I very much appreciate the opportunity to testify before this Commission on the subject of China’s Capital Requirements and US Capital Markets.

By way of introduction, I have closely followed US-China relations for the last three decades. In the early 1970s I was Senior Economic Staff Member on the National Security Council Staff of Henry Kissinger. During that period we began the search for a basis for more normal Sino-America relations after years of animosity, Cold War tensions, lack of effective communication and an absence of any kind of economic relationship.

How much things have changed over the ensuing years! The last three decades have witnessed dramatic reforms in China, dramatic improvements in Sino-America relations and dramatic increases in China’s economic and political ties with the outside world. China’s recent admittance to the WTO is just the latest example of the kinds of changes that we now see as almost routine, but that would have been virtually unimaginable 30 years ago. Then China was going through the very destructive and divisive Cultural Revolution and shunning global institutions.

The US, China And the WTO

Before I address the specific questions put to me in your letter of invitation, let me make a few comments about China’s recent admission to the WTO. I have provided copies of the text of a recent study conducted by a Task Force of the Council on Foreign Relations on this topic — a Task Force I had the privilege of chairing. I thought it would be useful to outline a few of the main conclusions:

1) China is already the world’s seventh largest trading power, with annual two-way trade of over $475 billion dollars and almost $120 billion dollars in bilateral trade with the US. For the United States, increasing trade and investment with China brings not only the potential for enormous economic gains but also the opportunity to advance cooperation on a fuller range of political, economic and security interests.

2) For China’s leaders, WTO entry poses a new set of challenges. Chief among these is to manage the tensions between: a) their desire to maintain the leadership of the Communist Party, and b) the social and political pressures arising from continued economic reform.

3) For the US the greatest risk in this process is that short-term difficulties and unevenness in the implementation of China’s commitments to the WTO will undermine rather than support the US goal of fostering long-term cooperation with the PRC. And all of this will be taking place along side the cooperation the US seeks from China in combating terrorist activities emanating from Afghanistan and other parts of the world.

4) The US should support China’s overall efforts to adapt its institutions and practices — at national and local levels — to the challenges of globalization. This will produce enormous benefits not only for China but also for the global economy.

5) Both countries should attempt to build mutual confidence with an agreed agenda of “early harvest” accomplishments in key sectors, such as agriculture and information technology. .

6) The US should foster private sector financial and technical support for China’s efforts to develop the market-based rules, institutions and expertise necessary for effective WTO compliance. And it should develop a Congressional-private sector partnership to ensure active oversight of China’s WTO compliance in ways that ultimately strengthen Sino-American relations.

All told, members of the Task Force believed that China’s entry into the WTO, while not without risks for both sides, presents a major opportunity for advancing market forces in China and for strengthening the fabric of the global trading system. It also can provide a framework for advancing other htmects of Sino-American relationships.

While the Report discussed many of the things that could go wrong during the transition period within which China implements its commitments to the WTO, its primary goal was to address the many ways in which cooperation between the US and China can improve prospects that things will go right. A realistic, determined and supportive approach to WTO implementation now and in the medium-term was deemed to have the potential to shape China’s economic and, perhaps, broader political prospects than any policy choice in almost thirty years of bilateral economic relations.

I would only add to this now by saying that a similar level of cooperation on a series of financial matters could also have very positive results. The modernization of China’s economy depends to a very great degree on the modernization of its financial sector. That same modernization is turning China into a nation of stockowners. There are today in China 60 million people who own stock — more stockowners than members of the Communist party.

In addition, subsidies to SOES will need to be further reduced in coming years — but the government is sensitive to the need to avoid large bankruptcies that displace large numbers of workers. Competitive companies need to have access to capital to grow and to create the new jobs required to hire the workers that inefficient, money-losing state enterprises — many of which will be subject to greater competition as the result of WTO membership — will be shedding and to hire the growing numbers of workers coming off of China’s farms.
Much of the internal, market-oriented restructuring that China must undertake will require enabling new private companies and restructured state-owned enterprises to obtain capital to grow their businesses. The US can play a constructive role in this process by ensuring — on terms similar to those of other countries —access to overseas markets, including our own.

Financial Issues

Turning to the topic at hand this afternoon, let me make a few broad points.
China’s economy has shown a remarkable resilience in the recent global downturn. That resilience is primarily the result of China’s capacity to sustain relatively robust domestic demand, in part through simulative fiscal policy. And home ownership (growing at around 20% annually) and increases in foreign direct investment (growing at 10-15% annually) have been important driving forces in an investment boom that also has proved to be remarkable robust, especially in contrast to the collapse of investment in many other parts of the world. Private savings continue to average between 15 and 20% of disposable income. This is a vital factor in China’s investment boom.

A large and growing investor community — estimated at 60 million at the end of 2000 — will be a potent force in China’s ongoing economic revolution. Ownership of stocks, bonds and private homes is transforming the country over time into a nation of owners of private assets. Well-managed capital markets, with improving disclosure and regulatory standards, are helping to broaden the scope of the rule of law in China as well.

Capital Market Access

It is useful to consider the role of external financing in the context of overall corporate financial requirements in the country. Foreign investment, while important, represents only about 6% of overall corporate investment. The vast portion of investment in China’s companies comes from within China — and draws on the high level of domestic savings mentioned earlier. Nonetheless, investment from abroad is important — not just for the many billions of dollars it brings in but for the quality of technology and management skills, plus the international corporate and marketing networking, that come with it. A portion of it also goes into private companies, many of which have not had much access to domestic funds.

The central government and the state banks are the dominant issuers in international bond markets. In the wake to the problems of the so-called ITICS (International Trade and Investment Corporations), several other types of issuers (including the banks) have been discouraged, if not restricted, from accessing international bond markets.

Because of their depth and variety of maturity choices, the US dollar markets, including the Yankee and Global dollar markets, have been the most important markets for China’s overseas financing. But Asian demand for Chinese credits has grown substantially of late, and has become a major determinant of pricing in the new issuance and secondary markets — helping keep interest rates on China’s foreign issues low relative to that of many other emerging market borrowers.
But even though strong Asian demand (and cuts in US interest rates) have lowered the price of Chinese foreign borrowing, domestic RMB debt markets still provide a more attractive cost of financing. Thus relatively little major international bond issuance can be expected from China over the next 12 months.

The bulk of domestic bonds that will be issued will come from the Chinese Treasury, while issuance of corporate bonds will likely remain quite low. Most Chinese enterprises still rely heavily on banks for their borrowing; bank loans are equivalent to a remarkable 120% of GDP.

Since 1996 China has borrowed roughly $11 billion abroad. Of this amount, a little more than 44% is sovereign borrowing, a little more than 40% is borrowing by financial institutions and most of the rest is borrowing by corporations. On a percentage basis, 15% was borrowed in the Yankee market, 64% in dollars in the Global and European markets, 11% in Yen, 4% in Euros, and 3% in Deutschemarks.

Turning now to stocks, the capitalization of China’s domestic stock market is equivalent at roughly $600 billion. It is the second largest in Asia. By contrast, China’s bond market capitalization is $220 billion (third after Japan and Korea).

There are several varieties of issuing vehicles: A-shares denominated in RMB and sold only to local Chinese investors. They have been the key form of stock issuance. Major issuers include Baoshan Iron and Steel. Shanghai Pudong Development Bank and Jiangsu Expressway. B-shares, denominated in both US dollars and Hong Kong dollars, were formerly for foreign buyers only — but have recently been made available to Chinese residents as well. Issuers tend to be much smaller companies than in the A-share market.

Several large Chinese companies have recently issued shares in the H-shares market, in Hong Kong. These include PetroChina, SINOPEC and Huaneng Power International. Other Chinese companies have incorporated in Hong Kong and listed their shares there. These are the so called “red chips” which include China Mobile (HK) Ltd., China Unicom, CNOOC and Legend Holdings. China Mobile, formerly known as China Telecom (HK), in 1997 successfully launched a groundbreaking issue in Hong Kong and New York in ADRs. Others subsequently have done likewise including PetroChina, China Unicom, SINOPEC and CNOOC.

Of the equity issuance since 1991, 75% has been in A–shares, 5% in B shares and 19% abroad. The total sum of this financing had been the equivalent of 92 billion US dollars.

The role of Japanese and European markets in raising equity for China has been minimal.

Reform of State Enterprises

There is a close correlation between reform of state enterprises and the expansion of China’s use of capital markets overseas. The ability to access private investment has facilitated the privatization and restructuring process. And the disciplines imposed on companies by their need to attract overseas private portfolio investment, and provide market returns to investors, requires management to improve performance and market practices. In addition, the ability to access foreign markets imposes accounting, registration and reporting requirements which again require higher performance standards by management.

Chinese enterprise reforms are aimed at increasing competition in many key sectors and over time significantly reducing control of the state. State monopolies in key sectors such as telecom, oil, foreign trade and financial services are being broken up to promote competition. Entry barriers for private and foreign investment are being gradually lowered. Trade barriers have been lowered significantly in recent years — and that will be continued and reinforced under the WTO agreement. Beijing has committed to further opening the country to foreign investment in a number of key sectors such as telecom, banking, insurance and distribution.

Professional management is being introduced into many SOEs. Stock options and other incentive-liked compensation schemes have been established — on an experimental basis — for some listed companies such as PetroChina. Internationally accepted corporate governance practices are beginning to be applied in China, first on a limited basis, with a view to widening their use in the future. Constitutional amendments to recognize the legitimacy of property rights have been established. Price controls have been gradually eased.

More companies have been permitted to list on the stock markets. Over 1,000 SOEs are listed on the stock markets at present. To accelerate growth and job creation more private companies need to be able to access these markets, and bank lending. One key reason China has been unable to tap venture capital more for its rising entrepreneurial class of talented businesspeople, scientists and engineers is that domestic stock markets so far have not been very welcoming to foreign VC-funded enterprises. There are thousands of emerging technology companies in China. If they were able to tap China’s expanding domestic capital market they would be able to attract far more domestic and foreign private equity investment than they do now.

Accelerated restructuring is underway to diversify state ownership and impose market discipline on companies through public market scrutiny and the need to comply with more rigorous internal and external financial regulation. The discipline of the private financial markets is pressing management to accelerate the pace of reform and increase transparency.

As part of the effort to strengthen the disciplines of the Chinese capital markets, the China Securities Regulatory Commission (CSRC) has been actively investigating cases of poor disclosure, market manipulation and fraud. Its Chairman, Zhou Xiaochuan, and deputy chairman, Gao Xiquin, are highly regarded in international markets and within China. And a new deputy chairman, Laura Cha, an experienced Hong Kong regulator, has just joined the team. Many of the young professionals in the commission also have a great deal of international experience. The CSRC’s efforts are extremely important in increasing investor confidence within China and in global markets.

Conclusion

All of this argues for providing Chinese companies that have good management practices and adhere to sound accounting and regulatory standards access to the US and other financial markets — and helping Chinese authorities to improve the regulation and efficiency of financial markets at home. Capital markets are a catalyst for corporate restructuring and improved management practices across a range of Chinese industries. They help China to become a nation of owners — which increases pluralism and helps to build a prosperous middle class.

China has one of the highest savings rates in the world, but the historic return on capital has been low under the central planning system and as the result of years of chronic mis-lending by state owned banks. The Chinese leadership now understands that well-functioning capital markets are crucial to increasing investment, corporate efficiency, raising productivity and sustaining growth. It is working to improve such markets.

To the extent that we support market reforms in China, and the continued shift from the state sector to the private sector, such changes make an important contribution to a more market-driven and prosperous China and a stronger trading partner for the US. Access for Chinese companies to our capital markets is an important incentive for the Chinese authorities to continue moving in this direction.