Securities industry faces challenge
(Barry Livett)
2005-11-25 06:17

There is no denying that China has achieved a considerable feat in establishing the basic infrastructure of a securities industry within the space of 15 years. However, there are numerous structural impediments that persist in China's securities markets which prevent them achieving the objective of allocating capital efficiently and functioning as a proper market mechanism. Many of the problems stem from the situation inherited when the theoretical foundations of the market were laid, and others relate to the restrictions resulting from the current environment in China.

Instead of developing a market where the most deserving efficient companies were awarded with funding opportunities, a quasi-market structure evolved to carry on financing those companies with the most urgent socio-economic problems aligned with the strongest government connections. Faced with minimal or no deposit interest from bank savings, China's savers were galvanised to channel their savings into pre-dominantly lacklustre investments, spurred on by artificial first-day trading closing prices and the misconception that the investments were essentially risk-free, because the markets were promulgated by the authorities.

Initially, the directing of funds to large State-owned enterprises did not adversely affect the fledgling securities markets. That is not the case now. A trend of diminishing dividend yields, poor investment opportunities, dire corporate performance, management malfeasance and the recurrent abuse of minority shareholders has led to the gradual stagnation of China's markets and a significant loss of confidence amongst the investing public. The state of creeping crisis in China's markets was adequately reflected earlier this year when China's stock market indices measuring company share price performance paradoxically hit four year lows whilst the economy continued to power ahead.

The condition of China's domestic markets has become so severe that local companies are now resorting to outsourcing their fundraising requirements to China's offshore market in Hong Kong and to other international exchanges. The domestic markets currently remain closed to new initial public offerings and secondary market fund-raising whilst the problems associated with the state remaining a major shareholder of untraded stocks are addressed. This in turn has exacerbated the woeful situation in the securities industry whereby most domestic intermediaries already financially undermined by ill-conceived guaranteed investment return schemes, poor proprietary trading and limited broking commission-oriented revenue models have lost a key source of income.

The problems which need addressing if the fate of China's securities industry is to be improved generally fall into the categories below. Fortunately, the local regulator with responsibility for the securities markets, the China Securities Regulatory Commission (CSRC), has already undertaken a comprehensive programme of reform to address many of these ailments but many enhancements still need to be introduced.

Restoring investor confidence

As many retail investors recently have lost money through investing in China's stock markets, strong efforts need to be made to reassure potential investors that fundamental structural improvements have been made.

Market intermediaries

Not only have investors had to worry about selecting the right investments from the limited portfolio available in China's markets, but there are also concerns over the ability to have the trades executed properly. The fear of having funds tied up in accounts with a broker that collapses or where the funds are purloined by unscrupulous staff is a strong deterrent to placing trades in China's markets.

Work undertaken through the EUFSCP has enabled the CSRC to strengthen its intermediary monitoring and supervisory capabilities. In the past year the CSRC has undertaken a high profile ruthless programme of closing down some of the 132 securities firms that have misappropriated client funds or failed to demonstrate that they have sufficiently robust systems in place to be able to manage their securities business effectively. It has also enforced the segregation of client and proprietary funds within the remaining firms, in order to safeguard the interests of investors.

Technical competence

Earlier failings in the market can partially be attributed to an insufficiently broad skills base within the securities firms and a lack of technical competence. Also, there was a failure of the intermediaries to manage the expectations of the investors sufficiently and a lack of sophistication amongst the investing public or appreciation of the risks associated with investing in the equity markets.

Investment opportunities

A frequent complaint by both retail and institutional investors is the absence of a sufficiently broad enough range of quality investments for consideration. This problem is compounded by the fact that companies which no longer qualify for listing are not de-listed from the exchanges and there is no facility for bankrupt companies to be liquidated, leading to the perception that China's markets comprise largely of companies that would not qualify for investment in more developed markets.

It is reported that Chinese savers retain up to 40% of their earnings, but little of this is currently targeted at the stock markets.

The CSRC and other regulatory authorities have recently introduced a joint initiative to support moves by listed companies to convert illiquid, untraded legal person and state-owned shares into fully tradable shares. The proposals tabled so far are for the newly converted shares to remain subject to a 'lock in' period, thus removing a key concern of investors that their holdings risked being diluted without compensation.

Derivatives market

Currently the market mechanism available to investors does not provide a derivatives market to enable trading risks arising from share positions to be hedged or for trading strategies to be executed completely.

The market-oriented structure

Although international investors can gain an amount of exposure to China's growth potential by investing in Chinese stocks or China-related businesses listed on the Stock Exchange of Hong Kong and other international exchanges, the range of investments is not as great as that available through the domestic 'A' share markets. Accordingly, it is to the benefit of international investors to have access to China's domestic markets and to the benefit of China to have alternative sources of investment to replace the withdrawn local funds. This has been achieved by the CSRC implementing a system through which selected international firms are able to invest a controlled amount of local currency into the domestic markets; the system is the Qualified Foreign Institutional Investment (QFII).

The CSRC has made commendable progress in addressing many of the earlier problems that have plagued the markets here, but there are still some much needed reforms that have to take place if the exchanges here are not to be rendered obsolete.

The reforms which should still be undertaken include:

Harmonising of the regulatory environment with other regulatory commissions to ensure regulatory arbitrage is avoided and that comprehensive supervisory coverage is maintained, especially across multi-disciplinary financial services (e.g. asset management spanning the securities and insurance industries; derivatives; securitised assets).

Intensify the investor education programmes which have been implemented previously to raise the awareness and understanding of the investing public about how stock markets work and to enable them to start to assess for themselves the potential risks associated with different investment instruments. Part of the aim should be to change the current pervasive 'casino mentality' many retail investors have to one of responsible planned strategic investment.

Promotion of international involvement in China's capital and securities markets by providing clearer guidance of the parameters within which new entrants operate and the approval processes and timetable. If China is serious about increasing international participation, it could include the official publication of all securities markets regulations in English (albeit with the Chinese versions remaining precedent) rather than relying upon the ad hoc provision of unofficial versions of rules by locally-based law firms.

Permit a greater degree of involvement of foreign firms in China's securities industry so that a greater infusion of needed capital and technical expertise can take place. Given the extent to which there is reputational risk associated with international securities firms engaging in merely minority stake purchases of domestic firms, the authorities should consider the framework under which majority control is attainable. Although the scope for international equity stakes to progress beyond the 33% limit was not addressed by the World Trade Organisation accession agreement that comes fully into force at the end of 2006, it is in China's interest to accelerate a relaxation of the shareholding restriction and thus benefit from a rapid strengthening of its securities industry.

The CSRC and SAFE should work together to increase the limits of foreign investment through the QFII scheme, and to relax the qualifying threshold criteria to enable more reputable firms to participate.

The CSRC should strengthen its Listing Committee further to enable it to consider a greater volume of listing candidates. This would enable the consideration of a greater number of private entrepreneurial for listing, and help to dilute the current base of often undesirable companies.

The CSRC should explore encouraging the international holding companies with extensive China operations to list on the domestic 'A' share markets. This would enable the local operations of multinationals to raise RMB funds for local application, and the listed shares could provide currency for rewarding domestic customers and staff members. The added benefit is that having such companies listed locally would help develop China's own stock markets whilst providing role model companies that would inculcate good standards of corporate disclosure and corporate governance. The relatively lower fund raising costs would demonstrate the advantages to the cost of capital of having balanced debt/equity capital structures and equitable treatment of shareholders.

The PRC government should capitalise upon the recent RMB denominated bonds, so-called 'Panda bonds', issued by various international donor organisations to explore making a number of its own issues. The borrowing from the international markets could fund the development of its pensions and social security industry. If the issuance programme was structured carefully to incorporate a broad range of maturities it would be possible to create a government yield curve from which corporate debt issues could then be priced. This would then allow a corporate debt market to be created to compliment the revamped equity markets.

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