It is a great honor and privilege for me to be able to testify before the U.S.-China
Commission. During a 25 year career in finance, consulting, and government service
in Greater China and Japan, I have observed first-hand how often perceptions
and preconceptions about financial and business relations between the United
States and these countries have departed from reality, and how usually U.S.
interests—both commercial and national—would have been better served
through careful analysis.
I hope that my testimony today will serve to clarify the reality as well as
the implications of the relationship between China and Chinese entities and
international financial markets. To the extent possible, my testimony will offer
quantitative support for my conclusions, as we are, after all, discussing money.
I feel strongly that speaking in quantitative terms—putting a price on
the matter, as it were—is an important, perhaps the most important, step
in reaching justifiable conclusions, at least concerning the question we are
discussing.
I. China’s Development Capital Needs – How Much from International Markets?
A. Investment and Fund-Raising During the Ninth Five Year Plan Period
For most of the past two decades, and particularly since 1992, China’s
economy has been in transition from the centrally-planned, wholly state-owned
system to a "mixed" system with a drastically reduced state-owned
sector. This transformation is nowhere complete and, indeed, is certain to last
at least another decade. During this period, the hand of government has been
and will remain strong, and "five year plans" remain highly relevant
as indicators of where government will directly or indirectly (through its control
of the financial system and major institutions) direct investment.
What will be the capital needs of China in the coming decade and, particularly,
during the next five years or so? And to what extent will foreign capital be
accessed or required? To answer this question, let us first observe the record
of the five years 1996-2000, the period of China’s Ninth Five Year Plan
(FYP).
Figure 1: China Fixed
Asset Investment as Percentage of GDP
Figure 1 provides data from the period 1996-2000 showing the robust investment
performance of the Chinese economy. In each of these years, investment in fixed
assets—including capital construction, technological upgrading and transformation,
and real estate—exceeded 30 percent of GDP. During the last three years
the number was between 36 and 37 percent. In absolute figures, this amounted
to cumulative investment of over USD 1.7 trillion. (Note: until 1999 these data
are greatly under stated, since non-state-owned units were not included. From
1999 the figures are for "the whole society" excluding collective
units and individuals.
Anyone who knows China knows that a significant part of the funds invested will
generate little or no returns, or were simply wasted. Still, it is reasonable
to accept the input figure as a measure of funds invested.
B. Contribution of Foreign Capital
What was the source of these investment funds? More specifically to our inquiry,
to what extent did foreign capital contribute funds to these capital investment
undertakings?
Figure 2 provides figures and identifies sources of that foreign capital that
entered China during the period 1999-2000. The total amount was USD 289.7 billion,
a figure roughly 17 percent of total fixed asset investment.
These figures leave no doubt that foreign capital has been a major contributor
to China’s development, and that foreign capital has played a role in meeting
China’s capital needs. But the issue becomes more complicated upon analysis.
Figure 2: Sources
of Foreign Capital Invested in China
1. The dominant role of FDI
What is clear from Figure 2 is that the lion’s share (74 percent) of foreign
capital entering China in the five year period was foreign direct investment
(which included "in kind" investment, including technology). The cumulative
total FDI was USD 213.5 billion during the period. This was money invested by
GM, Dupont, IBM, Sony, NEC, Volkswagen, Ford, BASF, BP, Unilever, Proctor &
Gamble, GE, Motorola, Coca-cola, and many other foreign companies in productive
plants, equipment, and real estate in China. Except for the occasional spin-off
floatation of a China-related infrastructure or other investment entity in the
Hong Kong market (of which more below), FDI –notwithstanding its substantial
volume—had little direct impact as a use of funds from the international
markets.
After FDI the next largest component of foreign capital was foreign loans, which
totaled USD 55.9 billion over the period. This category includes bank and IFI
loans to Chinese enterprises and government agencies and bond issues by government
entities. Unquestionably, these loans were drawn from the international marketplace,
but amount was small at approximately USD 11 billion a year. (It should be noted
that there is a discrepancy between the annual increase in this figure—up
USD 29.9 billion in 2000--compared with the figure of USD 10 billion for the
sources of foreign capital investment. Total foreign borrowing outstanding at
the end of 2000 was USD 181.8 billion
2. International equity issues
The final category of foreign capital absorbed by China, "other,"
captures the equity sold to foreign investors by Chinese entities, as well as
international leases. In 2000 the equity figure was USD 6.9 billion out of a
total "other" of USD 8.6 billion. In 1999 the equity figure was USD
6.1 billion out of a total of USD 610 million, out of a total of USD 2.1 billion.
International equity issues, as well as international bond issues, are straightforward
examples of capital markets fundraising. The very substantial beginning of this
activity was Chinese entities in 1997 was interrupted by the Asian financial
crisis which had the effect of shutting out most new issues during the following
two years. Clearly, 2000 saw a resurgence of international equity issues by
Chinese entities. We will examine this trend in detail below.
3. China’s recent record of capital earning self-sufficiency
It has been observed (Lardy, 1998) that net-net, China has proven to have a
limited absorptive capacity for foreign capital. The more precise and germane
point to our current discussion would be that China has proven able since 1992
to attract or earn far from international sources other than the capital markets,
than it has been able to use, despite large unofficial capital outflows, with
the result that international reserves have grown substantially.
Some figures and calculations illustrate this point. (Of course we accept that
these figures are rough and some can only be approximations.) In the period
1996-2000 net FDI (inward investment minus China’s outward investment)
and current account surpluses reached a cumulative USD 192.7 billion and USD
111.9 billion respectively. Thus, according to official accounts, China’s
receipt of foreign capital in excess of and after meeting its import requirements
came to USD 304.6 billion. During the roughly equivalent period of 1995-1999
the amount of foreign currency funds calculated to have left China "unofficially"
as capital flight was USD 144.5 billion, 3 while from 1996 to 2000 additions
to official exchange reserves totaled of some USD 92 billion (Figure 3). This
rough total of capital flight and additions to foreign exchange reserves comes
to USD 236.5 billion.
4. Actually a growing source of capital in the international markets
The difference of USD 68.1 billion between these figures evidences the deficiencies
in Chinese statistics. Very likely the figures failed to capture the huge volume
of smuggling that plagued the market during the 1996-1998 period. The strong
suggestion, however, is clear: At least in the recent past China has been extremely
successful at meeting its foreign exchange needs without necessarily accessing
international capital markets. Indeed, as its official reserves increase China
has become a net supplier of capital to the international markets, and, as we
see in Figure 3, the volume of such supply is expect to increase in the next
few years.
Figure 3: China's
Official Foreign Exchange Reserves
I. Capital Needs During the Next Five Year Plan period
Without question, China’s capital needs will increase during the Tenth
Five Year Plan period (2001-2005). These needs will include: 1) funds for fixed
asset investments (we saw above that during the previous FYP period these needs
came to some USD 1.7 trillion), including infrastructure; 2) funds for restructuring
the financial system, particularly for recapitalizing the state banks in advance
of the new Basel II Accord; and 3) funds for financing its pension system. Let
us look at each of these major requirements in turn, particularly from the standpoint
of demands on the international financial markets.
A. Fixed Asset Investment and Major Projects in the Tenth FYP Period
If investments in productive assets continue at roughly the same rate over
the 2001-2005 period as was witnessed in the previous five year period, China
will invest some USD2.5 trillion in projects within the country during this
period, an average of USD 487.6 billion each year. How much of this will be
financed in the international markets?
To help answer this question, it could be helpful to consider four the major
projects that will require funding. These are:
a. The Beijing-Shanghai rapid train system project
b. The East-West gas pipeline project
c. The project to divert southern water to the North
d. The project to transport hypopower from West to East
In addition to these massive projects, the campaign to "Develop the West"
will continue to require substantial funding of extensive infrastructure—highway,
bridge, railway—projects. In addition, a number of massive new industrial
material projects—particularly in petrochemicals—have been approved
and will be developed during this period. Also, localities will continue to
build and improve all manner local infrastructure, transport, and public utilities.
Without going into details, suffice it to say that all of these projects will
require some foreign technology and, in the case of the Beijing-Shanghai rapid
train and East-West pipeline projects, the requirement will be substantial.
In the past, when a project required considerable foreign technology, China
normally sought first to obtain some portion of foreign debt financing for the
project on concessionary terms from the foreign technology suppliers and their
governments (this is the case, for example, with the Three Gorges Project).
Alternatively, or perhaps concurrently, if the project were in an "open"
sector, foreign investment would be considered (this has been the case, for
example for the KruppThyssen-invested stainless steel plant in Shanghai, and
will likely be the case for the large petrochemical projects, the Beijing-Shanghai
rapid train project and East-West pipeline projects). If a new joint venture
was to be formed with the Chinese partner matching cash provided by the foreign
investor (a good example is the 50-50 percent investment of Shanghai Automotive
Industrial Corporation and General Motors in the USD 1.6 billion Shanghai GM
project) then the Chinese company could consider raising funds through an IPO
or addition equity issue, either in the domestic "A" share market,
or in off-shore markets. IPOs of SAIC, Baosteel, Sinopec, Petrochina, and CNOOC
(discussed in detail below) are examples the new approach.
In general, as we have seen, China evidences a preference for equity for debt,
and for FDI (i.e., equity investment from strategic investors) over portfolio
investment. We expect this preference to continue.
A. Recapitalizing the banks
Throughout the past twenty years, China has boasted a relatively low level of budgetary borrowing. (Note: In China’s unitary budgeting system, all debt is issued by the central government. Provincial and other lower level government units are prohibited from issuing debt instruments.) While domestic and, to a very limited extent, external government borrowing has increased during the second half of the 1990s to a level of over the equivalent of USD 56 billion annually in 2000 (Figure 4), the volume of outstanding government debt still remains at very low and manageable levels (Figure 5).
1. Bank loan assets as disguised government deficit spending
Government debt in China has been and remains low because the state banking
system has been used as an extra-budgetary vehicle to provide investment funds
to the state-controlled enterprises and projects. In this sense, loans from
the banking system to the state sector and infrastructure have been a disguised
form of government deficit spending (including, of course, investment).
It is the traditionally indistinguishable role of banks and central and government
agencies, and state-owned enterprises, in undertaking state-sponsored "investment"
and the consequently inextricable involvement large parts of the state-owned
enterprise sector that are in financial distress, that account for the massive
volume of uncollectible loans within the state-owned commercial banks, which
dominate the financial sector. The four big banks are Bank of China (BOC), Industrial
and Commercial Bank of China (ICBC), China Construction Bank (CCB) and Agricultural
Bank of China (ABC). Even the banks themselves do not know the scale of uncollectible
debts, but I would suggest that 25-35 percent of outstanding loans (an amount
equivalent to roughly USD 267 billion or some 25 percent of GDP) is a reasonable
estimate. This volume of bad debts is net of the RMB 1.45 trillion (USD 175
billion or some 16 percent of GDP) in non-performing loans (NPLs) transferred
by the four state-owned banks to so-called asset management companies (AMCs)
set up in 1999-2000 by the Ministry of Finance.
Non-state banks—which occupy a much smaller position—have not been
immune to the disease of bad banking practice engendered by the legacy of central
planning. As long as the state-owned banks dominate the financial markets and
thereby essentially set market and credit standards, "good banking"
will be difficult in China. I would estimate that NPLs in the ten commercial
banks account for an estimated 10 percent of outstanding loans. This would be
the equivalent of some USD 12.1 billion, or 1 percent of GDP.
Much more serious than the NPLs of the commercial banks, or even of the state-owned
banks, are the NPLs of the rural credit cooperatives and urban credit cooperatives
(now often converted into "city commercial banks") and the international
and domestic trust and investment companies (ITICs and TICs) that grew up throughout
China in the 1990s. These entities, even more than the state-owned banks, were
like piggy-banks in the hands of local officials. Most of the funds extended
as loans were for commercially unviable projects or enterprises. NPLs in these
entities are certainly greater than 50 percent of loans.
2. The recapitalization challenge: USD 466 billion
In aggregate, what is the magnitude of bad loans in the Chinese financial system?
Figure 6 takes outstanding loans of the financial institutions described above
(including the four AMCs) and calculates a level of write-offs and subsequent
recapitalization requirements of 30 percent of total loans outstanding at the
end of June 2001. The resulting figure is USD 466 billion, equivalent to 43
percent of China’s 2000 GDP.
Figure 6: China’s
Bad Loan Burden
This is not at all a surprising figure. It is roughly the same as the amount
calculated for Thai bank recapitalization in the wake of the Asian financial
crisis, and is on an order of magnitude of the amount of bad loans accumulated
in Japan’s financial sector after the collapse of the bubble economy. This
figure shows the extent of waste and resource mis-allocation inherent in the
state-controlled, planned economic system that is China’s economic legacy.
What we can appreciate from this figure is, in a real sense, GDP and GDP growth
rates have been overstated in the past twenty years by the magnitude of this
bad loan volume. It is equivalent to saying that 2 percentage points of China’s
recorded GDP growth over the past 20 years has been illusory.
3. How will the recapitalization be financed?
Whether it is the state-owned banks, the commercial banks, the rural or urban
cooperative banks, or the ITICs, Chinese policy-makers know that it is critical
that they take effective action to clean up the banks and other financial institutions
and to restore some measure of solvency to the financial system.
How will the recapitalization be financed? I would suggest three or four primary
sources, in order of importance:
1. For the four state-owned banks:
a. Accumulated retained earnings (bolstered by changes in reduction in taxes)
b. Periodic injections of cash equity or swaps of Treasury securities from the Ministry of Finance (i.e., future repetitions of the process seen in "transfers to the AMCs).
c. Issuance of subordinated debt (quasi-equity), primarily in the domestic marketplace, but also in overseas markets
d. Partial sales of equity in the domestic marketplace.
e. For Bank of China, China Construction Bank, and ICBC, sale of equity in overseas (especially Hong Kong and London) entities.
2. For the commercial banks:
f. Sales of new equity in IPOs and repeat issues in the domestic market
i. This has already been realized for Shenzhen Development Bank, China Minsheng Bank, and Shanghai Pudong Development Bank. All other commercial banks will follow in the next 12-24 months.
g. Accumulated retained earnings.
h. Sales of equity to strategic investors (i.e. other banks).
i. Issuance of subordinated debt (quasi-equity), primarily in the domestic marketplace, but also overseas.
3. For the urban credit cooperatives (city commercial banks):
j. Acceptance of new equity investment from domestic corporations and overseas IFIs (e.g., the International Finance Corporation)
k. Cash injections from provincial governments
l. Sales of equity in the domestic equity market
m. In a few cases (e.g., Bank of Shanghai), acceptance of overseas investment
n. Accumulation of retained earnings
4. For the rural credit cooperatives
o. Direct equity injections from government supervisory organs
5. For AMCs
p. Gradual liquidation through phased write-offs of NPL portfolio values (loss absorbed by Ministry of Finance)
4. Over what time frame?
Recapitalization of the financial system along the lines described above is in process. Completion of the process will take a decade at least.
5. Impact on global and, particularly, U.S. capital markets
As outlined above, recapitalization of China’s financial system will involve
accessing debt and equity markets outside of China. This is expected to become
spectacularly clear in 2002 when Bank of China Group floats its Hong Kong banking
franchise in the international equity market. The exact timing and amount of
the IPO is not know now, but it certainly going to be massive (see more details
on the Hong Kong market below).
Notwithstanding the above, we can confidently predict that for a variety of
reasons, international financial markets will play a minor role in financing
the recapitalization of China’s financial system, while domestic markets
will overwhelmingly dominate in this process. The recapitalization steps outlined
in the previous section rely primarily on the domestic debt and equity markets,
either directly for debt and equity issued by banks, or indirectly, for issues
bonds of by the MOF.
6. Real attraction only to domestic investors
As has been shown by the relative success of the few issues of bank shares
in China, the domestic equity market has a large and unsatisfied appetite for
financial institutions’ equity. Even after floating all of the commercial
banks shares, financial companies will be under-represented in China’s
equity market compared with other markets in the world. On a portfolio basis,
demand for bank shares (and hence P/E ratios and valuations) will be higher
in China’s domestic market than in foreign markets (where investors would
already have portfolios balanced by sector. Another factor will be that Chinese
financial companies—especially banks—are unlikely to be attractive
in risk/return terms, on a comparative basis, to investors outside of China.
U.S. capital markets will primarily continue to be the location for global debt
issues and for limited placements in shares of major Chinese financial offerings,
like that expected from Bank of China Group in which U.S.-based equity and bond
funds will have an interest. This point is discussed further below.
III. Funding China’s Pension System
A. A Large and Growing Pension Funding Gap
There is no question that China has a massive problem with unfunded pension
liabilities. Of course, it is not alone in this respect. With the former system
of cradle-to-grave security provided by state-owned enterprises in crisis, the
Central government is trying desperately to implement a new system based with
two Pillars: 1) a pay-as-you-go transfer from current enterprises and workers
to retirees (pooling funds) funded by a payroll tax and administered at the
city level as Pillar One, and 2) funded individual accounts as Pillar Two.
At a conference in Beijing last month that was partly sponsored by the Cato
Institute, researchers reported that the Ministry of Social Security calculated
a deficit in Pillar One of RMB 35.7 billion (USD 4.3 billion) in 2000, an increase
from the deficit position of RMB 18.7 billion in 1999.1 The actual on-going
shortfall in Pillar One is much more severe that these totals suggest, since
the deficit has been reduced by local government raids on funds in Pillar Two
individual savings accounts. According to the researchers, the amount already
transferred from individual accounts has already reached some RMB 200 billion
(USD24.2 billion), which creates an unrecorded future liability for the pension
system.
Another paper at the Cato conference2 quoted a 1996 World Bank estimate which
put the total size of pension debt (present value of pension obligations to
retirees and workers who accumulated pension credit under the old system) at
50 percent of GDP (1996 GDP was USD277 billion).
At some point, surely many years in the future, the vision of the government
is to have a fully, or largely, funded pensions system based upon fully funded
individual retirement accounts (more or less, the Chilean model). Significant
reengineering of the current system are needed to improve incentives for compliance,
foster more disciplined administration, and improve investment returns. Witnessing
how public pension systems are burdening even the richest countries, China’s
leadership—always mindful of the pressures of China’s huge population--seems
determined to avoid a similar fate. Still, China’s likely long term pension
system solution—fully funded private accounts—will not solve the problem
of today’s retirees, or, indeed, those scheduled to retire during the next
10-15 years. This is the "transitional" period during which a large
and growing shortfall must be financed.
B. Sales of SOE Equity and the Capital Markets
With the Chinese government apparently ineluctably committed to paying retirement
benefits to urban workers, a solution to the problem described above must be
found. The problem is partly a matter of lack of enforcement of the payroll
tax to fund Pillar One. But the problem also seems to be structural.
For the past several years, local and Central government agencies have been
seeking to plug the gap through sale of state-held equity in IPO and additional
share offerings for enterprises listed on the Chinese securities markets. These
sales were mandated under legislation in 2000. But with roughly two-thirds of
shares of all 1000 plus listed companies held by the state, the pressure of
state-owned share sales (threat of much more to come) contributed to the decline
of the Chinese equity market this year. This led the government in October to
suspend the state shares sell-offs.
The suspension is surely temporary. Proceeds from selling state shares are needed
both to plug the gap in the pension system noted above, but to pay for many
of the costs of the on-going restructuring and rationalizing the state-owned
sector, including the costs of providing for or retraining redundant workers.
C. Effect on the International and U.S. Markets
Notwithstanding that the large gap between short- and intermediate-term pension
commitments and current resources, the magnitude by which China or its enterprises
will seek to fill the gap through the international financial markets is surely
small. As suggested above, the gap in financing will be filled by 1) taxation,
2) sale of public assets (including shares in SOEs), or 3) public borrowing,
or, most likely, a combination of these three.
The burden of taxation will effectively fall on China’s workers in the
form of a payroll tax. Given the history and known mentality of China’s
financial authorities, we can be certain that public borrowing—to the extent
it is meant to pay pensions-- will be in the form of domestic debt issuance,
rather than international issues. This certainty is based on China’s record
of carefully controlling foreign borrowing and ensuring that such borrowing
(to the relatively limited extent it has been used) has been for investment
in productive assets, not for consumption.
The one category of sales of state assets, where proceeds have been used to
fund pension benefits, has been in the IPOs and subsequent equity offering of
state-owned enterprises in international markets. An example is the February
2001 IPO of China National Overseas Oil Corporation (CNOOC) which sold a 20
percent equity share for US$1.26 billion, with the intention of using the proceeds
for working capital for employee retirement benefits. Such instances have, however,
been few, and their numbers will certainly remain small in the future.
Over time, China’s pension system could become a source of capital for
the international financial markets.
China’s Financial Markets: Big Enough to Meet China’s Needs?
Are China’s financial markets big and deep enough to meet China’s
needs? This is a critical question. A precise and confident answer is difficult.
If forced to commit to an answer, it would be that China’s markets are
not as big as often thought or publicized, and that these markets are burdened
with many problems. Nevertheless, they are functioning well enough to meet most
of China’s needs. Most importantly, the markets—which are understandably
immature given that their history is only about a decade long--are expected
to continue to mature and develop, so as to become more capable of meeting the
very substantial financing needs described above.
I. The Equity Markets: Still Evolving, And Not What They Appear
Table 1 below describes China’s two domestic equity markets. The figures
are for end 2000. What is evident is that the markets are already an important
part of the economy. By year-end 2000 1088 firms had listed on Shanghai or Shenzhen
exchanges.
The figure for total market value of listed companies is deceptive, because
over about 35 percent of the shares of listed companies in China actually trade
on the exchanges. Market prices are based on this amount of float. If the remaining
65 percent of shares—held primarily by state agencies and state holding
companies, and also by state-owned corporations—were ever to fall onto
the market, they would undoubtedly sell at a great discount—perhaps only
20 to 30 percent—to the currently prevailing market price. It is appropriate,
therefore, to measure the size of the Chinese equity market, by the value of
traded shares, as we have done in Table 1. At the end of 2000 the size was some
RMB 1.6 trillion (USD 195 billion), or approximately one half the size of Hong
Kong.
Table 1: The Domestic
Equity Exchanges
A. A Market Dominated by Entrepreneurial Institutions
Officially there are over 60 million investors in China’s markets, meaning
that 60 million is the number of accounts opened by individuals with the securities
companies that are members of the exchanges. This figure gives the impression
of a market dominated by small investors, but this impression is erroneous.
For a variety of reasons, the number is probably only one-sixth this number.
It is estimated that there may be 6 to 9 million active individual investors
in the markets.
More important than these individuals are the many quasi-legal private investment
funds run by financial management and financial trust companies. Research by
PBOC has found that there are some 7,000 of these companies operating in Shanghai,
Shanghai, and Beijing. PBOC estimates4 that these funds manage an average of
USD 18 million. Chinese securities companies also offer discretionary and directed
asset management services as part of their core business. The combined total
of funds under management by securities companies is estimated by PBOC at USD
24 billion. China also has a fledgling mutual fund industry. Adding all funds
under management by these formal and informal institutions together, the amount
of funds invested in the stock markets reaches some RMB 800 billion (USD 98
billion), approximately 50 percent of the tradable market capitalization. This
is a level similar to the U.S. and other developed markets.
B. Big Problems Requiring a Supply Side Solution
If domination by small investors, and a dearth of sophisticated institutional
investors, is not the problem of the China equity markets, there are many others.
Most fundamentally, these problems stem from the fact that virtually all of
the listed companies are partial privatizations (public sale of a minority shareholding)
of a formerly 100 percent state owned enterprises. With majority control still
in state hands, and with corporate managers generally unchanged, it has been
seen that management style and mentality in many of these firms retains all
the pernicious characteristics of SOEs. The result is poor corporate performance,
abysmal disclosure or outright fraud, and widespread abuse of minority shareholders’
interests.
During 2001 revelations of abuses and malfeasance by listed company managements
and auditors and underwriters created a crisis of confidence in the market.
The situation was so serious that the China Securities Regulatory Commission
(CSRC) was forced to crackdown.
What the abuses, crisis of confidence, and subsequent market downturn revealed
in 2001 what that remedial efforts by CSRC and other government authorities,
to be effective, must be focused on the supply side. What the equities markets
in China and Chinese investors need, desperately, are better companies in which
to invest.
C. Performance and Capacity of the Market
As can be seen from Figure 7 below, the equity markets in China—and, to
a much lesser extent, abroad--played a crucial role in financing Chinese enterprises
during the Ninth Five Year Plan period. In the year 2000, Chinese enterprises
raised a total of RMB 153 billion (USD 18.5 billion) in the domestic A share
market and RMB 56.2 billion (USD 6.8 billion) in the overseas markets (primarily
Hong Kong). This equity financing was one-third as much as the increase in loan
volume of RMB 648.9 billion (USD 78.5 billion) of China’s state-owned banks
during the year.
On the other hand, it can be seen from Figure 7 that the performance of the
domestic equity market was uneven during the 1996-2000. To some extent this
reflected the Asian financial crisis (the crisis’ influence over China’s
domestic markets was more psychological than direct), but a greater effect was
the changing fortunes of listed companies and the conservative, cautious stance
of Chinese regulatory authorities evidenced during the period.
It can be said that in 2000 the Chinese domestic equity market finally really
proved itself as being capable of absorbing large issues. (Previously, doubts
about the capacity of the market was a key reason Chinese authorities pushed
large firms to list abroad, particularly in the Hong Kong "H" share
market.) Milestone transactions included the sale of RMB 7.7 billion (USD 930
million) in equity in an IPO by Baosteel Group. The floatation of China Minsheng
Bank was another such milestone.
Figure 7: Chinese Enterprises' Fund Raising
in Stock Markets
D. "B" Share Market Buy-Back
By the year 2000, the domestic "B" share market was playing no material
role in financing Chinese companies. This market—comprising foreign currency
denominated, non-resident investors purchase only shares of Chinese companies
that were listed and traded on the Shanghai or Shenzhen exchanges—became
largely irrelevant only a few years after its inception as China’s growing
foreign exchange reserves allowed the Central bank to relax control on converting
RMB to pay for imports. During 2000 B share market liquidity—and share
prices--reached new lows, causing disquiet and inconvenience for issuers and
regulators.
The solution to the B share market problem—adopted in June 2001--was to
remove the "non resident investors only" restriction and allow mainland
Chinese investors to purchase the shares with personal holdings of foreign currency.
(Foreign currency deposits in individual accounts in banks in China are large,
on the order of USD 175 billion. PBOC regulations generally requires that mainland
corporations sell foreign exchange to Chinese banks.) For a time, individual
and institutional Chinese investors piled into relatively underpriced B shares,
causing prices to rise dramatically and liquidity to increase.
Notwithstanding the market’s recent revival, the B share market remains
structurally flawed and as ceased to be a viable channel for fund-raising for
Chinese companies.
E. A Healthy, Growing Equity Market is a Strategic Imperative
The continued evolution and development of a healthy domestic equity market
is a strategic imperative if China is to achieve its many development objectives.
China’s leadership—and particularly Premier Zhu Rongji—are united
on this point. Vast resources are being devoted rectifying abuses and creating
the legal, administrative, and technical infrastructure required to ensure the
dynamic viability and efficaciousness of the domestic equity market in the future.
I believe that, in essence, China’s domestic equity market has come into
its own as a one of the main sources of funds needed for China’s development.
Notwithstanding that funds needs over the foreseeable future will be enormous,
as we have observed above, I believe that—to the extent these needs will
be finance by equity issues—the overwhelming majority of such issues can
be and will be executed in China’s domestic market.
a. Far to Go in Developing a Bond Market
While the domestic equity market is in good strategic shape, China’s domestic
bond market is so undeveloped—except as a receptacle for government debt--as
to be practically irrelevant. Given PBOC and CSRC restrictions and a dearth
of credit-worthy issuers, virtually all bonds issued are by the Central government
and certain government agencies. Corporate issuance in 1999 was just 2 percent
of total bonds issued. In 2000 corporate issues, at only RMB 8.3 billion (USD
1 billion), were less than 0.5 percent of bonds issued. Total bonds outstanding
in the market at the end of 2000 comprised RMB 1367.4 billion (USD 165.4 billion)
in government debt, and a mere RMB 86.2 billion (USD 10.4 billion) in corporate
debt. Stock market listed bonds represent just 2 percent of outstanding bonds.
Treasury bonds are traded exclusively in the interbank market and the volume
is miniscule (0.002 percent of outstanding bonds traded daily, compared with
8 percent in Hong Kong).
Obstacles to the development of a significant debt financing securities market
in China seem formidable. For this reason, in the future, as in the past, those
Chinese entities capable of issuing debt securities (and with funding vehicles
abroad) will have to do so in overseas markets, such as Hong Kong.
The Pivotal Role of the Hong Kong Capital Market
During the mid-1990s, and especially in the period 1996-98, dozens of Chinese
companies and administrative units sought and found sources of debt and equity
financing in the Hong Kong market. During this period, when the China’s
domestic markets were still young and suffering growing pains, a combination
of factors impelled Chinese entities to Hong Kong. Among the factors were:
1. The large number of international banks and securities companies willing to supply of debt and equity financing to Chinese companies registered in Hong Kong but controlled by mainland authorities (so-called "Red Chips")
2. The fear of Chinese regulators that domestic markets were too immature and thin to absorb large equity issues, and therefore the willingness to approve issuance of "H" shares by large domestic companies
3. The ability of Chinese firms as with Hong Kong vehicles to issue foreign currency debt securities, such as floating rate notes (FRNs), without approval of mainland authorities and without restrictions, taking the proceeds and upstreaming them as "equity" investments in mainland projects
4. The popularity of mainland infrastructure-related investments among Hong Kong individual investors and funds, which allowed PRC government entities as well as Hong Kong conglomerates like Cheong Kong Group to finance infrastructure investment through "asset injections" into Hong Kong funding vehicles
5. The ability of key provinces or provincial level entities like Shanghai and Beijing to raise long-term funds through Hong Kong-domiciled investment companies like Shanghai Industrial Holdings and Beijing Enterprises which began to function like captive merchant banks, taking equity positions in local projects and enterprises
Responding to the positive environment, by the late 1990s an astonishing number of mainland entities had listed vehicles in the Hong Kong market (see Relationship Chart of PRC Companies Listed Abroad below).
A. H Shares Issuers
Table 2 provides a list of H share issues and issuers by date and amount of
capital raised.
Table 2 Chinese
H-Share IPO's
B. H Share Characteristics
Looking at the H share companies, it is difficult to discern any particular
characteristic, except that these are all state-owned mainland companies which,
over the past eight years, had both the political clout in Beijing to obtain
approval to list in Hong Kong, and had some amount of market appeal. The companies
came from a variety of sectors, with the common feature that they are virtually
all old-line industrial companies with large fixed asset investment requirements.
Very often, the H share companies were in strategic industries in China in which
major international companies hoped to become involved. In some cases these
industrial sectors were closed to direct investment, or such investment was
highly restricted. Under these circumstances, international majors have seized
upon the issuance of H shares by PRC companies as a chance to form an equity
alliance by buying substantial amounts of the H share issues. This was the case
in Zhenhai Refinery’s IPO, in which Atlantic Richfield (ARCO) took a substantial
share. A large part of the issue of CNOOC was purchased by Royal Dutch Shell.
Vodaphone of the U.S. took USD 2.5 billion of the placement of China Mobile
shares. It is hoped that
C. The Growth of "Red Chip" Issues in Hong Kong
In the mid-1990s, as Chinese officials and organizations began to anticipate
the reversion of Hong Kong to China in July 1997, a large number of mainland
Chinese commercial groups and entities moved to establish or expand their commercial
presence in (then) colony.
Many of the PRC entities like China International Travel Service, China Overseas
Development, and China Resources had been operating in Hong Kong for many years.
In 1994-97 these companies were joined by many others, including large new groups
like China Merchants, China Everbright, and CITIC, with strong links to the
State Council. (See Relationship Chart of PRC Companies Listed Abroad below.)
A combination of the favorable market environment described above, permissive
regulation in Beijing, and the need for funds to execute unprecedented expansion
activities, including through acquisitions of established Hong Kong companies,
encouraged many of the PRC-controlled companies to raise capital in the Hong
Kong market, including through IPOs. These listed companies became known in
the market as "Red Chips."
Table 3 presents a list (not exhaustive) of well-known Red Chip companies, including
some of the IPOs executed by these companies. The year 1997 witnessed the peak
of Red Chip listing. A particular phenomenon during this time was the listing
of Hong Kong "window companies" of major mainland municipalities,
including Beijing and Tianjin, following the success of Shanghai Industrial
which had listed the year earlier
Table 3 Red Chip
Companies and Red Chip IPOs in Hong Kong
A. Hong Kong’s "Growth Enterprise Market"—Hope for China’s
Private Companies?
In 1999 and 2000, in a response to the success of NASDAQ in financing small
and start-up technology companies, Hong Kong’s Stock Exchange launched
a second board, called the Growth Enterprises Market (GEM), with less stringent
listing requirements than the regular HKSE.
Early optimism about the prospects for the GEM, and a number of successful early
listings by mainland companies, caused mainland regulators to consider establishing
a GEM-type second board in China. Following the decline in NASDAQ and similar
bourses, including the GEM, since early 2000 listing activity sharply declined.
PRC regulators apparently have deferred indefinitely any serious efforts to
launch a domestic second board.
Between April 1999 and April 2001, at least 17 mainland or Red Chip companies,
mostly small and some privately-owned, launched IPOs and listed on the Hong
Kong GEM (Table 4). The largest issue was that of Phoenix Satellite TV Holdings
in June 2000 which raised USD 680 million. This is double the proceeds of the
next largest issuer. Excluding Phoenix Satellite TV the average amount of equity
raised was about USD 100 million.
Table 4 Hong Kong
Second Board Listings of PRC Companies
It has been hoped that the GEM—and perhaps a similar board on the mainland—will
provide increased financing opportunities for China’s private sector. This
is not an unrealistic hope, though it is too early to definitely declare success.
The few listings in 2001 reflect a skepticism over the quality of mainland companies.
In general, as with China’s markets, better quality companies are needed.
By its very nature, as a vehicle for small companies, the GEM will not become
a significant factor in the Hong Kong or global capital markets for the foreseeable
future. Nevertheless, its importance for stimulating growth in China’s
private sector is not to be underestimated.
Global Placement of Chinese Equity and Debt Issues
The international capital markets are such that, while issuers and underwriters
usually make an effort to list on an exchange in the country or region where
the issue is expected to find the broadest and deepest market acceptance, the
world’s largest institutional investors and securities firms are active
in all the leading world markets. Therefore, rather than focusing exclusively
on where Chinese issues have been listed internationally (the location has normally
been Hong Kong), it is instructive to look the markets into which the shares
were placed by underwriters. This information is normally shared among underwriters
and is gathered by the trade press. The information in Table 5 was gleaned from
the Euromoney publication FinanceAsia.
Table 5 Placement
of PRC Equity Issues (recent sampling)
Expected New Equity Issues
There is no doubt that PRC entities and Red Chips will continue to seek new
listings and undertake new capital raising issues in the international markets.
Reflecting the interest of underwriters, the following table describes the pipeline
for large equity IPOs by state owned companies. This is only part of the picture,
however, as an increasing number of smaller companies, including some private
companies, are expected to list in Hong Kong in the next few years.
Table 6 Giant State-Owned Enterprise IPO
Pipeline
Issues and Issuers in the U.S. Markets
Table 7 presents the equity issues of Chinese companies that have been made
on the U.S. equity markets.
Table 7: Chinese
Firms Listing on the U.S. Equity Markets
Future Role of U.S. Markets in China’s Development Capital Funding
What the tables in the previous section make clear is that Chinese listings
and fundraising in U.S. capital markets have heretofore been modest. What about
the future?
It is certainly to be expected that Chinese entities and (importantly) their
underwriters will seek to access the U.S. markets for additional equity and
debt fundraising. However, for the many reasons and in view of the circumstances
described above, we can posit that for the foreseeable future, both the needs
and the efforts of Chinese issuers will be limited.
If the impact of China’s fundraising on the U.S. markets is likely to remain
small, the converse is not true: U.S. markets have previously exerted and will
continue to exert strong influence on the issuers and underwriters of Chinese
securities. This is because U.S. markets and market practice set the global
standard, and this standard is increasingly be adopted or, at least, htmired
to, in major world markets, not excluding Hong Kong. Also, New York along with
London is a center for global fund management, and the Chinese issuers will
always be keen to be attractive to these investors.
Thus, Chinese entities seeking access to international capital markets will
have to become increasingly better managed, transparent, and mindful of shareholder
interests in order to attract international capital. In China, as in many other
countries, entry into global capital markets will become one key factor promoting
economic and social reform and progress.
Notes:
1 David D. Li and Ling Li, “The Pension Reform Debt: A Simple Resolution
of China’s Pension System Crisis,” November 20001 (unpublished paper)
2 Yaohui Zhao, “The Feasibility and Benefits of a Fully Funded Pension
System,” November 2001 (unpublished paper)
3 Li Qingyun, Journal of Economic Research (Beijing), August 2000.
4 Stephen Green, “Taking Stock,” CFO Asia, October 2001 quotes a study
by Xia Bin, People’s Bank of China
References:
Yabuki Susuma & Stephen M. Harner, China’s New Political Economy –
Revised Edition (Westview Press 1999)
Relationship Chart of PRC Companies Listed Abroad
(including domestic B share listings)
Relationship Chart of PRC Companies Listed Abroad (continued)
Relationship Chart of PRC Companies Listed Abroad (continued)
Notes:
***People’s Bank of China
(SH) means Shanghai-listed B share. (SZ) means Shenzhen-listed B share.
(HKSB) means Hong Kong Second Board (Growth Enterprise Market)
Source: Yabuki & Harner, China’s New Political Economy (1999). Updates
by author.