China's Financial Markets
Outlook Positive but Change Still Needed

Bonnie Handy
OMBA606
01.12.03

  
     


Executive Summary

    China’s financial markets, like most developed countries, consist of stock exchanges, bank loans, bonds, and some international equity. For the past two decades, under DENG Xiaoping, China has been trying to liberalize its markets and adopt a more open and competitive environment for investors. Unfortunately China’s communistic roots still have a firm hold through state-owned companies, strict controls on who can invest in what vehicles and in what amounts and a majority ownership in non-tradable stocks and bonds. This has left the state-owned companies free to continue operating as they always have rather than own up to and improve their lack of governance and transparency. Instead they gain funding from the government and the financial markets as needed. Sadly, the losers are the more productive privately owned enterprises, restricted from listing on the stock market, issuing bonds or borrowing from the banks. The greatest obstacle they face to growth is lack of funds and yet they are the future of China.


Introduction

Limitations

Limitations encompassing this paper may include:

(1)  Time. The research and writing of this paper was conducted during the half-week period from 01.08 – 01.13, 2003.

(2)  Resources. Research was limited to information accessible online and in English. Many of the resources regarding China are in Chinese.

Definition

    According to investorwords.com, the definition for financial markets is “a market for the exchange of capital and credit, including the money markets and the capital markets.” For purposes of this paper, the definition will be applied to businesses in regards to how they obtain funding for continued operations and expansion. There are several ways in which a firm can acquire capital or funds for these business purposes. There is of course self-funding or the utilization of internal cash flow in which case financial markets are not needed. But when a company isn’t self-sustaining or needs additional capital to grow, there are several external options available ranging from short-term to long-term debt as well as both domestic and foreign equity positions.

Background

    The different external options are the basis of financial markets and are fairly similar from country to country. Financial institutions (banks) make short-, mid- and long-term loans in exchange for interest and eventual payment of the principle. Equity positions in a company can be purchased via venture capital (direct investment) and public equity (stock shares). Finally a company or government can issue a bond which is a loan of sorts, but rather than coming from a single financial entity, bonds can be open to multiple individual and institutional investors.

Although the vehicles might be the same, financial markets can differ significantly from country to country depending on how open or closed the markets are to domestic and international lenders, borrowers and investors. At one end of the spectrum, the United States represents an open and competitive financial market. Conversely, China exemplifies a controlled and more often closed financial market. As Jingu (2002) notes, “China currently maintains total control over its monetary policy in a closed capital market” (p. 5). The country is striving to move toward the open end of the market spectrum, but is doing so at a conservative, some would say snail’s, pace. But it is moving. “Since the late 1970’s… China has expanded opportunities for business by … loosening central control on regional government enterprises, opening foreign investment, and, increasingly encouraging private domestic business” (Barro, 2002, ¶1).

A thorough examination of China’s financial markets will provide a better understanding of why a closed market is typically not competitive or efficient. It will also show the steps that China is taking to move towards a more open, competitive and capitalistic version of the market and the reasons behind the conservative approach. If Staples is going to expand its office supply business into China, it must have insight into the barriers to investment as well as an appreciation of the opportunities provided by the financial markets. Armed with this knowledge, Staples can make an informed decision on what strategy to pursue.


Financial Markets -- China

    A pegged exchange rate, significant controls to limit investment and “state-owned” everything are some of the primary reasons that China is viewed as a closed or restricted market. What does “state-owned” everything mean? It refers to the fact that before China began undertaking massive reforms to support membership in the World Trade Organization (WTO), it was, and still is in most respects, a communist country. The World Factbook (2002) explains that “the Communists under MAO Zedong established a dictatorship that, while ensuring China's sovereignty, imposed strict controls over everyday life.” Mao’s successor in 1978, DENG Xiaoping, realized the need for change and began to introduce market-oriented economic and financial modifications while maintaining strict political control. The result was tremendous growth over the next two + decades for China, despite the fact that its industries still remain largely state-owned rather than privately developed. 

Bank Loans

Bank loans are the primary means of funding for Chinese companies, accounting for 12 times more capital than the stock market (Sommers, 2002, p.15). But the presence of the communist government is clearly seen in the banking industry. Although there are numerous regional and private banks, there are only four big banks that are government sanctioned – 1) the Agriculture Bank of China (ABC), 2) the Industrial and Commercial Bank of China (ICBC), 3) the China Construction Bank (CCB), and 4) the Bank of China (BOC)[i]. This means that only these banks can offer investment banking services domestically in China. “Even regional and private Chinese banks are restricted from such activities” (Sommers, p. 10), which explains why, between the four banks they “control about three-quarters of the country’s deposits and commercial loans” (¶5) and “90% of loans are almost all for state-owned enterprises” (SOEs) (Murphy, 2003, ¶13).

What makes this process inefficient is that a huge number of these loans are non-performing, or in other words the businesses are significantly past due on interest / principle payment. Despite a clean up effort to remove 20% of the “dead capital” in 1998, “nearly 30% of the BOC’s loans” were still non-performing in 2001 (Dorn, 2001, August, ¶1-2). Unfortunately because of the political structure and still controlled markets there isn’t much incentive for the SOEs to pay off their loans. They know that the government won’t let them fail due to the large ownership interest of the government. In addition, with SOEs employing a significant portion of the population, and providing exports, it’s important to keep these companies afloat to stave off instability and unemployment. This explains why the big four “continue to issue government-directed policy loans and accumulate nonperforming loans, or NPLs, estimated to total some $500 billion” (Murphy, 2003, ¶5). Murphy goes on to quote Anna Borzi, who heads up financial services at a Hong Kong Securities firm, “’ If stability and growth are required, it is smarter in this transitional phase for them to continue to fund large companies that keep people employed because the costs in economic instability to the banks of not doing so are immense,’ she says” (Murphy, ¶17).

Interestingly, these non-performing loans have become a valuable commodity on the international market, as foreign investors purchase them to gain a foothold in Chinese domestic industries where they otherwise wouldn’t be eligible.

Stock Exchange -- China

A critical component of the United States financial markets are the stock exchanges which allow individuals and institutions to purchase an equity share in a company. Under DENG Xiaoping, two stock exchanges were established, one each in Shanghai and Shenzhen in 1990 and 1991 respectively. In all appearances a step in the right direction towards competitive markets, but in reality is a closely controlled mechanism for allowing SOEs “to raise capital from Chinese households and from foreign entities by initial public offerings (IPOs) of unseasoned (never before traded) shares as a substitute for continued central government funding of such capital investment” (Gabriel, 1998, ¶1). Unfortunately, the lucky SOEs that were listed burned through the raised capital and then went back to the central government for more financial support. (Gabriel, ¶8).

According to Gabriel (1998), Jingu (2002), Yabuki & Harner (1999) and several other sources, there are four “official” classes of stock: A, B, C and H shares. Each class of stock can be classified by investor, issuer, or currency and is either tradable or non-tradable. “In terms of liquidity, stocks in China can be classified into four categories by the type of shareholder: state shares (government-owned), corporate entity shares (mainly owned by state-owned enterprises), employee-owned shares, and general public shares.” The general public shares account for 40% and are really the only shares listed and traded – they are divided among, A, B & H shares. (Jingu, 2002, p. 5).

Chinese Public or A shares – As of 2002 there were approximately 1,200 companies offering A shares. Approval to list as an A share must be obtained by the China Securities Regulatory Commission (CSRC). These are the only class of shares that Chinese citizens are allowed to purchase, and foreigner purchase is currently prohibited. The majority of the A share companies are SOEs rendering a significant portion (70%) of the shares non-tradable.

As a sign of the financial markets opening and becoming more competitive there is a proposal pending that will allow foreign investors into the $500 billion A share market, the Qualified Foreign Institutional Investors (QFII) scheme. Unfortunately, in typical controlling fashion, the entry conditions are extremely stringent, requiring a potential investor to have $10 billon in assets, be willing to invest $50-800 million, keep their money in the country for over a year and be backed by a top-100 global bank. All of these requirements and only 10% of a company listed can be purchased (Lo, 2002, ¶1; Latelinenews.com, 2002, Decmeber 1, ¶5-7 ).

Foreign-person or B shares – Available for purchase by foreign entities, there are only a little over 100 companies listed. The good news is that 90% of the shares are tradable. In another move toward more open markets, the B shares were opened up to domestic investors in February of 2001, as long as they had legal foreign currency accounts. (Jingu, 2002, p. 4).

Legal-person or C shares – Slightly misnamed, these shares are only available to “provinces, government agencies, official organizations, and other such institutions” (Gabriel, 1998, ¶5).

Hong Kong or H shares – Similar to B shares but listed on the Hong Kong exchange, there were only 41 companies listed as of 1998.

A shift has become evident on the Chinese stock exchanges as more privately held companies are being allowed to list. According to Wonacott (2002) the number has “climbed to more than 200, or about 15% of the exchanges’ total. The proportion soon could reach one-third, securities officials say” (¶7). Comparatively, the two US primary stock exchanges, NYSE and Nasdaq have approximately 2,800 and 4,000 privately owned companies listed respectively.

The difficulties encountered by private companies trying to obtain funding have led to what are referred to as “back-door listings” resulting from the purchase of a stake in a state company already listed on the exchange. The mis-managed and often financially troubled SOEs are eager to sell, but a 30% equity limit enforced on the private company limits their ability to manage and control the SOE to improve productivity and profit (Wonacott, 2002, ¶10).

Despite over a decade of trading, there is still plenty of room to move the Chinese equity market toward open competition. There is no doubt that advancement is taking place with the consideration of QFII, the inclusion of B markets in domestic investment opportunities, a shift toward more privately owned company listings and finally the delisting of poorly performing companies (unheard of until recently). However, due to the extent and nature of the SOEs and the government’s non-tradable shares, it will take time and carefully planning to divest the government of ownership and fully open up the markets.

 International Capital Markets

In the meantime, “many Chinese companies are finding it difficult to fund their needs from the domestic stock market, handing an advantage to foreign corporations who this year are expected to invest more than a record $50bn in China” (Country Briefing, 2002, December 13, ¶6). The are also turning en masse to International Capital markets. Examples provided by Latelinenews.com (2002, December 3) include:

Even state owned companies such as People’s Insurance Company of China  and China Life Insurance Company are hoping for oversease listings. But Hong Kong provide a great opportunity,  

“Hong Kong is without a doubt, and will remain, China’s indispensable market for raising international capital, especially international equity capital… Unlike anywhere on the mainland, Hong Kong possesses all the elements necessary for financial innovation: a sophisticated investor market, experienced and reputable commercial and investment bankers, a body of financial law, sophisticated legal and accounting services, and a stable, strong, and convertible currency” (Yabuki and Harner, 1999, Chapter 21, ¶11). 

Bonds

The bond market in China is yet another example of a seemingly open market approach until you dig into the specifics. The majority of bonds issued in China are government or treasury bonds, issued to boost the economy and totaling 510 million yuan over the past four years (Jingu, 2002, p. 7). According to a Country Briefing (2002, December 13, ¶5), China has been hesitant about creating a more robust bond market for fear that it would divert liquidity expected from stocks. This of course won’t stop the government from issuing special Treasury bonds this year in the amount of Rmb140bn in hopes of continued economic stimulus and growth maintenance (Country Briefing, 2003, January 3, ¶12).

According to Sommers (2002) the majority of the bond market is made up of long term maturity (greater than one year) with over half at a 7-10 year period. Treasury bonds account for 69% of the total Rbm2.9 trillion market while corporate bonds make up less than 2%. In fact the corporate bond market has remained stagnant for the past seven years. And as with the other forms of funding, private companies have been left out of the funding although Beijing has apparently promised to allow them to issue bonds in the future (Country Briefing, 2002, December 13, ¶8). Further hampering the bond market is the fact that almost 25% of Treasury voucher bonds are non-tradable.

[i] It was interesting to discover that 3 of the 4 banks offered an English version of their Internet site.


Investment in China

Risks

Added to the difficulty of participating in China’s financial markets is a very real fear regarding the potential risks involved. The cyclical trend of government funding, ipo, government funding pursued by many SOEs is the result of poor controls and governance from a corporate perspective. Sommers (2002) identifies “poor quality of disclosures and accounting standards of China listed companies” as a reason for the failure of the B-share market (p. 16). This is indicative of all SOEs which could help explain why they produce at a 30% lower rate than privately held companies (china.org.cn, 2002, December 5, ¶22) and more importantly why the stock market is not being heavily utilized by investors.

The Money is There

The problem certainly isn’t a lack of money to invest. China has one of the highest annual savings rates in the world, about 40% of GDP. By law of numbers, even if only 5% of the population were to invest, it would be 60 million. That’s not an unreasonable number considering 18% of Honk Kong and 49% of the US populations invest in the stock market (Cha, 2001, ¶2).

Impact on Private Enterprise

Private firms, particularly small and medium-sized enterprises (SMEs) are playing an extremely dynamic role in the economy through growth and the creation of new jobs. In some developed countries SME’s provide up to 70% of the new jobs. As is to be expected given China’s financial market situation, private companies in China are finding it difficult to grow largely because they don’t have access to funding. “In 2001 only 1.4% of the funds lent as working capital by banks in China were borrowed by private firms or foreign-invested enterprises (FIEs)” (Country Briefing, 2003, January 3, ¶10). Lack of demand isn’t the problem but rather the bias on the parts of Chinese banks toward funding SME’s v their favored SOEs. The result is that “the typical SME in China gets about 10% of its working capital financing from banks; in Korea or Thailand, the typical SME gets 40% of its financing from the banking systems” (china.org.cn, 2002, December 5, ¶22).

The bottom line is that for a privately owned company in China, there are innumerable barriers to obtaining external funding within the domestic market.

“Industry remains dominated by state-owned enterprises (SOEs), despite the government’s recently articulated commitment to the private sector. Where free-market practice runs ahead of what the law countenances, the government periodically intervenes to reverse developments” (Country Briefing, 2002, December 30, ¶2).

That’s the bad news. The good news is that with China’s entry into the WTO, they appear to be making a concerted effort to turn the tide and revamp their financial markets. “Chinese securities regulators are reviewing the nation’s Securities Law, enacted in mid 1999, ahead of a milestone amendment that will eliminate a major threat to China’s creaking financial system” (china.org.cn, 2002, December 24, ¶1). Latelinenews.com (2002, September 26) further reports that a top priority is to “cut the government’s huge stake in listed companies, aimed at freeing up trade in two-thirds of the stock market” (¶18).


Staples Analysis

Understanding the financial markets and potential barriers and benefits for private firms is critical in determining whether or not Staples’ Office Supplies should consider expansion into China and if so, how it would be funded.

Traditionally, Staples “uses a combination of cash generated from operations and debt or equity offerings to fund its expansion and acquisition activities” (Staples 2001 Annual Report, p. 25). Most recently, Staples sold $325 million in senior notes due 2012 to finance it’s purchase of Guilbert SA. A mail order business, Guilbert is providing Staples with a means to expand further into the European market. Staples also has procedures in place to protect it from foreign exchange rate and interest rate fluctuations when it expands.

Were Staples to consider immediate expansion into the Chinese market, it would face a number of barriers. One of the major barriers doesn’t pertain to the financial market but is worth mentioning as it could present significant problems. China has a foreign-owned ceiling of 65% that cannot be exceeded. Carrefour, a French retailer recently came under scrutiny for violating the ceiling and was “ordered to reduce their holdings to the permitted limit” (Country Briefing, 2002, December 30, ¶3). Fortunately for the long-term, the ceiling will be increased as a result of China’s new membership in the WTO, but in the meantime, China is hoping to give its domestic chain stores the opportunity to consolidate and become more efficient before facing stiff foreign competition.

Staples will also face funding barriers due to the stringent controls on foreign investments, if the company decides to seek funding in China's domestic markets. However, Staples would be wise to seek funding in the domestic U.S. rather than relying on the financial markets of China. Staples might do best to wait for China’s membership in the WTO to take a firm hold and the financial markets and open economy to catch up to the European and US environments. Part of China’s commitments for WTO entry “calls for opening up a range of sectors previously off-limits to foreign investment” including “domestic retail trade, and distribution” (Hu, 2001, p. 105-106). Once these commitments are met, the markets opened to competition and foreign investment and the state removed from controlling everything, Staples will have a much better opportunity at success in China.  


Conclusion

The bottom line is that until the government is willing to add its shares in SOEs to the tradable market, privately owned companies are given equal opportunity to list on the exchanges, capital controls are removed and banks are free to compete, China’s financial markets do not offer a very viable means for obtaining funding. “As long as state dominates China’s banking system and stock exchanges, domestic capital markets will fail to provide the liquidity needed for future growth and will continue to waste scarce capital” (Dorn, 2001, August, ¶4).


Appendix

Source: Hu, 2001, p. 103


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