Capital Markets in China

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China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. I’ve thus tried to educate myself about the Chinese economy, and earlier posted a summary of an excellent article on corporate governance in China by Professors Fuxiu Jiang and Kenneth Kim. This has turned out to be one of my most-viewed posts, so in this post I provide an introduction to the capital markets in China. It’s taken from another paper by Fuxiu and Kenneth, also with Zhan Jiang. I summarize the article in bullet-point format below. All of these points I learned from the original article, so please cite it (not me) if you use anything from it (Jiang, Fuxiu, Zhan Jiang and Kenneth A. Kim (2018): “Capital Markets, Financial Institutions, and Corporate Finance in China.” Journal of Corporate Finance, forthcoming.)

This post covers only the “capital markets” and “financial institutions” parts of that paper. In a future post I will cover “corporate finance”.

Stock Markets

  • Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) started trading on 12/19/90 and 7/3/91, respectively
    • Common features:
      • Two trading sessions (9:30-11:30am, 1-3pm)
      • Completely order-driven – no specialists or market makers
      • 10% limit on daily price change
      • Allow short-selling and margin trading since March 2010
    • SZSE has:
      • Main board
      • Board for SMEs (5/7/04)
      • Board for fast-growing firms called Growth Enterprise Market / GEM / ChiNext Market (10/30/09)
    • SSE has only a main board
    • In July 2019 (after the paper was published), the SSE launched the Star Market, for tech firms similar to Nasdaq in the US
  • Over-the-counter trading on National Equities Exchange and Quotations (NEEQ) from September 2012
  • Two share classes
    • A-shares are regular domestic shares
    • B-shares are in USD or HKD. Same cash flow rights as A-shares but initially restricted to foreign investors. Less than 0.5% of total market cap
    • Since 2001, local Chinese can own B-shares
    • Since 2003, qualified foreign institutional investors (QFIIs) can own A-shares
  • Government often interferes in Chinese stock markets
    • China Securities Regulatory Commission (CSRC) has restricted firms’ ability to conduct SEOs and IPOs, for long periods of time
    • At present, firms can only issue an SEO if they’ve paid dividends for three consecutive years and have an ROE of at least 6%
    • Number of IPOs and SEOs fluctuate wildly year to year, and are generally low, both due to government intervention
  • Most non controlling shareholders (both individuals and institutions) are short-term speculative investors
    • Mutual funds have an average turnover rate of above 200% (they turn over their shares at least twice per year)
    • Average turnover on main exchanges was over 500% in 2015
  • High P/E ratios (48 in SSE in 2015) due to
    • CSRC restricting IPOs and SEOs, limiting supply of shares
    • Short-term speculation
  • Little market for corporate control
    • Initially, most shares were nontradable shares, held by the state, so hard for outsiders to take control
    • April 2005 split-share reform transformed all nontradable shares to tradable shares, but still hard for outsiders to get control
      • State or families own large stakes
      • Regulatory hurdles to changes of control
  • Stock markets aren’t the primary venue for raising new capital. Bank loans are a much bigger source of capital
    • Many Chinese firms list abroad (1,003 in HK, 158 in US as of mid-2017), perhaps because raising equity capital in China is difficult

Bond Markets

  • Three types of bond, identified by regulatory agency and investor types rather than maturity:
    • Corporate Bonds: > 1 year maturity, traded on stock exchanges, regulated by CSRC
    • Enterprise Bonds: > 1 year maturity, traded on stock exchanges and interbank bond market (commercial banks, credit unions, financial firms), regulated by National Development and Reform Committee (NDRC)
    • Midterm Notes: > 1 year maturity, traded on internbank market, regulated by Central Bank of China
  • Bond market has exploded: > 1,000 times between 2000 and 2015, 27% from 2014 to 2015
    • But still < 20% of new external financing is from bonds. Bank loans dominate, which are more short-term
  • Reasons for slow development of bond market:
    • Government largely determines interest rates. Yield curves aren’t market determined and so may not accurately reflect risk
    • Credit ratings aren’t well established; SOE may get a good credit rating despite not being creditworthy
    • Three different types of bonds, with different regulatory agencies and investors, complicates the decision to issue bonds
    • Powerful Chinese banks impede bond market development

Financial Institutions

  • Prior to mid-1980s, banking sector very concentrated. Only the central bank and four state-owned commercial banks known as the Big Four: Bank of China, China Construction Bank, Agriculture Bank of China, Industrial and Commercial Bank of China
  • Now, banking industry is much more competitive
    • Large commercial banks: not just Big Four but also Bank of Communications
    • New national commercial banks, e.g. China Merchants Bank, CITIC Bank
    • Urban commercial banks: city banks such as Bank of Nanjing / Changsha / Chongqing
  • Nonbank financial institutions have also grown, e.g. mutual funds. 3 open-ended funds in 2001, 2,559 in 2015
  • Despite more financial institutions (banks and mutual funds), they don’t play a governance role
    • Mutual funds, insurance funds, QFIIs each own < 5% of shares outstanding; largest shareholder (state or family) owns 25%
    • Some are speculative short-term investors
  • VC/PE has grown dramatically and are very important, especially for GEM