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Chinas Securities Markets And Global Economic Integration Finance Essay


China’s stock markets are today bigger than the bourses in London and Tokyo and have become second largest in the world after the United States.

After nearly four decades of abandonment, China’s efforts to reactivate its stock exchanges in the early 1990s have successfully attracted a great many international investors in pursuit of the benefits of international diversification.

The total market capitalization of the Chinese stock market is 24.393 trillion yuan as at end 2009 equivalent to US$3.576 trillion (source: CSRC 2009). China’s markets have become the fastest growing in the world. Although in existence since 1990, the stock markets have exhibited phenomenal growth over the last decade and more so since 2005 when a series of major stock market reforms were announced by the government.

Since China opened its stock markets on December 19, 1990, the Chinese government has employed various policies in an attempt to reform its underdeveloped stock markets.

The stock market development in China has been a logical extension of the Chinese economic reforms process, which began in the mid 80’s. Increasing decentralization of the Chinese economy resulted in falling Central revenues and the government started looking for newer sources of capital to fund the capital expenditures in the State –owned enterprises’ (SOE’s). Despite the risk of loss of monopolistic control, the central government saw that a functioning stock market could facilitate the mobilization of private savings to finance SOE’s and to diversify investment risks otherwise concentrated in the state-owned banking system.

However, the government imposed many supply and demand controls till the late 90’s aimed at restricting the size and growth of the stock markets. The government generally favored the banking system over the stock market as the primary vehicle of financial intermediation, and domestic funds were channeled mainly to the banking sector instead of the stock market. However, with the banking system under tremendous pressure in the mid-90’s due to high non-performing assets (State-owned banks had NPA’s as high as 40% (Wong and Wong 2001)), in 1997, the government decided to make greater use of the stock market as an alternative fundraising vehicle for SOEs to allow state-owned banks some room for restructuring. In order to enable this, nearly all the restrictive regulations that had been imposed on both the supply of and the demand for stocks were relaxed, step-by-step. Regulations were strengthened by the China Securities Regulatory Commision (CSRC), the main regulatory body for the Stock Markets and investor protection laws enacted.

Apart from seeking to spur economic growth, the reforms have also been aimed at attracting foreign investors and enhancing financial market development.

Equity market growth leads to higher economic growth. “Equity market liberalizations, on average, lead to a one percent increase in annual real economic growth over a five-year period”(Bekaert et al. (2004))

Equity market liberalizations give foreign investors the opportunity to invest in domestic equity securities and domestic investors the right to transact in foreign equity securities. Equity market liberalization directly reduces financing constraints in the sense that more foreign capital becomes available, and foreign investors may insist on better corporate governance, which indirectly reduces the wedge between internal finance and external finance. Hence, the cost of capital may go down because of improved risk sharing or because of the reduction in financing constraints or both. Moreover, better corporate governance and investor protection may promote financial development (La Porta et al. (1997)) and hence growth (King and Levine (1993), for example). Much of recent literature corroborates this. See, for example, Phylaktis (1999), Henry (2000), Bekaert and Harvey (2000, 2003), and Bekaert et al. (2005).

The primary benefit of a securities market is that it constitutes a liquid trading and price determining mechanism for a diverse range of financial instruments. This allows risk spreading by capital raisers and investors and matching of the maturity preferences of capital raisers (generally long-term) and investors (often short-term). This in turn stimulates investment and lowers the cost of capital, contributing in the long-term to economic growth.'

Stock markets also result in considerable financial integration with the world. There are significant potential benefits to be had as a result of increasing financial integration for both developed and developing countries. The possibility of diversification of savings should have a direct positive effect on individuals' wealth (see Anders C. Johansson 2009). Consumption smoothing is another potential benefit (see Obstfeld, 1994, among others). However, many regional financial crises and episodes of so-called financial contagion show that more open access to international financial markets also brings with it potential risks for individuals and the economy as a whole. Even though most financial crises are the direct result of misaligned fundamentals (Agenor, 2003), these crises have shown the importance of having developed strong domestic financial systems with efficient regulatory overview and supervision.

The emergence of China as an Economic Superpower in the last decade with very strong trade links with developed countries has made it more integrated with the world. The stock market reforms have only spurred this integration by enabling foreign capital inflows. The internationalization of Chinese firms, which are listed on the stock exchanges further, provides a degree of global integration. In the case of China, the government is taking financial liberalization step by step.

The aim of this study is to investigate whether stock market reforms in China have spurred significant domestic economic growth. The study also looks at whether China has achieved significant integration with the world markets as a result of its Stock Markets. The learnings can be transplanted to other transition economies.

Section 2 reviews the relevant literature in regard to Stock market reforms impacting economic growth and global integration and also provides a brief account of the Chinese stock markets and the key reforms undertaken.

Literature Review

The reformation of China from a socialist centralized economy to an open market driven one, albeit by keeping the socialistic tenets intact has attracted the attention of various economists, scholars and sociologists alike. Many have sought to analyze the Chinese economic success and study it in the context of traditional and modern economic theories.

The Chinese Stock market evolution and its stupendous growth in the last decade have also drawn the attention of economists who seek to study China and its financial market liberalization model. There is rich literature pertaining to the Chinese stock market reforms and their role in the Chinese economic growth and its global integration.

The Literature review is being undertaken under 2 broad heads –

Stock Markets and Economic development

Stock Markets and Global Integration.

Stock Markets and Economic development

A large body of empirical studies clearly shows that the development of stock markets

is strongly and positively correlated with the level of economic development and capital

accumulation. This is a solid and uncontroversial result, and it appears to be true across

time and for many countries. Indeed, the data confirm that as economies develop, equity

markets tend to expand both in terms of the number of listed companies and in terms of

market capitalization (Atje and Jovanovich 1993; Demirgüç-Kunt and Levine 1996a,

1996b; Demirguc-Kunt and Maksimovic 1996; Korajczyk 1996; Levine and Zervos

1996, 1998).

The theoretical and empirical literature concerning stock markets and economic development is vast and this section does not attempt to cover it in its entirety. Like financial institutions, the channels through which stock markets influence economic development are (a) the savings rate, (b) the quantity of investment and (c) the quality of investment (Singh, 1997, p.774).

Stock markets do spur savings rate in the economy, however it is important to assess whether the overall level of savings in the economy has gone up as a result of investments in the stock markets and that merely a substitution of bank deposits hasn’t occurred.

Traditionally, an important debate in the literature has been whether a stock market-based financial system or a bank-based system impacts upon channels a) – c) more effectively.

Most literature on stock markets are agreed on the following benefits that stock markets provide to an economy:

Efficient Capital Allocation

Increase in the quantity of investment in the economy

Better Corporate governance and firm performance

Reduction of government ownership and control

Increase in productivity in the economy

Risk diversification through internationally integrated stock markets

Acquisition of information about firms

Enabling Monetary Policy setting

Effect on banking reforms

Savings rate, higher capital raised and growth

Stock markets are expected to increase the amount of savings channelled to the corporate sector. Some evidence can be found in the work of Greenwood and Jovanovich (1990). In terms of raising capital, Greenwood and Smith (forthcoming) show that large, liquid, and efficient stock markets can ease savings mobilization. By agglomerating savings, stock markets enlarge the set of feasible investment projects. Since some worthy projects require large capital injections and some enjoy economies of scale, stock markets that ease resource mobilization can boost economic efficiency and accelerate long-run growth.

Disagreement exists, however, on the importance of stock markets for raising capital. Mayer (1988), for example, argues that new equity issues account for a very small fraction of corporate investment.

Increased Liquidity and growth

Apart from the ability to raise capital, liquidity is an important feature of the stock market. The ability of investors to buy and sell securities easily is called the liquidity of the market. Liquidity is the main indicator of stock market development.

Liquid markets help in mobilizing capital for committing to long- term projects. Many high-return projects require a long-run commitment of capital. Investors, however, are generally reluctant to relinquish control of their savings for long periods.

Levine (1991) and Bencivenga, Smith, and Starr (1996) show that stock markets provide much needed liquidity to the system: savers have liquid assets—such as equities—while firms have permanent use of the capital raised by issuing equities. Liquid stock markets reduce the downside risk and costs of investing in projects that do not pay off for a long time. With a liquid equity market, the initial investors do not lose access to their savings for the duration of the investment project because they can quickly, cheaply, and confidently sell their stake in the company. Thus, more liquid stock markets enable investment in long-duration, potentially more profitable projects, thereby improving the allocation of capital and enhancing prospects for long-term growth.

Theory is unclear, however, about the effects of greater liquidity on growth. Bencivenga and Smith (1991) show that by reducing uncertainty, greater liquidity may reduce saving rates enough to slow growth. Earlier studies based on international panel data returned differing results. For example, Atje & Jovanovic (1993), using a data set of 39 countries over the period 1980 – 1988, found that a strong, positive and statistically significant relationship existed between stock markets and economic growth. However, this result was later criticized by Harris (1997) on the basis of the methodology employed. Using an expanded data set and an alterative model specification, Harris (1997) concluded that the evidence suggesting that stock markets promote economic development was “at best very weak”. More recent studies by Levine & Zervos (1998) and Khan & Senhadji (2000) have been particularly informative due to the utilization of nested models and more detailed model specifications that consider separately the channels through which financial institutions and markets impact upon economic development. The findings of these studies suggest that the stock market has its greatest impact on economic development through its creation of liquidity.

“Stock market liquidity is a robust predictor of real per capita GDP growth, physical capital growth, and productivity growth after controlling for initial income, initial investment in education, political stability, fiscal policy, openness to trade, macroeconomic stability, and the forward looking nature of stock prices.” (Levine & Zervos (1998))

Risk Diversification and growth

Internationally integrated stock markets also influence economic growth by enabling risk diversification. Intuitively, because projects with high expected returns also tend to be comparatively risky, better risk diversification through internationally integrated stock markets will foster investment in projects with higher returns. Saint-Paul (1992), Devereux and Smith (1994), and Obstfeld (1994) demonstrate that stock markets provide a vehicle for diversifying risk. Their models also show that greater risk diversification can influence growth by shifting investment into higher-return projects. However, theory also suggests circumstances in which greater risk sharing slows growth. Devereux and Smith (1994) and Obstfeld (1994) show that reduced risk through internationally integrated stock markets can depress saving rates, slow growth, and reduce economic welfare.

Corporate governance and Economic growth

The role of stock markets in improving corporate governance has also been widely studied. As stock markets mature and investor protection laws inevitably get passed, it results in improved corporate governance. It is widely accepted that better corporate governance eventually improves firm performance and results in better capital mobilization and allocation to the most efficient firms.

The corporate governance role of financial institutions and markets in particular is often discussed in terms of two distinct models (Mayer, 1994, p.189). The first model is labeled the outsider, stock market-based approach (OS) and is associated most notably with the US and the UK. Under the OS model, firm ownership is typically diffuse and individual shareholders are outsiders in the sense that they only have arms length input into the firm's decision-making through a board of directors. Corporate governance in this model is performed primarily through a market for corporate control. Therefore, the stock market plays a central role in corporate governance via the takeover mechanism.

The second model is labeled the insider, bank-based model (IB) and is most typically associated with Germany and Japan. In the IB model, firm ownership is concentrated in the hands of a few key shareholders that rarely trade their shares. Corporate governance is exercised from within the firm by these insiders rather than through a market for corporate control. Banks, rather than stock markets, feature predominantly in this model.

Their influence is through several channels, including being important suppliers of external finance, holders of firm equity and holding seats on the firm's management board (Corbett, 1994, p.316).

With respect to transitional economies, there is considerable debate as to whether such economies are best served by the OS or IB model (Popov, 1999, p.1). On one hand, the IB model seems the most natural choice because banks are already established and have a history of lending to firms (Aoki, 1995). Stock markets only exist in embryonic form in many transitional economies and hence cannot be expected to play a significant role in corporate financing and governance, at least in the short and medium term. Scholtens (2000, p.535) also argues that stock markets require a much more elaborate legal system and prudential framework than banks to function effectively. On the other hand, it could be argued that there is little scope for the development of bank-led corporate governance because the state banks that dominate the financial sector in transitional economies are not skilled in making decisions according to commercial principles (Rowstowsi, 1995).

In addition, some studies conclude that stock markets could improve corporate governance by alleviating the principal-agent problem between the owners and managers (Jensen and Murphy, 1990). In turn, weaker corporate governance impedes effective resource allocation and slows productivity growth. Asli Demirguc-Kunt and Vojislav Maksimovic (1996) show that firms in countries with better functioning banks and equity markets grow faster than predicted by individual firm characteristics and Raghuram G. Rajan and Luigi Zingales (1996) show that industries that rely more on external finance prosper more in countries with better developed financial markets.

By contrast, there are studies that point out the negative effect that stock market development could have by facilitating hostile counter-productive takeovers (Vishny, 1990). Takeover threats could hassle managers that discourage long-term investment, and therefore lead to inefficient allocation of resources (Singh and Weiss, 1998). More liquidity also makes it easier to sell shares and can reduce the incentives of shareholders to undertake the costly task of monitoring managers (Andrei Shleifer and Robert W. Vishny 1986; and Amar Bhide 1993). The experience in most markets, especially transitional economies and heavily centralized economies which have undertaken rapid stock market reforms shows that continuous monitoring and control provides the most effective incentives for managers to choose investment projects, which maximize firms’ market value. This increases the average return on capital and investment.

Private ownership and economic growth

Capital markets increase private ownership in an economy. Governments tend to make use of markets to raise funds for meeting their fiscal targets by undertaking disinvestment programmes. Stock markets in centralized economies ensure the passing over of considerable ownership from the government to the private sector thereby aiding in profit maximization of firms and a wider control structure. Sun, et al. (2002) suggest, that too much government ownership might result in a lack of focus on profit maximization and excessive bureaucratic interference, while too little government ownership might result in a loss of the government’s “helping hand”.

Banking reforms and economic growth

The role of stock markets in effecting banking reforms has also been studied in the context of developing economies. An active securities market provides some competition to commercial banks in the provision of debt financing, thus spurring banks to improve efficiency and service levels, as well as providing the banks with a means to securitize their debt and better manage the maturity match and risk profile of their balance sheets (Pardy 1992). An efficient banking system helps boost economic growth by making credit available to industry at market determined interest rates.

Monetary Policy and economic growth

Stock markets enable monetary policy setting by governments and thereby influence the economy. James Laurenceson 2002 in his paper “The Impact Of Stock Markets On China’s Economic Development” states that an active securities market provides a means for the exercise of monetary policy through the issue and repurchase of government securities in a liquid market. This is an important step in financial liberalization. On the other hand, active securities markets alter the pattern of demand for money, and booming stock markets create a liquidity and wealth overhang which is potentially inflationary. Money management is therefore more complicated in an environment of an active stock market and an open capital account. Because one factor in an inflationary cycle is the supply of money, tightening money supply is an important tool of government in keeping control over inflation. But where there is an active corporate bond market, the private sector is able to issue debt instruments, which have many of the characteristics of money. This lessens government's direct control over the quantity of (near) money in circulation. It can respond with more stringent policies, especially raising interest rates in an attempt to make corporate bonds less attractive as investments, thus reducing their supply. But this use of interest rates may have damaging ramifications if it diverts savings from productive investment to passive interest earning, or of it fuels foreign interest in the local currency and creates so called "hot money" which destabilizes foreign exchange management.

Another important contribution of recent empirical studies has been to show that the impact stock markets have on economic development appears to display considerable diversity between individual countries. For example, evidence presented by Arestis & Demetriades (1997, p.785-790) concluded that the relationship between stock markets and economic development in the US was largely positive but insignificant in the case of Germany. Such findings should not be surprising. Okuda (1990, p.240), for example, earlier noted that the causal link between financial factors and economic development is crucially dependent upon the nature and operation of financial institutions, markets and policies pursued by individual countries.

Alternate views also exist regarding the role stock markets play in economic growth. Apart from the view that stock markets may be having no real effect on growth, there are theoretical constructs that show that stock market development may actually hurt economic growth. For instance, Stiglitz (1985, 1994), Shleifer and Visgny (1986), Bencivenga and Smith (1991) and Hide (1993) note that stock markets can actually harm economic growth. They argue that due to their liquidity, stock markets may hurt growth since savings rates may reduce due to externalities in capital accumulation. Diffuse ownership may also negatively affect corporate governance and invariably the performance of listed firms, thus impeding the growth of stock markets.

Despite alternative views, empirical works continue to show largely some degrees of positive relationship between stock markets and growth.

Stock Markets and Global Integration

“A market is financially integrated if a project with identical risk has identical expected returns across different markets”. Much of the recent literature indicates that financial market liberalization will increase emerging markets’ integration into global markets, attract foreign investment, and will reduce the cost of equity capital thereby ultimately increasing economic welfare. Indications of stock market integration have been found in different contexts where national stock markets move together, where one market is affected by the other markets, or where a national market is integrated with the global market. Many factors affect stock market integration such as market liberalization, policy reform, close trading partnerships, stock market crisis, regional interrelationships, and related macroeconomic influences.

The various dimensions of integration are trade integration, higher FDI’s, increasing international portfolio investments and the high speed at which news and investor sentiment can spread across the world.

Bekaert and Harvey's (1995) study on a large number of developed countries and twelve emerging markets showed that some emerging markets seem to be more integrated with other markets even though there are strong investment restrictions in place. On the other hand, their study indicates that other emerging markets are segmented, even though foreign investors have relatively free access to investment opportunities. Their results thus indicate the possibility of increasing financial market integration over time even when a market appears to be quite insulated from the rest of the world's markets. Their findings are interesting and of significant important to this study, since the present study focuses on China, a market that is commonly seen as being very much insulated from the rest of the world.

Bekaert and Harvey (2003) in their paper “Capital Flows and the Behavior of Emerging Market Equity Returns” state that the opposite of market integration, ‘market segmentation’, can cause fundamental distortions in an economy. In the segmented market, local investors are restricted to investing in local securities and foreign investors are not allowed (or the cost is high) to invest in the local market. Obstfeld (1494) and Stulz (1999) detail some of the distortions that occur in the segmented market. Local investors are unable to diversify their equity portfolios because they can only invest in local securities. Further, the local market is usually very small with only a small number of securities. Since investors will pay a premium for diversification, new local firms will arise that inefficiently operate in industries that provide diversification. Current firms may also diversify away from their core activities by accepting negative net present value projects that make them more attractive to investors. One can see that segmentation directly leads to an inefficient allocation of productive resources.

The process of integration should reverse these inefficiencies. Investors will no longer be interested in investing in inefficient domestic companies when they can purchase a foreign stock that is efficient. If the economic liberalization occurs at the same time, the inefficient companies will likely be driven out of business because of price and quality competition from foreign producers. Similarly, the current producers in the local economy may reallocate capital from the inefficient conglomerate divisions to the divisions that have a comparative advantage. Nevertheless, Bekaert and Harvey (1995, 1997,2000) argue that it is particularly difficult to pin down the exact date when the local market becomes integrated with world markets. Using the legislative dates of capital market liberalizations is fraught with danger. For example, a country might initiate widespread reforms-but foreign investors ignore the country’s equities because of market imperfections, because the reforms are incomplete, or because they deem the reform program not credible. Hence, while technically open, the market is effectively segmented.

The patterns in net capital flows should reveal much information about market integration. After legal reforms are initiated and the market structure is satisfactory-that is, if the market becomes truly integrated-we should see an increase in capital flows. It is also possible that the market moves in the other direction, that is, toward segmentation. If restrictive measures are initiated or the political and economic environment is not conducive to international investors, capital flows should “dry up.” It is therefore also important to carefully consider the particular economic and political environments within each country.

By measuring the linkages of real interest rates, Phylaktis (1999) finds that integration of six Asian countries with Japan and with the U.S. increases after these countries reduce restrictions on their financial markets. He also finds that after market deregulation, real interest rates in a group of Asia-Pacific countries tend to co-move with world interest rates and that the influence of Japan is greater than that of the U.S. This study indicates that stock market integration is closely related to financial market deregulation and liberalization.

Connolly and Wang (2003) test the comovements among stock markets in the U.S., Japan, and U.K. and find that returns of domestic markets are closely associated with previous returns of foreign markets rather than macroeconomic factors.

Barberis et al. (2005) argue that price comovements reflect both fundamental-based news and sentiment-based noise. The fundamental-based comovement depends primarily on news correlation between stocks, while the sentiment-based comovement depends on noise traders who allocate funds by fund category. Froot and Dabora (1999) document that the location of trade causes the return of Royal Dutch shares to differ significantly from the return of Shell shares even though these two stocks have the same earnings streams and fundamental values. Ng (2003) examines return and volatility spillovers from Japan and the U.S. to six Pacific-Basin equity markets and finds that both world factors and regional factors play important roles. Hsin (2004) measures transmission of stock market indexes among major developed markets and finds strong evidence of regional transmission effects in market returns and return volatility. Forbes and Rigobon (2002) report high levels of market comovements during stable periods as well as during crisis periods. Johnson and Soenen (2003) investigate equity market integration among eight Latin American countries with the U.S. and find that comovements of these markets are associated with macroeconomic factors, conclusions supporting Campbell and Hamao (1992). Bracker et al. (1999) argue that the degree of comovement represents the level of stock market integration and find that the extent of market integration is closely related to the degree of bilateral import dependence and geographical distance between the markets. Brooks and Negro (2004) find that the degree of comovement across national stock markets has increased dramatically since 1990 and that this phenomenon is driven primarily by stock market bubbles rather than by global integration. They argue that international diversification is still effective in reducing risk after the tech stock market bubble broke in 2000.

As a latecomer on the stage of regional financial markets, China constitutes an interesting case. There are a growing number of studies that focus on China's financial relationship with neighbouring economies. Shin and Sohn (2006) analyze trade and financial integration in Asia and include China in their sample. To identify possible regional financial integration, they focus on co-movements in interest rates using standard correlation measures. They find that the current level of financial integration in the region is low and that it is difficult to identify the possible effect that financial integration has on macroeconomic variables such as output and consumption. In a study on spillover effects among financial markets, Johansson and Ljungwall (2009) focus on the equity markets in

the Greater China region (China, Taiwan, and Hong Kong). They show that there are spillover effects between the markets and that the Chinese market is affected by its neighbours even though it is commonly seen as an insulated market. Cheung, Chinn and Fujii (2003) study financial integration in the Greater China region. Using data on interbank rates, exchange rates, and prices, they show that there is an increasing trend in financial integration in the region, especially between China and Hong Kong. Finally, Wang and Di Iorio (2007) show that there is an increasing integration between China's A-share market and Hong Kong's stock market, but that there is no evidence that the Chinese A-share market is becoming more integrated with the world market.

Despite increasing trade integration, a large part of the Chinese market remains relatively inaccessible to the international investor, as severe restrictions limit both the possibilities for foreigners to buy Chinese stocks and for Chinese investors to buy stocks abroad. This lack of arbitrage possibilities leads to situations where large discrepancies exist between the returns on shares of the same company as quoted on the Shanghai and Hong Kong markets. On the other hand a sudden plunge of the Shanghai Composite index (down nearly 9%) on 27 February 2007 sparked a major sell-off in both developing markets as well as emerging markets, most of which were growing strongly till then. Clearly this indicates that though trading restrictions limit the direct impact of and on Chinese markets, the links via investor sentiment, news and other indirect links can have a great influence on the comovement.

When it comes to China, Masson, Dobson and Lafrance (2008) argue that China is less financially integrated with the rest of the world, even though the country is becoming more and more important for the world economy. The authors list a number of reasons for why this may change over the coming decades, including China's increasing investments abroad, the continued development of the domestic financial system, a development towards a more flexible exchange rate system, and the possibility of a continuation of the relaxation of capital controls. These reasons for anticipating China's increasing level of financial integration with the rest of the world are important, as is a more detailed analysis of why financial integration is already increasing as seen in this study.

The Chinese Stock Markets

The modern stock exchanges in Shanghai (SSE) and Shenzhen (SZSE) were set up in late

1990 and 1991 respectively, in order to provide capital for the reform of state-owned companies and reduce the banks' burdens of providing various types of financing. To this day, they remain relatively inaccessible to the international investor, due to participation and capital account restrictions. During the past 15 years, the main composite indexes evolved similarly across the two markets: trending strongly upward in the early 1990s, until early 1993, when expectations of state-owned shares becoming publicly traded caused fear and led, for example, to an 80% drop in the Shanghai Composite Index in mid 1994.

Government intervention caused the index to recover sharply, followed by a 1.5-year recession, which ended in 1995. Most of the year 1996 brought a steady rise in the indices, while 1997 saw them somewhat more stabilized and the isolation of the Chinese market prevented large immediate repercussions of the Asian crisis and the Russian financial crisis. Mid 1999 marked the start of a two-year speculative bubble, amid a general slowdown in the economy. Mid 2001 saw the beginning of a 4 year slump, triggered by new rules on previously non-tradable state-owned shares, which led to a halving of the indexes and finally came to an end in mid 2005. Since then, the Chinese stock markets have been soaring at unprecedented rates.

Notably, there are different categories of shares traded on the exchanges, the two most important being the A-shares, which are quoted in Chinese currency (RMB), and B-shares quoted in USD (Shanghai) or Hong Kong dollars (Shenzhen). The A-shares (often referred to, especially in the older literature, as 'domestic-only' shares) are available to mainland investors and, since the introduction of the QFII (Qualified Foreign Institutional Investor) scheme in October 2004, to a very restricted number of foreign institutional investors.

The A-shares constitute a vast majority of the market, in terms of both capitalization and trading volume. The B-share market (or 'foreign-only') was set up in order to provide a Chinese stock market for foreign investors and was initially available only to the latter. However, since March 2001, it has been made available to mainland investors with foreign currency accounts. Due to a lack of arbitrage and other investment possibilities, the two types of markets exhibited sharp discrepancies,8 especially in the 1990s, leading to a divergence in prices of the shares of the same company and high first-day appreciations; however there seems to be a tendency toward creating a single market for Chinese shares. At the end of 2006 annual total trading volumes on the SSE and SZSE reached approximately USD 740bn and 420bn respectively, while the total market capitalizations of traded stocks were USD 915bn and 228bn, with 832 and 579 listed companies. This placed the two Chinese markets combined as the third largest Asian-Pacific stock market in terms of capitalization, after Japan and Hong Kong. Moreover, in terms of the two variables, the markets grew at the fastest (SSE) and second fastest (SZSE) rates in the world, increasing substantially in both categories over 2006.9

Among other distinct features of the Chinese markets is that initial public offerings were suspended between April 2005 and May 2006 due to share-reform aimed at reducing state ownership of listed shares. The markets remain characterized by a large amount of non-tradable shares (above 50% of market capitalization on the SZSE and above 60% on the SSE) held directly or indirectly by the state. Generally, the stock markets remain relatively isolated, at least in terms of participation.

Aforementioned restrictions in the A-share market limit the number of foreign participants and impose caps on their involvement, while the B-share market is relatively shallow and does not offer a wide range of companies. A limited number of shares have secondary listings of various forms on the Hong Kong Exchanges (H-shares), London Stock Exchange and New York Stock Exchange, but, as mentioned, the lack of arbitrage possibilities between the markets leads to large discrepancies between quotations in mainland China and the other markets. Moreover, capital account restrictions severely limit the possibilities for Chinese investors to buy stocks abroad.

Key Stock Market Reforms in China

IPO Reforms

From 1993 to 1998, the government imposed an explicit annual quota on the total amount of capital that could be raised through IPO’s issuance. Similarly, regulations were imposed to restrict the amount of post-IPO issuance, including both secondary and rights offerings. First, these restrictions limited the size of the stock market and thus limited potential competition between enterprise shares and other financial assets. Second, the restrictions tended to inflate share prices and thus reduce their returns. In this way, the restrictions effectively increased the implicit tax rates levied on stock ownership and thus made stock ownership less appealing (Gordon and Li 2003).

Of the supply controls, the quota system on IPO issuance was the first to be relaxed in 1999 and eventually abolished in 2001, while the requirements for post- IPO issuance were also made less restrictive after 1999.

Non Tradable Shares reform

Non Tradable shares (NTS) were a special class of shares entitling the holders to exactly the same rights as holders of ordinary shares but which could not be publicly traded. Typically, these shares belonged to the State or to domestic financial institutions ultimately owned by central or local governments. NTS represented more than two thirds of the overall capitalization of the stock market and had long been recognized as one of the major hurdles for domestic financial development in China.

The 2005-2006 reform aimed at eliminating non-tradable shares in the capital of listed firms. Regulatory authorities soon recognized the issues associated with the predominance of NTS. First, NTS hindered the functioning of an active market for corporate control: holders of tradable shares (TS) were typically minority shareholders with limited power to affect management decisions. Second, NTS made the major shareholders relatively indifferent to stock price movements due to the impossibility to sell the shares. Third, the limited free float made the domestic market extremely illiquid and volatile. Fourth, the inefficiency of the domestic market induced many valuable Chinese companies to list overseas, Hong Kong being one of the most preferred destinations. This adversely affected domestic investors who, prevented from investing in the best companies, were stuck with holdings the less performing local companies.

Share classes Reform

In May 1992, the State Council issued a regulation that categorized the shares of a shareholding enterprise into three types:

(1) State and legal person shares, which are owned either directly or indirectly by the state and which cannot be traded freely on the stock exchanges but can be transferred only with administrative approval;

(2) A-shares, which are yuan-denominated and are available for trading by domestic private shareholders on the stock exchanges; and

(3) B-shares, which are available for trading by foreign investors in foreign currencies on the stock exchanges.

This regulation effectively institutionalized a unique feature of China’s stock market—the creation of three distinct markets for the stocks of a listed enterprise, namely, the one-way transfer market for state-owned shares, the A-shares market for domestic private shareholders, and the B-shares market for foreign investors.

First, domestic individuals were prohibited from owning and trading in B-shares, which were issued only to foreign investors, and, conversely, foreign investors were prohibited from owning and trading in A-shares, which were issued only to domestic individuals. This measure enabled the government to access funds from foreign investments while maintaining control over both domestic and foreign capital. On the demand side, domestic individuals were permitted to buy B-shares starting in February 2001, and the A-share market was opened to foreign investors under the scheme of Qualified Foreign Institutional Investors in 2002.

Bank Funding to Stock markets reform

Domestic individuals and institutions were prohibited from using bank loans to invest in the stock market in order to control the amount of funds that could be diverted from the banking sector to the stock market. Starting in February 2000, some selected securities enterprises were allowed to borrow funds from banks with their shares as collateral. This marked the first step toward allowing bank credits to enter the stock market.

Institutional investors reform

Financial institutions and major institutional investors such as insurance funds and pension funds were not permitted to buy shares and could only invest in government bonds and bank deposits. From May 1997 to September 1999, all SOE’s and listed enterprises were prohibited from buying any shares, even with funds from their own operations.

Beginning in September 1999, institutional investors, including SOEs, listed enterprises, investment funds, insurance funds, and pension funds were gradually permitted to invest in the stock market either directly or indirectly through investment vehicles such as investment funds.

Relaxing the restrictions on the demand for shares was intended not only to accommodate the increase in the supply of IPO and post-IPO issuance but also to support the government’s plan of reducing the state ownership stake in listed enterprises (Naughton

2002a, 2002b). In early 2001, the central government decided to sell its ownership of the listed enterprises to raise funds to replenish the newly established National Social Security Fund (NSSF). As the state stock reduction program would significantly increase the supply of shares in the A-share market, the government paved the way for allowing more funds to enter the stock market.

Regulatory reforms

Brockman and Chung (2003) document that China’s weak investor protection increases the bid-ask spreads and that China-based stocks suffer higher transaction costs than Hong Kong-based stocks. La Porte et al. (1998) examine the relationship between law and finance in 49 countries around the world and find that differences in law origins explain why investor protections and law enforcements differ across countries. There is significant evidence that a legal system with strong investor protection is associated with effective corporate governance and leads to better financial development and economic growth.

In September 1998, CSRC was promoted to a ministry rank unit, which was directly under the State Council, and CSRC established 10 regional branches. In tandem with removing regulatory barriers and reducing government ownership stakes, the China Securities Regulatory Commission (CSRC) introduced a series of measures aimed at improving corporate governance and legal protection for shareholders in the 2000s. Early in the year, CSRC declared 2001 the “year of market supervision” and commenced a series of investigations into irregularities and illegitimate activities in the stock market, including illicit use of bank funds for stock speculation, market manipulation, and earning falsification by listed enterprises. CSRC also introduced a series of rules and regulations aimed at improving listed firms’ corporate governance, including the requirement that firms must have at least two independent directors on or before June 30, 2002, and that at least one-third of the board members must be independent directors on or before June 30, 2003.

In terms of legal protection for shareholders, the most important development was a judicial interpretation issued by the Supreme People’s Court in January 2001, which stated that fraudulent accounting cases could be pursued in courts by civilians if CSRC had already punished the listed enterprises involved or if criminal proceedings had already taken place. This document introduced for the first time civil threats to China’s listed enterprises. In January 2003, the Supreme People’s Court issued another judicial interpretation that further clarified ways to define losses suffered by shareholders and to

calculate related civil compensation. The interpretation also enabled shareholders to launch collective civil suits in which a number of plaintiffs could gather to sue a listed enterprise through a few representatives, giving the shareholders a more powerful voice in these cases. The provision of such a legal framework led to a substantial increase in the number of civil cases brought against listed enterprises.

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