Messer Co-chairmen and Members of the Commission:

I serve as the Managing Director of New China Management Corp., a Greenwich, Connecticut based company that, in turn, serves as Investment Manager of The Cathay Investment Fund, Limited (“Cathay”). Cathay is a closed-end investment company established principally to undertake direct investment in the People’s Republic of China. Since its establishment in 1994, Cathay has made close to twenty direct investments targeting greater China, in industries as diverse as pharmaceuticals, foodstuffs, real estate development, home appliances, insurance services, toll bridges and the Internet. Historically, Cathay has been an active, not a passive, investor and I have served personally on the Boards of Directors of the majority of, and in some cases helped create, the companies in which Cathay has invested. Some of those companies are classified as State Owned Enterprises (“SOEs”), and some have been previously identified to this Commission as having links to the People’s Liberation Army (“PLA”). Others are privately owned by members of China’s emerging entrepreneurial class. I serve on the Board of one Chinese enterprise listed in New York, one listed in Hong Kong and one listed on the Shenzhen Stock Exchange.

I have been asked to speak on the extent to which China is relying on the US capital markets to meet its capital needs, the nature of the Chinese companies seeking access to those markets, and US investor interest in Chinese listings. This presentation will give a short history of where we are and how we got there. Our particular niche, as direct investors, is at the lower reaches of the financial “food chain.” The perspective that I bring is not that of a policy maker or regulator of the capital markets, but rather that of a financial investor, on the ground in China, just trying to “make a buck.”

Before we begin, some ground rules. While it is possible to define US capital markets simply as those stock and bond exchanges and distribution networks within the US, this definition does not adequately take into account the global nature of today’s international capital flows. The effect of technology has been to facilitate transactions by US investors in capital markets worldwide. It doesn’t matter if a security is sold on a US exchange or some other exchange open to US investors around the world—it still may be US-sourced capital.¹ We should also keep in mind that many of the inputs are subject to varying interpretation, shrouded in the complexities of Chinese government/business relations, or simply unknown. Lastly, many of the impressions reported below are borne out of personal experience and should be weighted or dismissed accordingly.

1. Development of Investment in China. Foreign investment in Chinese companies can be categorized according to who is making the investment and in what form or venue that investment takes place. Direct investment—that is, investment in the illiquid ownership equity of unlisted companies—came first. Within that category, the first direct investment following the “opening up” of China came from “natural” investors, largely foreign companies in related businesses seeking to establish new manufacturing facilities and new markets for their goods and services. This was followed by financial investors like investment funds, or institutions with investment portfolios that were willing to commit the time and expend the effort necessary to source, evaluate and monitor these investments on their own. Unlike natural investors, strategic investors generally seek only a good return on their invested capital, without ulterior strategic interest. The emergence of interest in direct investment by foreign financial investors in China then cleared the way for the listing of the securities of Chinese companies on established public exchanges, providing theoretical liquidity to potential investors and greatly expanding the universe of potential financial investors. Investment in China was now open not only to those institutions limited by charter or policy to investment in listed securities, but also to anyone willing to open a brokerage account and write a check.

Using Chinese government generated data, we estimate that, since 1999,² Chinese companies have raised US $81 billion³ through nominally foreign direct investment (before deducting out funds which were actually Chinese but were “recycled” through an offshore entity for tax or other purposes), of which approximately 10 percent, or $8.1 billion, came from US sources.⁴ Most of that foreign direct investment has in fact come from natural investors, with only a portion coming from purely financial investors, such as Cathay. Based on our own compilation of the available data, we estimate that the amount of equity and debt raised by Chinese companies, directly or indirectly, in public capital markets open to US investment, has probably been about US$13.2 billion⁵ over that same period. Of that amount, approximately US$10.6 billion has been raised by companies listing on US-based stock markets (chiefly NYSE and NASDAQ), $1.8 billion by the sale of securities on the Hong Kong Stock Exchange, and $215 million by companies listing on the Chinese domestic Shenzhen and Shanghai B Share markets (the three most important venues for hard currency-denominated public listings of Chinese companies).

These are big numbers, but they need to be put into perspective. During that same period, approximately $267 billion was raised by equity and debt offerings listed on the NYSE alone,⁶ while another $109 billion was raised through offerings of securities traded on NASDAQ.⁷ The “Chinese” portion represented only three percent. From the standpoint of US financial investors, investment in China represents a very small portion of the overall national investment portfolio. The typical allocation of investment capital by a US institution to emerging markets is in the single digits, much of which goes to Latin America. For the US financial investment community, investment in China, while large on an absolute basis, is not overly meaningful on a percentage basis. And while China is second in the world in absorbing inbound foreign direct investment capital flows, it is a distant second to the US, which absorbs more foreign direct investment than any other country.

In contrast, from the standpoint of Chinese companies seeking financing, the scale of US and other foreign investment has been extremely important. This is illustrated by a comparison of the figures set forth above to relevant figures for both domestically raised equity and commercial debt. According to the World Bank, since 1999, commercial loans made by domestic banks provided US$14.4 billion in renminbi to Chinese companies ⁸, and the sale of domestic commercial bonds provided another US$4.5 billion in renminbi .⁹ Offerings of securities on China’s fast-growing “A Share” reminbi-denominated domestic stock markets was the largest single category of contributor, raising an estimated renminbi equivalent of $26.7 billion in equity capital.¹⁰ The amount of private investment funded from corporate earnings or individual savings—the domestic equivalent of foreign direct investment—is extremely difficult to estimate, but was undoubtedly a very significant contributor as well.

2. Ongoing Trends. As late as 1995, the bulk of investment capital in China came from domestically generated loans and equity investments from government-related enterprises (including SOEs and the PLA). Foreign direct investment, as well as domestic private investment, was just beginning to grow in significance. Industrial investors were the first to bring foreign capital, as they entered into Joint Ventures with SOE partners to establish manufacturing plants in China. As Chinese companies sought to tap international capital markets to fund their own projects, they experimented with a number of different approaches. The early focus was on “Red Chips” listed in Hong Kong (overseas companies controlled by Chinese SOEs or government entities), the “itics” (provincial-based investment companies used to raise foreign debt for equity investment in local projects), a few listings of overseas holding companies in New York and London, a handful of Chinese “H Share” companies listed directly in Hong Kong and Chinese companies listed on the hard currency “B Share” domestic stock markets established in Shanghai and Shenzhen. Given the difficulties of obtaining government approval for these fund raising activities (like US sensitivity to Japanese investment in the 1980s, the Chinese government has always been concerned about the effects of foreign investment on its own economy), the overwhelming majority of participants in this market were either SOEs or recently restructured nominally former SOEs. The quality of most of these companies was poor—management was weak and had little understanding of the expectations of foreign investors. Corporate direction was dictated more by concerns of covering losses and maintaining employment than return on capital (a concept that, even today, remains largely under-weighted in the thinking of many Chinese managers). By the year 2000, the situation had evolved significantly. Private companies, accounting for a disproportionate percentage of economic growth, were still largely shut out from both foreign and domestic listings, which (through the government approval process) remained largely reserved for SOEs and former SOEs. Capital continued to be raised through Red Chip and “H Share” offerings in Hong Kong. But a large percentage of total foreign capital raised was being provided through a very limited number of “blockbuster” offerings of privatizing SOEs, often through dual listings in Hong Kong and New York. The “itics”—after a couple of spectacular failures—were finished as an effective vector for capital raising. The domestic B Share markets had ceased to provide any meaningful capital. But in their place had arisen the now robust renminbi-denominated A Share markets, closed to foreign investment. In addition, private domestic direct investment, provided by successful entrepreneurs and their companies, was playing an important role.

The development of the A Share markets, together with the growth of private domestic capital sources, helped bring about a bifurcation in the markets in which Chinese companies raised capital. Total capital raised in offerings in Hong Kong and New York from 1999 to 2001 is estimated at $12.4 billion.¹¹ But over 80 percent of that came from four large offerings of oil and telecom stocks: PetroChina, CNOOC, SinoPec and China Unicom. The total for all other companies was less than $2.5 billion. That represents less than ten percent of the almost $27 billion raised in the A Share markets over the same period. The companies listing on the A Share markets, however, were in a wide variety of businesses, many of which were not even profitable (under any internationally accepted standard of accounting). There are good reasons for this phenomenon. First, required government approval was now more freely granted for A Share listings, as China sought to develop its own capital markets while at the same time absorb growing domestic renminbi savings. Second, valuations for Chinese companies were (and remain) higher in the domestic markets. The average IPO valuation on the Shanghai A Share market during the year 2000 was approximately 15 times expected earnings; the market as a whole traded at an average of 39 times earnings.¹² But, most importantly, many of the companies offering shares in the A Share market simply could not sell their shares in western markets: no one would buy them.

3. US Investors’ Perception of Market Risk. Adam Smith’s invisible hand is generally powered by the profit motive. This Commission previously has seen descriptions of perceived “bad actor” risk associated with Chinese companies. While such risk can be demonstrated, it probably pales in comparison with the more commonly understood risks faced by investors in China. Investment in China has been negatively affected by risks as diverse as adverse market development (often too much competition), competition from profit-insensitive SOEs, changing government regulation, poor management, lack of transparency, deficient legal process, dubious accounting, protectionism and corruption. Generally, the perceived overall risk level is quite high—and rightly so. As experienced as we, at Cathay are in the market, we nevertheless suffered from a number of these issues, most of which we have been able to recover from. But the typical passive financial investor would have little chance. The market has reacted appropriately, resulting over time in allocation of US capital away from smaller, less-developed enterprises and towards the larger, more-developed companies described above, concentrated in just a few core industries. This movement is natural. The market potential of the telecom and petroleum businesses in China, for example, is well understood and proved: China is already the world’s largest market for mobile phones, and its expected increase in demand for energy (especially petroleum products) is enormous. At the same time, competition is limited in both industries by legal restraints. But, just as important, the scale of these enterprises has made it worthwhile to go through the restructuring exercise, as insisted upon by the Western investment banks that have aided these listings required to make these companies attractive to the type of public investment to which they were trying to gain access. New management has been installed, poor quality (or politically sensitive) assets hived-off to corporate parents, accounting improved—basically, the companies have been “scrubbed up” to be more acceptable to international capital markets. Are these companies operated to the same standards of efficiency as their counterparts in the West? Unlikely, as should be reflected in the pricing of their shares by Western investors.¹³ Do these companies continue to operate to serve perceived strategic needs of the state? Yes, often. But there is a perception in the market that these companies are the vanguard of corporate China, and that although the government may occasionally call upon them to perform some service for the perceived common good, the government will also do what is necessary to protect them and cause them to succeed economically. In fact, some of these companies have performed quite well.

As for the rest of the lot, the smaller or less strategically blessed companies seeking access to financing through the listing of their securities are more likely to be relegated to domestic capital markets or the more speculative end of the Hong Kong market. The quality of supervision and discipline of management of companies within these capital market segments are questionable to say the least. While there are some quality companies, a significant amount of funds raised in the Chinese domestic stock markets probably never makes it to the intended—or at least announced—use. Some of the money has been recycled into the market in speculation on other A Share issues. Much of the capital raised has been used inefficiently, or wasted in an effort to sustain businesses long ago doomed by economic realities. But if the A Share markets collapse, as many outside observers fear they may, the main victims are likely to be the Chinese investors (both corporate and individual) who buy the shares in renminbi, not US investors, who are legally prohibited from the market.

4. Effect of WTO on Foreign Investment. The biggest effects of WTO as they relate to investment in (as opposed to import/export trade with) China will probably be on the direct foreign investment sector. In 1994, most foreign direct investment in China was in the form of Joint Ventures or other shared Sino/foreign enterprises. Teaming up with a Chinese partner was seen not only as a way of negotiating legal restrictions on investment, but also as a way of learning the market. This business model proved to be largely ineffective. Many foreign investors ran into constant disagreements with their Chinese partners over everything from employment levels, to marketing strategy, to production methods, to employment of capital. In hindsight, this should not have been surprising. Management of the Chinese partner (which was often itself an SOE or a privatized company one step away from an SOE) was often motivated by entirely different concerns than its foreign counterparts. Generally, local political authorities strictly limited management’s compensation and rewards were meted out mostly for meeting such non-economic goals as employment, generation of local tax and raw production numbers. Corruption was also a problem, as significant amounts of capital ended up otherwise than intended, to the enrichment of the locals but to the detriment of the enterprise. To make matters worse, the Chinese party to the Joint Venture was often unable to fund its portion of the required capital, leaving the foreign party with the lion’s share of the financial risk but only a portion of the potential benefits.

By the year 2000, the situation had significantly evolved here as well. While the idea of the Joint Venture still survived (largely in industries protected by government regulation), more and more direct foreign investment was in the form of Wholly Foreign Owned Enterprises. While these enterprises often had local participation (usually through shared ownership of an offshore holding company), the local participants were more often private companies and individuals motivated strictly by return on capital and personal gain, rather than the SOEs so common in the joint venture days. WTO will accelerate this trend, as more and more industries and markets become open to wholly foreign owned investment, freeing foreign investors in China (both natural and financial) from the burden of unproductive and potentially uncooperative local partners.

5. Socializing Effect of Foreign Investment. Despite the lure of raising cheap capital domestically, raising capital in the US still remains attractive to many Chinese companies. First, there is the matter of prestige. A New York Stock Exchange or NASDAQ listing brings far more prestige than a listing in Shanghai, Shenzhen or Hong Kong. Second, in the case of privatizing SOEs, foreign investment brings more structural opportunities for personal enrichment. Many provinces still strictly limit the amount of money that senior executives of local SOEs can make, irrespective of their company’s success. Creating offshore holding companies and listing vehicles provides numerous opportunities for personal enrichment, including more generous cash compensation (along international standards), stock options and other schemes.¹⁴ Third, although a domestic A Share listing might carry with it a higher valuation, it is still accepted that, long-term, more capital can be raised in international capital markets than within China—an important consideration for larger companies in capital intense industries contemplating periodic return to the capital markets. Last, the government of China has been encouraging foreign listings of its bellwether companies as a means of “technology transfer”—in this case, not patents and scientific processes, but rather business standards (and ethics), corporate process and financial know-how. The government believes that exposure to the discipline and requirements of international capital markets will cause these companies to raise themselves to international standards in these areas, which are correctly perceived to be sorely lacking in China. They hope that this improvement will then set the standard for China, both improving the efficiency of the Chinese economy and creating the necessary conditions for future access to ever larger capital sums from the international market, changes so vital to sustaining China’s growth. With increasing frequency, the presence of foreign investment (whether private or public) is the “excuse” used by management to deflect demands by local political authorities for investment in locally-favored but diseconomic projects, or for increased but unnecessary employment levels (similar to the way that China’s WTO membership has been seen as being used by political authorities in Beijing as the “excuse” for much needed but painful reforms). True, many Chinese companies still think of foreign investors as “rubes” ripe for the picking. But the desire of many other Chinese companies to reform their methods, from the traditional “Chinese style” to the US model, is evident enough to be regarded as a genuine trend.¹⁵

6. Nexus with US National Security. The Chinese economy is too big to be ignored, and as long as there is profit to be made by investing there (the expected returns adjusted by the perceived risk), investment in China will continue. China’s influence in world events will continue to grow with its economy. One hears much talk about encouraging China to act as a responsible citizen as it takes its place at the world table, meaning that it should act to preserve world order, stability, and, consequently, peace. It is logical to expect that the bigger the “stake” China has in world order and stability, the more likely that China will act to preserve it. This notion is not new, having been first formulated by John Foster Dulles as the doctrine of “peaceful evolution” (originally proposed as a strategy for dealing with post-war Soviet Union). Mao read Dulles closely¹⁶ and understood as well as anyone the risk that peaceful evolution (in Chinese, heping yanbian) posed to the maintenance of revolutionary Chinese communism. Mao feared (as Dulles envisioned) that if China were to become more entwined with the West, and most especially if it became dependant on its economic system, it would gradually adopt more Western values over time, becoming “co-opted,” leaving the Communist Party communist in name only. In the 1960s, espousing peaceful evolution or even being seen as facilitating peaceful evolution through word or deed, was a crime to be severely punished. Today, despite denials from the Party’s remaining ideologues, it appears to be de facto state policy.


FOOTNOTES


1. Similarly, to a Chinese recipient of an investment dollar, it doesn’t matter if the provider is American or European—dollars have no nationality.

2. Matters are evolving at a staggering speed, especially in the methods by which Chinese companies raise capital. This portion of the discussion is thus limited to the last two and one-half years.

3. China National Bureau of Statistics, Foreign Direct Investment By Country or Territory, 2000, (); China National Bureau of Statistics, Utilization of Foreign Capital, Jan – Jul., 2001, (); China Statistical Yearbook, 2000: Table 17-14: Amount of Utilization of Foreign Capital and Foreign Investment, 1999.

4. Hong Kong was the largest contributor of utilized foreign direct investment for the year 2000 at 38%, followed by the EU at 11%, the US at 10.8% and Japan at 7.2%.

5. Bloomberg Financial Services, Equity Offerings; China Securities and Regulatory Commission,
Table 2-2 Summary of Raising Capital for Security Market, (); Hong Kong Stock Exchange, New Listing Report 1999-2001, (); NASDAQ, NASDAQ International Companies: November, 2001, (); New York Stock Exchange, Complete List of Non-US Companies, 2001, (); World Bank, Global Development Finance. International Bond Issues 1999 –2001.

6. The New York Stock Exchange, NYSE Fixed Income Market, 2000; The New York Stock Exchange, NYSE Fixed Income Market, 1999; The New York Stock Exchange, Quick Reference Sheet, 2001; The New York Stock Exchange, The Year in Review 2000.

7. NASDAQ, Total Initial Public Offerings on Nasdaq, ().

8. World Bank, Global Development Finance. Commercial Bank Loans 1999-2001.

9. China National Bureau of Statistics, China Statistical Yearbook, 2000: Table 19-10:Issuance of Domestic Securities. (1999-2001 corporate bond issuances estimated based on 1998 data.)

10. China Securities and Regulatory Commission, Table 2-2 Summary of Raising Capital for Security Market, ().

11. Bloomberg Financial Services, Equity Offerings; Hong Kong Stock Exchange, New Listing Report 1999-2001, (); New York Stock Exchange, Complete List of Non-US Companies, 2001, (http://www.nyse.com/pdfs/forlist011127.pdf).

12. In contrast, the valuation for PetroChina at the time of its international IPO was 9-10 times expected earnings.

13. Shares of oil giant Sinopec listed in Hong Kong, open to international investment, sell at only about one-third of equivalent Sinopec shares trading in the domestic A Share market, reserved for Chinese investment only.

14. Employees of SOEs, in general, still expect an across the board raise in pay when the company becomes foreign invested.

15. The effect of market socialization is evident in foreign direct investment as well, as we have personally witnessed with a number of the companies in which Cathay has invested. The acceptance by Chinese managers of the need for this market socialization has, in turn, reduced many of the difficulties previously faced by foreign direct investors.

16. “Mao Zedong and Dulles’s ‘Peaceful Evolution” Strategy: Revelations from Bo Yibo’s Memoirs, introduction and translation by Qinag Zhai, CWIHP Bulletin 6-7, Cold War International History Project, Woodrow Wilson International Center for Scholars.