China's stock market entered 2001 in dramatic fashion. In February, the China Securities Regulatory Commission (CSRC) appointed a senior Hong Kong securities regulator to help combat market abuses. Ms. Laura Cha, deputy chairman and. executive director of the Hong Kong Securities and Futures Commission, will serve a two-year term as vice-chairman of the CSRC starting in March.
Shortly afterwards, the regulator announced a new policy of opening up B-shares to domestic investors, signalling an acceleration of market reforms. B-shares ceased trading for a week after the announcement, while A-shares moved sharply upwards on improved sentiment.
Earlier in the year, the CSRC lost its first-ever court case and promptly lodged an appeal. At the same time, officials launched an investigation into price manipulation and accounts falsification by two listed companies and reiterated their determination to scrutinise all ?abnormal' market behaviour. Through the media, the watchdog issued a stern warning that senior officials of securities firms would be summoned if they were suspected of any violations of rules.
These clampdown measures resulted in a sharp fall in all the four stock indices in mid-January, less than a week before market closed for the Spring Festival holidays. It was quite unusual for the CSRC to set the scene for the New Year by enforcing the rule of law rather than trying to talk up the market. In the past, officials have been eager to give up-beat interviews or even publish lead articles in national newspapers in an attempt to improve market sentiment prior to the Chinese New Year.
"The Securities Law has undoubtedly given them new strength," said Mr. Ju Xinxing, company secretary of a local listed company, Shanghai International Travel. He has worked closely with regulatory officials in recent years. The other equally important factor, he believes, is the appointment of a new chairman, Zhou Xiaochuan. "Unlike his predecessors, he's very much against administrative interference and publicly advocates his role of maintaining market order through cracking down on illegal behaviour."
Ju believes that the recent court case was "extremely significant" in ensuring that the concept of the rule of law prevails in all market activities and that the CSRC is not above the law. The case involved Kaili Co, a road construction company in Hainan province that applied to the CSRC in June 1998 for a public offering of its shares to domestic investors. The Hainan Securities Regulatory Office initially cleared the application.
According to a story published in China Youth Daily last October, officials from the CSRC flew to Hainan to verify the application only to conclude that 97 percent of Kaili's claimed profits were false. Consequently, the CSRC rejected the company's application even before it was submitted.
Kaili filed a lawsuit, which went before the Beijing First Intermediate People's Court on October 19. The company won, the court's verdict being that the CSRC had breached the law in rejecting the application documents submitted by the plaintiff. It ordered the CSRC to resume its examination regarding the issuance of A-shares in Kaili and announced a decision either to approve or reject the plaintiff's application within two months of the date the verdict went into effect. On January 4, the CSRC announced that it had filed an appeal.
Challenge to the regulator's role
Further hearings will put under detailed scrutiny the whole examination and approval procedures for listing set out by the regulatory body. In essence, the CSRC's control of access to the capital markets and ultimately its role in the marketplace is being challenged for the first time.
A quota system was initially set up to allow orderly entry into the markets. Quotas were allocated to local governments which had the power to nominate candidates. In practice, some favoured companies in a region were put forward without sufficient thought over their future viability, while others with better track records were ignored.
Since the start of the Asian financial crisis in 1997, the quota system has effectively been rendered redundant. The markets have little appetite for an influx of mediocre companies; some 200 listing quotas are still waiting to be used.
Over the years, the regulator has also managed a system of controlling the supply of initial public offerings (IPOs) in the primary market in response to the observed demand in the secondary market. If the secondary market is quiet, implying a lack of demand, the supply of companies is held back. Such a practice has created a market expectation that issue prices should be sufficiently low to ensure a successful launch. Consequently, IPOs have been consistently under priced over the past three years. Issue prices, on average, have doubled on the closing of the first trading day.
In a New Year interview, the CSRC's chairman Mr. Zhou Xiaochuan pledged to reduce administrative interference. The quota system would be completely abolished by the end of March, he said. "Administrative controls of pricing in the primary market will be loosened and eventually share prices will be determined by the supply and demand in the market," he was quoted as saying.
Mr. Anthony Neoh, chief adviser to the watchdog, calls for a more radical approach. "The regulator should consider whether it is now time to adopt the role of purely looking for legal and disclosure compliance in a public offering," he wrote in a recent article. The CSRC's role of `ensuring compliance' is implicit under Article 28 of the Securities Law, which came into effect on July 1, 1999.
"The timing at which a company should go to market should be dictated by the issuer and its underwriter, with any bunching problems to be dealt with by the exchanges and the choice of exchange for listing to be left to the issuer and the underwriter," he argues.
As for issue prices, Neoh says the Securities Law clearly leaves the matter to be decided by the issuer and the underwriter, subject only to regulatory approval. He believes that the – regulator should intervene only in extreme instances – for example, in cases of under pricing or overpricing without adequate explanation so as to suggest irresponsibility on the part of the underwriter.
Although Zhou recognises that economic factors are beyond the CSRC's regulatory reach, he appears convinced that the market mechanism has yet to function properly.
China's markets are dominated by some 50m individual investors, most with limited means and often with little understanding of risk. Institutional investors such as investment funds have begun to operate, but there are only 23 at the moment. Foreign fund managers are unable to enter the domestic markets due to the inconvertibility of the local currency.
In August 1999, life insurance companies were allowed for the first time to allocate up to 15 percent of their assets portfolio for investment in the stock market. State-owned enterprises were also permitted to enter the stock market if they bought without leverage and held the shares for at least six months.
Zhou hopes that large funds such as the social security fund, private pension funds and open-end investment funds will eventually become the mainstay of the market. For years, there have also been discussions over joint venture mutual funds so that foreign fund managers can bring in their expertise as well as capital.
But for the market to develop this way would largely depend on economic and political decisions beyond the remit of the regulator. The CSRC alone does not have the power to ensure that the market matures as it would like. For example, an eventual merger of A and B-shares would depend on the convertibility of the Chinese currency and other external factors.
Many analysts believe that the concept of rule of law will need time to take root. How-ever, Ju of the listed travel agency believes that the markets could attain maturity in a relatively short time: "Things can happen very fast in China. That's the power of administrative orders."
The rigorous clean-up of the markets by the CSRC and its determination to fight its corner in the courts are at least a start. In the meantime, we are likely to see further crack-downs by the CSRC and many more companies taking the regulator to court.
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