they must wait formatching buy and sell orders, which may take several hours.

- 42 -

China Investment Funds

5.15 Closed-end national index funds (or country funds) targeted at emerging capital markets shareshave expanded considerably since the mid-1980s. The value of such indirect investment vehicles, asidefrom the mobilization of external resources, is that they also promote pricing efficiency in theoriginating stock markets. Since 1992, a total of 18 China country funds had been launched by endNovember 1993, attracting some US$3.0 billion of foreign investment. Although some China fundsinitially commanded a premium, boosted by rarity value, these China funds, like most other closed-end funds, have traded mostly at a discount to net asset value, with discounts ranging from zero toabout 20 percent over the last few years. The rising trend in discounts could be attributed to (i) thefall-off in rarity value, with the rising supply of Chinese equities; but also, (ii) sluggish performancein the home markets in Shanghai and Shenzhen since late 1993.

Figure 5.2 Country Funds - Average Discount-40

35 -- 0- 0- -- 0- 0- 0- O\ 0' O- 0' 0 0' 0' 0 -0 0' 0' 0 0 0- 0- - -- - 0 - 0- 0- 0-

3 -0- --- -5- -- 0- - -M - 0

to to o o o to to to 0to to to o to to o to o o to l to ost to rf o to o to

-2 -- X o - o - - - - - - - - - -0 t- - CO - 0 0 - - -- 0- 0 - -_

- China -- Emerging Gobal India -South Korea

Source: upper Analytical Services; World Bank (IEC).

5.16 As Figure 5.2 indicates, the relative performance of China's closed-end funds, initiallysuperior to other emerging markets, deteriorated. This is confirmed by an analysis based on a selectedgroup of China funds, which had average annual returns of 9.4 percent in the third quarter of 1994.2This was considerably lower than many other funds, especially those for Latin American countries, butfared better than large emerging Asian economies of India (6.5 percent) and Indonesia (5.7 percent)during the same period. The deteriorating performance of China funds, like many China equities listedon overseas exchanges, which have traded at discounts to their offer price, reemphasize the importanceof first strengthening the domestic market.

D. Fixed Income Securities

5.17 China's domestic fixed income securities are today closed to foreign investment. Given thecurrent weak infrastructure in money and bond markets, it would not be advisable to proceed withdirect foreign investment in yuan denominated fixed income securities within the medium-term. Thefirst steps to take before such markets can be opened up are to develop money market instruments toconduct efficient policy actions, such as sterilization, to deal with large inflows of foreign capital. Inparallel, domestic bond markets should be strengthened, and domestic bond instruments expanded, tolonger maturities, more sophisticated structures (such as convertibles), and more non-governmentissuers. As a long-term objective, China may follow a gradual and sequential approach to the bond

2 A group of 13 'best performing' funds, for China .

- 43 -

market internationalization, such as the approach adopted by Japan (1970s) and Korea (1990s). Aclosed-end fund for local currency bonds is during initial phases another possibility for the early phaseof the market opening.

5.18 Meanwhile, China's annual volume of new overseas bond issues has grown remarkably fast,expanding from less than $200 million a year, on average, over 1989-91, to over $2 billion per yearfor 1992-94. In 1994 overseas bond issues reached $3.5 billion, an all time high. In termns ofcurrencies, China's overseas bond issues have been concentrated in two currencies, the Japanese yenand the U.S. dollar. Currency denomination of new bond issues has recently shifted away from theyen, which was the dominant currency before 1992, to the U.S. dollar, due to the combined effects ofthe strengthening yen and relatively low dollar interest rates. In terms of rate structure, recenthistorically low interest rates in major markets led to a concentration of new issues in fixed rates (70percent). 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 1992. Yen bonds in1994 averaged close to seven years, compared to around five years in 1992 and 1993. Althoughgrowing, these maturities have not yet achieved the levels desirable for long gestation infrastructureprojects.

5.19 Interest spreads on new issues, on average, have had some downward trend since 1989 untillate 1994. While lower interest rates in the early 1990s partly reflect declining global interest rates, itis interesting that the relative spread on new issues for China, compared to other emerging markets,is low. In 1994 China enjoyed lower spreads over LIBOR (56 basis points) than India (218 basispoints), or Thailand (89 basis points), not too far from Korea (35 basis points), and better thancountries outside the region, such as Hungary (150 basis points) and Mexico (139 basis points beforeits crisis). The favorable terms enjoyed by China until recently reflect in large part its goodmacroeconomic performance. Following the Mexico crisis, developing countries as a whole witnessedsome decline in their terms. In the case of China, there was some deterioration in secondary marketprices on bonds.,

Figure 5.3 International Bond Issues by Chinese Borrowers: Currency, Type and Maturity

US$m equivalent Years to maturity

1800

1600 - 000004 X 04

1400- -- 5 -- 2 ___

1200 -- 6 _

100 5[_ sn IW1

I~~ .___- __ 2_

800 -- .- . - - 4

600 --- - - 3

400 -. 2

200 I --------- I .

0 LU---~~~~~~~~~~ ~0 1989 1990 1991 1992 1993 1994 1989 1990 1991 1992 1993 1994

IUY'en fix~ed 3$S fixed COYen float Q $ float a SPR cony 3 DM fixed~ *Yen den. a $ den. 0 Dm den. 0SFr den.

Source: Euromoney Bondware: World Bank (IEC).

Since China's overseas bond issues are not traded on the exchanges, but are traded largely over the counter between majorinternational investors, the measurement of the true deterioration in these terms is difficult.

- 44 -

5.20 China's credit rating enjoys an above-investment grade by all major rating agencies. Thecountry's sovereign rating was upgraded to A3 by Moody's in September 1993, thanks to the agency'sassessment of China's strong potential to attract foreign investment; the low external debt burden andlikely 'soft-landing' for successful transition to a more advanced market economy., This was followedby a similar upgrade for three major financial institutions; Bank of China, CITIC, and People'sConstruction Bank.

5.21 Meanwhile, China can take measures to improve the domestic administration of its overseasbond issues. First, overseas bond issues, like other securities, still form a part of the annual creditplan, and specifically, a part of the foreign borrowing quota. The allocation is carried out inconsultation 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, andother Chinese entities. Approvals are also required by the State Administration of Exchange Controlfor medium- to long-term issues. The SAEC imposes stricter controls on bond issues, relative tocommercial loans and short-term debt. Convertible securities are regulated by both the SAEC and theCSRC. As with other securities, these procedures imply that it is difficult to ensure that proceeds fromforeign 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 beintroduced. It is recommended that the role of the credit plan be gradually limited in this sphere, andthat the selection procedure be left more to independent credit rating agencies.

5.22 Second, China's international bond issues continue to be carried out by a limited number ofauthorized financial institutions, comprising selected banks and those trust and investment corporationsauthorized to engage in international operations. By 1993, around ten such institutions had beenauthorized, referred to as the '10 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,' CITIC and the Bank of China (BOC) have been the most active. In the late 1980s, thesewere the only two institutions issuing debt. Gradually, the government's authorization of additionalbond issuers has reduced their share.

5.23 The merits of 'window-based' overseas borrowing requires careful thought. While thisapproach may accrue benefits to China, mainly in the form of cost savings due to the higher creditstanding 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 couldalso be an issue. Onlending terms for overseas loans to eventual domestic borrowers do not appear tobe clearly defined and may not be governed by creditwortiness considerations alone. Exclusiveemphasis on the windows can encourage back-door financing activities, such as inducing offshoreborrowing by Chinese enterprises through their foreign subsidiaries. Greater direct access by non-windows to overseas funding should therefore encouraged for more efficient resource mobilization andallocation. China has already expanded the range of institutions permitted to access the overseas bondmarkets, and enhanced flexibility in this direction is suggested.

4 At this time, Moody's rated Argentina, Brazil and Mexico, as well as Venezuela, Turkey, Pakistan and Hungary, belowinvestment grade. Chile, Colombia, India and Indonesia were investment grade but below China. However, three Asianemerging economies enjoyed higher ratings; Korea (Al), as well as Malaysia and Thailand (A2).

6. INSTITUTIONAL INVESTORS

A. Institutional Investors and Securities Markets

6.1 China's securities markets are characterized by relatively low liquidity and high volatility.Among the factors which give rise to such characteristics is the investor profile, which is biasedtowards small retail investors. The absence of professional investors in China is notable even relativeto other emerging market economies. Increased participation by institutional investors such asinsurance companies, pension funds, and mutual funds, would stabilize the market. The focus of thepresent chapter is an analysis of the reasons for the limited participation of institutional investors inChina, and suggestions for how such participation could be increased.

The Growth of Contractual Savings in Different Countries

High Income Countries with relatively Low Social Pensions: (USA, UK, Canada, Australia, New Zealand,as well as some European countries, such as Denmark, the Netherlands and Switzerland): These countries rely mostly onfunded occupational schemes for supplementary pensions. Rapid growth of cotntractual savings. Institutional investorsplay a dominant part in these countries' capital markets.

High Income Countries with relatively High Social Pensions: (France, Germany, Italy, Austria): Relativelyunderdeveloped occupational pension schemes. Lower contractual savings. Limited role of institutional investors

Developing Countries with Funded Pensioii Schemes: (Singapore, Malaysia, Egypt, Cyprus, Chile andZimbabwe) These countries have accumulated large long-term financial resources. Relatively large contractual savings

Developing Countries with Partially Funded Pension Schemes: (Brazil. Indonesia, the Philippines, Jordanand Turkey). These countries have partially funded private or public pensioni schemes, and the size of their assets inrelation to total financial assets is not very large.

Developing Countries with Pay As You Go Pension Schemes: (Most Latin American. Eastern European andCentral Asian countries). These countries have pay-as-yvu- on penSion swstems that make no or little contribution to theaccumulation of financial savings.

Source: World Bank. FSD.

6.2 A first difficulty concerning the participation of institutions for contractual savings in thesecurities market in China, is that such participation has been limited by restrictive regulations. InChina, contractual savings institutions have been obliged to invest their resources in a combination ofgovernment securities and bank deposits, which have often paid low or sometimes negative rates ofreturns. Aware of the consequences of such restrictions, the government is considering the graduallifting of these constraints, with appropriate safeguards against speculative investments that may leadto large-scale losses for individual savers. Yet China's contractual savings institutions today also face asecond serious handicap, the problem of low relative levels of contractual savings, of only threepercent of GDP. This is an apparent anomaly in a country with a notably high savings rate. While it istrue that China is a low-income country, contractual savings as a proportion of GDP in China aremuch lower than other developing East Asian countries, such as Korea (18 percent), Malaysia (48percent) or Singapore (78 percent). A primary reason is that under the system of central planning, thestate assumed the functions of providing pensions, housing and social security primarily through stateenterprises. Services such as domestic insurance were not permitted. With the transition towards amarket economy, China today has to face the problem of how to build up such institutions. The

- 46 -

The Three Segments of Instituional Investors:Pension Funds, Life Insurance and Mutual Funds

Se o Growth of Pension Insurance and Size of Mutual

Funds nsion F n

Growth of Pension Funds Total Assets of Life Insurance Net Assets of Mutual Funds(% GDP): Companies and Pension Funds (% GDP, 1993)

(1990, % GDP)Singapore (1976-86) 28% to 73% France 39%Malaysia (1980-87) 18% to 41% UK 97% USA 16%Chile (1981-90) I%to26% USA 75% U.K. 14%

Singapore 78% Japan 11%Malaysia 48% Korea 21%Chile 30% India 12%Korea 18% Mexico 5 %

The main factors behind the growth of contractual savings are: (i) coverage (ii) contribution rates (iii) wagegrowth and (iv) returns to investment. eg., In Chile (i) a mandatory personal pension plan was introduced in 1981;(ii) there were high returns to investments in the 1980s, averaging 13% per year. In the USA, and UK (1980s): therewere large rise in stock market prices. In Switzerland and the Netherlands: there was expansion to near universalcoverage of the working population by funded pension schemes.

The slower relative growth of mutual funds is due to their voluntary nature. Pension fund participation, even if notmandated by the government, is usually conmpulsory at the company level. Growvth in mutual funds has beenstimulated by the development of money market funds, bond fi4nds, and recently, in developed countries, by lowdeposit interest rates.

Source: World Bank, FSD.

emphasis of the present chapter is therefore on the second and more structural problem of building upefficient vehicles for contractual savings.

6.3 The principal issues raised here are first, that the insurance industry is growing rapidly but isstill dominated by PICC. It is still structurally biased towards non-life insurance, which providesrelatively 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, lack of profitable financialinvestment opportunities, in the face of the relatively high inflation rate, lower the real financialperformance of PICC. Yet, the insurance industry is better poised today to potentially contributeinvestible funds to China's capital markets in the medium term than pension funds. These may taketime to emerge, as a reform of the current unfunded pension system and reduction of its highcontribution rates may first have to be undertaken and such a reform program is unlikely to beimplemented in the short-run. While the difficulties of China's pension system are sometimesattributed to its enterprise-based nature, the real drawbacks of the system lie on the complete relianceon pay-as-you-go schemes. Today pension funds have negligible accumulated balances to invest incapital markets, and the building up of these balances through pension reform must occur before theirserious participation in capital markets can begin. Other contractual savings funds are beginning totake shape but are still very small, and they are not analyzed in detail here. Housing funds areeffectively still forced saving schemes with very low real returns and with little incentive to attractinvestors' funds. Prospects for mutual funds have been constricted by the lack of an appropriate

- 47 -

supervisory framework, and ad hoc changes in the regulations they face, reflecting the government'sconcerns about their possible effect on diversion of bank deposits.

B. The Insurance Industry in China

6.4 Prior to 1979, domestic insurance, including life insurance in particular, had been bannedsince 1959. Insurance has experienced phenomenal growth since 1979. Between 1986 and 1992,premiums grew from Y 5 million to almost Y 25 million. In 1993 alone, total annual premiums areestimated to have doubled and life premiums trebled. Yet, relative to other countries, includingcountries in Asia, the industry is still poorly developed (Figure 6.1). These countries illustrate thatapart from income levels, the development of the insurance sector is also related to factors such theregulation of the industry, especially to permit competition, including foreign entry. Countries whichhave allowed market forces to play a greater role in their domestic markets and have encouragedgreater integration with international markets through freer retention policies and freer entry of foreigncompanies have experienced high growth of their insurance markets.

Figure 6.1 China: International Comparison of Insurance Premiums (1992)

Asia Africa

..1.M_... r - - XT Korea I

TJapan 1 f South Africa

M alaysia a Zimbabwe

Singapore

PhilippinesK y

Thailand I r lj

China -.tg-7t=jMrcol<

00 20 40 6 208 0100120140 00 20 40 60 80 100 120 140

% GDP %GDP

Latin America

Brazil

Panama I

Chil

Venezuel

llruguay l i

Colo m bia I

A rge nUn t in a eI nxico

00 05 10 15 2.0 25 30 35 40 45

% GDP

Source. Sigma, W orld Insuraarice in 1992, Swiss Reinsurance Conspany, M arch 1994.

6.5 Although there are signs of new competition in the insurance industry, it is still dominated bythe state-owned People's Insurance Company of China (PICC) which in 1992 held over 90 percent ofthe market.' There are a total of 24 companies in China but most of these are regional and are partlyowned by PICC. Two independent domestic companies also exist, which are evolving towardcompeting and innovative nationwide insurers. PICC modernized and expanded its operations in the

Because of the creation of many regional companies in which PICC has a controlling stake, the share of insurancebusiness attributable to PICC seems to have fallen to around 60% in 1993 (31 billion yuan out of a total of 54 billionyuan for the market as a whole). But PICC may still effectively control 90% of the market.

- 48 -

1980s. Its household property insurance policies increased from 30,000 in 1980 to 130 million in1993. Life insurance contracts grew from 300,000 in 1982 to 300 million in 1993. Motor insuranceand more specialized lines of business also grew at very high rates. In 1993 foreign insurancecompanies were selectively allowed to enter the market. As in most developing countries, theinsurance industry in China is strongly tilted toward nonlife business, although the rapid growth of lifeinsurance enabled it to account for 30 percent of the total in 1992. The rapid growth of life insuranceis primarily explained by by the growth of group life insurance, for workers in joint ventures, foreignand private companies, and small rural cooperatives, which are not covered by the social pensionsystem but are required to be covered by group policies arranged through insurance companies.

Figure 6.2 China: Comparisons of the Performance of the Insurance Industry in Selected Countries

Nonlife Insurance: Loss Ratios andExpense Ratios life Insurance: Payback Ratios andExpense Ratios

140

70 LOS rti

40

1a LOSS rat ir

ratio : Eol

Source: Munsalem et al (1993) and World Bank Staff Estimates.

6.6 An evaluation of the financial performance of China's insurance shows that non-life insurancein China has relatively high loss ratios, unusually low commission ratios, and modest expense ratios,even comnpared to typical developing countries. But the financial management of life insurance isrelatively good. The PICC's reported loss ratio for life insurance amounted to 28 percent, butincluding additions to reserves and policy surrenders, the pay-back ratio amounted to 107 percent.PICC also reports an investment income equal to 17 percent of life premiums. This is used to covercommissions (which amount to only 3 percent of premiums) and expenses (7 percent of premiums)The rest is credited to policyholders in the form of life funds. These loss and expense ratios comparevery favorably with those of other developing countries. The commission and expenses ratios are lowby the standards of most developing countries and the payback ratio to policyholders is 107 percent.Yet, overall financial performance in life insurance is weak, due to low returns on investment income.Very recently, in March 1995, China passed a new Insurance Law. On the positive side, the lawestablishes limits for investment in a range of securities. Although conservative and favoring safeinvestments, the new law does encourage diversification. Taken as a whole, the prospects for theinsurance industry are bright. Continuing high economic growth is likely to stimulate the demand fornonlife insurance, while the high rate of saving and the need to cope with the aging population willstimulate the demand for life insurance. On the supply side, the ongoing regulatory reform, themodernization of the operations of PICC, the creation of new domestic companies and the entry offoreign insurers are all pointing to higher efficiency and an expansion of the insurance habit amongChinese firms and households.

- 49 -

6.7 The government could also undertake supplementary measures to stimulate the growth of theinsurance industry and enable it to achieve its potential and contribute to the development of thesocialist market economy, including: (i) a clarification of the law in areas dealing with the relationshipbetween banks and non-bank insurance companies; (ii) continuing present policies of broad guidelinesfor the setting of rates, with generous margins for variation within tariff bands to allow forcompetition; (iii) providing for the training of regulators and insurance examiners and establishing aneffective new supervisory authority; (iv) increasing the contestability of the insurance market byencouraging new domestic companies; (v) authorizing more foreign and joint venture insurancecompanies to stimulate competition; (vi) improving accounting and information disclosure standards tofacilitate the solvency monitoring of the industry and protect the interests of policyholders; (vii) takingmeasures to strengthen links with international insurance and financial markets, especially by openingup the reinsurance market to foreign companies; and last, but most important, (viii) liberalizinginvestment rules and encouraging insurance companies to invest prudently and profitably to permitthem to contribute to the further development of the capital market.

C. The Pension System

Current Structure

6.8 Chinese pension funds are even less developed than the insurance sector. A major reason whypension 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 ofChina. With the urban population representing 30 percent of the total population and a coverage ratioof urban workers of about 60 percent, the overall coverage of the pension system is probably onlyabout 18 percent of the economically active population. The current system also suffers from a veryuneven burden among enterprises and provinces, reflecting large differences in demographic structuresand dependency ratios. A further problem confronting the system is the rapid aging of the population,which makes future pension reform of critical importance. But the system also has three mitigatingfactors that enhance the potential for reform: the current low level of pension spending (which makespension reform and the transition to a new system easier and less costly); the high rate of economicgrowth; and the very high rate of household saving.

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

6.10 Looking at national efficiency ratios for pension schemes, the general finding is that whilecosts are relatively low, so is coverage, and the volume of contributions in terms of pension fundsavailable for investment is very low. Thus, in 1993, the overall system dependency ratio was 23percent, which is not much higher than the demographic dependency ratio, of 18 percent .2 The average

2 The system dependency ratio is derived from the ratio of retired workers receiving pensions (19 million), to activecontributing workers (83 million). In many developing countries in Latin America and Eastern Europe, there is a muchgreater gap between the system and demographic dependency ratios.

- 50 -

replacement ratio is 65 percent. I Though lower than the targeted rate of 70 percent to 80 percent, it isquite high in view of prevailing inflation.4 The required contribution rate for break even in China hasbeen estimated at 15 percent, while the implied share of covered wages in GDP is only 10 percent. Acomparison with other countries shows that the cost of pensions in China is currently quite low, bothbecause of the low dependency ratio and because of the low share of covered wages in GDP.

6.11 Annual contributions are low, amounting to only Y 50 billion, or around 1.5 percent of GDP.In Eastern Europe, pensions correspond to 10 percent or more of GDP. Annual pension expendituresare around Y 45 billion, leaving a very small investible surplus per year, of only Y 5 billion. By1993, the total accumulated capital amounted to Y 27 billion, of which Y 7 billion was invested inspecially issued non-marketable treasury bonds and the rest mostly in bank deposits. The rate ofreturn has been well below the rate of inflation in recent years and has eroded the real value ofaccumulated balances.

6.12 Another difficulty today is the geographically uneven burden of pension funds. Provinces suchas Shanghai, Beijing and Tianjin, with many loss-making enterprises and aged labor forces, bear agreater burden from pensions than new cities like Shenzhen, which have profitable firms and younglabor forces. The difficulty of transferring pension and other employee benefits is impeding therestructuring and downsizing of state enterprises. To cope with this problem, a program of'socializing social security' has been under implementation since 1986. This involves the 'pooling' ofthe social responsibilities of enterprises either along geographical lines or on a sectoral basis.However, as the pools are not connected across provincial or industrial lines, pools with heavierburdens are forced to increase their contribution rates.

6.13 For example, in Shanghai, contribution rates, although not in cash, of 54 percent of aggregatebenefits, or 28.5 percent of the nominal 'base' wage for pensions alone, are very high by internationalstandards, especially for a country with the level of income of China and pension reform should aim tolower contribution rates. Maintaining current pension payments requires a lower (20 percent)contribution rate for break even. A small surplus has thus accumulated, amounting to Y 450 million in1993, and projected to reach Y 1.2 billion by the end of 1994. The management of these funds isentrusted to the Pudong Development Bank. While a diversion away from traditional investments inspecialized banks or treasuries is to be welcomed, and indeed returns at PDB are higher than thesecomparators, care must be taken against investing in institutions with high risk portfolios, or thosewhich are obliged to direct their investments towards ares deemed to be of priority to the localgovernment. In the long term, the aim should be to permit pension funds to invest in a diversifiedportfolio of publicly traded securities. In Beijing, the average monthly pension and averagereplacement rates are similar, and the pension system should be running a small surplus. But manyloss-making companies are unable to pay their contributions and thus the system suffers from a smalldeficit. Meanwhile the Beijing Municipality has introduced additional savings plans, involving a twopercent contribution from employers and five percent from employees. In Tianjin, the situation interms of funding is thus worse than Beijing or Shanghai. The level of both wages and pensions islower than in the other two municipalities, but the average replacement rate is much higher at 84percent. Average contributions are about 26 percent, compared to a breakeven contribution rate of 28percent, leaving a small deficit for the system. The accumulated reserves of the fund for the TianjinMunicipality amounted to only Y 340 million, which corresponded to just over a third of the totalspending on pensions in 1993.

3 Estimated as the ratio of the average pension (Y 2,400 per year) to the average wage (Y 3,650 per year).4 Pensions are not fully indexed to inflation but are adjusted on an ad hoc basis.

- 51 -

Reform Options and Policy Recommendation

6.14 The Chinese authorities at the Ministry of Finance, Ministry of Labor and the StateCommission for Restructuring Economic Systems are fully aware of the problems facing the pensionsystem from its uneven burden and the rapid aging of the population, and are considering a range ofreform options. The reform that appears to command widest support involves the creation of a dualpublic-pillar structure; with the option of additional pillars to be provided by company schemes orpersonal pension plans.

6.15 The drawback of the present proposal is that the two public pillars would not be funded andwould require a rising contribution rate to break even. Despite the acknowledged difficulty of raisingresources for funded schemes, it must be recognized that a largely unfunded pension system would bedifficult to sustain in the long run, given the projected rapid aging of the Chinese population. It wouldappear that with the low cost of current pensions, China today has a golden opportunity to introduce a

Pension Reform Policy Options: Funded and Unfunded Pillars

Many options are available. For instance, the unfunded pillar could be financed from payroll taxes or from general taxrevenue, although given the low coverage of the formal pension system the latter approach would not be advisable. Thebenefit from the unfunded pillar could be a flat pension paid to all workers irrespective of their career earnings and years ofcontributions, or it could follow the structure of the Swiss public pillar and divide the public pension into two components:one based on years of service and the other on career earnings with a clear ceiling on the public pension.

Similarly, the funded pillar could be based on centralized management by a public agency analogous to the Central ProvidentFund in Singapore or it could be operated by competitive fund management companies as in Chile or by employers as inSwitzerland. The funded pillar could also cover the housing accounts that have been established in many provinces as well assaving for other uses such as education and medical care. Care should also be taken to ensure that the resources accumulatedin the funded pillar are invested prudently and wisely, with the objective of maximizing the returns for their members subjectto a reasonably low degree of risk.

Over time the funded pillar would become a major source of institutional funds and would complement the operations of theinsurance companies in modernizing the capital markets. Initially, its investments would be tilted toward marketablegovernment bonds and other lower risk instruments but later on as the equity market gets better organized and accountingstandards and information disclosure considerably improved, a growing proportion of funds could be invested in corporateequities. At that stage, a move away from centralized management would be advisable, both in order to ensure a competitiveand efficient fund management industry and in order to avoid undue state influence in corporate affairs.

fully funded, fully vested and fully portable second pillar that would be based on individualcapitalization accounts, supplementing an unfunded public pillar. Combined with a gradual raisingof the normal retirement age, such a system would not only be sustainable in the very long run butwould then be able to generate substantial long-term funds that would be available for investment. Acombined unfunded/funded structure would also in the long run reduce contribution rates and thuslower the burden on labor costs.

6.16 An unreformed pension system will face major pressures in the future. Projections carried outby Chinese researchers shows that the system dependency ratio may exceed 50 percent and the requiredcontribution rate may reach over 30 percent by the year 2050 if no reforms are carried out. A reform ofthe system, based on the forms suggested above, suitably adapted to any special features in China, andoffering adequate but affordable and therefore sustainable benefits should be undertaken as soon aspractically possible. The benefits from an effective and sound reform and from the creation of a newmulti-pillar structure will be very large not only for the pension system itself but also for the labor andcapital markets and thus for the national economy.

-~ 9'Si 0

INA

Z)

Date post:	21-Feb-2021
Category:	Documents
Upload:	others
View:	0 times
Download:	0 times

World Bank Document · 2016. 7. 17. · DTC Depository Trust Company ... GATT General Agreement on...

Documents