Global capital markets are becoming an increasing source of funds for Chinese businesses. As part of a broader assessment of the US-China economic relationship, under the direction of US lawmakers, the US-China Economic and Security Review Commission held a hearing in August to weigh the policy implications of the ever-increasing fundraising by Chinese firms in the US and other over-seas capital markets. Excerpts of the opening statement and testimonies at "China and the Global Capital Markets" hearing:
Opening statement of C. Richard D'Amato, head of the US-China Economic and Security Review Commission who prominently opposed CNOOC's Unocal bid:
"The vast majority of Chinese enterprises listed on international capital markets are owned and operated by the Chinese state. Questionable corporate governance, accounting practices, and minority shareholder rights make this a subject of particular concern to the Congress … As Chinese financial institutions prepare for an estimated combined $15 billion in listings, questions need to be raised regarding the loan portfolios of these institutions. I am concerned that U.S. investors may not have sufficient information to make informed decisions about the risk of these investments.
Furthermore, the possible links between listed state-run firms and banks and China's military industrial complex has heretofore lacked comprehensive examination."
"The China story"
Testimony of Michael Geezi, managing director at The Torrenzano Group, a US communications consulting firm, which provides strategic communications counseling to companies based in the PRC:
"Ironically, the biggest challenge and the biggest opportunity for PRC companies generally can be described by the same three words: 'the China story.'
… Western investors are drawn to PRC stocks exactly because they are from China, and therefore possess all the explosive growth characteristics one associates with an economy that is growing at 8% or 9% annually. Conversely, the biggest cautionary advice that one could give a prospective investor in PRC equities is that these stocks possess all the explosive growth characteristics that one associates with a market bubble – and that the stock market's reaction probably is going to hit each end of the spectrum.
The issue isn't how PRC companies are marketing themselves. It is how investors are investing. It goes back to the OECD statement … "Capital is rarely patient." Given the globalization of world markets over the past decade, the issue of whether a PRC stock is listed in the U.S. or in Hong Kong has gotten very close to being irrelevant. The fact is, U.S.-based institutional investors do not limit their investments to shares listed only on U.S. exchanges."
Is the new capital funding Beijing, Inc?
Testimony of Frank J Gaffney Jr, President, The Center for Security Policy: "[China's] aim is, I believe, to displace the United States as the world's preeminent economic power and, if necessary, to defeat us militarily.
I believe that it is neither in the interest of American investors nor of the country as a whole to be underwriting Communist China's state-owned enterprises engaged in such activities as: the manufacture of intercontinental-range ballistic missiles and space-based weapons designed to blind our satellites; the proliferation of weapons of mass destruction. Take, for example, the prospective IPOs of Chinese government-owned banks that are each said to be hoping to raising billions of dollars when listed in Hong Kong and perhaps New York later this year or early next year … These are foreign government-owned entities, not private firms.
Despite such efforts, the PRC seems simply to be dressing-up what were, until recently, insolvent banks in the hope that international capital markets will contribute to bailing them out.
I would suggest that a far more accurate indicator of Chinese intentions to foster a free market economy, one in which American businesses and investors can safely and constructively participate, would be if private sector Chinese companies were coming to the U.S. capital markets. Instead, reportedly some 90% of those being listed in overseas exchanges are state-owned enterprises – despite the fact that, according to some estimates, SOEs only comprise 40-50% of today's Chinese economy.
I am concerned that the PRC's efforts to bring its dubious state-owned enterprises to the world's capital markets is not evidence of a Communist Chinese commitment to free trade. Rather, it is a reflection of Beijing's refinement of the quote attributed to Lenin: They want the capitalists to buy the rope with which China ultimately will hang them.
Testimony of Robert G. DeLaMater, securities lawyer and partner, Sullivan & Cromwell LLP:
"It is … noteworthy that in recent years those Chinese companies that have listed in the United States have principally been smaller, technology-oriented companies seeking to list on Nasdaq. There have been over 15 of these IPOs since 2002 … Far from being methods for funding the Chinese government, these offerings are rewarding the entrepreneurs who built the company and the early investors, often U.S. investors, who financed them.
In contrast, since 2002 only a handful of Chinese state-owned enterprises have sought U.S. listings and SEC-registered IPOs. The initial public offerings and NYSE listings by China Netcom in 2004 and China Life in 2003 echoed the Chinese privatizations that commonly were listed on the New York Stock Exchange through 2002. The other large initial public offerings by state-owned enterprises that have been completed in recent years have listed only in Hong Kong or London and have gained access to U.S. investors by means of a private placement to institutional investors, including growing numbers of hedge funds and private equity funds, pursuant to Rule 144A.
Always assuming that our regulations meet the threshold requirement to provide appropriate levels of investor protection, we would not be serving the interests of the millions of Americans who depend upon the investment performance of their pension managers, insurance companies, mutual funds and financial advisors if we lead Chinese and other foreign companies to avoid U.S. capital markets in favor of listings in London, Japanese retail offerings or other offerings in Europe and the international markets."
Will China succeed in reforming its financial markets?
Testimony of Marshall W. Meyer, Professor, Wharton Business School, University of Pennsylvania:
"Reforming the Chinese banks may prove more difficult because China, though politically centralized, has been economically decentralized since the beginning of the reform era. Chinese firms are overwhelmingly local and small by global standards. Large centralized firms, save for state quasi-monopolies in the electricity, petrochemical, and telecom sectors, are unusual. Perhaps of greater concern [is] a gap between the rhetoric and the reality of corporate governance in China opened last year.
Despite these problems, the lure for foreign investors is powerful. The size and, more importantly, growth potential of the Chinese market is unmatched elsewhere in the world: where else can 1.3 billion potential customers and 8-10 per cent annual growth be found? There is also a substantial advantage afforded foreign banks investing in the big four and national commercial banks: instant access to markets throughout China. Foreign banks investing in the smaller city banks gain access only to local markets; foreign banks seeking to open de novo branches in China must negotiate tedious licensing procedures city by city and province by province. Still, WTO poses huge risks for Chinese banks with or without foreign investors. Their liquidity could be threatened by relaxation of currency controls and a rapid outflow of deposits from China. Their best and potentially most profitable customers, customers for fee-based services, could be lost to foreign competitors.
There is also an important mitigating factor. China has no choice but to reform its banks. The alternative is nearly unimaginable. The reform of state-owned enterprises has been more rapid and more successful than most people predicted. It is possible that pragmatism will overcome inertia and that the banks will repeat the performance of the SOEs."
Testimony of Donald Straszheim, CEO of China-focused financial markets research firm Straszheim Global Advisors, LLC and former chief economist for Merrill Lynch:
"There is a solid consensus view that the financial system is China's weakest link. If destabilizing economic trouble erupts in the next decade, it likely will start in the financial sector … the only way to describe the state of finance in China is both primitive and weak.
China's two domestic equity markets, Shanghai and Shenzhen, are simply not equity markets in the conventional sense. China's debt markets are even less developed. China's "big-4 commercial banks" are not banks in the American sense of the word. They are lending arms of the government. They serve the lending function for the other SOEs in China quite adequately, but do not allocate capital as a scarce resource to the best returning alternative in any meaningful market-tested sense. This is an ultimately fatal flaw … The banks don't really support the best projects and starve the worst ones. Record keeping remains hamstrung by lack of technology.
In the long run, we see the big-4 banks as dinosaurs bound for either extinction or a role limited to some kind of development role for the government. The investments being made in the big-4 banks by western banks are unlikely to provide any real returns. Likely they are being made in order to establish relations rather than on any expectation of a real return. The future of banking in China is more likely with the smaller municipal banks in China which are also government-owned, but which do not have the baggage of the big 4."
Testimony of Pieter Bottelier, Professor, Johns Hopkins University:
"Though still weak, the major state-owned commercial banks (SOCBs) and the banking system as a whole are in better shape now than only a few years ago. Prospects for further improvement appear good … China's state banks have been gradually shedding their de-facto status as fiscal agents of the state for many years and are slowly becoming real banks, responsible for their own bottom line. It is my impression that subsidized interest rates for favored customers have become rare and that commercial risk management by the four large state-owned commercial banks (controlling about 53% of total bank assets and over 60% of deposits) is rapidly improving.
Reform progress is uneven across the spectrum of banks and continues to be marred from time to time by policy contradictions and corruption scandals. In spite of the scandals, there are many indications that risk management and corporate governance standards for state banks in general are improving."
Chinese international IPOs here to stay
Testimony by Howard Chao head of the Asia Practice of the international law firm O'Melveny & Myers LLP "China IPOs are attracting very large volumes of capital and at an accelerating pace. In 2003, new Chinese international stock issuances attracted approximately $8 billion. Last year the figure was in the vicinity of $13 – $14 billion. This year Chinese IPOs have already reached more than $8 billion and upwards of $17 billion is expected by the end of the year according to some estimates. The Boston Consulting Group reported that China accounted for 14% of the global IPO market for 2003 and 10% in 2004.
Not only has the number of deals increased, but the average size of China IPOs is up considerably. Less then a decade ago, China's international IPOs were relatively small in dollar value terms and there were far fewer listings in the international market outside of Hong Kong. Since the late 1990s, however, an increasing number of Chinese issuers have launched IPOs on a range of international markets and raised proceeds in excess of $1 billion in some cases, ranking among the largest in the world.
The pace of Chinese companies going public is only likely to increase going forward. It appears that the flow of SOE IPOs will likely continue in waves as new sectors are privatized. The next wave of sectors appears to be financial services, energy, industrial (especially automotive), and possibly media.
The pipeline of Chinese companies planning to access international capital markets may be the largest that it has ever been. Given the numbers of Chinese companies projected to come to market, it appears likely that within a few years, Chinese companies will constitute a significant and increasing portion of the market capitalization of international capital markets. Trading volumes in Chinese company securities will be significant. Revenues generated by Chinese companies for international financial services firms will become increasingly important and stock exchanges that capture this business may significantly benefit as well.
A trend has emerged where many non-technology Chinese companies are avoiding listing in the United States and are instead listing elsewhere. Although the U.S. market (especially NASDAQ) continues to draw Chinese technology companies because of the favorable valuations and analyst research coverage it offers for that sector in particular, this year there have been no SOE or other Chinese non-technology registered offerings in the United States.
What is behind this redirection of these mega-sized China deals away from U.S. exchanges? One concern that Chinese issuers have voiced when contemplating a U.S. listing is regarding the Sarbanes-Oxley Act of 2002, or SOX. In particular, SOX Section 302, which requires that CEOs and CFOs certify their company's annual and quarterly reports, and SOX Section 404, which relates to internal controls, are often mentioned as reasons to avoid the U.S. market. Direct costs associated with Sections 302, 404 and other Sections of SOX … have … shifted the cost-benefit balance in favor of listing outside the United States."
Testimony of Donald Straszheim, CEO of China-focused financial markets research firm Straszheim Global Advisors, LLC and former chief economist for Merrill Lynch:
"There are 23 high-tech companies from China that have done IPOs on NASDAQ since 2000. These are young companies with young managements, largely educated in the West. Some will succeed and some will fail – with good and bad plans, technology, management and execution. These companies represent the heart of China's most promising young companies. These firms choose to list on NASDAQ instead of on the domestic Chinese exchanges because they are well aware of the shortcomings of the domestic markets.
We can't imagine a quality young Chinese company listing domestically under anything that remotely resembles the current environment. To use a baseball analogy, why play in the minor leagues (Shanghai, Shenzhen) when you can play in the majors (NASDAQ, NYSE)?"
Not what it seems
Testimony of Solomon Tadesse, professor, Moore School of Business, University of South Carolina:
"While Chinese firms are getting increasingly visible in international capital markets, at this point, the role of external capital-raising (including from Chinese domestic markets) in the Chinese economy is negligible.
In China, investments of non-financial enterprises are financed through four main sources: (i) self-fundraising including retained earnings, (ii) government capital transfer to State Owned Enterprises, (iii) bank loans channeled from the household sectors, and (iv) foreign direct investment. The predominant source of funding investment in the non-financial enterprise sector, as is common in other countries is internal funds.
While what a nation's banking system does is, to a large extent, an internal affair, given China's increasing economic integration with the global economy, the institutional arrangement of the banking sector and the manner it channels funds from the household to enterprise sectors has significant implications, some harmful, to other countries … The state is providing subsidized financing through its state-owned or directed financial institutions to its state-owned companies (in effect, agencies of the government), providing unfair cost advantage that can be utilized, for example, as is happening recently, to acquire strategic assets around the world … Financial repression provides the basis for the government's power and unparalleled influence … As a result, the state has no incentive for financial development. It is better off with financial repression rather than without it. Hence, it is naive to presume that governments will reform their financial sectors by their own."
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