Pieter Bottelier, Johns Hopkins University, SAIS
China’s Domestic Capital Markets and Interaction with International Capital Markets[1].
U.S.-China Commission - Hearing on 16 April 2004.
The setting.
1. China’s financial system is a “work in progress”. Perhaps the greatest challenge is the integration of China’s system with that of the developed nations, including the US. If this process is not well managed, e.g. if domestic financial markets in China or international capital transactions are liberalized prematurely, major problems could develop. A financial crisis in China would have significant negative side effects on the US economy and put the completion of China’s market reforms under WTO principles at risk.
2. Financial sector reform in China has become a top priority of the Government in recent years, particularly in light of commitments that were made upon China’s accession to the WTO, December 2001. Sectoral policy changes and institutional developments, including new legislation and regulations, are unfolding at a fast pace. It is very difficult for any outside observer to be fully informed on all current developments.
Brief history of banking reform and key facts on China’s external and internal debt, including NPLs.
Ø China had a mono bank system until 1984.
Ø In 1984 the responsibility for SOE financing was shifted from the budget to four newly created state-owned commercial banks (lifted out of the Central Bank), which served essentially as de-facto fiscal agents of the State until the early or mid-1990s.
Ø By allowing the State sector to continue expanding output and employment through easy access to State bank credit (until about 1995), China preserved full urban employment and growth dynamics throughout the initial stages of its economic transformation, but in doing so, also created the NPL problem.
Ø Because of this unique sequencing of reforms, the modernization of China’s financial sector lagged significantly behind reforms in the real economy.
Ø The seriousness of the NPL problem was not fully recognized by China’s leadership until the Asian financial crisis of 1997/8.
Ø China began to take serious measures to address the problem in 1998/9, including a limited initial recapitalization ($32 bn in ’98), the creation of 4 AMCs in ’98 and the transfer of $169 bn worth of “old” (pre-1996) NPLs to the AMCs in ’99.
Ø Even today, China’s State banks are still struggling to become real banks.
Ø Banking reform is now a top priority of the Government in light of the far reaching commitments that China made as part of its WTO entry conditions and the pressure of time. The time table for final reforms is extremely tight: China’s banking sector will be fully open to foreign competition from January 2007.
Ø The Government is now racing to get its two best performing commercial banks (CCB and BOC) fully recapitalized and ready for listing (partial privatization), probably in 2004 and 2005. The other two big state commercial banks (ICBC and ABC) are tentatively scheduled for full recapitalization and listing in 2006 and 2007. The Government will probably retain majority ownership, at least initially, in all four of these banks and try to sell part of the shares internationally.
Ø A major struggle has ensued over how to share the NPL burden between the owner of the banks (Central Government) and other creditors, local Governments, the debtors themselves (SOEs), and the Central Bank (which allocated $45 bn from official reserves to CCB and BOC on 12/31/03).
Ø Although the officially reported NPL ratio of the four big state commercial banks has come down significantly in recent years (to 15.2% at the end of 2003), the absolute amount of NPLs remaining on the books of State banks is still very large (about $200 billion). To this should be added the NPLs remaining on the books of AMCs and the likelihood that a wave of new NPLs will emerge as a result of the extremely high rate of credit expansion since the beginning of 2003.
Ø Only a small portion of China’s NPLs has been sold to international buyers. The bulk is being recycled domestically (through discount sales, debt/equity swaps, debt rescheduling and debt write offs). If China could sell more NPLs abroad, it would.
Ø The first international Huarong NPL auction (2001) was a qualified success. The average cash return rate was 21%. The auction also led to the establishment of two China/foreign JVs to engage in NPL resolution (Huarong/Goldman Sachs and Huarong/Morgan Stanley DW).
Ø The second international Huarong NPL auction (December 2003) was a flop. Sixteen of the 25 bidders walked out; 5 of the 22 NPL lots received no bids at all and the cash return on 3 acceptable bids was only about 10%. This will make it much harder for China to market NPLs internationally in future.
Ø China’s official domestic State debt is rapidly growing, but still relatively modest in size – about 17% GDP. However, total contingent and non-official State debt (including NPLs) is much larger, perhaps 100% of GDP or more.
Ø China’s external debt is well managed and relatively modest in size ($193.6 bn at the end of 2003, or about 15% of GDP). It has a sound maturity structure and the debt service ratio is low (about10% and declining).
Ø Unauthorized external borrowing by State agencies was substantially brought under control when the Government allowed GITIC to go bankrupt in 1998, signaling to foreign creditors and domestic agencies of the State that foreign loans are not automatically guaranteed by the Central Government. Many TICs have since been closed.
Ø In spite of the financial weakness of China’s State banks, the banking system is essentially stable, because of the banks’ high liquidity ratio and the implicit State guarantee for household deposits, which are the banks’ main financial resource.
State bank lending to domestic private borrowers; inward and outward FDI.
Ø Domestic private companies had little or no access to China’s State banks for investment credit or working capital, until recently. They were mostly dependent on own capital, “back-alley banking” and FDI.
Ø The record levels of FDI that entered China since the early 1990s (the accumulated total is now over $500 billion) point to China’s attractiveness for foreign investors, but also to the problems in domestic financial intermediation.
Ø If domestic non-State enterprises had had full access to domestic credit and equity capital, the levels of FDI flowing into China would have been considerably lower.
Ø The domestic financial intermediation problems were partly due to “cultural” factors - the private sector wasn’t trusted in China – and partly to institutional factors - State banks had, until very recently, no incentives to lend to private entrepreneurs, because of high transaction costs and State interest rate controls. Moreover, private companies often did not have acceptable collateral for bank loans.
Ø These problems are only gradually being resolved. In recent years, State bank lending for mortgages, including private mortgages and consumer loans, has grown faster than traditional lending to SOEs. The Constitutional amendment of March 2004 recognizing private property rights as equal to State property rights, has in principle solved the collateral problem.
Ø Greater State bank freedom in setting interest rates – the margins were widened on January 1, 2004 - will probably lead to a significant expansion of State bank lending to domestic private companies.
Ø In recent years China has become more active as an investor on other countries. Chinese enterprises have invested in the US, Australia, New Zealand, Peru, Brazil, Kazakhstan, and other countries (in the Middle East, Africa and Europe). Among developing countries, China is currently the largest source of outward FDI ($3-4 billion p.a. in recent years).
Brief overview of domestic capital market development.
A. Bond markets.
Ø The Central Government began to borrow domestically for fiscal purposes in 1980, but domestic bond trading did not develop until the mid-1980s. Initially Government (MOF) bonds were force placed, essentially as a form of taxation, and not tradable.
Ø In the late 1980s the Government was embarrassed by defaults on bonds issued by several State agencies and corporations. The Government made good on many of them, but clamped down severely on new non-MOF bond issues.
Ø The only State bank that was allowed to issue significant amount of bonds (almost half as much as MOF) is CDB, which also placed $500 mn worth of dollar denominated bonds on the domestic market in September 2003. This may be the start of a domestic China dollar market.
Ø Corporate bond issues fell sharply in the early 1990s, but started rising again in recent years. However, the corporate bond market remains small and issue rights are essentially restricted to large State-owned corporations (such as e.g. the 3G Corporation).
Ø All local Governments in China are supposed to balance their budgets; they do not have the right to issue bonds or borrow from banks, except for temporary cash flow management. Many local Governments nonetheless borrow, either informally, or indirectly through companies they own.
Ø China’s local Governments are believed to be much more highly indebted than official sources indicate; almost all their debt is domestic.
Ø MOF bond issues climbed very steeply after 1997 as part of a fiscal stimulus plan designed to prevent sharp economic contraction in the wake of the Asian financial crisis.
Ø There have been relatively few international Chinese Government bond issues. Such bonds are all highly rated by US rating agencies and sought after by institutional investors and portfolio managers.
Ø Domestic Chinese Government- and corporate bonds are traded on the two stock exchanges (mainly Shanghai), over-the-counter and, most importantly, in the interbank market.
Ø For the purpose of “sterilizing” part of the additional money supply resulting from unwanted “hot” money inflows since early 2003, the Central Bank has issued large amounts of short maturity bills that also trade on the interbank market.
Ø China’s domestic bond markets have been growing very rapidly in recent years, but compared to the financial markets of more developed nations such as the US, they are still quite small, relatively illiquid and otherwise underdeveloped. Yield curves are unusually flat due to state interest rate controls.
Ø The emergence of large domestic institutional investors in recent years (pension funds, insurance companies, etc.) has added momentum to domestic debt market development in China and to the creation of many funds.
B. Equity markets and derivative trading.
Ø Informal SOE share issues and (authorized) OTC trading started in China in the mid-1980s.
Ø The Shanghai and Shenzhen stock markets started operations in December 1990, initially without Central Government supervision.
Ø CSRC wasn’t established until October 1992, mainly in response to scandals and riots triggered by stock market irregularities. The first reasonably comprehensive Chinese Securities Law became effective in 1999.
Ø Still, in 2000, one of China’s leading independent economists, Wu Jingliang, said that China’s stock exchanges were “worse than casinos – at least casinos have rules”.
Ø Many SOEs that were accepted for listing saw the stock market – at least initially – as a source of “free” capital. Most private buyers of stock were poorly informed, believing that the market could only go up; they had no interest in or influence on corporate governance. Nor could they have such influence, because minority share holder interests were (and still are) poorly protected.
Ø The number of registered stock owners in China is now over 70 million, but only about 10 million accounts are active.
Ø China’s approach to listing has been to partially privatize – about one third in most cases - SOEs, a unique approach, not found elsewhere.
Ø Of the approximately 1300 companies listed at present, only about 20 are private, the rest are all SOEs (see below for additional comments on the partial privatization of SOEs).
Ø Shares of listed SOEs are divided into three categories, usually about one-third each: (1) tradable shares sold to the public, (2) legal person (LP) shares held by a state-owned parent company (in principle non-tradable), and (3) non-tradable State shares.
Ø Only about one third of the total market capitalization of the Shanghai and Shenzhen stock markets (about $550 bn at present or about 45% of GDP) is tradable. There are some 70 million individual share holder accounts in China of which about 10 million are active.
Ø The sale of LP shares (with Central Government authorization) has led to the two-thirds privatization of over 200 listed SOEs during the past few years.
Ø The effect of the change from minority to majority non-state ownership of SOEs on corporate governance standards is believed to be significant.
Ø Similarly, international IPOs, even when the Government remains majority owner initially, are thought to be having a much greater positive influence on domestic corporate governance standards in China, than domestic IPOs.
Ø In 2001 China sold some State-owned shares to strengthen the National Social Security Fund, but the scheme failed and was abandoned, because market reactions were strongly negative. The question what to do with the State-owned shares (nominally worth about $170 billion at current market prices) remains largely unresolved.
Ø To stimulate domestic stock markets and upgrade corporate governance standards, China opened the domestic A-share markets to QFFIs in 2002.
Ø The Government announced in March that it eventually planned to close the B-share market. This would be an important step towards domestic equity market regularization and integration.
Ø The Hong Kong stock exchange and, to a lesser extent, the NYSE, have been important vehicles for the international marketing of Chinese shares.
Ø China is making progress in improving the quality of new listings and in the supervision of domestic stock markets, but much remains to be done. On paper, China’s regulatory standards are now approaching those of Hong Kong.
Ø Corporate Government standards in general still leave much to be desired.
Ø To promote domestic capital market development the Government recently announced that additional forward and derivative trading vehicles would be authorized. This might also be a prelude to the flexibilization of China’s exchange rate regime – traders need adequate hedging opportunities if/when the RMB is de-linked from the US dollar and allowed to be traded in a wider band.
Domestic and international IPOs.
Ø During the four-year period 2000-2003, there were 119 international IPOs by
Chinese corporations, mostly in HK, but also NY, for a total amount of $21.2 bn
(average:$178 mn). See table below. The largest IPO was by China Life, late
2003, for $3.4 bn (now under preliminary investigation by the SEC for alleged
accounting irregularities). Mainland China shares now account for about 30% of
the Hang Seng index. The index did very well last year, mainly thanks to China
stocks.
Ø In same period there were 326 domestic IPOs for a total of $25 bn (average: $77 mn).
Ø The frenzy for China IPOs (e.g. China Green Holdings IPO in January was over-subscribed 1600 times!) seems to have cooled recently as a result of the 9% price drop of SMIC shares (Semi-conductor Manufacturing International Corporation) and the 7% price drop of Tom Online (a Chinese Internet company) on their first day of trading in March. The Minsheng Bank Board scandal contributed to he recent cooling of market enthusiasm for international China IPOs.
Ø Additional international IPOs planned for 2004 include: CCB ($5 bn), China Netcom ($2 bn), Minsheng ($1 bn), China Post ($?), and Air China ($?).
|
Table IPOs by Chinese Issuers from 1/1/01 - 3/17/04 |
|
|||||||
|
|
Chinese -Share IPOs |
International IPOs[2] |
|
|||||
|
|
Amount in US $ |
Number of deals |
Amount in US $ |
Number of deals |
||||
|
2000 |
|
9,626.61 |
|
134 |
|
10,146.35 |
|
26 |
|
2001 |
|
4,413.04 |
|
59 |
|
2,327.48 |
|
29 |
|
2002 |
|
5,978.21 |
|
66 |
|
2,497.75 |
|
29 |
|
2003 |
|
5,037.60 |
|
67 |
|
6,296.43 |
|
35 |
|
2004 |
|
976.56 |
|
17 |
|
2,764.34 |
|
8 |
Source: dealogic.
Concluding notes.
1. Although China has been a net-exporter of savings since 1994 (i.e. China had a current account surplus on its balance of payments every year), it has used (and needs) international capital markets to finance part of domestic investments (through FDI, international IPOs, loans from MDBs, loans from commercial banks, etc.). Since 2000, all those sources together have financed an estimated 17-20% of total investment in China. Inward FDI and IPO funds raised through foreign equity markets (including Hong Kong) account for about 11-14% of total investment. The US is a relatively modest source of FDI flowing into China – generally less than 10% of annual FDI inflows. US investments in China accounted for at most about 1% of total domestic investment in China during the past decade.
2. The amount of China’s outward FDI has been growing rapidly in recent years, but still accounts for less than 10% of inward FDI. It is to be expected that China will become a more important source of outward FDI in the years ahead.
3. In theory China could finance all of its investments (about 40% of GDP 2003) from domestic savings, because the gross domestic savings rate (about 42% in 2003) exceeds the gross domestic investment rate. China’s excess savings accumulated in the form of foreign assets. Approximately half of China’s foreign exchange assets are held by the Central Bank in the form of official reserves ($403 bn at the end of 2003) on which returns are typically very modest. The other half is owned by companies or households and held in cash and numerous accounts, both inside and outside China. Most of China’s foreign financial assets are held in US dollar denominated instruments. China’s official foreign exchange reserves are mostly invested in US Treasury paper. The total amount exceeds accumulated US private investment in China by a factor of 7-8.
4. The Chinese Government’s large domestic contingency debt (in the form of NPLs and other components) presents a huge challenge to the authorities. In principle China could “fiscalize” this debt through the issue of long-term Government bonds. It has been reluctant to do so to any significant extent, preferring instead to solve the problem piecemeal. Whether this is the right approach, time will tell. The Chinese State does in principle command enough resources (State assets and fiscal power) to pay off the NPL-related debt and recapitalize the financial system, but it has not as yet laid out a definitive plan for this. The State realizes that the use of fiscal resources for recapitalization purposes may entail serious moral hazard problems and wishes to ensure that the State banks themselves contribute to their own capital base to the fullest extent.
5. Corporate governance standards in China remain seriously inadequate in many cases. Through tighter listing requirements, new legislation, education, better supervision of financial institution, pressure on State banks to assume full responsibility for their own bottom-line, the strengthening of regulatory agencies etc., the Government is making serious efforts to improve corporate governance standards. International pressures (e.g. through the listing requirements of foreign stock exchanges and regulatory agencies) are having a positive influence on corporate governance standards in China, but ultimately domestic factors will have a decisive influence on this.
6. There is no need for special measures to protect US financial markets against the potentially adverse affects of inadequate corporate governance standards in China. Existing institutions and market forces can be relied upon to handle the challenges.
Acronyms
ABC Agricultural Bank of China
BOC Bank of China
CCB China Construction Bank
CDB China Development Bank
CSRC China Securities Regulatory Commission
FDI Foreign direct investment
GDP Gross domestic product
GITIC Guandong International Trust and Investment Company
ICBC Industrial Credit Bank of China
IPO Initial public offering
LP Legal person
MDBs Multilateral Development Banks
MOF Ministry if Finance
NPLs Non-performing loans
OTC Over the counter (trading)
QFFI Qualified foreign financial investor
RMB Renminbi Yuan – China’s national currency
SOE State-owned enterprise
TICs Trust and Investment Companies (state-owned)
3G Three Gorges (Corporation)
PB 4/7/04