Healthy alternatives

As the collapse of Wall Street filtered through global markets last fall, regulators rushed to restrict short selling, fearing it would result in prices atrophying still further. The mood in Beijing was more relaxed. A-shares had long since fallen from their heights and seemed, for a time, to have settled. The China Securities Regulatory Commission (CSRC) announced that, contrary to the prevailing global trend, it would approve short selling and margin lending.

It was a PR coup, but less than a month after the initial fanfare, reports emerged that the move would be put on hold. The exact state of the launch of short-selling and margin trading now remains something of a mystery.

"Recent comments by CSRC officials suggest that a trial launch of margin trading and short selling may be delayed, [but] China’s securities regulator is expected to eventually proceed," said Jing Ulrich, chairman of China equities at J.P. Morgan.

How and when it will proceed is a more complicated question. The CSRC must strike a balance between resistance to change and the fact that the development of diverse investment options is crucial to the continued health and utility of China’s securities market.

Innovation required

Although the derivaties products in question have been pilloried for their role in the global financial crisis, many market watchers believe the rot begins with lax regulation. China stands out in this respect because, if anything, it errs toward over-regulation, said Frank M. Song, director of the Research Institute of China Finance at the University of Hong Kong

"More financial innovation at this stage is helpful for China," Song said. "I don’t think those things should be prohibited just because the US had a problem."

Unfortunately, while innovation may be laudable in theory, the declining health of the domestic economy has given the  regulators pause. China’s retail investors, who comprise the majority of market participants, have proven susceptible to short-term sentiment fluctuations. There is a risk of speculative selling if short selling is launched at a time when the economy could still weaken.

"The atmosphere of profitable speculation is too strong in our market … [These products] will be harmful," said Yin Zhongli, a professor at the Institute of Finance & Banking at the Chinese Academy of Social Sciences.

What is more likely, say some observers, is for Beijing to focus on stabilizing A-shares while promoting the development of more markets. The corporate bond market is a likely candidate. 

Falling under the jurisdiction of at least three government bodies, China’s corporate bond market is fragmented and fraught with onerous regulatory processes. Furthermore, the credit rating agencies within the market lack credibility, according to Dr Chen Chung-Hsing, the head of Xinhua Finance Ratings.

The need for a vibrant corporate debt market is underscored by very real problems facing the corporate sector. Unable to raise money through the equity market, and with banking facilities restrained by a global credit crunch, bonds provide a much-needed financing window.

"You want to make sure that major corporations [will] be able to issue debt so that they will not be crowding out small and medium-sized enterprises in the banking market," said Chen.

Escaping their bind?

The regulators have yet to streamline their approach but they are taking steps on an individual basis to simplify and improve access to the market. In January, the banking regulator said it would allow foreign banks to underwrite and trade corporate bonds on China’s inter-bank market, while the central bank plans to let companies issue bonds beneath the minimum threshold of US$73 million.

A source close to the regulators said the moves reflect a changing attitude behind the scenes. Where before corporate bonds were seen as exclusive products for major state-owned firms – with banks offering implicit guarantees that debts would be honored – now regulators are hoping that relaxed requirements will help the market to reach its full potential by improving pricing efficiency.

For now, enthusiasm for opening up corporate bonds seems unlikely to spill into the stock market. That is true even for index futures, which Kang Huanjun, then-vice director of the CSRC, said were "absolutely necessary," during a speech he gave in 2000. Index futures are still expected eventually, but there are few signs of any sense of urgency.

That is frustrating for many investors and for China’s brokerages, which are looking to new products as a means of shoring up business during a market downturn. Despite hopes for a more laissez-fair approach, caution and government direction look to remain the norm.

"China’s leadership will continue to pick and choose the systems which best fit the country’s unique development goals," said J.P. Morgan’s Ulrich.