It was fitting that the pronouncements should have coincided with Spring Festival, China's lunar New Year celebration, which began this year on a particularly chilly late January day. When the State Council issued its Nine Articles on the Reform of China's Capital Markets on February 1, the long, dark winter, was still far from over – and yet there were unmistakable signs of a thaw.
As pressure for reforms mounts, China's new leaders appear far more willing than their predecessors to loosen political restraints. The Nine Articles placed foreign-funded and private enterprises on equal legal footing with SOEs in the approval process for listings, hinted at the launch of a qualified domestic institutional investor (QDII) program led by the social security fund and followed by pension funds and insurance companies, and gave a green light to the Shenzhen exchange to launch its long-delayed SME sub-board (on which trading began in June). And while it fell short of a clear mandate for overhaul and lacks either a specific timetable for implementation or any prioritization, the State Council's program embraced many of the reforms that the largely foreign-educated members of the China Securities Regulatory Commission (CSRC) have long championed.
Recent signs of reforms have not been limited to equities markets. Beijing has, for example, signaled its willingness to loosen its regulatory grip on new bond issues. The cumbersome approval process for corporate bond issuance is expected to be streamlined within the year, and analysts report that the working group tasked with reforms to the debt market is even likely to allow some flexibility in corporate bond interest rates – "some 2 or 3 percentage points above treasury note rates," according to Ivan Chung, Managing Director for Xinhua Far East China Credit Ratings in China.
More commodity futures contracts have been approved, and even financial derivatives are now on deck for approval. "All of this bodes well," said Frederic Cho, Manager of Chinese equities at Hagstromer & Qviberg in Stockholm. "They've realized that capital markets need a range of products to function, and these are now formally allowed."
Liberalization may still be taking hold only at the periphery, and remains circumscribed by Chinese realities. But after nearly five years without any substantial regulatory changes, it's hard to fault the more exuberant market watchers. "Sure, it's often three steps forward and two steps back. But they're finally touching the fundamental issues, not just addressing problems as they arise," said Chung.
But at least two things aren't going to change any time soon, says Walter Hutchens, who teaches business law at the Robert H. Smith School of Business at the University of Maryland: "They will not allow major currency movement out of China, and they will not allow listings without approval. This is the sanctum sanctorum."
Behind this sanctity is a pervasive – and not unfounded – fear that reforms reaching too far might provoke a national banking crisis. Total outstanding loans in the Chinese financial system are still rising rapidly in spite of the present credit squeeze, said Scott Kennedy, Assistant Professor of Political Science at Indiana University, who studies the impact of politics on China's capital markets.
"At the end of 2002, it was over 137% of GDP, and over 140% at the end of 2003," he said. "Even if you put the [non-performing loan] problem at only 33%, that means that 45% of GDP is bad loans. In the American savings and loan crisis, the bail-out amounted to only 4% of GDP, the Japanese crisis is about 15-25% of GDP, and Thailand's during the [Asian Economic] Crisis was 25%. Policy makers are smart: avoiding a banking crisis is their top priority."
No one is about to schedule radical surgery for China's capital markets – at least, not until the patient is stronger. "True national treatment for domestic and foreign banks under the context of liberal interest rates, or an opening up of the capital account – either of which could result in a quick outflow of money from Chinese banks – would be likely ways to get into a disastrous financial crisis," Kennedy warned.
Fundamental reforms in securities markets remain tricky. The release of non-tradable state-owned shares in listed SOEs – often cited as a necessary fix – would be catastrophic in the short run, analysts say. "The government is holding half to two-thirds of the A-share market's value, but any move they make to sell assets will crash the market," said Bruce Richardson, head of research for Evolution Securities China. "Release that number of shares into any market and you'll be seriously taxing liquidity."
From his uncomfortable perch on the horns of this dilemma, Li Rongrong, Director of the State-owned Assets Supervision and Administration Commission (SASAC) of the State Council, could only defer action: "We will wait for a while, until the shareholders calm down," he said in February, "for this will avoid unnecessary fluctuations of the stock market."
Still, pressure for action is mounting, and a growing sense of urgency is helping the reform camp to overcome institutional inertia. With bank credit squeezed tight to slow growth and prevent further ballooning of NPLs, there is more need than ever for new channels of access to capital – especially for China's credit-starved private enterprises, which are expected to continue providing job growth but have faced bureaucratic obstacles to stock listings.
One step squarely in that direction was the launch of the SME sub-board in Shenzhen in June. Listing requirements remain strict -the same as for the main boards, which call for three consecutive years of profitability among other criteria. And the rate of approvals for new IPOs will remain tightly controlled. But the sheer number of small-cap companies looking to list – more than 1,000 had applied before the board began trading – testifies to the private sector's hunger for capital, just as the huge bounce the eight first-day IPOs witnessed, with average stock price rises of 133%, testifies to the pent-up demand of investors for new paper. Still, the CSRC is loath to flood the market with new issues, and as of mid- July, only 16 companies had listed on the new sub-board.
China's stock markets, once plagued by manipulation scams, have been cleaned up considerably in the last year. One reason is that CSRC commissioners and staffers at the Shanghai and Shenzhen bourses are savvier, better equipped, and more willing to go after errant players than before. Late last year, for example, jail sentences were handed down to five people implicated in a stock price manipulation case involving listed company Yi'an Science and Technology Corporation, and also to the chairman of Minfeng Holding Co. Ltd for cooking that company's books and inflating its share price. Early this year, the CSRC took control of Southern Securities Ltd, one of China's largest securities firm, after allegations of misconduct.
China's regulators have also recently begun a long-anticipated probe into the Xinjiang-based D'Long Group, once the country's largest privately-owned enterprise, with 177 subsidiaries involved in industries from tomato paste to concrete. Long-standing accusations of stock manipulation have prompted a freeze on the company's assets. Tang Wanxin, chief among the five brothers who co-founded D'Long, disappeared in June as investigations gathered steam.
Not all of this has to do with better policing. "As the market has become more mature," observed Wu Zuyao, Senior Economist and Vice Director of Research for Galaxy Securities, China's largest securities brokerage, "It's not just the regulators who have gotten smarter: Investors are no longer so easily fooled by stock manipulation schemes."
China's debt markets have seen the same kind of controlled reforms as the equity markets. Chinese corporations issued over US$4.3 billion in bonds last year, and issues were down significantly in Q1 2004 at only $664 million. But there are signs that relaxed regulations are in the pipeline. Following the PBOC's decision to allow banks to charge a wider range of interest rates on loans, Beijing looks ready to allow corporations more leeway in setting rates on debt issues. Also, said Chung, "[regulators] will lower approval criterion and simplify the application process. Everyone is aware that that is the critical issue – more so than interest rates."
"The government is also considering allowing issuance of bonds on a limited guarantee basis," added Chung, "which means that the credit risk will be differentiated and credit ratings agencies will help the market to establish risk."
That's something they're not doing at the moment. "Right now," Kennedy said, "credit rating agencies in China are irrelevant. Bonds are rated only after the NDRC [National Development and Reform Commission] and State Council approve the issue. Since the state has given its stamp of approval and bonds have guarantors, all but three bond issues in the last three years have garnered AAA ratings." Doubts also arise as to the ability of credit rating agencies to provide objective ratings: issuers routinely threaten to take business elsewhere unless given AAA ratings. As a result, the NDRC currently only approves bond offerings by companies that have virtually no chance of default and strong guarantors.
Securities companies, hard pressed over the last three years as commission income dwindles and their own portfolios bleed, were finally approved to issue bonds in October of 2003 (approval was given to equity funds for bond issuance earlier this year). It was largely on the solidity of their backers rather than their own financial health that three brokerages – CITIC Securities, Great Wall Securities and Haitong Securities – were approved to issue bonds in early March worth a combined total of 4.23 billion yuan.
Given the level of scrutiny that would-be issuers must undergo – not just by the CSRC, but also by the NDRC – it's no wonder that REVIEW AUGUST 2004 convertible bonds (CB) have proved popular with Chinese enterprises this year. "For a CB offering, you don't need the NDRC's approval, just the CSRC's," said Kennedy. "It's a way to get out of that long line (for stock listing). It's also one of the ways that the CSRC is trying to get around being controlled and dominated by the NDRC." Many more companies – including the China Merchants Bank – are planning offerings of CBs this year.
Inexorable demographic realities are also adding urgency to reform. Faced with China's rapidly aging population – the median age will rise from 32 today to 44 by 2040 – Beijing is desperate to head off a crisis in its social security system. The NCSSF (National Council of the Social Security Fund) reported only a 2.71% return in 2003 – higher than the average one-year yield for a treasury bond, but short of the rates it would need to ensure solvency as China's baby boomers reach retirement age. In April, NCSSF chairman Xiang Huaicheng announced that the fund would increase the cap on securities holdings, now at 5% of total assets, to 15% this year.
Under new guidelines expected later this year, insurance companies, social-security funds and newly approved open-ended funds will be allowed to invest directly in Chinese listed companies; they are currently limited to investing in funds. This change could result in a rush of new funds to market, boosting stock prices. The regulators also hope these institutional investors will help lower volatility and the notoriously high turnover on China's bourses.
But simply allowing retirement savings to be invested in domestic securities isn't enough. "If you're the pension fund, you need assets diversified across borders," said Evolution's Richardson.
That much was obvious to the State Council, which in February gave its blessing to the NCSSF's plans to put some US$500 million into Hong Kong stocks. Insurers are expected to follow. "As the amount of money they have under management grows, and with the looming pension crisis, it doesn't make sense not to allow it," said Stephen Green, a China market-watcher who heads the Asia program of the Royal Institute of International Affairs. "China Life would probably be one of the biggest investors in the world."
Premiums in the China insurance industry topped $40 billion in 2003, up 27% on the previous year, and China's insurance companies now boast assets of $126.3 billion dollars, over 90% held in disposable capital, mostly in banks: a mere 6.85% is actually in funds. In 2002, investment yields were only 3.14% – barely over the 3% required just for repayment capability.
Will this mean a loosening of currency restrictions? Probably not. "Each individual investment abroad will still have to be approved," said Kennedy, "and they'll be in safe places." Still, it does set a precedent, and QDII assets abroad will in all likelihood only increase.
Not that QDIIs and their funds are likely to venture far from home: "They'll buy stocks that they're familiar with," said Wu. "That actually makes a lot of sense, since they can pick up stocks in companies that are high in value on the Shanghai or Shenzhen boards, but cheap in Hong Kong."
QFII – now a year old – still represents only a tiny percentage of the total tradable A-share market. To some extent, it has become a vehicle for another form of speculation: "Clients are telling the QFIIs to put their money in treasury bonds and wait for the expected revaluation," said Richardson. And the A-shares they are buying tend to be no-brainers. "There's a limited universe of shares that they're prepared to invest in – probably 30 to 50 companies," observed Richardson. "The majority is only going to invest in the blue chips, and the irony is they can get access to those through the H share market in Hong Kong."
But QFII has had at least some of the effect its proponents envisioned. "The QFIIs have really opened our eyes," said Wu. "It's been enlightening: They have a totally different approach to investing, to choosing stocks. When QFIIs buy into a company it really boosts our confidence in that company and makes us believe in its value."
A Future for Futures
Having been burned with early experiments in futures trading, Beijing's regulatory officials are taking cautious steps to expand futures trading. Cotton futures began trading in Zhengzhou in June, fuel oil is set to begin in Shanghai in August, and soy bean contracts have been trading in Dalian since the beginning of the year.
Given the number of traders who need to be able to hedge against price volatility, more commodities are likely to be approved this year. CSRC has already approved 17 SOEs to trade on overseas futures markets – a nod to the fact that many trading companies already play futures markets abroad through overseas partners and brokerages.
Regulators have been more reticent about financial derivatives. Shanghai has been testing foreign exchange and interest rate derivatives, and the CBRC's relaxation in February of currency derivatives trading rules means that major Chinese financial institutions will be allowed to trade derivatives including futures and options. It remains to be seen whether SAFE and CSRC will follow suit.
Shanghai applied in 2002 for permission to launch stock-index futures, but even were the exchange to be given the green-light, there remains one glaring problem: "There's no one generally accepted index – not one that rises to the top as clearly superior," said Green.
And what of the new indices – the S&P, the Dow Jones 800 and the Xinhua FTSE" "No one in China really looks at the any of them, mainly because they don't have a good feel for what the numbers mean," said Wu. "Everyone is still used to looking at the Shang-Zhen (Shanghai and Shenzhen) index."
In the end, meaningful capital market reforms depend on the health of the banking sector. As the big four state banks prepare to list, dumping bad debt and issuing multi-billion-yuan subordinated debt offerings to plump up their capital adequacy ratios, there's an optimistic view and a pessimistic view.
To the pessimists, banking sector reforms so far "are all basically accounting," as Scott Kennedy asserts. "All they've done is move debt from one column to another. It's still owned by the same entity – the state."
And even as the banks clear their books of existing bad debt, there's the worry that more is piling on. "They're selling off the worst of the debt, and in the near-term the NPL ratio will go down," noted Richardson. "But it takes two years for a loan to go bad, and a lot of money has been loaned in the last two years."
But Wu Zuyao of Galaxy sees the glass half full. "The banks are being encouraged to list not for the money, but because the government wants them to be more market-responsive, self-reliant, and not dependent on government bail-outs," he said. "As listed companies, they'll be far more transparent, with international auditing companies scrutinizing them. There's less chance that they'll go on making bad investments."
Are the dark days of winter behind us at last? "A hundred flowers might not be in bloom just yet," said Frederic Cho, "but we may well be in the very preliminary days of early spring."
In Beijing, that means warmer days ahead – but some nasty dust storms as well.