Outline of remarks to the U.S. – China Commission
Public Hearing: December 6th 2001
Professor Warren Bailey
Johnson Graduate School of Management
Cornell University
Red Star Over Wall Street:
Chinese Companies and U.S. Stock Markets
1a. Stock markets in China: A large and growing phenomenon 1
Over 1000 listed companies
About 60 million brokerage accounts
Market capitalization (the value of all listed companies) is about US$500 billion
Turnover (the value of all transactions per year) is about US$700 billion
1b. PRC companies listed on U.S. stock markets
(Appendix I: Chinese
stocks listed in the U.S. market ) (PDF file)
Several dozen listed formally on a stock exchange, or “over the counter
Lots of “traditional” industries, energy and telecoms seem largest
Listing in U.S. often coincides with privatization
2a. (Textbook) purposes that stock markets are intended to serve
Mobilize savings and channel funds to economy’s most pressing or promising
investment needs
Spread risk over many investors, therefore more businesses are initiated
Provide price "signals": which industries are most highly valued and,
thus, deserving of more investment?
Facilitate privatization of state enterprises
- end government subsidies, raise revenue for the government
- free enterprises of political influences, improve performance
- help build the local capital market
- disperse ownership of companies among citizenry
Enable external corporate control (mergers, takeovers, etc.) as an alternative
to internal control, political/legal/regulatory control, or the indirect discipline
of the product market
Attract foreign portfolio investment
2b. What purposes might the PRC leaders have in mind?
Raise domestic and foreign funds for investment
“Mop up” vast domestic flow of savings (~40% of GDP?)
Put indirect pressure on the banking system
Offer citizens the opportunity to own “a piece of the rock”
2c. How does listing (especially in U.S.) benefit PRC firms?
Raise funds for investment
Raise profile within China and overseas, perhaps to facilitate future issues
Little risk of loss of control since government and other entities typically
hold illiquid shares with effective voting control
No risk of default since dividend is not fixed, unlike bond interest
3. Problems in China's capital market
a. Bad accounting and corporate governance
Premier Zhu is quoted (Far Eastern Economic Review, November 8 2001, page 32)
stating that bad accountants and accounting practices are a “malignant
tumor” that threatens China’s economy.
Numerous outrageous examples of misbehavior (see Appendix 2).
Investors are beginning to demand more accountability and transparency
b. Law 2
PRC securities law is inadequate, pressure to improve is mounting.
Recent court decisions explicitly recognize the inadequacy of existing securities
law and regulation
c. Government fears of social instability originating in the financial markets
Large sales of new securities (IPOs, state shares) drag down the market
Market declines generally anger investors
Corruption and other scandals anger investors
Sour market conditions weaken support for economic liberalization, or weaken
the legitimacy of the Communist Party.
4. Mass public stock investing: Has Zhongnanhai got a tiger by the tail?
Increasing demands from citizens, some politicians, and others for regulation,
transparency, good governance, and functional legal remedies.
Crusading journalists and online chat rooms expose fraud, discuss legal matters,
and seek a more modern capital market.
It is increasingly difficult for the government to ignore these demands and,
indeed, some reformist politicians want to address them constructively.
Implication: The growth of PRC stock markets unleashes forces that the government
must address. If successful, better law, courts, disclosure, and corporate accountability,
and a smaller rule for state interference and corruption, may emerge.
5. How raising capital in the U.S. fits reformist Chinese goals (and perhaps U.S. goals too)
a.] Listing in the U.S. demands greater disclosure
144A ADR program requires only an English translation of the annual report
Over-the-counter Level 1 ADR program also requires SEC registration form
Exchange listed Level 2 and Level 3 ADR programs require substantial disclosure
including an annual Form 20F and a “current events” Form 6K which
can include extensive information.
NYSE also requires semi-annual reports by home country GAAP and encourages quarterly
reports as well.
CONCERN: do higher reporting requirements have a substantial real impact?
b.] Listing in the U.S. puts PRC companies nearer the U.S. legal system 3
Mismanagement, false reporting, and other misbehavior can lead to delisting,
put pressure on auditors, and can draw legal action against companies, auditors,
or investment bankers in U.S. courts.
U.S. listing can signal that a PRC firm intends to uphold high standards
CONCERNS:
Explicit legal recourse against PRC companies in the U.S. may be limited, especially
for over-the-counter listings and for companies with no assets in the U.S.
There is little precedent for using U.S. courts to discipline or reform foreign
corporations even if they are listed in the U.S.
c.] Listing in the U.S. imposes other types of scrutiny
Recommendations of U.S. stock market analysts affect the market for the company’s
shares and the ability to sell additional shares.
Environmental and social issues (example: Sudan) draw pressure and attention
from the U.S. press, politicians, and NGOs, and can dissuade U.S. institutions
from investing.
6. Conclusions
Raising equity capital in the U.S. increases expectations and pressure for
higher quality governance, disclosure, and legal standards to be imposed on
PRC corporations.
To garner the benefits of U.S. listing, PRC firms must submit to these pressures
and adhere more closely to U.S. capital market norms.
QUESTION: Will U.S. norms filter back to China and influence the Chinese trading,
legal, and disclosure environment?
Listing in the U.S. adds to the cacophony of voices of PRC investors, reform
minded politicians, and economists who want better legal and disclosure standards
and better corporate performance.
QUESTION: Are improved stock market practices part of the “thin edge of
the wedge” that separates business and government in China, increases the
efficiency and fairness of the economy, and compels PRC governmental institutions
to be more responsive to the needs of citizens? If so, listing in the U.S. should
be encouraged.
Prepared by my Ph.D. student, Miss Yuan Gao. Source is http://www.cnstock.com
(specific link no longer works).
Guangxia (Yinchuan) Industry: Once regarded as the No.1 blue chip, the
company reported a non-existing profit of 745 million RMB in 1999, and 567 million
in 2000. They did this by falsifying sales contracts, export custom report,
tax documents, and financial/accounting receipts. Widely reported in media.
Zhenzhou Baiwen Co (retailer): Inflated profit by 19.08 million RMB before
its IPO by reducing expenses, recognizing revenue in advance, and making IPO
application based on those manipulated accounting numbers. Within three years
after IPO, further inflates profit by minimizing expenses and expensing items
across financial periods. The total inflated profits are 143.9 million RMB.
Moreover, the firm’s assets are unsubstantiated, there are major omissions
in its IPO prospectus, and its annual financial statements contain falsified
records, misleading statements, and major omissions.
Macat Optics & Electronics: Falsified three years’ profits of
93.2 HK$ before its IPO. They also falsified imported equipment financing-renting
contract, and fabricated fixed assets and import-export receipts to be approved
for IPO.
Sanjiu Medical & Pharmaceutical: The company has been listed for about
one year. Big shareholders of the company and related parties use (abuse) 2.5
billion RMB in capital, which is 96% of the company’s net assets.
Beijing Centergate Technologies: Provided collateral for one of its major
holding company’s bank loan of 2.56 billion RMB. The amount of this loan
is 145% of net assets.
China Kejian: The company provided collateral for 24 loans for other
people within 12 months of listing in 1994. The value of the total collateral
is 639.13 million RMB, which is 300.35% of the company’s net assets after
year 2000’s audit.
Hainan Dadonghai Tourism Center: Within the five years, 1993-1997, inflated
profits to 228 million RMB.
Hubei Lantian: The firm inflated its intangible assets by 11 million
RMB, and falsified the firm's and subsidiaries' bank deposit receipts to inflate
bank deposits by 27.7 million RMB. In its IPO application material, it changed
the firm's pre-IPO shares from 83.7 million to 66.96 million shares, and decreased
state, LP, and employee's holdings correspondingly.
Admati, Anat R., and Paul Pfleiderer, 2000, Forcing Firms to Talk: Financial
Disclosure and Externalities, Review of Financial Studies 13, 479-520.
Bailey, Warren, 1994, Risk and Return on China's New Stock Markets: Some Preliminary
Evidence, Pacific Basin Finance Journal 2, 243-60.
Bailey, Warren, Gao, Yuan, and Connie X. Mao, 2001, Business, Government, and
the Information Environment: Stock Trading and Earnings Shocks in China, Indonesia,
and Singapore, unpublished Cornell University and Temple University working
paper (October).
Bailey, Warren, Karolyi, G. Andrew, and Carolina Salva, 2001, Market Segmentation
and the Capital Market Reaction to Earnings Announcements: Evidence from International
Cross-Listings, unpublished Cornell University and Ohio State University working
paper (November).
Ball, Ray, Robin, Ashok, and Joanna Shuang Wu. “Incentives versus Standards:
Properties of Accounting Income in Four East Asian Countries, and Implications
for Acceptance of IAS.” unpublished University of Rochester working paper
(March 2000).
Chen, Zhiwu, and Peng Xiong. “Discounts on Illiquid Stocks: Evidence from
China.” Unpublished Yale University working paper (September 2001).
Fan, Joseph P. H., and T. J. Wong. “Corporate Ownership Structure and the
Informativeness of Accounting Earnings in East Asia.” unpublished Hong
Kong University of Science and Technology working paper (March 2001).
Foerster, Stephen, and G. Andrew Karolyi, 1999, The Effects of Market Segmentation
and Investor Recognition on Asset Prices: Evidence from Foreign Stocks Listing
in the U.S., Journal of Finance 54, 981-1013.
Fuerst, Oren, 1998, A Theoretical Analysis of the Investor Protection Regulations
Argument for Global Listing of Stocks, unpublished Yale University working paper.
Hertz, Ellen. The Trading Crowd: An Ethnography of the Shanghai Stock Market.
Cambridge: Cambridge University Press (1998).
Karolyi, G. Andrew, 1998, Why Do Companies List Their Shares Abroad? A Survey
of the Evidence and its Managerial Implications, Volume 7, Number 1, Salomon
Brothers Monograph Series, New York University.
La Porta, Rafael, Lopez-de-Silanes, Florencio, Shleifer, Andre, and Robert W.
Vishny. “Legal Determinants of External Finance.” Journal of Finance
(July 1997) 52, 1131-1150.
La Porta, Rafael, Lopez-de-Silanes, Florencio, Shleifer, Andre, and Robert W.
Vishny. “Law and Finance” Journal of Political Economy (December 1998)
106, 1113-1155.
Moel, Alberto, 1998, The Role of Information Disclosure on Stock Market Listing
Decisions, unpublished Harvard University working paper.
FOOTNOTES
1. See http://www.csrc.gov.cn/CSRCsite/eng/tongjiku/199908/e-default.html
for more extensive information
2. I thank Professor Zhiwu Chen of Yale University for helpful conversations
on this subject.
3. I thank Professor Andrew Karolyi of Ohio State University for a conversation
on this subject.