Despite the June IPO by the Bank of Communications, China's banking sector is still plagued by non-performing debt, inefficiency and the occasional scandal. Meanwhile, China's stock markets have recently tested eight-year lows and Xinhua Finance Far East China Credit Ratings has issued a report on the dismal state of the brokerage industry, in which 50 "reasonably healthy" domestic brokerages reported a collective net loss of US$562m in 2004. Ivan Chung, managing director of Credit Ratings at Xinhua Finance, is of the view that in the absence of adequate recapitalization and reform, the problems in the brokerage industry could wreak havoc on China's capital markets and banking reforms. In a conversation with the China Economic Review, Chung sized up the Mainland's financial markets. Excerpts:
Q: What do you think are the main problems in China's securities industry?
A: I think the business model is a bit problematic because [the brokerages] can only make money when the market keeps going because the majority of their income is brokers' trading fees. And secondly, they are trying to do proprietary trading, betting their own money on the equity market. And China, there's no hedging instrument like futures, so when the market goes down – or even when it is good – they have no way hedge their risk. So it is not a sustainable business model.
Q: What is the business model in other countries?
A: In other countries, most brokerage houses are actually investment banks… most of their income comes from fee-based services like advisory and underwriting services. Relatively, this is more stable, and allows them to diversify their income sources. However in China, there had been limited opportunities. Also, when you talk about doing advisory underwriting, you need a lot expertise, for example in valuation, legal, accounting. And most brokerages in China do not have those kinds of skills. This is a historical problem because in the past it was so popular to become a brokerage and so easy to get a brokerage license. They think it is just a vehicle for them to invest in the equity market. That was fine five or six years ago when the market was so good, everybody was lining up to buy shares.
Q: What progress is there on the development of the futures market?
A: There have been some rumors in the market that the government will open it up. I think there are two schools of thought: one sees a futures market as a tool to hedge risk; in order for the market to further develop, you need this. But the other school of thought says that at this stage, the Chinese market is still not perfectly regulated. So it may enable people to speculate more instead of diversifying their risk, and thus intensify the problem in the equity market.
Q: So, what is the answer?
A: I think the government still has to make up its mind on this in order to build a well-functioning capital market, particularly when China opens up further its financial services market in 2007, as it committed to in the WTO accord. On the other hand, the recent abuse of derivatives by Singapore-listed China Aviation Oil reveals the risks of launching futures in the Chinese market. This is a classic case of a Chinese company being overexposed to the derivatives market without proper risk management and control. It's a big question mark whether a general Chinese company can execute adequate risk management and internal control alongside the use of derivatives. Even if the brokerages are allowed to use hedging tools like futures, it's unclear if they will be able to use them properly or whether they won't overexpose themselves. They may just use these tools to leverage their speculations.
Q: What is the status of China's developing bond market?
A: I think there's been a breakthrough this year. Early this year, [China's central bank] issued some new rules for bonds trading in the inter-bank market. Before that, the Chinese bond market was a bit complicated in terms of regulatory structure, [as] there are several regulators. Effectively, they are making it very difficult for corporations to use bonds. Many institutional investors like insurance companies are very interested in investing in bonds instead of equities. And also many private enterprises want to use bonds to raise funds because it's getting increasingly difficult to get money from the banks. However, the existing rules make it very difficult and I can give you an example. In the past couple of years, there have been only 10-15 corporate bonds issued every year. Most of the bonds in the market are treasury bonds or financial bonds issued by government-linked organizations like China Development Bank. But there are only a few corporate bonds. And earlier this year PBOC liberalized lots of arrangements for bond issuance and trading in China's inter-bank market.
Q: For example?
A: Arrangements for bond issuance – for example, the interest rate, the type of bond, pricing – have been liberalized. This is the first time that private enterprise can also use bonds as a funding option because they don't restrict the use of bond types for certain enterprises. Along with other deregulation, this makes it possible for private enterprise to use bonds very easily. Starting from June 1, deregulation has taken effect for the commercial paper market as well, for bond maturity less than 365 days. In the past, bonds upon issuance had to be subject to interest rate control; they cannot offer higher or lower than the government-assigned interest rate. But now in the commercial paper market, they can offer the market interest rate. So, effectively, you will create a market. Actually, in the first three weeks of June, the issuance of commercial paper – literally called short-term financing note in Chinese – has already reached RMB15bn.
Q: Are the new currency pairs trading in China's foreign exchange market a precursor to China using a basket approach to revaluing the yuan?
A: I think it is a necessary condition for China to link the currency to a variety of currencies. If there's no trading platform for that, how can they link to all these currencies? Now, if they link to a basket currency, first they will need to readjust the basket, then they need to trade them. Second, when they introduce further reforms like establishing a trading band instead of a fixed-exchange rate, they have to intervene in the market when necessary. Thus, they need a trading platform. And if they don't have a trading platform in China, it means they have to do the intervention overseas – then there will be lots of uncertainty for the Chinese government, and it will lead to ineffectiveness.
Q: Let's talk about banking reform. Do you think the banks will be ready for foreign competition before 2007 begins?
A: They will still be quite vulnerable to direct foreign competition if you open the market. I don't think they're strong enough to compete head-to-head with the foreign players even after 2008, assuming that they get the IPOs in this year and next year. In terms of structure, there are still lots of problems and IPO is only one of the big steps in the reform of the banking system. But, if they change the shareholding structure, it will speed up the reform process. Without such change, it is hard for the bank management to pursue any substantial changes because the shareholders, [the] government, are generally very conservative and they may have different views on aggressive changes. But, if they have the foreign shareholders, it will be easier for management to overhaul projects to gain support from shareholders. And yet, owing to different cultural background and management styles, it will still be a long process for domestic and foreign shareholders to reach consensus on management reforms. This means that it will take years or even decades to transform the big four state banks into commercially competitive banks.
So I guess in the banking industry, the government will open limited shareholding to foreign players in the large state banks as a way to get the expertise to help overhaul these banks – at the same time, to open certain niches to foreign players but not open them totally to foreign players. Otherwise it will put overwhelming competitive pressure on the state banks that have yet to fully overhaul. For instance, in the retail banking business, they won't allow a foreign player to open branches all over China. What they want is to get some foreign involvement, like strategic investment in a bank, to help them work together.