Agenda for Capital Market Reforms in the People’s Republic of …aric.adb.org/pdf/aem/external/financial_market/Republic_of_China/ch… · Agenda for Capital Market Reforms in the

Agenda for Capital Market Reforms in the People’s Republic of China

Sang-Koo Nam, Kyung Suh Park,and Yu-Kyung Kim

Professor, Korea University; Professor of Finance, Korea University; Director, International Relations,Korea Stock Exchange

66 A STUDY OF FINANCIAL MARKETS

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Executive Summary

The securities regulatory system in the People’s

Republic of China (PRC) is still fragmented. The

China Securities Regulatory Commission (CSRC)

with no regional branches lacks adequate authority

to impose its regulations, especially at the regional

level, and some regulatory authorities are divided

between the CSRC and the People’s Bank of China

(PBC), causing duplication of regulations, while leav-

ing some gray areas for regulators. At the minimum,

the regulatory responsibilities of the PBC and the

CSRC on capital market institutions including secu-

rities companies, trust and investment companies

(TICs), and mutual funds should be streamlined.

In the equity market, a larger role for listing de-

cision should be given to the stock exchanges while

restricting the municipal authorities’ discretion.

More objective and transparent listing criteria should

be employed in the initial public offering (IPO) pro-

cess and firms with sound financial fundamentals

should be given first priority to list their shares. The

Government’s influence on corporations should also

be minimized by allowing the State-owned enter-

prises to be privatized by increasing the proportion

of shares sold to the public so that private investors

may play a role in the management of the firms.

Problems stemming from the geographical segmen-

tation of the stock exchanges between Shanghai

and Shenzhen could be significantly alleviated by

allowing the cross-listing of A-shares on the two

major exchanges.

The foremost concern in the Chinese securities

tax system is the fairness of tax burdens among

different taxpayers. The tax exemption on capital

gains of individual investors should be gradually re-

moved, and differential tax burdens among corpo-

rations should also be corrected. The current stamp

duty system on securities transactions should be

replaced by a securities transaction tax system and

the double taxation on dividend income should be

corrected as well.

In the bond market, the PRC Government should

consider announcing a schedule for a year’s issue of

long-term bonds, based on the Government’s financ-

ing needs, spread more or less evenly over the year.

The Ministry of Finance also needs to issue short-

term debt to meet short-term liquidity needs. Gov-

ernment bonds can be sold by auction, with the cou-

pon rates fixed in advance. It is also imperative for

the PRC Government to create a nationally integrated

money market, paving the way for the introduction

of open market operations. Moreover, well-function-

ing depositories, preferably a single nationwide cen-

tral depository, are vital to aggregate bond issues of

small denominations into wholesale packages that are

readily tradable.

The restrictive regulation on financing and op-

eration of funds of the institutional investors needs

to be mitigated. Higher priority in listing on the stock

exchanges should be given to the capital market

institutions as a part of deregulation. Risk-based

capital requirements need to be imposed on capital

market institutions and, if necessary, an indepen-

dent “Investor Protection Fund,” consisting of the

contributions by capital market institutions, could

be established.

For the sound development of institutional inves-

tors, the degree of freedom in the operation of their

funds, especially those for capital market invest-

ments, should be expanded. A performance evalu-

ation system that emphasizes the profitability of the

institutional investors should be introduced. To ex-

pedite the active participation of institutional inves-

tors in capital market operations, a favorable tax

treatment on profits and losses in securities invest-

ment can be considered. The trust and investment

companies (TICs), in the short run, need to be al-

lowed to access individual investors and manage

their trusted properties including financial assets.

In the longer run, the integration of TICs and mu-

tual funds industries can be pursued as a policy al-

ternative to promote the efficiency and soundness

of industries.

67AGENDA FOR CAPITAL MARKET REFORMS IN THE PRC

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Introduction

The recent financial crisis in Southeast Asian coun-

tries has led the leaders of the People’s Republic of

China (PRC) to refocus on a model of how to run

the economy. The Government-driven economy that

dictates which company will receive funding seems

to have exhibited its limitations. Evidence of a troubled

controlled economy can be found in the banking sec-

tor. As Chinese leaders witnessed in the Asian fi-

nancial crisis, weak banks can undo years of strong

growth. These days Chinese leaders are beginning

to accept some aspects of a market economy that is

similar to the economy of the United States (US).

The PRC’s central bank, for instance, is remodeling

itself after the US Federal Reserve System. Its com-

panies are adopting US-style accounting principles.

Beijing is studying how the US Resolution Trust Corp.

(RTC) helped untangle the 1980s savings-and-loan

mess, hoping a Chinese RTC could do the same for

the PRC’s technically insolvent banking system.

To loosen the intimate links between banks, big

business, and the Government, the PRC is reviewing

the financial system of the US, which is known for

its independence and profit-oriented management.

Key to the PRC’s banking reforms is restoring State

companies to health so that they can pay back at

least some of their outstanding loans. Those State

enterprises, which are the banks’ largest debtors,

received most of the PRC’s $62 trillion in loans in

1997. To pursue the reforms, the Communist Party

Congress in October 1997 endorsed a plan to turn

10,000 or more State companies into publicly traded

concerns. The hope is that market forces will help

winnow out the weaker companies, as cash-rich busi-

nesses start acquiring the poor companies and the

chronically unprofitable are finally allowed to exit

from the market. As a result, stock market listings,

now basically confined to State companies, will start

to include a higher proportion of firms with private or

Sino-foreign ownership. As the number of private

companies grows and companies become more re-

sponsive to shareholders, the country’s economy will

be more open, transparent, and market-driven. The

PRC is moving away from an Asian model of closed,

export-driven development and toward an open

economy with a huge domestic market. However,

the country may find it difficult to totally abandon the

Asian-style economic growth model that has proved

itself useful during the past decades of Asia’s break-

neck growth.

Although the development of securities markets

in the PRC can be traced back to as early as 1914, it

was not until 1990 that the first stock exchange was

established in Shanghai. Unable to wait for the na-

tional securities laws to be enacted, the local authori-

ties of Shanghai and Shenzhen developed their own

respective local company and securities laws, and

on 19 December 1990, the Shanghai Stock Exchange

(SHSE) officially opened as a nonprofit organiza-

tion. The Shenzhen Stock Exchange (SZSE) followed

suit on 3 July 1991. Its organization and structure

closely resemble those of its Shanghai counterpart.

The two markets are comparable in both market

capitalization and trading value.

In 1993, the first set of national securities regula-

tions were enacted by the State Council Securities

Committee (SCSC) and China Securities Regulatory

Commission (CSRC). The SCSC is the highest regu-

latory body in the PRC and the CSRC is the executive

arm of the SCSC. On 19 June 1993, the regulatory

authorities of the PRC and Hong Kong, China, signed

the Chinese Hong Kong Memorandum of Regulatory

Cooperation, which paved the way for the issue of H-

shares on the Stock Exchange of Hong Kong, China.

Tsingtao Brewery became the first Chinese company

to be officially listed in Hong Kong, China. A Memo-

randum of Understanding signed by the New York

Stock Exchange (NYSE), the CSRC, and the US Se-

curities and Exchange Commission on 27 April 1994

made it possible for shares issued by Chinese compa-

nies (called N-shares) to be listed on the NYSE.

As the basic statistics indicate (Table 1), the size

of the PRC’s stock market has grown at a very rapid


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Table 1: Some Basic Statistics of the PRC Equity Market

Item 1992 1993 1994 1995 1996 Feb 1997

Listed Firms (number) SH 30 106 171 188 293 383a

SZ 24 77 120 135 237 362a

Listed Stocks SH-A 30 101 169 184 287 377

SH-B 9 22 34 36 42 50

SZ-A 24 76 118 127 227 351

SZ-B 9 19 24 34 43 51

Year-end Index SH-A 816 848 668 575 955 1,258

SH-B 66 103 63 48 67 56

SZ-A 255 246 144 117 342 406

SZ-B 112 141 87 59 145 99

Year-end Market Value (RMP billion) SH-A 48 209 249 245 533 912

SH-B 4 13 12 9 16 19

SZ-A 45 124 102 86 413 800

SZ-B 3 8 6 7 23 20

Market Capitalization to GDP Ratio (percent) SH & SZ 3.93 10.20 7.89 5.94 14.52 23a

Average Daily Return, Standard Deviation (percent) SH-A 0.64 0.09 0.02 (0.10) 0.24 0.14

(8.33) (3.88) (4.96) (3.21) (2.76) (2.22)

SH-B (0.26) 0.20 (0.18) (0.10) (0.16) (0.05)

(2.32) (2.36) (1.57) (1.05) (2.23) (2.38)

SZ-A (0.10) 0.03 (0.12) (0.44) 0.48 0.10

(4.04) (3.03) (4.56) (2.93) (3.12) (2.52)

SZ-B (0.43) (0.10) (0.19) (0.15) 0.42 (0.13)

(1.33) (2.11) (0.90) (0.95) (3.31) (2.42)

Price/Earnings Ratio (percent) SH na 42.5 23.4 15.7 31.3 37.0

SZ na 42.7 10.3 9.5 35.4 39.2

Average Daily Trading Value (RMB million) SH-A 91 879 2,239 1,208 3,651 5,579

SH-B 7 31 49 24 38 88

SZ-A 195 427 932 362 4,873 6,891

SZ-B 2 11 5 7 79 88

Average Daily Turnover Ratio (percent) SH-A 0.43 3.81 3.55 2.18 3.32 3.48

SH-B 0.04 0.51 0.42 0.24 0.28 0.39

SZ-A 1.49 2.01 2.39 0.98 4.99 2.94

SZ-B 0.07 0.19 0.10 0.11 0.52 0.38

Number of Membersb SH 106 481 550 558 521 467a

SZ 117 426 496 532 542 373

Number of Investors (million) SH 1.11 4.24 5.75 6.85 12.08 17.13a

SZ 1.05 3.54 4.84 5.57 10.99 16.20a

na = not available; ( ) = standard deviation and negative average return are enclosed in parentheses; SH = Shanghai Stock Exchange; SZ = Shenzhen Stock Exchange.a Year-end 1997.b Foreign brokers do not qualify as members. They are permitted to solicit orders for B-shares but have to route their orders through local exchange members for execution. But in

1993 the SHSE invited foreign brokers to sponsor memberships and they are entitled to put a trader on the floor but have to clear and settle through a local member with whomthey share the commission.

Sources: Shanghai and Shenzhen stock exchanges, the PRC Securities Regulatory Commission. Various unpublished manuscripts.


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pace. The number of listed firms increased from 54

at year-end 1992 to 745 as of end of February 1997.

The number of listed stocks and market capitaliza-

tion increased more than 10-fold in a rather short

period of five years. More than 700 A-share issues

are now listed on the SHSE and SZSE. Total mar-

ket capitalization exceeds $200 billion, or nearly one

fifth of the country’s gross domestic product (GDP).

The daily trading volume typically hits 750 million

shares, more than the roughly 500 million shares

that change hands every day on the London Stock

Exchange.

Considering a relatively short history of stock mar-

kets, it is too early to judge the long-term perfor-

mance of the PRC’s stock market. However, Chi-

nese securities markets have some unique features

that are not found in other Asian emerging mar-

kets. Some of these characteristics originated from

historical reasons or political considerations. The

main purpose of this paper is to evaluate some of

these unique features, and make some policy rec-

ommendations. Given its immense financing needs,

the PRC’s economy cannot grow without capital

markets. The danger is that capital markets built on

planned economics and political connections – and

without a free press as a watchdog – may some-

day collapse, wiping out the investments of tens of

millions of investors.

The Securities RegulatorySystem in the PRCSecurities Legislationand RegulationThe PRC today has no national securities law. This

fact has been a major frustration to analysts and bro-

kers who wish to see the markets developing more

rapidly. The ratification of a national securities law

has been held up for years. Officials had hinted that

the Securities Law, which was in the drafting pro-

cess for roughly five years since 1993, would finally

be ratified in March 1997. It was not. Many people

working in the securities market had hoped that the

long bureaucratic journey might come to an end in

the meeting of the National People’s Congress, the

PRC’s parliament, in March 1998. Again, Congress

failed to put an end to this long and tiresome pro-

cess. The absence of a national securities law makes

the regulatory framework sometimes confusing. It

appears that the Government usually plays the sub-

stantial role and oftentimes initiates ad hoc interven-

tion, especially in the primary market. Another diffi-

culty is in enforcing and ensuring compliance with

the regulations. The enactment of a national securi-

ties law will certainly improve regulatory transpar-

ency and effectiveness.

Early securities regulations were promulgated in

1987 and were supplemented with a State Council

circular and People’s Bank of China (PBC) circular

in 1989. The first national regulations on securities

issuing and trading, known as the Interim Regula-

tions on Share Issuing and Trading, were issued in

May 1993 by the SCSC. This set of more than 20

regulations forms the framework within which the

present regulators of the securities markets, namely

the SCSC and the CSRC, operate.

Meanwhile, the new national Company Law came

into effect on 1 July 1994. The Law contains several

provisions regarding the issuing, trading, and listing

of so-called “public” securities, which normally would

be included in the securities law. In the absence of a

securities law, the Company Law has been a major

step forward for securities market regulation. It does

not replace or abrogate previous regulations, and must

be incorporated as a new layer into the existing legal

framework.

National Regulatory StructureThe basic framework of Chinese securities market

regulation is a two-tier structure that is split between

the national and regional levels. Until 1992, the Fi-

nancial Administration Department of the PBC su-

pervised all securities-related matters. Following the

Shenzhen riot of August 1992 over a new issue, the


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State Council on 17 December 1992 issued Docu-

ment 68, which spelled out details for a new, national

regulator for developing securities markets.

At the national level, the first arm of the new

regulatory structure is the SCSC. The SCSC is re-

sponsible for (i) macro policy issues relating to the

securities markets, including approval for the es-

tablishment of new stock exchanges and approval

of new securities legislation and regulations; and

(ii) setting the level of securities issues over a given

period for both bonds and shares at the national

and provincial levels.

The second tier of the regulatory framework is

the executive body of the SCSC, namely, CSRC.

The CSRC is an independent legal entity. As such, it

has taken over most of the functions previously per-

formed by the Financial Administration Department

of the PBC. The major functions of the CSRC are to

• draft securities legislation and regulations;

• supervise and administer the public issuance and

trading of securities;

• supervise and administer securities firms, settle-

ment and delivery operations, mutual funds, and

the professionals engaged in the securities in-

dustry;

• set up qualification criteria and issue licenses for

securities professionals;

• supervise and monitor companies that issue se-

curities;

• regulate companies that want to list their share

overseas; and

• supervise the operation of securities exchanges

and an automated quotation system.

In addition, the CSRC gives approval for all list-

ings pursuant to both the Company Law and the In-

terim Securities Regulations issued based on Docu-

ment 68.1

The Company Law also names the CSRC

as the authority to suspend a listing if the company

fails to meet the conditions for listing.2 This responsi-

bility requires a substantial amount of time on the

part of the CSRC. The CSRC is responsible for su-

pervising commodities futures trading as well.

Considering the substantial list of responsibilities

and securities market activities (para. 12), the CSRC

is understaffed with approximately 180 employees

as of April 1998. Already limited by its inadequate

staff, the CSRC has no regional offices, further weak-

ening its authority. To exercise its present mandate

effectively, the CSRC needs to be strengthened con-

siderably. Meanwhile, even though most of the regu-

latory functions of the PBC were transferred to the

SCSC and the CSRC since December 1992, the PBC

still remains responsible for the licensing of all finan-

cial institutions including securities firms. The impli-

cation is that the regulatory functions are still split

between the PBC and the CSRC. The role of the

PBC in the licensing of securities intermediaries is

one anomaly in the PRC that occurred for historical

reasons. That is, over 90 percent of the brokers origi-

nated as the subsidiaries of banks.

Regional Regulatory StructurePrior to November 1992, regional regulation was

carried out by the provincial governments. The PBC

was also closely involved at the regional-level regu-

lations through its branch offices. Local securities

regulatory bodies, namely the Shanghai Securities

Commission and the Shenzhen Securities Commis-

sion, were established in Shanghai and Shenzhen by

the local municipal governments.

A local regulatory body does not have authority in

any area where there is a national regulation. How-

ever, municipal regulations can be enforced if na-

tional regulations are silent on a particular point. The

local regulatory body (e.g., Shanghai Securities Com-

mission) reports on a day-to-day basis to the munici-

pal government, and not to the SCSC or the CSRC.

But it is responsible to the CSRC for the proper ad-

ministration of the national regulations, and is required

to bring to the attention of the CSRC any observed

breaches or problems within the CSRC’s jurisdic-

tion. The three-way links between the central and

regional regulators and the PBC are more complex,

especially with respect to securities dealers. Although


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the PBC is responsible for the licensing of securities

dealers and their ongoing financial soundness, the

regional regulatory body is also responsible for their

business performance. At the same time the direct

operation of a secondary market is overseen by the

SCSC and the CSRC. Therefore, if a broker is in

violation of regulations, the CSRC is responsible for

investigation and penalties. In most serious situations,

it can suspend a broker from trading, but only the

PBC can revoke the broker’s license.

EvaluationThe provisions of existing securities regulations of

the PRC, in general, are sound by international com-

parison, and fairly well defined, although the provi-

sions sometimes are not well organized (i.e., they

are put in unusual places, perhaps due to the ab-

sence of a national securities law). The regulatory

framework is still somewhat confusing, however. One

key issue at present is the fragmentation of over-

sight. The regional and institutional division of re-

sponsibilities best characterizes the current regula-

tory system in the PRC. Because of this fragmenta-

tion of oversight, there is a strong possibility that

those who are actually in (or near) the exchanges,

and therefore know best what is going on, do not

always have the authority to investigate or penalize

the illegal activities. Theoretically, the CSRC has

power to conduct investigations, but it has no

branches in the regions, nor has it delegated any

authority to the regions. In reality, the regulatory

power is geographically separated from where the

actions take place. This may cause inefficiency and

duplication of regulations.

Even though in 1995 the status of the CSRC was

raised to an institution directly under the State Coun-

cil, some unusual aspect of the CSRC undermines

its effectiveness and authority. Since the CSRC has

no regional offices, its regional authority depends on

inputs from autonomous securities’ regulatory orga-

nizations over which it has no direct control. As a

result, the CSRC lacks adequate authority to impose

its regulations, especially at a regional level. There is

clear duplication of work between the CSRC and

the municipal securities regulatory agencies. More-

over, the CSRC has no licensing authority (the PBC

has maintained that authority) for exchanges or se-

curities market institutions that are under its jurisdic-

tion. The current division of regulatory authorities

between the CSRC and the PBC leads to instances

where very few regulations are imposed, leaving gray

areas for regulators. One such example is the moni-

toring and regulation of activities of securities deal-

ers. Whether or not the CSRC should be given more

power for securities-related matters seems to be

pretty much a political issue at present. One thing is

obvious, however; for the regulatory framework to

be effectively implemented, the CSRC should be

strengthened and properly staffed and through its own

regional offices (the CSRC at present has no re-

gional offices), it should be given jurisdiction over

regional trading centers.

At present, the concept of a self-regulatory frame-

work in the PRC is not well established although

Document No. 68 and the Interim Securities Regu-

lations did introduce such a concept a number of years

ago. The proposed securities industry legislation has

discussed a self-regulatory association with possible

membership for securities companies. Various secu-

rities organizations in the PRC (including two official

exchanges, the Securities Trading Automated Quo-

tations System [STAQS], the National Electronic

Trading System [NETS], and the Securities Asso-

ciation of China [SAC]) are referred to as self-regu-

latory organizations (SROs), but none of them, in

reality, perform such functions satisfactorily.

The two exchanges and the two trading systems

(STAQS and NETS) regulate their marketplaces in

terms of listing and trading rules, but they do not ap-

pear to exercise any regulatory functions concern-

ing sales practices or other activities of their mem-

bers. For example, they do not perform regular in-

spections of their members to determine compliance

with the law and their own rules. The CSRC, in fact,


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has raised questions about the commitment of the

exchanges to enforce disclosure requirements on the

listed firms.3 Although the two exchanges are

equipped with advanced electronic systems, neither

of them is enthusiastic about operating a market sur-

veillance system.

The SAC was established as a regulatory body,

but it has not fulfilled the role of self-regulation as

expected. There is discussion that a securities asso-

ciation be established in each province in the hope

that it would become an SRO. For uniformity in regu-

lation, however, it is not desirable to create additional

securities associations at the national or regional level.

Eventually, it may be necessary to establish regional

branches of the nationwide organization, but, in any

case, having one such nationwide organization would

be the best solution. After all, self-regulation will not

function properly if regulation is more strict or le-

nient in one province than it is in another.

The Equity MarketThe Shareholding Systemin the PRCThe concept of shareholding in the PRC has been

formalized in the Company Law. Yet, the private

shareholding system in the PRC still has some spe-

cial characteristics that are not found in other capital

markets. Privatization of State-owned enterprises

(SOEs) and the sale of existing Government shares

to private shareholders are now permitted, following

a resolution by the 15th Congress of the Communist

Party in early 1998. However, the SOE’s primary

aim for listing is to raise capital for investment. SOEs

normally issue new shares when they go to the mar-

ket, making the initial public offering (IPO) process

important. The IPO process and the listing proce-

dure are still very much under the control of the Gov-

ernment. Unfortunately, however, the Government-

controlled IPO process is not always transparent

enough, causing some serious distortion in capital al-

location (pages 72–73). The Chinese Government

also introduced a surprising variety of shares (A, B,

C, H, and N); as a result, the market segmentation

problem has become a very important issue in the

PRC today. A securities taxation system is yet to be

well established and unified to support the develop-

ment of the securities markets (for securities taxa-

tion, see pages 79–80).

The Process for New IssuesEnterprises in the PRC list their shares on stock ex-

changes primarily to raise capital for investment, and

not for the purpose of privatization. Thus, all enter-

prises listed on stock exchanges have issued new

shares, virtually all of which have been IPOs. With

debts piling up at the country’s troubled State banks,

Beijing wants its equity market to assume the bur-

den of corporate financing and to lead the pace of

economic reform. More than 100,000 State enter-

prises are scheduled for financial overhauls in the

next three years, and many hope to gain stock mar-

ket listings. As cash-strapped State enterprises line

up to sell their stocks, the plan is for individual share-

holders to finance the companies and to encourage

the enterprises to become more profitable.

New quotas for A-shares (pages 74–75) are de-

termined jointly by the SCSC, the State Planning Com-

mission (SPC), and the central bank (PBC) as part

of the national investment and credit plan.4To con-

trol the flow of new offerings, the CSRC, Beijing’s

market overseer, allocates annual share quotas to

each of the 29 central Government ministries that

oversee various industries, and the 30 provinces and

autonomous regions. The allocation to provinces takes

into account such factors as balanced regional dis-

persion of resources and recognition of wide regional

differences in the production structure.

LISTING CRITERIA

The local securities authorities within each region

invite enterprises to apply for listing, and then make

selections based on the performance of the firms

and sectoral development objectives. The local gov-


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ernment selection criteria for listing are, among other

things, asset size, financial conditions, recent perfor-

mance, and future prospects of the enterprises. As a

result, the real selection of enterprises for listing takes

place at the regional level, and the subsequent pro-

cess is virtually automatic. This listing process dif-

fers considerably from those of more mature securi-

ties markets in other countries, where the decision to

list a company would be determined mainly by the

exchange on which it seeks a listing. The ultimate

power of municipal authorities for listing decisions

creates some serious problems (i.e., geographical

segmentation and inefficient listing decisions); there-

fore, a reduction in the power of municipal securities

authorities should be sought in the near future. De-

spite the fact that objective listing criteria are em-

ployed in the IPO process, the overall procedure has

not been transparent enough, and some of the firms

for listing were found to be surprising.5 The enter-

prises selected for listing are perhaps a little more

successful than the average SOEs, but are not al-

ways the same as the ones that would have been

selected by the market. In several cases, listed firms

showed poor performance after their listing. Although

the arbitrariness of the selection process can be con-

siderably reduced by the establishment of indepen-

dent review panels, it could make the system vulner-

able to a different type of influence. Unclear listing

procedures and disappointing results tend to under-

mine the growth of the capital market. After all, an

efficient allocation of resources can hardly be

achieved if the major criterion of listing is anything

but the soundness of underlying performance.

Recently, however, there has been a significant

change in the principles of A-share quota alloca-

tion and selection of companies for listing. Before

1997, the A-share quota was allocated by relevant

departments under the State Council among prov-

inces and ministries that, in turn, distributed their

shares among their own enterprises within the

quota. Beginning in 1997, however, each province

and ministry shall first submit a limited list of com-

panies applying for listing, and the relevant depart-

ments under the State Council then allocate the A-

share quotas among provinces and ministries based

on the limited lists. This practice reduces the power

of the regional authority considerably.

NONDISCRETIONARY SHARE ALLOCATION

After an IPO is announced, a prospectus is published,

and underwriters are chosen largely at the discretion

of the local securities authority. Prospective inves-

tors, for a small fee, obtain application forms from

banks or brokers. This creates a potential problem

(see page 74). The IPOs are usually oversubscribed;

consequently, a lottery is conducted to determine the

final allocation of available shares to investors. New

issues tend to be clustered in lumps so that lotteries

have to be used to determine whether an investor is

eligible to apply at all, and which enterprise’s share

he/she can buy. The whole process typically takes

as long as one and a half months.

The lottery system and nondiscretionary share

allocation make it impossible for investors to know

which enterprises’ shares they may acquire, mak-

ing investment decisions based on fundamentals all

but irrelevant, if not useless. Thus, the demand for

equity is largely driven by speculation. While lim-

ited availability of information due to poor disclo-

sure is certainly a problem, under the current sys-

tem of share allocation, investors would find such

information meaningless even if it were available.

The IPO process would be greatly improved if

(i) the clustering of new issues could be avoided,

and (ii) each new offer is backed by widely avail-

able and reliable information about the fundamen-

tals of the company.

The securities commission also controls pricing,

requiring that new offerings be pitched at no more

than 15 times earnings, regardless of fundamentals.

The controls are in place to guarantee that new is-

sues won’t flop. This requirement results in signifi-

cant underpricing, limiting the efficiency of the re-

source allocative function of the primary market. This


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restriction makes IPOs attractive because the aver-

age market-multiple is currently over 40 for A-shares,

raising false and unrealistic expectations among in-

vestors. Such expectations lead to herd behavior,

speculative bubbles, and excessive volatility. Together

with their underwriters, the companies eager for list-

ing, battle for the cheap capital by influencing the

government officials through various channels.6 The

result is that many of the companies listing now are

only marginally profitable. Some are so financially

strapped that underwriters must extend bridge loans

to them before contracts are signed.

With the fee charged to investors for application

forms, the lottery system may provide revenues to

local authorities. Naturally, this revenue increases

with the degree of oversubscription. The system

adopted in the past, with the State securities au-

thorities and participating banks or brokers sharing

such revenues, tended to reduce the incentive for

all agents (except the enterprise itself) to raise the

offer price, as it would reduce the demand for ap-

plication forms. It is difficult to assess how wide-

spread such revenue-sharing arrangements are to-

day. In any case, the recommendation is that any

remaining attempt to charge a fee for application

forms should be discouraged.

Corporate governance structure is another issue.

On average, only about 25 percent of the total shares

of an SOE is sold to the public, and the State and the

SOE still maintain absolute majority of shares. Since

less than 25 percent of stocks are in the hands of

private investors, they are in no position to exercise

voting power with any prospect of control. The ab-

sence of a controlling right for shareholders

oftentimes results in inefficiency in the management

of listed firms as the managers of listed firms do not

have to deal with the market pressure for improved

efficiency. The prospect of no voting power in real-

ity implies that stocks are in general undervalued since

shares are evaluated according to their cash flow

values only, excluding the voting rights. In addition,

since only about 25 percent of all shares are traded

in the market, the liquidity of a stock becomes lower

than desired.

For the sound development of a Chinese capital

market, the privatization scheme of SOEs would have

to be reexamined very carefully. Priorities in listing

should be given to firms with sound financial status,

and the capital market and the intermediaries’ role

have to be expanded in the process. The proportion

of shares sold to the public should be enlarged so

that more active investors can play a role in the man-

agement of firms. Above all, the Government’s in-

fluence on the corporations should be minimized, and

the governance of a listed firm should be market-

based, rather than State-determined.

Types of SharesA-SHARES FOR DOMESTIC INVESTORS

A-shares are equivalent to the ordinary common

shares as generally accepted in other market econo-

mies, and are known as individual or natural person

shares in the PRC. They are strictly restricted to

Chinese nationals, and denominated in renminbi with

a par value of RMB1. Naturally, the A-share mar-

ket dominates the equity market of the PRC in terms

of both size and activity. The A-shares may only be

traded by individuals or legal persons within the PRC

(i.e., two domestic stock exchanges). The A-shares

are different from the legal person shares (type C),

which individuals may not purchase. Due to the mi-

nority nature of the A-shares in corporate gover-

nance structure (column 1), they provide investors

very little, if any, voting power or any prospect of

control.

Although foreign investors are not permitted to

hold A-shares, it is widely believed that some A-

shares are already in the hands of overseas inves-

tors, probably under the borrowed names of Chinese

nationals. The size of such share holdings is likely to

be small. However, this type of secret and illegal

entry of foreign investors into the domestic equity

market was what prompted the Chinese Government

to allow legal share holdings by foreigners in terms


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distributions to foreign shareholders are all paid in

foreign currencies based on the latest exchange rates

quoted by the PBC. With the exception of the re-

striction on the status of shareholders, the B-shares

are exactly the same as A-shares. That is, B-shares

are in fact domestically listed and foreign-invested

ordinary shares.

The first B-shares to foreign investors were pub-

licly issued in 1992 by Shanghai Vacuum, already

listed on the SHSE. In the same year, the SZSE per-

mitted trading of the B-shares of another Chinese

firm, Southern Glass. The distinction between A- and

B-shares was established to limit foreign ownership

of enterprises. However, as the two shares do not

differ, except for the convertibility of Chinese cur-

rency, there is no reason to prevent Chinese nation-

als with access to foreign currency from purchasing

B-shares. In reality, some Chinese are believed to

have been investing in B-shares through overseas

relatives and friends, making current regulations in-

effective. Ultimately, A- and B-shares are due to

merge. This may be a boon to foreign investors who

hold B-shares that currently trade at substantial dis-

counts to their A-share equivalents (see Table 1).

The CSRC has been quoted as stating that B-shares

as a separate category will be abolished when the

yuan becomes freely convertible. Considering the

Chinese Government’s cautious approach due to the

recent financial turmoil in Asian countries, however,

foreign investors may have to be a little more patient

on this matter.

C-SHARES FOR LEGAL PERSONS

C-shares are unique to the Chinese equity market.

They have been created to designate holdings in

SOEs by official bodies having legal person status.

Individual investors are not allowed to hold C-shares.

Only legal persons (State institutions, SOEs, and

Government departments) can hold C-shares. But

the legal persons are entitled to purchase A-shares

as well as C-shares. C-shares are, in general, very

illiquid, and are traded over the counter (OTC) on

of B-shares. In July 1994, the CSRC announced a

plan to permit non-Chinese nationals to purchase A-

shares through specially authorized joint-venture

mutual funds, but the details of the plan are yet to be

spelled out.

Table 2 shows the growth of the A-share market

of the PRC in recent years. The A-share market

experienced a huge change in both trading volume

and market capitalization in 1995 and 1996. There

are three main reasons. First, there was a large jump

in the number of listed companies between 1995 and

1996. At year-end 1995 there were 188 for SHSE

and 135 for SZSE. The figures at year-end 1996 were

293 for SHSE and 237 for SZHE, respectively. More-

over, the IPOs were relatively large as one com-

pares the increase in the stock market index (Table

1) and the stock market capitalization. Second, many

Chinese citizens found the stock market to be inter-

esting and a potential for profit making. The number

of investors increased from around 12 million to 23

million between 1995 and 1996. Third, the total trad-

ing volume included repos of treasury bills, which

experienced the highest trading volume in 1995.

B-SHARES FOR OVERSEAS INVESTORS

B-shares are the same ordinary shares bearing the

same voting and ownership rights and obligations as

the A-shares. Like the A-shares, B-shares are de-

nominated in renminbi, but traded in either US dol-

lars (in Shanghai) or Hong Kong dollars (in Shenzhen).

B-shares can only be subscribed by, and traded

among, foreign investors including the residents of

Hong Kong, China; Macau; and Taipei,China. Sub-

scriptions for foreign shares, and dividends and cash

Table 2: The A-share Market of the PRC

Sources: Shanghai and Shenzhen Stock Exchanges, 1998, Guotai Securities, 1998. 3.

Item 1994 1995 1996 1997

Number

Listed companies 291 323 530 745

$ million

Daily trading volume 400 213 1,175 1,654

Market capitalization 44,520 41,880 119,340 211,200


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STAQS and NETS, the official electronic OTC mar-

kets in the PRC. As a result, firms with a large

proportion of their equity capital in C-shares are

subject to higher cost of capital than their competi-

tors with more A- or B-shares. Only a few C-shares

are listed on either STAQS (10 issues) or NETS (7

issues), but over 4,000 joint-stock companies are

known to have issued C-shares by private place-

ment. Since June 1993, new listings of C-shares

have been prohibited.

Many companies now want to convert their C-

shares into A- or B-shares. However, the Govern-

ment is hesitant to allow the conversion because it is

worried that the State assets may be transferred to

the private sector (if converted to A-shares) or even

foreign ownership (if converted to B-, H-, or N-

shares).7 Another concern is that the conversion of

C-shares may cause an oversupply of shares, put-

ting some downward pressure on stock prices. But

this concern seems to be unwarranted. If the con-

version of C-shares is allowed, the proceeds from

the conversion could be used to purchase another

class of shares, thus adding to the liquidity in the A-

or B-share markets.

H-SHARES LISTED IN HONG KONG, CHINA

H-shares refer to the common stocks of Chinese

companies listed on the Hong Kong Stock Exchange

(HKSE), and traded in Hong Kong dollars. The Gov-

ernment of the PRC introduced this new category of

shares officially in July 1993 to establish a legal av-

enue for overseas listing. H-shares may only be sub-

scribed by and traded among foreigners and resi-

dents of Hong Kong, China; Macau; and Taipei,China.

As of 1998, 34 H-shares are listed on the HKSE.

Before the creation of H-shares, some Chinese com-

panies acquired controlling interest in companies listed

in Hong Kong, China, to access overseas equity fi-

nancing. As a result, a variety of companies based in

Hong Kong, China, are in fact controlled by main-

land Chinese. These companies are called the “red

chips,” and include such high-profile companies as

China Investment and Trust Corporation (CITIC)

Pacific, and Guangdong Investment. The creation of

H-shares is partly in response to such backdoor list-

ing of Chinese companies in Hong Kong, China.

H-shares are effectively a primary listing of a for-

eign company on the HKSE, and, therefore, are not

unusual in principle. What makes H-shares unique

is the fact that special arrangements have been

adopted and certain concessions have had to be

made to accommodate the current lack of a con-

ventional legal infrastructure in the PRC. Another

prestige of listing H-shares as compared to the stan-

dard B-share offering has to do with the PRC’s

opaque corporate culture. Foreign investors feel

more comfortable investing in Hong Kong, China,

which seems to make greater demands on Chinese

firms for transparency and modern corporate gov-

ernance, than the small community of investors in

Shanghai and Shenzhen require.

N-SHARES LISTED IN NEW YORK

Similar to the backdoor listing in Hong Kong, China,

some so-called “Bermuda listings” of Chinese com-

panies in New York through overseas registered hold-

ing companies had occurred. In response to such

offerings, and encouraged by success in H-share

offerings in Hong Kong, China, the Government au-

thorized the legal registration and listing of Chinese

enterprises on the NYSE, in the form of American

depository receipts (ADRs). These shares, with no

corresponding A- or H-shares, are referred to as

N-shares. But the term is sometimes used more

broadly to include all PRC-related NYSE listings.

Market SegmentationMarket segmentation across both exchanges (geo-

graphical segmentation) and share categories (seg-

mentation by investor type) is an important policy

issue confronting the Chinese equity market today.

At present, cross-listing of stocks at the two official

exchanges (SHSE and SZSE) is not permitted. The

A-share market, the largest portion of the Chinese


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serve holdings by individuals, there is a strong possi-

bility that domestic investors see B-shares as a means

of hedging their investment risk from high inflation

and the possible devaluation of the yuan.

The fact that A-share price movements and re-

turns exhibit high correlation across the exchanges

suggests that the cross-listing of A-shares on the two

major exchanges could be encouraged. Such cross-

listing would potentially benefit both investors and

enterprises by creating a deeper and more liquid eq-

uity market. Moreover, the cross-listing of securities

will cause the exchanges to compete with each other

for business and national market share, improving

the efficiency of their trading services. Unfortunately,

however, there still exist some obstacles, both insti-

tutional and technological, to the cross-listing of

shares. The current regional equity quota allocation

system, in which local municipal authorities deter-

mine share allocations, is a major obstacle since the

local municipal authorities have a strong interest in

having those new issues listed on the local exchange.

Investors should also be able to trade and settle any

given share on both exchanges.11

For the cross-list-

ing to be successful, the information dissemination

system should be improved up to international stan-

dards (next paras.). An order routing system such

as the Intermarket Trading System (ITS) and the

Consolidated Quotation System (CQS) of the US se-

curities market may be introduced for this purpose.

This kind of electronic linkages would enable prices

set in one market center to be in tune with prices

being set in other market centers.

Information Disclosureand DisseminationAn important aspect of stock market quality is inves-

tor protection, which includes transparent financial

reporting; full, timely, and accurate disclosure; and

effective monitoring and enforcement. Securities-re-

lated international organizations such as the Federation

Internationale des Bourses de Valeurs (FIBV) and In-

ternational Organizations of Securities Commissions

equity market with more than 700 listed stocks, is

off-limits to foreign investors. Such market segmen-

tation stemmed from historical background and po-

litical considerations.8The costs of market segmen-

tation are very high. It decreases the liquidity of the

market and reduces the pricing efficiency of the

market due to the thinness of trading, reduction of

investor bases, and possible illegal transactions

across markets.

The average returns from A-shares are generally

higher than those from B-shares. The performance

of B-shares has been disappointing, with negative

average returns in most years except 1993 and 1996.

The performance of H-shares listed on the HKSE is

equally disappointing, with negative returns in 1994

and 1995. The average returns from A- and

B-shares in the SHSE are higher than from their coun-

terparts in the SZSE. In terms of return volatility,

A-shares tend to have higher volatility than B-shares,

in general. A-share index movements seem to be

closely related across exchanges as are those of

the B-share index, but the integration between A-

and B-share index movements is low.9 The B- and

H-share indices are highly correlated, indicating that

international investors tend to look at similar eco-

nomic factors in making their investment and pric-

ing decisions.

Some B-shares are, in fact, already in the hands

of domestic investors (page 75). Considering the low

return and low liquidity of B-shares, it is hard to un-

derstand why some domestic investors would hold

B-shares in violation of the law. One possible expla-

nation is the investors’ expectation that A- and

B-shares will eventually be merged, in which case

B-share prices will approach A-share prices. As of

March 1998, the price/earning (P/E) ratios of

A-shares and B-shares are, respectively, 43.7 and

11.6 on the SHSE. On the SZSE, the P/E ratios are

41.8 and 10.2, respectively. As the Government eases

the foreign exchange regulations, the individual in-

vestors will have better access to foreign exchange

reserves.10

With this trend of increasing foreign re-


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(IOSCO) have been striving for many years to re-

duce the regulatory barriers and encourage cross-bor-

der, capital-raising efforts while protecting the sound-

ness of the world’s capital markets. The harmoniza-

tion of disclosure standards has been proposed as one

means to help achieve this goal.

Corporations whose stocks are listed on the stock

exchange are expected to notify the public quickly

of any news or information that might reasonably

affect the market for securities. This is one of the

most important and fundamental purposes of the list-

ing agreements, which each corporation makes with

the exchange where it wants to list its shares. The

disclosure system is expected to provide reliable and

accurate information on the basis of which stock in-

vestors make their decision on the company they

should invest their financial resources in. Because

the value of a company depends on an objective

evaluation of corporate information that ensures a

fair stock price, it is essential that tangible corporate

information be disclosed to the public in a manner

that does not discriminate against any individual in

obtaining such data. Such action is a basic condition

of an efficient market, i.e., the perfect competitive

condition in the securities market.

The basic conditions of corporate disclosure in-

clude the following:

• Accuracy of information. False or uncertain in-

formation can lead an investor’s decision to an

investment failure. Information must be accu-

rate and be announced even if it may harm ex-

isting corporations. Moreover, important matters

should not be left unmentioned. If the informa-

tion is false, the disclosure officer may be sub-

ject to civil or criminal punishment.

• Promptness of disclosure. Corporate informa-

tion should be released promptly and be provided

lest the investors be guided to a wrong decision.

If the corporate information is outdated, the se-

curities market will be flooded with rumors, which

may distort stock prices and cause unexpected

damage to investors.

• Availability of stock data. Public disclosure

should be easily accessible to potential inves-

tors, and the message should be clearly and lu-

cidly written. Information providers should also

make available several alternative media chan-

nels for information disclosure so that informa-

tion users can have easy and fast access to

relevant information. The language used in any

form of disclosure document should be under-

standable so that most of the information seek-

ers can grasp the content of the data without

major difficulties.

• Impartiality of information. Corporate informa-

tion should be disseminated to all investors in an

equal manner. For this purpose, disclosing of-

fices should adopt proper media channels to ob-

tain relevant information, through which fair trade

will be secured and a complete competitive mar-

ket will be established.

Speculative Investment BehaviorThe PRC’s domestic market (the A-share market)

is dominated by locals with an estimated 40 million

brokerage accounts. Almost all of the domestic in-

vestors are unsophisticated individuals with little ex-

perience or skill to make systematic decisions in share

trading, and they tend to show strong “herd behav-

ior.” In addition, many of them treat the stock mar-

ket like a casino. That makes the Chinese stock market

one of the world’s most volatile markets–with shares

routinely moving by their 10 percent daily price limit–

and one of the most impenetrable. Most Chinese in-

vestors think a cheap stock is one that has a low

price, not a low P/E ratio. The high turnover ratios of

stock transactions suggest that the investment hori-

zons of stock investors in the PRC are extremely

short. Such short-term investment behavior tends to

increase the price volatility of the stock market.

Since foreign investors are prohibited from par-

ticipating in A-share markets, lack of institutional in-

vestors in the A-share market in particular makes it

a market of wild rumors and panic. Absence of insti-


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corporate governance also helped to weaken the in-

vestors’ incentive for long-term investment. Since

investors do not expect to profit from improvement

in management through their monitoring roles, they

have less incentive to analyze the future prospects

of firms and invest based on rumors, which tend to

be volatile by nature.

The Securities Tax Systemin the PRCAs the Chinese capital market grew and as its weight

in the economy increased, the Government began to

understand its importance as a source of tax rev-

enues. As a result, the current securities tax system

is under close review by the authorities. The securi-

ties-related tax system in the Chinese capital market

is not well integrated on a national scale. It lacks

fairness to taxpayers, and, as a consequence, dis-

torts the behavior of related parties participating in

the capital market transactions. The incomplete tax

system is blamed as one of the causes for the specu-

lative investment and trading behavior of Chinese

investors. Issues of concern include taxes on securi-

ties transaction, capital gains tax, and taxes on inter-

est and dividend income.

TAXES ON SECURITIES TRANSACTION

Currently the Chinese tax authority is imposing taxes

on securities transactions in the form of stamp duties

according to the Provisional Regulation Ordinance

on Stamp Duty and its implementing rules, which

came into effect on 1 October 1988. This is in con-

trast with the transaction tax system of other coun-

tries where transaction taxes are levied on securities

transactions. Stamp duties of 0.05 percent are im-

posed in the primary market on the purchaser of

financial bonds issued by banks and nonbank finan-

cial institutions (NBFIs), and stocks issued by cor-

porations, based on their purchase price. In the sec-

ondary market, stamp duties of 0.5 percent are im-

posed on both parties in stock trading according to

the amount of the transaction. All legal entities or

tutional investors makes the Chinese stock market

much more volatile than other stock markets. With

the State Council approval for the establishment of

mutual investment funds in October 1997, financial

analysts hope the Government has laid the founda-

tion for institutional investment in the PRC–a much-

needed stabilizing force in a notoriously volatile mar-

ket. As the legal person shares or legal institutional

shares, i.e., the shares owned by companies for in-

vestment purpose, cannot be traded according to the

regulations of the CSRC, the investment funds are

locked up, contributing to the illiquidity and volatility

of the market.

Much of the blame for speculative behavior has

been laid on the inexperienced individual investors.

However, there are other built-in mechanisms in the

equity market that affect the short-term investment

behavior of individuals. First, the systematic under-

pricing of IPOs is as much responsible for the insta-

bility as the unsophisticated investors. It led to high

returns on IPO investment and helped to bolster the

speculative investment of stock investors. In some

cases, the turnover ratio during the first day of listing

exceeded 40 percent. Second, limited disclosure is a

pervasive problem. Poorly informed investors tend

to place very little importance on underlying economic

fundamentals such as dividends and earnings. Ac-

cordingly, they tend to invest in stocks following what

other investors would do during the next couple of

days or weeks. Such herd behavior results in high

volatility in stock prices. Third, the weak role of in-

stitutional investors also contributes to the instability

of the stock market. While the weight of long-term

investors such as pension funds or insurance com-

panies is small, other capital market institutions like

securities companies show investment behavior simi-

lar to that of individual investors since they pursue

short-term capital gains on their own accounts to meet

the performance requirement. Lack of long-term fi-

nancing source especially induces them to shorten

their investment horizons to match the maturities of

their assets and liabilities. Fourth, the State-dominant


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individuals who execute or receive specified docu-

mentation including securities are subject to the duty.

Foreign-funded enterprises that were subject to the

consolidated industrial and commercial tax (abolished

effective 1 January 1994) used to be exempt from

the stamp duties, but are no longer entitled to such

treatment. On the other hand, there are no explicit

laws or regulations that specify taxation on transac-

tions in the OTC market, or taxation on transactions

in securities other than corporate stocks or financial

bonds. The Chinese tax authority is contemplating

the introduction of a securities transaction tax that

will partly replace the current stamp duties. Differ-

entiating tax rates among different types of inves-

tors or security transactions could be considered in

the new tax system. The introduction of a more com-

plete tax system that governs all kinds of securities

transactions is also in order.

CAPITAL GAINS TAX

Taxation of capital gains on securities transactions is

specified in the Provisional Ordinance on Corporate

Tax and its enforcement decree, Foreign Corporate

Tax Law and Personal Income Tax Law. In general,

corporations are taxed on the capital gains accord-

ing to the applicable corporate tax rates. Individuals

are taxed at a flat rate of 20 percent, but are cur-

rently exempt by a special decree on tax exemption.

One problem with the capital gains tax on corpora-

tions is lack of fairness since different firms are lev-

ied different tax rates depending on their legal enti-

ties. As the Chinese capital market develops further,

the tax authority should consider gradually removing

the tax exemption on capital gains of individual in-

vestors, the differential tax burdens among corpora-

tions, and, at the same time, providing preferential

tax treatment to long-term investors.

TAXES ON INTERESTS AND DIVIDENDS

The laws that apply to the capital gains tax also ap-

ply to taxation of interest and dividend incomes. In

the case of corporations, interest and dividend in-

comes are added to their earnings and taxed at cor-

porate tax rates. However, individuals pay taxes on

interest and dividend payments from corporations at

a flat rate of 20 percent, while the interests on de-

posits are exempt from taxation. To avoid the double

taxation problem on dividends, the tax authority needs

to consider providing partial deduction of dividends

from corporate earnings, or exempting individuals

from dividend taxes to the extent that corporations

have already paid the corresponding corporate taxes

on their earnings.

Stock Market Performance Duringthe Asian Financial CrisisThe Asian financial crisis of 1997 was ignited by the

devaluation of the currency of Thailand, the baht. In

1997, the Asian stock markets in Hong, Kong, China;

Republic of Korea; Malaysia; Singapore; and Thai-

land saw their stock index values falling by 20, 42,

52, 21, and 55 percent, respectively. In the first half

of 1998, the indices of these markets went further

down by 20, 21, 23, 28, and 28 percent, respectively.

During the whole of 1997 and the first half of 1998,

while the official exchange rate of RMB yuan to the

US dollar was pegged at close to 8.3, the currencies

of other Asian countries fluctuated drastically. Rela-

tive to the US dollar the currencies of the Republic

of Korea, Malaysia, Singapore, and Thailand in 1997

depreciated by 50, 35, 17, and 44 percent, respec-

tively. In the first half of 1998, the currencies of Re-

public of Korea and Thailand appreciated by 24 and

11 percent, respectively, while the Malaysian cur-

rency depreciated further by 6 percent. There was

no significant change in the Singapore dollar. Given

the devaluation of currencies in East Asian coun-

tries, the stock market returns during 1997 and the

first half of 1998 could be far worse than they ap-

peared, had they been converted to the US dollar.

According to various indices calculated by Credit

Lyonnais Securities Asia (CLSA), the Shanghai A-

30 Price Index and Shenzhen A-30 Price Index in-

creased by 32 and 19 percent, respectively, in 1997.


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On the other hand, the values of CLSA Shanghai B

Price Index, CLSA Shenzhen B Price Index, and

CLSA Red Chip Price Index declined by 7, 35, and 4

percent, respectively. Moreover, in the first half of

1998, CLSA Shanghai A-30 Price Index and CLSA

Shenzhen A-30 Price Index saw their values change

by 8 and –2 percent. In contrast, CLSA Shanghai B

Price Index, CLSA Shenzhen B Price Index, and

CLSA Red Chip Price Index moved by -29, -17,

and -44 percent, respectively, during the same pe-

riod. These stock index value changes indicate that

A-shares either are immune to the changes in the

international economy, or do not reflect the funda-

mental changes that are expected to influence the

listed companies of stock exchanges in the PRC. In

contrast, B-shares are heavily affected by the eco-

nomic changes in the neighboring countries.

Given the current global trend of deregulation in

the areas of capital market and foreign exchange

market, it is apparent that the PRC’s domestic capi-

tal market is still very much closed to the interna-

tional community. These findings should be a con-

cern to the PRC’s stock market officials because if

a stock market is not information efficient, the cor-

porate disclosure and information dissemination sys-

tems in the stock market have ample room for im-

provement. If only people who have access to infor-

mation can benefit from investing in the stock mar-

ket, the stock market in the long run will no longer

function as it was originally intended. Investors will

lose confidence in the market, and the market can-

not be a reservoir of new long-term capital, or a dis-

tributor of newly created wealth to shareholders.

The Bond MarketThe bond market in the PRC today is a market in

transition. It seems that the Government is caught in

between its commitment to develop an efficiently

functioning capital market and the inherited traits of

a planned economy such as a credit plan, controlled

interest rates, and absence of market pricing of risk.

The link between bond market activity and underly-

ing real sector developments is still somewhat weak,

and the bond market does not function properly as a

mechanism for efficient capital allocation or pricing

of risk. As a result, there still exist many conflicting

features in the Chinese bond market.

There are four kinds of bonds in the PRC today:

treasury bills, corporate bonds, financial institutional

bonds, and convertible bonds. The respective issu-

ers are the Government, corporations, financial insti-

tutions, and unlisted companies. Convertible bonds

are somewhat different from what they are in other

markets as they are issued by unlisted companies in

the PRC, and maturities are anywhere from one to

seven years. Purchasers of bonds are corporations,

financial institutions, and retail investors. Bond issu-

ance is determined by the PBC and the State Plan-

ning and Development Committee. After securing

approval for issuance, the issuer selects the under-

writer, and the issue goes public through banks or

stock exchanges.

Nearly all bonds are traded at stock exchanges;

those traded OTC are less than 2 percent. All trans-

actions are executed via a computerized automatic

trading system, and the bid-ask spread is RMB0.01.

The bond trading system itself is relatively sophisti-

cated. The main supervisory agencies in the bond

market are the stock exchanges and the CSRC where

the former is the first-line watchdog, and the latter is

the Government regulatory agency. If any urgent

problem such as large price fluctuations occur, the

stock exchange immediately notifies the CSRC. Once

the CSRC decides how to respond to the emergency,

it notifies the exchange to implement its decisions.

When the emergency subsides, the stock exchange

must submit a written report on the incident.

As of April 1998, the total value of listed bonds on

the SHSE and SZSE exceeded RMB197 billion. A

large portion of the Chinese bond market today is

the treasury bonds, while the corporate bonds are

rather limited. Most of these bonds are of medium

terms. The short-term bonds are increasing at a very

rapid pace, however. The bill market is still very small


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at present, with a limited variety. The majority of the

bills are the bank acceptance bills. Although the bill

market in coastal cities is developing fast, the mar-

ket is still underdeveloped compared with other mar-

kets, and the participants in the bill discount and re-

discount market are limited.

Primary MarketSince the Chinese Government resumed the issu-

ance of domestic bonds in 1981, the bond market in

the PRC has grown by leaps and bounds, in terms of

both volume and variety. (All securities were abol-

ished in 1949 when the Chinese Communist Party

came to power.) Until 1987, the majority of the debt

issue was Government bonds, particularly the trea-

sury bills,12

which still remain the largest single cat-

egory of debt issue in the PRC today. Since 1986,

State financial institutions (financial bonds) and State

enterprises (enterprise bonds) have also been per-

mitted to issue debt securities. From 1994, there has

been a dramatic increase in treasury bill issues, pri-

marily due to the Government’s decision to cease

financing its deficit through borrowing from the cen-

tral bank. By 1995, Government debt issues had

reached as high as RMB125 billion, comprising a

larger part of the total debt issues.

Government debt issues come in a wide variety.

The primary reason is that various Government bonds

are earmarked for specific budgetary purposes, fol-

lowing the compartmentalization of fund flows under

the credit plan.13

The coupon offered on a specific

bond was not always homogeneous, but varied with

the purchaser (typically with a lower coupon rate for

enterprises than for individuals). This practice was

abolished in 1992. All treasury bills now carry the same

coupon regardless of the purchaser. The maturities

offered also varied from year to year. Such differen-

tiation was possible largely because of administered

placement, coupled with restrictions on tradability. This

lack of homogeneity in Government bond issues made

the bond market rather thin due to segmentation, even

after trading of bonds in the secondary market was

permitted in 1988. In recent years, after recognizing

some of the drawbacks of the wide variety of issues,

the Government has made some efforts to reduce their

variety, focusing more on treasury bills. This trend is

in the right direction, and should be encouraged.

ISSUANCE OF GOVERNMENT BONDS

At the outset, all Government bonds were placed ad-

ministratively, and on a mandatory basis. Quotas were

assigned by the Ministry of Finance (MOF) to the

provincial and local governments, and then, at the lo-

cal level, the quotas were distributed among produc-

tion units. By 1987, unhappy bondholders went to the

illegal black market in treasury bills to trade their bonds,

at a discount of as high as 50 percent or more. This

upsurge of the black market prompted the Govern-

ment to permit trading of treasury bills (two years af-

ter their issue) and to move away from administered

placement toward more market-based methods. This

effort was partly successful. As the underwriting

method, which had been introduced on an experimen-

tal basis in 1991, failed to sell the desired quantity of

treasury bills in 1993, the Government reverted to

mandatory administrative allocation. The Government

nevertheless made efforts to improve bond distribu-

tion and, as a result, 19 financial institutions were ap-

pointed as primary dealers. It is now using different

issuing methods for treasury bills14

as a compromise

between more market-oriented issuing procedures and

the traditional issuing method of mandatory allocation

adopted under the planned economy.

The frequency of Government bond issues has

also been a problem. Treasury bills have been of-

fered in a small number of issues (usually concen-

trated in the first half of the year) rather than in sev-

eral offerings evenly spread over the year. As a re-

sult, the State’s cash flow needs cannot be synchro-

nized with the timing of the sales of bonds. The con-

sequence of this nonsynchronization is that the cost

of funds to the Government is increased. It is equally

difficult for investors to plan orderly acquisitions of

new issues in line with their cash flows. In addition,


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the infrequent bond issuance puts a considerable strain

on the liquidity management and risk management

of banks and other financial institutions. Last, but

not the least, the absence of a regular supply of

Government bonds of any maturity makes it very

difficult to set a benchmark issue, either long or

short term. In view of these reasons, it would be

desirable for the Government to announce a sched-

ule for a year’s issue of long-term bonds, based on

the Government’s financing needs and spread more

or less evenly over the year. In parallel, MOF should

undertake regular issues of short-term debt to meet

short-term liquidity needs.

When the PRC first resumed issuing debt securi-

ties, the maturity of Government bonds (10 years)

was set solely by the Government’s needs. This was

possible due to the administered placement method

adopted. But the emergence of a black market in

treasury bonds in the late 1980s, where Government

bonds were traded at a large discount (as much as

50 percent), forced the Government to progressively

shorten maturities on treasury bills from 10 to 5, and

then to 3 years. This is evidence that, while the Gov-

ernment bond market is still far from market based,

the Government has become more responsive to in-

vestor preferences and the advantages of taking them

into account when planning a bond issue. While there

is a need to widen the range of maturities to satisfy a

wider range of investor preferences, investors in the

PRC, up to now, show very little enthusiasm for debt

of long maturity. Thus, even if the Government were

to issue long-term bonds, it would be difficult to sell

those bonds to investors on a voluntary basis.

Government bonds are issued at par with a pre-

determined coupon. Coupons are set at a margin

above deposit rates of comparable maturity, without

reference to the secondary market yields on issues

of comparable maturity. This is a reflection of the

administratively determined interest rate structure in

the PRC today. Most bonds are redeemed at matu-

rity at an amount consisting of the principal plus ac-

cumulated simple interest estimated on the basis of

the coupon at issue. This practice makes the yield to

maturity at issue less than the coupon rate.15

Usu-

ally, bonds of two- to three-year maturity, aimed at

the retail investors, are issued at yields above those

in the secondary market. The Government should

consider selling the bonds by auction.

ISSUANCE OF CORPORATE BONDS

The corporate bonds in the PRC include local en-

terprise bonds as well as short-term enterprise fi-

nancing bills and other locally issued bonds. Local

enterprise bonds were first issued in 1984 initially

to employees and clients. But, recently, they have

been issued to a wider range of the investing pub-

lic. These enterprise bonds issued by SOEs are used

to finance investments, and carry maturities of two

to three years. The SPC and the local PBC (within

the quota allocated to the locality by the credit plan)

give local State enterprises approval to issue bonds.

Quotas are jointly administered by the SPC and lo-

cal PBC. However, central regulation on the quan-

tity of local bond issues has not always been suc-

cessful, the issue quantity being larger than the ag-

gregate quota. The PBC regulates the aggregate

volume of corporate bond issue in response to li-

quidity conditions. On past occasions, however,

when the enterprise bond issues appeared to threaten

bank deposits or the banks’ ability to meet lending

quotas, the PBC clamped down on enterprise bond

issues. The allocation of the quota to companies is

based on a combination of financial and political

criteria. An acceptable rating by a credit rating

agency is required, but it only carries minor impor-

tance in practice. Corporate bonds are tradable, with

a very low default risk due to the socialized owner-

ship structure.

The coupon on enterprise bonds is restricted to no

more than 140 percent of the deposit rate. In addi-

tion, the coupon should not exceed that on treasury

bills to reduce competitive pressure on treasury bill

sales. This restriction, however, has been avoided by

using fees and discounts. Corporate bond yields are


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two to three percentage points higher than treasury

bill yields at issue, contributing to the failure of vol-

untary placement of treasury bills in 1993.

A joint-stock company and a limited liability com-

pany can also issue corporate bonds,16

but to do so

they must have net assets of no less than RMB30

million and RMB60 million, respectively. The cumu-

lative bonds issued should not exceed 40 percent of

the net assets of the company. The interest rate on

the bond issued is regulated by the SPC. The pro-

ceeds of bond issue should be used only for pur-

poses that comply with the national industrial poli-

cies in the manner approved by relevant authorities;

they may not be used to cover deficit or nonproduc-

tive expenditures. In addition, the company will have

to provide guarantees. Some corporate bond issues

are guaranteed by their parent group while others

are guaranteed by financial institutions.

Secondary MarketSince 1990, the secondary bond market of the PRC

has made considerable progress in terms of trading

volume (Table 3), increased liquidity, greater geo-

graphic price unity, and more sophisticated trading.

However, liquidity is still not sufficient to meet the

transaction needs of larger institutions, and uniform

pricing and trading practices across different ex-

changes are yet to be achieved. Since the bench-

mark issue has not developed well (page 82), trading

activities and pricing are driven, in large part, by the

liquidity in the market.

The lack of liquidity in the secondary market stems

largely from practices in the primary market. The

absence of a regular supply of Government bonds in

the primary market (page 82) reduces the amount of

any one type of bond available for trade. The fact

that the retail investors are the major purchasers of

bond issues also reduces liquidity in the secondary

market, since individuals do not trade as much as

institutions do. Treasury bills are sold in small pack-

ages of RMB100 to RMB1,000 to accommodate in-

dividual investors, and securities firms have difficulty

accumulating a sufficient amount of bonds to form a

wholesale package. Since the yield to maturity of a

treasury bill at issue is not linked to secondary mar-

ket yield, some treasury bills are issued at yields be-

low the secondary market yield. Those issues with

lower-than-market yields restrain market trading as

investors are reluctant to sell at a loss. Another fac-

tor reducing the liquidity of the secondary market is

the limited variety of maturities of primary issues.

Since the market is dominated by issues with maturi-

ties of two to three years, short-term papers are not

readily available to institutions to match their short-

term liabilities. A greater variety of maturities would

stimulate bond trading as the institutions would ac-

quire more bonds of different maturities to adjust the

durations of their portfolios.

Weak market infrastructure is another cause of

low liquidity in the secondary market. First, the rela-

tively underdeveloped money market inhibits bond

market liquidity. Loans and repurchase agreements

in the money market help increase the liquidity of the

bond market by enabling investors to obtain funds

without having to sell their bonds. Thus, a liquid money

market is essential to the development of a second-

ary bond market. The major problems of the money

market in the PRC are its geographical and institu-

tional segmentation, besides the controlled interest

Table 3: The Listed Public Bond Market in the PRCa

a Figures include bonds listed on the Shanghai Stock Exchange only (not theShenzhen Stock Exchange). However, since 98 percent of bonds in the PRC arelisted on the Shanghai Stock Exchange, the contents of the table would qualify asstatistics on the PRC’s bond market.

Source: Shanghai Stock Exchange, Asian Development Bank.

Trading Ratio of TradingNumber Volume Volume to

Year of Issues (RMB billion) GDP (percent)

1990 5 0.0 0.0

1991 7 3.2 0.2

1992 9 7.0 0.3

1993 33 6.1 0.2

1994 24 52.0 1.1

1995 11 193.6 3.3

1996 15 1,740.1 25.4

1997 15 1,538.1 20.6


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rate system. It is, therefore, imperative for the Gov-

ernment to create a nationally integrated money

market, paving the way for the introduction of open

market operations. Second, the lack of a common

depository, which reduces interregional trade, ham-

pers the secondary market liquidity. Well-function-

ing depositories (preferably a single nationwide cen-

tral depository) are vital to aggregate bond issues of

small denominations into wholesale packages that are

readily tradable. It is recommended that a central

depository be established, or, at least, regional de-

positories make arrangements to recognize others’

depository receipt as good proof of title.

While the trading systems in the major bond trad-

ing centers (Shanghai, Wuhan, STAQS, and

Shenzhen) are relatively sophisticated, and price dif-

ferences are small, regional price segmentation still

exists in the Chinese bond market. Local prices thus

reflect local liquidity conditions. The major barrier to

price unity is the lack of a unified depository system.

Without a centralized depository, prices tend to be

higher where the liquidity is high. Depository prac-

tices for all classes of debt securities, not just Gov-

ernment bonds, should be standardized.

EvaluationIn the primary market, the Government controls the

bond issue quotas, selects the issuer, and regulates

coupon rates on debt securities in line with its control

on deposit and lending rates. It can also set margins

on coupon rates on corporate bonds, relative to Gov-

ernment securities coupon rates. Since the Govern-

ment is in a position to change the relative rates on

different securities, the coupon rates on bonds are

raised when large new Government debt issues are

due to come out. Thus, any meaningful reform in the

primary market will be difficult without parallel re-

forms in other basic features of the PRC’s transi-

tional economy today. Within the framework of a

credit plan, completely abandoning the administra-

tive placement system seems to be difficult as the

successful placement of assigned quotas could no

longer be assured in the market. The administered

interest rate and the subsequent control on bond cou-

pon rates effectively discourage price competition

among underwriters or primary dealers. To develop

a more sophisticated bond market, the PRC should

consider modifying at least some of the features of

its current planned economic system.

Since most of the problems in the Chinese bond

market stem from the primary market, greater at-

tention should be given to the weaknesses of the pri-

mary market. Any remaining features of the admin-

istrative placement of bonds should be reduced as

much as possible, and all bond issues should be made

tradable. In addition, the PRC should increase the

relative emphasis on the wholesale investors com-

pared with the retail investors. Focusing on the whole-

sale investor base will eventually allow the move to-

ward a market-based auction system. The present

placement system, size of bond packages, and title

transfer system are not well suited to a wholesale

market, or to the development of a liquid secondary

market. The Government should announce the

schedule for the year’s debt issues, which should

be evenly spread out throughout the year. This will

help to improve liquidity management by the whole-

sale buyers, and assist in the development of a

benchmark bond.

Capital Market InstitutionsDespite the short history of the Chinese capital mar-

ket, the number of institutions directly related to and

participating in the capital markets has grown rap-

idly (Table 4). The PRC has two stock exchanges

and 105 securities companies that have business

scopes similar to those of their counterparts in other

advanced capital markets. The mutual fund industry

is still at the first stage of development, and trust and

investment companies are yet to be considered as

the asset management institutions that are found in

other countries. Currently, 14 futures exchanges with

329 brokerage offices are in operation, but they are

focusing on commodity futures trading only.


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Securities Companies

INDUSTRY STRUCTURE

As of the end of 1997, there were 105 securities

companies of diverse sizes and business scopes in

the PRC. Their total paid-in capital and total assets

as of the end of 1996 exceeded RMB12 billion and

RMB159 billion, respectively. This is a result of the

fast-growing capital market in the country. However,

the total assets of the securities companies are still

less than 1.42 percent of the total financial assets in

the PRC. Five to seven large securities companies

with extensive national branch networks dominate

the market in both brokerage and primary market

services, while small to medium-size companies tend

to focus more on brokerage service.17

The largest

securities companies maintain about 3,000 staff mem-

bers and 60 branches, with asset sizes of about RMB4

billion. They also have several overseas offices in

major international financial centers. In addition to

their three major business lines (i.e., brokerage, deal-

ing, and underwriting), securities companies in the

PRC also function as intermediaries of mergers and

acquisitions (M&A) deals, participate in national or

local investment projects through project financing,

and issue investment funds sponsored by national or

regional governments.18

OWNERSHIP STRUCTURE

Despite the segregation policy of the PBC, many

securities companies are still under the strong influ-

ence of the central bank or the State-owned banks.19

Involvement of the State-owned banks in the man-

agement of the securities companies, especially the

largest ones, at the early stage of the industry has

contributed to their stable growth and financial sound-

ness. However, direct control of the management of

the securities companies by the parent companies,

and regulatory intervention by Government authori-

ties have imposed a heavy burden on the securities

companies. Recently, through the restructuring in the

ownership structures, most securities firms have been

segregated from their parent companies as indepen-

dent legal entities.20

LEGAL FRAMEWORK OF THE

SECURITIES INDUSTRY

While the securities law is yet to be finalized in the

PRC, several regulations are applied to the activities

of securities companies. The principal national regu-

lations are the Provisional Regulations on Securities

Companies of 1990 and the Provisional Regulations

for the Management of Financial Institutions of 1994,

both issued by the PBC. Document No. 68 of the

State Council (issued in 1992) was also an important

legislative step, which set up the SCSC and the

CSRC. These regulations mainly prescribe the licens-

ing requirements, business scopes, and capital re-

quirements for securities companies. The capital re-

quirement for a license varies depending on the scope

of the business. The minimum capital requirement

for brokerage service is RMB10 million, and adding

the dealing business requires an additional RMB20

million of capital. The provisions for protection of

customer funds and securities, audit requirements,

codes of conduct as well as the accreditation scheme

for securities professionals are not well defined on a

national level, however.21

According to the Provisional Regulations of 1990,

securities companies in the PRC may operate as

Table 4: Capital Market Institutions as of 1996

Stock Exchanges Securities Companies Futures Exchanges(Trading Centers) (Branches) Mutual Funds Trust and Investment Companies (Brokerages)

2 105 73 332 14

(28) (2,420) (329)

Sources: China Securities Regulatory Commission, 1997. Various unpublished manuscripts.


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agents for securities issuance; engage in brokerage

and dealing; and act as agents for payment of princi-

pal, interest, and dividends of securities. With ap-

proval from the CSRC, securities companies may

act as depository of securities; trustees for collect-

ing principal, interest, and dividends of securities; and

trustees for registration and transfer of securities.

They may also engage in securities discounting, pro-

vide funding against securities collateral, act as in-

vestment advisors, and engage in other businesses

as approved by the CSRC. These regulations, how-

ever, are not specific on the issues of underwriting,

trading, or investment for their own account, nor on

the investment fund or portfolio management, which

are generally performed by Chinese securities com-

panies with additional approvals as necessary. Their

business scopes include services closely related to

banking so that they can act as agents for payment

and collection of principal, interest, and dividends,

and for lending with securities as collateral.

FINANCING SOURCES AND USES

The major sources of financing for securities com-

panies in the PRC include money market borrow-

ings, treasury bill financing, and customer deposits.

Securities companies can participate in the money

market consisting of interbank lendings, and borrow

money overnight. They also rely on the discount win-

dow of the PBC for longer term borrowing with

maturities up to four months by means of bills dis-

count or rediscount. Treasury bill financing is the most

important means of financing. Securities companies

can discount treasury bills, which are either borrowed

from clients or purchased, through the repurchase

contracts. While customer deposits are a major source

of funds for securities companies, bank borrowings

are prohibited.22

As an exception, the three largest

securities companies were specially allowed to issue

financial bonds to the amount of RMB500 million to

support their primary market activities. In the use of

funds, securities companies participate in the money

market, and invest in securities on their own accounts

and on behalf of customers with the entrusted money

or securities. The investment in risky assets includ-

ing stocks is implicitly controlled within the level of

50 percent of the owner’s capital.

Securities companies in the PRC generally have

limited financial resources in terms of both diversity

and quantity. The issuance of financial bonds, in gen-

eral, has been restricted, and it was not until 1996 that

the three major securities houses were allowed to is-

sue a limited amount of financial bonds. Bank bor-

rowing is prohibited to safeguard the overall financial

system. Limited financing sources for securities com-

panies have definitely hindered the sound development

of the industry in the sense that better performing se-

curities companies miss the opportunity to grow fur-

ther. For example, even though the underwriting busi-

ness provides the most lucrative business opportuni-

ties as a large number of State-owned companies go

public, securities companies cannot find the needed

capital for underwriting these issues. Lack of resources

also causes a possible mismatch between sources and

uses of funds of securities companies, which may con-

strict their ability to hedge financial risks. Another

side effect of limited financing sources is that the se-

curities companies tend to have short-term investment

horizons in stock markets, thus increasing the volatil-

ity of stock prices rather than stabilizing the market as

institutional investors.

Despite their capital needs for business expan-

sion, the securities companies in the PRC are not

allowed to list their stocks on the exchanges, thus

limiting the opportunities for growth. In general, the

authorities prohibit the listing of financial institutions

for the purpose of maintaining the State’s control of

those institutions and permitting nonfinancial compa-

nies more opportunities for listing.23

However, con-

sidering that the capital of the securities companies

raised through listing on the exchanges would be

eventually used as funds for underwriting and invest-

ing in the securities of real sector companies, the

policy of restricting the listing of financial institutions

including securities companies should be reevaluated.


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LACK OF INTEGRATED

RISK MANAGEMENT SYSTEM

As is the case with the financial institutions of other

developing countries, risk management is not a fa-

miliar concept to the management of the securities

companies in the PRC. The management usually does

not have an internal risk management procedure, nor

is it much concerned to take active steps to hedge

risks. This is partly due to the lack of financial de-

vices for risk diversification. Even though regulators

impose strict restrictions on the sources and uses of

funds, the overall prudential regulations target indi-

vidual items, and still have not accommodated the

concept of the capital adequacy requirements of the

Bank for International Settlements (BIS) type. Such

lack of concern about risk management on the part

of both the regulators and the management of secu-

rities companies is related to the governance of the

securities companies.24

Since securities companies

had been part of the overall SOE system, most of

their financial failures were dealt with through the

State’s intervention.

Recently, however, the Government changed its

paternalistic policy and urged problematic financial

institutions to undergo restructuring through market

mechanisms such as M&As. The threat of forced

exit is taking effect and the securities companies are

now paying more attention to internal risk manage-

ment. Under the new policy, some large securities

companies are actively pursuing an expansion strat-

egy by taking over other securities companies. The

segregation policy also helped to promote the mana-

gerial independence of securities companies. How-

ever, the management positions are filled with former

government officials or officers of higher authorities

including the PBC. Measures to protect the integrity

of securities companies as capital market institutions

need to be introduced. These include the listing of

securities companies on the stock exchanges, ap-

pointing top management from insiders, removing the

restrictive regulation on financing and operation of

funds, reducing State subsidy to failing securities

companies, and promoting a stronger self-regulatory

organization, among others.

The risk management of securities companies in

the PRC becomes more important since their busi-

ness scope includes services closely related to bank-

ing (i.e., acting as agents for payment and collection

of principal, interest, and dividends, and lending with

securities as collateral). At the time this report was

prepared, there was no solvency or reserve require-

ment applied to securities companies that provide

those services. Also, even though there is a capital

requirement for licensing certain types of businesses,

there is no requirement for maintaining a certain level

of liquidity or capital based on the risks of related

businesses. In sum, the Chinese securities industry

needs risk-based capital requirements that prescribe

adequate levels of capital for different forms of se-

curities-related services and activities.

CUSTOMER PROTECTION

Securities companies in the PRC have frequently

been accused of illegal activities in their brokerage

services, underwriting, and dealing businesses.

Among the cases are appropriation of clients’ money,

conflicting interests in fund management due to the

existence of the securities companies’ own accounts,

unauthorized execution of trading orders, and forced

loans to securities companies by issuing firms. Such

forms of misconduct are partly due to the ambiguity

and absence of related provisions to regulate the se-

curities companies’ behavior. Current regulatory pro-

visions are silent or ambiguous on such matters as

protection of customer deposits and securities, codes

of conduct for securities professionals, and the risk-

based capital requirements.

Trust and Investment CompaniesDEVELOPMENT OF THE INDUSTRY

Trust and investment companies (TICs) in the PRC

emerged during the period of economic reform in

the late 1970s.25

The TICs are classified into three

groups depending on their origin. First, the State-


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owned banks started the trust services as part of

their business. The rapid economic growth, coupled

with the restrictive rules and regulations on the bank-

ing business, made the banks realize that they could

no longer meet the financial needs of the market for

increasing intermediary roles. Accordingly, banks

were encouraged to set up trust departments to in-

vest customers’ money in various forms of securi-

ties and loans, which would have not been permitted

on bank account. These lines of trust business later

were spun off and were set up as independent trust

and investment subsidiaries. Second, many State and

local governments, and other government agencies

also encountered the need for extra funds to finance

local projects. As a result, they sought to establish

TICs that were mainly funded by extrabudgetary fi-

nancing sources of related government agencies.

Third, the central Government itself established the

CITIC to tap overseas financing sources, and other

major provincial or municipal governments were al-

lowed to set up their own international TICs.

The Provisional Regulations of 1986 define the

business scope of TICs: trust investment and trust

loan business, lease financing business, custodial ser-

vices, collection and payment agent services, debt

guarantee services, credit investigation, and consult-

ing services, among others. The TICs have enjoyed

a wider range of freedom than the other financial

institutions in the PRC in their business scope and

operation. For one thing, they were not subject to

the credit plan of the State, which restricted the

uses of funds of financial institutions. And the TICs

had more discretion on the rates and terms they

offer for lending, and could provide a wider range

of services not offered by banks. They also had

access to sources of funds other than conventional

deposits, and could invest in riskier projects, while

banks were not allowed to do so.

At the end of 1995, 332 TICs were registered

with total assets amounting to RMB458.6 billion

(Table 5). However, the number of TICs has shrunk

as consolidation in the industry has been in progress

due to the increasing restrictions on the management

of TICs. During the mid-1990s, some diversion of

deposits from banks to nonbank institutions, espe-

cially to TICs, occurred, but on a relatively small scale

(Table 6). Among the NBFIs, the share of TICs in-

creased sharply from 18.1 percent in 1986 to 32.3

percent in 1994, exploiting the less strict regulatory

interventions in their operation (Table 7).

The assets of TICs in the PRC are concentrated

among the five largest ones, which account for

roughly half of the total assets of all TICs.26

The av-

erage TICs, excluding the five largest ones with over

RMB10 billion in assets, have asset sizes of only

RMB500 million. Such a skewed distribution of as-

sets suggests much room for restructuring and in-

creasing the efficiency of the industry. Besides their

lack of expertise, small TICs with assets of less than

RMB100 million do not seem to justify their adminis-

trative costs.

SOURCES AND USES OF FUNDS OF TICs

Throughout the 1990s, the Government has pursued

the policy of segregation of banks and nonbank insti-

tutions. The funding sources and uses of TICs have

been restricted to limit their risk-taking propensity,

and eventually to maintain the stability of the overall

financial system. Sources of funds of TICs are mainly

entrusted or trusted deposits from the Government’s

financial departments, enterprises, labor or insurance

funds, and funds from other institutes or foundations.

The distinction between these two types of deposit

is not clear. For the trust funds, the TICs are re-

quired to maintain reserves with the local branches

Table 5: Growth of Trust and InvestmentCompanies in the PRC (RMB billion)

Source: Almanac of China’s Finance and Banking, various issues.

Item 1986 1989 1992 1995

Assets 29.2 88.1 230.9 458.6

Loans 21.7 69.4 169.7 241.0

Liabilities 29.2 88.1 230.9 458.6

Deposits 13.0 52.2 126.4 250.0


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of the PBC to which they belong. No such require-

ment exists for the entrusted funds.

Even though there are no explicit restrictions on

the issue of bonds or equities for funding, the TICs in

the PRC have not been able to utilize domestic capi-

tal markets due to the PBC’s implicit discourage-

ment of such attempts. Restrictions on bank loans

further limited the TICs’ funding capability, and the

closing of the borrowing window of the PBC in 1994

resulted in serious shortfalls in the sources of funds.

Short- and long-term borrowings, repurchase agree-

ments, securities payable, and accounts payable cov-

ered such shortage of funding. On the other hand,

the international TICs have enjoyed more freedom

in their funding since they functioned as the win-

dows for raising foreign capital. In fact, the interna-

tional TICs were the country’s largest bond issuers

in overseas capital markets.27

Overseas borrow-

ings are also allowed for these international TICs

under the overall borrowing quotas of the central

Government. As for the uses of funds of TICs, loans

used to take the lion’s share of more than 75 percent

of total assets, but the ratio had decreased to 50 per-

cent by 1995.28

Other major uses of funds are in-

vestment in subsidiaries, joint ventures, and equity

positions in other companies.

Because the business scope of the TICs is similar

to that of banks, there has been increasing concern

about the risk management of the TICs. Reserve

requirements have been imposed on the trusted de-

posits, but not on the entrusted deposits that consti-

tute more than 60 percent of the total. Increasing

reliance on short-term borrowings poses another

potential problem as the gap between uses and

sources of funds widens. Investments, especially in

riskier assets such as construction projects, real es-

tate, merchandising, and various types of subsidiar-

ies have seriously increased the credit and market

risks of the TICs, while the trust business with no

risk on the part of the TICs has assumed less weight

in their business over time.

The current regulatory framework has been

blamed for the slow development of the asset man-

agement industry in the PRC, and poor financial

soundness of the TICs. A single regulatory authority

should be in charge of granting business licenses to

Table 6: Shares of Trust and Investment Companies’ Assets in Total Financial Assets

Source: Almanac of China’s Finance and Banking, various issues.

1986 1991 1993 1994

RMB RMB RMB RMBItem billion % billion % billion % billion %

Banks 1,233.7 71.3 3,714.1 71.5 5,646.0 69.5 8,291.3 73.6

Nonbanks 161.6 9.3 578.2 11.1 1,140.1 14.0 1,208.7 10.7

TICs 29.3 1.7 167.4 3.2 257.0 3.2 390.7 3.5

Others 334.5 19.4 901.1 17.4 1,338.7 16.5 1,758.8 15.7

Total Financial Assets 1,729.8 100.0 5,193.4 100.0 8,124.8 100.0 11,258.8 100.0

Table 7: Shares of Trust and Investment Companies’ Assets in Total Assets of Nonbank Financial Institutions

Source: Almanac of China’s Finance and Banking, various years.

1986 1991 1993 1994

RMB RMB RMB RMBItem billion % billion % billion % billion %

Rural Credit Cooperatives 122.5 75.8 369.0 63.8 614.2 53.9 505.4 41.8

Urban Credit Cooperatives 3.2 2.0 5.6 1.0 187.8 16.5 214.8 17.8

Insurance 6.6 4.1 36.2 6.3 60.0 5.3 70.3 5.8

Finance Companies 20.1 1.8 27.6 2.3

TICs 29.3 18.1 167.4 29.0 257.0 22.6 390.7 32.3

Total Financial Assets 161.6 100.0 578.2 100.0 1,139.1 100.0 1,208.7 100.0


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and supervising the TICs. The TICs should be al-

lowed to serve individual investors and manage their

properties. This may require partial integration in the

business areas of the TICs and mutual funds. Con-

sidering the potentially damaging effect of the TICs’

failure on the financial market, the change in the regu-

latory framework is of utmost priority. The integra-

tion of the two industries of the TICs and mutual

funds would take some more time since both indus-

tries are at the early stage of development, and each

has internal problems. Possibly, after going through

a restructuring process of M&As in each industry,

the integration policy could be pursued.

Mutual FundsThe mutual fund was first introduced in the PRC in

1991, when two closed-end funds with total assets

of RMB90 million were established by local govern-

ments. The first mutual fund, listed on the SHSE,

was approved by the PBC in 1992, and trading com-

menced in 1993. Afterwards, the number of mutual

funds grew rapidly, and by the end of 1993, there

were 73 mutual funds with total assets of about

RMB6 billion.

In addition to the domestic mutual funds, foreign-

related mutual funds with both Chinese and non-Chi-

nese sponsors also developed. The first joint-ven-

ture fund, namely the Shanghai Pacific Technology

Investment Fund, was sponsored by nine Chinese

financial institutions and a US-based fund manage-

ment company. By the end of 1995, more than 50

foreign-related mutual funds had been set up and

traded both in and outside the PRC.

Mutual funds in the PRC maintain mixed invest-

ment policies. A representative fund invests approxi-

mately 40 percent of its assets in securities, and the

rest in direct investment. To diversify their invest-

ment, mutual funds also invest in treasury bills, fu-

tures, corporate bonds, real estate, bank deposits, and

industry. Most of the domestic funds have banks as

the custodians for the funds’ units and agents for

dividend payment. Due to the relatively small sizes

of mutual funds and lack of professional manage-

ment technique, they suffer from high operation costs

and low returns on investment. Foreign-related funds

are usually operated outside the PRC, and invest in

listed shares of B or H type, and in corporations as

direct investments.

The growth of the mutual fund industry may con-

tribute to the increase of a stable demand for securi-

ties investment. However, the Government has not

been very enthusiastic about the excessive growth

of the asset management industry due to worries

about the shift of funds from bank deposits to the

asset management companies, thus destabilizing the

financial market. The PBC’s policy on fund alloca-

tion is based on the assumption that the State-con-

trolled capital allocation scheme through banks is a

more effective way of implementing financial policy

than relying on the capital market mechanism. This

assumption, however, is losing ground as the Chi-

nese economy grows larger and more sophisticated.29

With the number of small and large mutual funds

increasing, the PBC, the regulator of mutual funds, is

very much concerned about the soundness of their

operation. Accordingly, the PBC issued an Emergency

Directive in 1993 to prohibit listing of mutual funds

without the PBC’s approval, and two additional funds

larger than the previous ones had to wait until 1996

before they could list their shares on the stock ex-

changes. This issue can be met with stricter pruden-

tial regulations and codes of conduct imposed on mu-

tual funds. For this purpose, an independent Investor

Protection Fund, consisting of the contributions by each

mutual fund based on its size, could be established.

For the regulatory framework to be effective, the

regulatory responsibilities of the PBC and the CSRC

should be clarified, and a national-level regulatory

framework should be in place. At the time this re-

port was written, the licenses for mutual funds were

granted by the PBC (or its regional branches) while

the CSRC implicitly had the authority to supervise

the mutual funds. At the minimum, the licensing pro-

cedure should be streamlined and dealt with by one


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regulatory body to stimulate new participation as well

as to increase supervisory effectiveness. The regu-

lations for mutual funds at the national level should

include, among other things, the forms of mutual funds

incorporation, their business scope, licensing require-

ments, qualifications for fund management compa-

nies and fund managers, and provisions for protect-

ing clients’ property and custodial arrangements.

Insurance CompaniesThe insurance industry in the PRC is still at the na-

scent stage of development. The industry began to

move into its second stage of development after the

Insurance Law was promulgated in 1995. With the

new law in place, notable changes occurred. First,

the insurance business, which used to be the subsid-

iaries of the State-owned banks, was segregated and

established in independent entities. Second, the busi-

ness scopes of insurance companies were clearly

demarcated so that companies may specialize in each

area of nonlife insurance, life insurance, and reinsur-

ance. Third, the number of insurance companies in-

creased from 12 to 21 during 1996. The establish-

ment of the People’s Insurance Company, which in-

corporates 17 regional life insurance companies, was

one of the major innovations that will bring about

many changes in the industry. The establishment of

the joint-venture insurance company with the Swiss

Winterthur Insurance Company also reflects the

changing policy of the authorities. Total insurance

coverage also increased to RMB15,676.4 billion, up

by 15.2 percent from the previous period, with the

premium income increasing to RMB77.6 billion, up

by 26.1 percent.

The role of insurance companies in the capital

market of the PRC is still a passive one. The invest-

ments in stocks are implemented as a part of the

overall State policy, which seeks to maintain the

Government’s control on State-owned or listed com-

panies, rather than as a profit maximization process.

Since the insurance companies do not have much

discretion in the investment decisions, their role as

institutional investors is rather limited. No special

benefit as institutional investors is given in their pri-

mary and secondary market participation, which tends

to render these institutional investors passive in se-

curities investments.

For the sound development of the insurance com-

panies as institutional investors, the degree of free-

dom in the operation of their funds, especially those

for capital market investments, should be enlarged.

To expedite the active participation of institutional

investors including insurance companies, favorable

tax treatments on the profits and losses in securities

investment should be allowed. To protect the cus-

tomers of insurance companies against the increased

risk related to a more active participation in the capi-

tal market operations, their capital bases and insur-

ance coverage ability need to be improved, and a

capital-based risk management system should be

implemented.

Summary and PolicyRecommendationsThe Securities Regulatory Systemin the PRCThe existing securities regulations of the PRC in gen-

eral are fairly well defined, although the provisions

sometimes are put in unusual places (perhaps due to

the absence of a national securities law). The regu-

latory framework is still somewhat confusing, how-

ever. One key issue at present is the fragmentation

of oversight and duplication of regulations. Theoreti-

cally, the CSRC, an institution directly under the State

Council, is the top securities regulatory authority. But,

due to some unusual characteristics, the CSRC

(which has no branches in the region, for example)

lacks adequate authority to impose its regulations,

especially at the regional level. Moreover, some regu-

latory authorities are divided between the CSRC and

the PBC, causing duplication of regulations while leav-

ing some gray areas for regulators. The monitoring

and regulation of the activities of securities dealers


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constitute one such example. For the regulatory

framework to be effectively implemented, the CSRC

should be strengthened and properly staffed, and it

should be given jurisdiction over regional trading cen-

ters through its own regional offices (the CSRC at

present has no regional offices). The present con-

flict between central and regional regulations should

be removed, leaving a single, centrally based regula-

tory authority.

The Equity MarketMany SOEs list their shares to obtain capital for in-

vestment. Thus, virtually all of the new listings are

IPOs. Although the Government authorities such as

SCSC, SPC, PBC, and CSRC allocate new share

quotas to Government ministries and provinces, in

reality listing decisions are made by municipal secu-

rities authorities. The larger role of municipal authori-

ties in the listing decision is an important source of

the geographical segmentation of the stock market

and inefficient listing decisions. Thus, a reduction in

the power of municipal securities authorities should

be sought, and the exchanges where the shares are

to be listed should be the ultimate authorities for the

listing decision, giving a greater role to market forces.

It is equally important that objective listing criteria

should be employed in the IPO process, and the over-

all procedure should be made more transparent. The

arbitrariness of the selection process can be consid-

erably reduced by the establishment of independent

review panels; however, it could make the system

vulnerable to a different type of influence.

For the IPOs, underwriters are selected largely at

the discretion of the local securities authority, not by

the issuing enterprises themselves. The selection of

underwriters should be left to the issuing enterprises,

and underwriters must be allowed to compete freely

on the various terms of issuing. Since the IPOs are

offered at below-the-market prices, they are gener-

ally oversubscribed. This creates two potential prob-

lems. First, a nondiscretionary lottery system for

share allocation is employed causing an investment

decision to be made that is not based on fundamen-

tals. Any remnant of the lottery-based share alloca-

tion system must be phased out in favor of an auc-

tion-type share allotment. Avoiding the clustering of

new issues may help reduce reliance on the lottery

system of share allocation. Second, in a highly com-

petitive IPO market, prospective investors are

oftentimes asked to pay a fee (though small) for ob-

taining application forms, thus providing revenues to

local authorities. Since the revenue increases with

the degree of oversubscription, this fee system en-

courages underpricing of the IPOs as well. There-

fore, charging fees for application forms should be

abolished.

For a sound development of the Chinese capital

market, firms with sound financial fundamentals

should be given first priority in listing their shares. In

the process, the market’s role (not the Government’s

intervention) must be expanded. The Government’s

influence on corporations should also be minimized

by allowing the SOEs to be truly privatized. This

can be achieved by increasing the proportion of

shares sold to the public so that the more active

investors may play a certain role in the manage-

ment of the firms.

Problems stemming from geographical segmen-

tation (between Shanghai and Shenzhen) could be

significantly alleviated by allowing the cross-listing

of A-shares on the two major exchanges. Poten-

tially such cross-listing would benefit both investors

and enterprises by creating a deeper and more liquid

equity market. The exchanges also will have to com-

pete with each other for business and national mar-

ket share, thus improving the efficiency of their trad-

ing services. However, for the cross-listing to be suc-

cessful and beneficial some major obstacles, both

institutional and technological, should first be removed.

The current regional equity quota allocation system,

in which local municipal authorities determine share

allocations, is a major obstacle since the local mu-

nicipal authorities have a strong interest to have the

new issues listed on the local exchange. Investors


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should also be able to trade and settle any given share

on both exchanges.30

In addition, the order routing

and information dissemination system should also be

improved up to international standards. An order rout-

ing system such as the ITS and the CQS of the US

securities market may be introduced for this purpose.

Such electronic linkages would enable prices set in

one market center to be in tune with prices being set

in other market centers.

The Chinese securities tax system is not well in-

tegrated on a national level, nor is it under close

review by the related authorities. The foremost con-

cern is the fairness of the tax burden on different

taxpayers. The current stamp duty system on secu-

rities transactions should be replaced by a securities

transaction tax system. The proposed new tax sys-

tem should consider the introduction of differentiat-

ing tax rates among different types of investors or

security transactions. Capital gains taxes are cur-

rently not levied on individuals (normally, a flat rate

of 20 percent is levied), but different tax rates are

levied on different corporations. The exemption of

individual investors from the capital gains tax should

be gradually removed, and the differential tax bur-

dens on corporations should be corrected. At the

same time, there should be measures to provide a

preferential tax treatment for long-term investments.

Double taxation on dividend income should be elimi-

nated as well. This can be done by allowing a partial

(or full) deduction of dividends from a corporation,

or by exempting individuals from dividend taxes to

the extent that the equivalent income taxes are paid

on the corporate level.

The Bond MarketIn the primary market, it is necessary (i) to synchro-

nize the State’s cash flow needs with the timing of

the sales of bonds, (ii) to ensure that retail and insti-

tutional investors can plan the orderly acquisition of

new issues in line with their investment horizon, and

(iii) to set a benchmark issue either long or short

term. To achieve these objectives, the Government

should consider announcing a schedule for a year’s

issue of long-term bonds, spread more or less evenly

over the year, based on the Government financing

needs. In parallel, MOF should undertake regular

issues of short-term debt to meet short-term liquid-

ity needs.

The system for setting the coupon rates for the

Government bonds must also be overhauled. Cus-

tomarily, Government bond coupons are set at a

margin above rates for deposits of comparable ma-

turity, without reference to the secondary market

yields on issues of comparable maturity. Usually,

bonds of two- to three-year maturity, aimed at the

retail investors, are issued at yields above those in

the secondary market. The Government should con-

sider selling the bonds by auction, with the coupon

rates fixed in advance, letting market conditions de-

termine the yields on the Government bonds.

The relatively underdeveloped money market in-

hibits bond market liquidity since short-term loans

and repurchase agreements in the money market

could increase liquidity in the bond market by en-

abling investors to obtain funds without having to

sell their bonds. It is, therefore, imperative for the

Government to create a nationally integrated money

market, paving the way for the introduction of open

market operations. Moreover, well-functioning de-

positories (preferably a single nationwide central

depository) are vital to aggregate bond issues of

small denominations into wholesale packages that

are readily tradable. It is recommended that a cen-

tral depository be established, or, at least, that re-

gional depositories make arrangements to recog-

nize other depositories’ receipts as good proof of

title. In addition, depository practices for all classes

of debt securities, not just Government bonds, should

be standardized.

On the whole, any meaningful reform in the pri-

mary market will be difficult without parallel reforms

in other basic features of the PRC’s transitional

economy today. Within the framework of a credit

plan, completely abandoning the administrative place-


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ment system seems to be difficult as the successful

placement of assigned quotas could no longer be as-

sured in the market. The administered interest rate

and subsequent control on bond coupon rates effec-

tively discourage price competition among underwrit-

ers or primary dealers. To develop a more sophisti-

cated bond market, the PRC should consider modi-

fying at least some of the features of its current

planned economic system. Greater attention should

be given to weaknesses of the primary market. Ad-

ministrative placement of bonds should be curtailed

as much as possible, and all bond issues should be

made tradable. To move toward a market-based auc-

tion system, the Government should give more em-

phasis to the wholesale investors relative to the retail

investors. The present placement system, size of bond

packages, and title transfer system are not well suited

to a wholesale market, or to the development of a

liquid secondary market.

Capital Market InstitutionsThe regulatory responsibilities of the PBC and the

CSRC on capital market institutions including se-

curities companies, TICs, and mutual funds should

be clarified (or unified, if possible). The Provisional

Regulations of 1990 on securities companies should

be revised to explicitly specify underwriting, trad-

ing, or investment for their own account, and in-

vestment fund and portfolio management as the busi-

ness lines of securities companies. In addition, a

regulation for mutual funds on a national level should

be in place to cover provincial markets as well as

central markets. The new regulations on mutual

funds at the national level should include, among

other things, the forms of mutual funds’ incorpora-

tion, their business scope, licensing requirements,

qualifications for fund management companies and

fund managers, and provisions for protection of cli-

ents’ property and custodial arrangements. A more

specific code of conduct for employees of capital

market institutions is needed to prevent conflicts of

interest with their customers.

The limited financing sources of capital market

institutions in the PRC are believed to have caused

the mismatch between sources and uses of funds,

constrained their ability to hedge their financial risks,

and worked to destabilize the capital market. Their

financing sources need to be expanded. The restric-

tive regulation on financing and operation of funds of

institutional investors should be removed as much as

possible. As a part of deregulation, higher priority in

listing on the stock exchanges should be given to the

capital market institutions. However, to maintain their

financial soundness, there should be risk-based capi-

tal requirements that prescribe adequate levels of

capital for different forms of securities-related ser-

vices and activities. If necessary, an independent in-

vestor protection fund consisting of contributions from

capital market institutions could be established. It

would partially replace the State’s safety net.

The TICs, in the short run, should be allowed to serve

individual investors and manage their trusted properties

including financial assets. In the long run, the integra-

tion of the TICs and mutual funds industries should be

pursued as a policy alternative to promote the efficiency

and soundness of the industries. Possibly, the integra-

tion policy could be deferred until after each industry

goes through its own restructuring process.

The role of insurance companies in the capital

market of the PRC is still a passive one. Investments

in stocks are implemented as part of the overall State

policy, which seeks to maintain Government control

on State-owned or listed companies, rather than to

maximize profit. For the sound development of insti-

tutional investors, their freedom in the operation of

funds, especially those for capital market investments,

should be expanded. A performance evaluation sys-

tem that emphasizes the profitability of institutional

investors should be introduced, and their top man-

agement should be appointed according to their abil-

ity to create profit. To expedite the active participa-

tion of institutional investors in capital market opera-

tions, a favorable tax treatment on the profits and

losses in securities investment can be considered.


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Notes

1According to the Company Law and the Interim Securi-ties Regulations issued pursuant to Document 68, all list-ings must be approved by the SCSC/CSRC. After an ex-haustive approval process, shareholding companies areselected on the basis of assets, management, and profit-ability. The documents required include (i) an approvalfrom the State Commission for Restructuring EconomicSystem; (ii) three years’ audited accounts; and (iii) anasset statement audited by an approved accountant certi-fying to the company’s net asset value, and a statementas to the reasons for issuing shares.

2The CSRC may suspend a listing if the company (i) nolonger has sufficient capital or distribution of sharehold-ers; (ii) makes no accounting disclosures, or makes falsedisclosures; and (iii) commits a serious violation of thelaw, or suffers losses for three continuous years.

3The exchanges fear that they may lose listing to otherexchanges due to the severe competition between them.The listed companies themselves are not very enthusias-tic about complying with disclosure requirements, as theyare not required to do so when they were State owned.

4In 1993 the A-share quota was RMB5.5 billion of whichonly RMB2.8 billion had been used by the end of the year.The quota for 1994 was originally set at RMB5.5 billion,but in July 1994 a moratorium was announced on newshares due to the perceived instability in the stock market.As a result, the year’s quota was underutilized.

5On one occasion, a State-operated woman’s organiza-tion was given a listing quota, which was later passed onto another company.

6There are other problems. Employees at the State-ownedexchanges sometimes trade on earnings information be-fore it is made public; brokerage firms frequently borrowclient funds to trade on their own accounts; and bankssometimes pump capital directly into the markets, ratherthan lend to marginal State enterprises.

7The Dazhong Taxi case highlights the worries of Chineseauthorities. The Dazhong Taxi company of Shanghai pro-ceeded to convert 10 million C-shares into 10 million B-shares. When the Dazhong case was approved in 1994,its C-shares represented only 7.9 percent of the overallshareholding structure of the company. Now Dazhonghas foreigners holding 47.6 percent of the shares while

the State holds 44.4 percent. C-share holders benefitedthe most as the holding of B-shares made it possible torealize capital gains (the trading inactivity on C-shareseffectively ruled out such possibility).

8Geographical segmentation in the PRC arose due to thefact that the exchanges were established independentlyat different locations in the absence of a uniform nationalframework. Segmentation by investor type, i.e., domesticand overseas, has arisen because of fears of a potentialdestabilizing effect of foreign capital flows.

9Anjali Kumar et al. 1997. China’s Emerging Capital Mar-kets. Financial Times Publishing, Asia Pacific. p. 147.

10The Research Institute of International Finance, Bankof China, estimates that individual holdings of foreignreserves could be as high as $20 billion.

11At the technical level, there seems to be no difficultiesin undertaking this task.

12Government bonds in the PRC are issued primarily bythe Ministry of Finance (called treasury bonds); part ofthem are used for general budgetary purposes and arereferred to as “treasury bills.”

13For example, the National Construction Bonds were is-sued to finance infrastructure and State enterprise invest-ment in general, while Key National Construction Bondswere targeted toward priority national projects.

14Currently, four issuing methods are used: (i) under-writing agreements for paperless treasury bills of sixmonths to one-year maturity; (ii) allocations to localgovernments for two-year bearer treasury bills; (iii) di-rect placements to financial institutions for five-yearbearer treasury bills; and (iv) allocations to specializedbanks in the form of certificates for three-year bills,which is the largest portion of the Government bondissues. These certificates are redeemable at the bankof issue.

15For example, a RMB100 bond with 13 percent couponrate and two-year maturity would pay RMB126 at matu-rity. This is equivalent to a yield to maturity of 11.9 per-cent on a semiannual basis.

16An SOE may be restructured into a joint-stock limitedcompany if it meets certain conditions. The SOE mayhave no more than five promoters, and must be incorpo-rated by public subscription.


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17The market share of the five largest securities compa-nies, namely, Guotai, Shenwan, Huaxia, Nanfang, andHaitong in the IPO market was about 59 percent in 1996.

18They also used M&As as a way of expanding their ownbusinesses.

19The business segregation policy has been pursuedpartly to enhance the efficiencies and the stability of theState-owned commercial banks and the central bank. Ac-cordingly, former subsidiaries or divisions of these bankswere segregated and established as independent enti-ties such as the securities companies, insurance compa-nies, trust companies, finance companies, credit coop-eratives, etc.

20Some 20 securities companies used to be branches ofthe People’s Bank of China.

21There have been numerous reports of misconduct in-volving securities companies.

22The draft securities law is known to prohibit the use ofclients’ deposits.

23Existing listed companies range from industrial to com-mercial, property investments, utilities, and conglomer-ates. The State Planning Committee (now renamed theState Development and Planning Commission) sets theoverall stock quota, and the CSRC has the primary re-sponsibility for approving particular companies to belisted.

24Interviews with the management of the securities com-panies in the PRC confirmed that they are not very muchconcerned about the concept of risk management.

25The first trust business in China emerged after WorldWar I and the number of trust companies increased to 54by the end of the 1930s, when they were closed or ab-

sorbed by state banks with the establishment of thePeople’s Bank of China.

26The five largest TICs are the Shanghai InternationalTrust and Investment Co., Guangdong International TICs,and three largest provincial TICs.

27The CITIC, with a total asset over RMB170 billion, isthe largest of the international TICs.

28The TICs were exempted from the credit plan, but are stillsubject to control by the PBC in their lending activities.

29Recently, two mutual funds were listed on the stockexchange and another one was scheduled to be listed inMay 1998, reflecting a partial change in the policy of thesecurities authorities.

30At the technical level, there seem to be no difficulties inundertaking this task.

References

China Securities and Futures Statistical Yearbook. 1997.China Securities Regulatory Commission. China Statis-tical Publishing House. October.

Guotai Securities. 1998. Annual Reports.

Kumar, Anjali, et al. 1997. China’s Emerging Capital Mar-kets. Financial Times Financial Publishing, Asia Pacific.p. 147.

People’s Bank of China. Almanac of China’s Finance andBanking. Various years.

Shanghai and Shenzhen Stock Exchanges, 1998.


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Appendix 1

The Stock Market of the PRC

DEVELOPMENT

The first stock market in the People’s Republic of

China (PRC) was informally set up in Shanghai in

1914, but it was not officially opened until 1920. The

market’s focus was on the trading of Government

bonds. Thereafter, stock markets were also opened

in Beijing and Tianjin. In 1949 when the Chinese Com-

munist Party came to power, the stock exchanges

were closed and all securities were abolished. How-

ever, the Chinese securities market re-emerged in

the early 1980s, following the introduction of eco-

nomic reform programs.

As the State itself badly needed to raise funds

due to the persistent losses of State-owned enter-

prises and poor tax collections, the Government first

issued treasury bills in 1980. Soon after, Government,

financial institutions, and State-owned enterprises

issued various types of bonds. The first public issue

of shares took place in Shanghai in 1984, and a secu-

rities trading center was opened in 1986. This was

prompted by the State-owned enterprises’ desire to

have greater autonomy from the control of Govern-

ment ministries, which was only possible through

privatization by issuing shares to parties other than

the State.

Unable to wait for the enactment of the national

laws, the local authorities of Shanghai and Shenzhen

developed their own respective local company and

securities laws. On 19 December 1990, the Shang-

hai Stock Exchange (SHSE) officially opened as a

nonprofit organization. The Shenzhen Stock Ex-

change (SZSE) followed suit on 3 July 1991. The

organization and structure of the SZSE closely re-

semble those of its Shanghai counterpart, except

that a regulatory fee imposed on new listings on the

SZSE came into effect in 1992. Dual listing on the

SHSE and SZSE is not allowed: each company’s

issue is restricted to its area and the markets in the

two exchanges remain distinct. In 1992, Shanghai

Vacuum, already listed on the SHSE became the

first Chinese company to publicly issue B-shares

to foreign investors. The first B-share traded on

the SZSE was Southern Glass in 1992. The dis-

tinction between A- and B-shares was established

to limit foreign ownership in these enterprises.

Trading also takes place in H-shares on the Hong

Kong Stock Exchange (HKSE) and American

Depository Receipts (ADRs) known as N-shares

on the New York Stock Exchange (NYSE). Until

the end of 1995, the SHSE enjoyed greater mar-

ket capitalization and trading value than the SZSE.

Since then, the two markets have been compa-

rable in both measures.

STOCK EXCHANGES

The major functions of the stock exchanges in the

PRC are nearly the same as those in other advanced

market economies. They provide markets for trad-

ing of securities including stocks, bonds, and other

financial instruments. And, as an official intermedi-

ary and provider of the capital market, they regulate

and supervise the member firms, evaluate the appli-

cations for listing in the primary market, and monitor

securities trading to maintain a fair and orderly mar-

ket. However, the exchanges’ role as a self-regula-

tory organization is somewhat limited in the PRC

(pages 71–72). The SHSE and the SZSE are both

nonprofit membership organizations, and are oper-

ated with similar organizational structures.

As of the end of 1997, 383 companies and a total

of 467 securities of four categories were listed on

the SHSE. The securities consisted of 372 A-shares,

50 B- shares, 15 investment funds, treasury bonds of

9 spots and 8 repos, and 5 financial and corporate

bonds. The total market capitalization of the stocks

at the SHSE was RMB921.8 billion, with an annual

trading volume of RMB2,984.2 billion. The number

of registered investors is 17.1 million, with 47,200

institutional investors. A total of 39 companies list

both A- and B-shares, and 12 companies have dual

listings in both Shanghai and Hong Kong, China. Four


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companies list the ADRs on the NYSE and one com-

pany lists the global depository receipts (GDRs) on

the London Stock Exchange.

The SHSE has 467 members: 105 members are

securities companies and the rest are financial insti-

tutions authorized to deal with securities-related busi-

nesses. It also has two subsidiaries: the Shanghai

Securities Central Clearing and Registration Corpo-

ration, which is responsible for the central deposi-

tory, registration, and clearing of the securities trans-

actions; and the Shanghai Securities Communication

Company, responsible for the communication of trad-

ing orders and execution. As of the end of 1997, the

exchange had a staff of about 300 people, eight de-

partments, one office, and two centers for research

and information. The trading system of the SHSE is

hosted by HT-T520 to support its paperless trading

system, which can process more than 10 million trans-

actions a day.

The SZSE is comparable to the SHSE in many

respects. As of the end of 1997, the SZSE had 352

members with 1,359 seats and 14 special seats for

B-shares. It had a staff of about 230 people who

handled the operation of the exchange, the comput-

erized trading system, and the depository functions.

As of March 1998, the SZSE had 370 companies

and 438 securities listed. The listed securities con-

sisted of 358 A-shares, 52 B-shares, 2 corporate

bonds, 16 treasury bonds (7 spots and 9 repos), and

10 investment funds. The total market capitalization

of the SZSE amounted to RMB869 billion with an

annual trading volume of RMB1,754.7 billion.

Documents

Agenda for Capital Market Reforms in the People’s Republic of …aric.adb.org/pdf/aem/external/financial_market/Republic_of_China/ch… · Agenda for Capital Market Reforms in the