China - The emerging capital market (Vol. 2 of 2) : Detailed technical analysis

Report No. 14501-CHA China The Emerging Capital Market (In [vvo Voltimes) Volomre II: Detadled Techniali Analvsis November 3, 1995 East Asa ancd Pacific Region Chiina andc Mongolia Department uLintr% C)pirations Division -m f v j - . .- - -  ACRONYMS AND ABBREVIATIONS ABC Agricultural Bank of China ADD American Depository Debentures ADR American Depository Receipts AIA American International Assurance AIG American Insurance Group AMEX American Stock Exchange AMSET Association of Members of the Stock Exchange of Thailand BAPEPAM Badan Pelaksana Pasar Modal (Capital Market Executive Agency) (Indonesia) BOC Bank of China BOCOM Bank of Communications BOT Build-Operate-Transfer CAIC Chinese American Insurance Company CBOE Chicago Board Options Exchange CD Certificate of Deposit CIB China Investment Bank CITIC China International Trust and Investment Corporation CPA Certified Public Accountant CPF Central Provident Fund CPIC China Pacific Insurance Company CSRC China Security Regulatory Commission CSTS China Securities Trading System Corporation Ltd DM Deutschemark DR Depository Receipt DTC Depository Trust Company FDI Foreign Direct Investment FIBV Federation Internationale des Bourses de Valeurs GATT General Agreement on Trade and Tariffs GDP Gross Domestic Product GDRs Global Depository Receipts GITIC Guangdong Industrial Trust and Investment Corporation GNP Gross National Product IBCA International Banks Credit Agency (originally; today officially IBCA. An international credit rating agency headquartered in London). ICBC Industrial and Commercial Bank of China IFC International Finance Corporation IFI International Financial Institutions IMF International Monetary Fund IOSCO International Organization of Securities Commissions IPO Initial Public Offering ISC International Securities Consultancy ITIC Investment and Trust Corporation ITS Intermarket Trading System JCR Japan Credit Rating Agency Limited KSDA Korean Securities Dealers Association LTS Local Tax Service MAS Monetary Authority of Singapore MICEX Moscow Interbank Currency Exchange MOF Ministry of Finance MOFTEC Ministry of Foreign Trade and Economic Relations MOU Memorandum of Understanding NASDAQ National Association of Securities Dealers Automated Quotation System NETS National Electronic Trading System  NBFI Nonbank Financial Institution NIS Nippon Investor Service NSCC National Securities Clearing Corporation NYSE New York Stock Exchange OECD Organization for Economic Cooperation and Development OTC Over-the-Counter PAIC Ping An Insurance Company PASBD Philippine Association of Stockbrokers and Dealers PBC People's Bank of China PCBC People's Construction Bank of China PDB Pudong Development Bank PICC People's Insurance Company of China Portal An OTC cross-border clearing system PRC People's Republic of China QIB Qualified Institutional Buyers RADRs Restricted American Depository Receipts S & P Standard and Poors SAEC State Administration for Exchange Control SC Securities Commission (Malaysia) SCRES State Commission for Restructuring the Economic System SCSC State Council Securities Policy Committee SDB State Development Bank of China SEAQ Stock Exchange Automatic Quotation System SEBI Securities Exchange Board of India SEC Securities Exchange Commission SEEC Securities Exchange Executive Council SES Stock Exchange of Singapore SESDAQ SES Dealing and Automated Quotation System Market SETC State Economic and Trade Corporation SEZs Special Economic Zones SFC Securities and Futures Commission (Hongkong) SFR Swiss Franc SHSE Shanghai Securities Exchange SITICO Shanghai International Trust and Investment Corporation SOEs State-Owned Enterprises SOU State-Owned Unit SPC State Planning Commission SRC System Reform Commission SSB Securities Supervisory Board (Korea) STAQS Securities Trading Automated Quotations System SZSE Shenzhen Stock Exchange T BILL Treasury Bill T BOND Treasury Bond TICs Trust and Investment Corporations TSDA Taipei Securities Dealers Association TSE Tokyo Stock Exchange UCC Urban Credit Cooperative US United States of America YTM Yield to Maturity   CHINA: THE EMERGING CAPITAL MARKET Part II. Detailed Technical Analysis 1. THE CONTEXT OF CAPITAL MARKET DEVELOPMENT ............................ I A. The Growth of China's Capital Markets ................................................. 1 Size and Growth ................................................................1 Diversification ............................................................... 2 China Relative to Other Emerging Markets ....................................... 3 Overseas Investors in China's Securities Markets ............................... 4 Securities Market Institutions and Market Participants ......................... 5 B. The Role of Capital Markets in China's Economy . . 6 1. Role in the Financial Sector .............................. ....................... 6 2. Macroeconomic Role ........................................................... 10 3. Links to the Real Sector ......................................................... 12 C. Issues to be Examined ............................................................... 15 Plan of the Study ............................................................... 18 2. THE REGULATORY FRAMEWORK ........................................................ 19 A. Introduction ............................................................... 19 B. The Regulatory Framework .............................................................. 21 National Securities Legislation and Regulation ........... ...................... 21 National Regulatory Structure .............................. ....................... 22 Regional Regulatory Structure ..................................................... 23 The Regulation of Bonds ........................................................... 24 Regulation of Derivatives ........................................................... 25 Regulations for Overseas Share Issues ........................................... 26 Links to Other Regulations: (1) The Companies Laws and Securities Markets ................................................................ 27 Links to Other Regulation: (2) Banking Laws and Securities Laws . ....... 28 Other Issues Which Affect The Effectiveness Of Regulation ................ 29 C. Regulation of Securities Issue and Trading: An Evaluation ........................ 30 D. Regulation of Participating Institutions ..................... .......................... 34 Brokers, Dealers and Underwriters: Domestic Securities .................... 34 Securities Dealers in the B Share Market ........................................ 34 Other Professionals ............................................................... 35 Credit Rating Agencies ............................................................. 35 E. Distribution Of Oversight Within The Government ........... ...................... 36 Comparisons With Other Countries ................... ........................... 37 The Medium Term: Government Control Versus Self-Regulation ......... 38 New Self-Regulatory Organizations ................... ........................... 38  - ii - Annex 2.1 China: Laws And Regulations Related To Securities Activities ....... ........ 40 Annex 2.2 Central And Local Authorities' Approvals Required For Listing ....... ....... 44 Annex 2.3 Central And Local Regulations: Listing Criteria ................................... 46 Annex 2.4 The Trading Systems .............................................................. 50 Annex 2.5 Restrictions Against Insider Dealing .................................................. 52 Annex 2.6 Regulation Of Securities Dealers ...................................................... 53 3. DOMESTIC BOND MARKETS ............................................................. 55 A. Introduction ............................................................. 55 B. The Primary Market ............................................................. 58 Volume and Composition of Debt Issues ........................................ 58 Issue Method ............................................................. 61 C. Secondary Markets in Debt Securities ........................ ......................... 70 Secondary Market Trading Volumes and Liquidity .......... ................. 71 Causes of the Lack of Liquidity: (1) Primary Market Practices ............. 74 Causes of the Lack of Liquidity: (2) Market Infrastructure .................. 75 Secondary Market Pricing Efficiency: Price Unity ............................ 77 Benchmark Issues, Market Pricing, and the Yield Curve ........ ............ 79 4. EQUITY MARKET PERFORMANCE ........................................................ 82 A. Introduction: Equity Markets and the Shareholding System ....................... 82 B. Characteristics of China's Equity Markets .................. .......................... 84 C. The New Issue Process And Public Offerings ........................................ 89 The Pre-offer process ............................................................. 89 The Post-offer process ............................................................. 90 The Efficiency of the New Issue Process ........................................ 91 H Shares and N Shares ............................................................. 94 Comparisons with Other Countries ..................... .......................... 95 Causes of Inefficiencies in the IPO Process ..................................... 96 Elapsed Time Lags ............................................................. 96 The Lottery System and Non-Discretionary Share Allocation ............... 97 The Underwriting Process .......................................................... 97 Credit Availability ............................................................. 98 D. Stock Price Volatility And Returns to Investors ............. ........................ 99 E. Market Integration: Current And Potential ........................................... 104 F. Other Issues: Enterprise Debt Securities .............................................. 108 Annex 4.1 Clearance, Settlement And Depository Systems ................................... 110 Annex 4.2 Technical Note On The Analysis Of Equity Markets ............................. 118 S. INTERNATIONALIZATION OF CHINA'S SECURITIES MARKETS ............ 125 A. The Scope for Safe Participation in International Securities Markets ........... 126 B. International Participation in China's Equity Issues ................................ 129 Foreign Investment in Domestic Share Markets: B Shares ................. 129 Tax Treatment of Foreign Equity Investment .................................. 131 Overseas Listing of Chinese Equities: H and N Shares; Depository Receipts ............................................................. 132 The Performance of China's Overseas Equity Listings ..................... 134 Other Options for Overseas Listing of China's Equities ..................... 135 China Investment Funds ........................................................... 136  - iii - C. Opening of Fixed-Income Securities Markets ....................................... 137 D. China's Access to Overseas Securities Markets ..................................... 138 Overseas Bond Issues ........................................................... 139 Syndicated Loans .......................................................... 142 E. Trading in Derivative Instruments on International Markets ...................... 144 6. INSTITUTIONAL INVESTORS ............................................................... 146 A. Institutional Investors and Securities Markets ....................................... 146 B. The Insurance Industry in China ....................................................... 148 The Financial Performance of China's Insurance Industry .................. 151 Regulatory Reform of the Insurance Industry and Future Prospects ...... 153 C. The Pension System ................................................................. 155 Current Structure ................................................................. 155 Uneven Burden of Pension Funds: Shanghai, Beijing and the Railways Industry ................................................................. 157 Reform Options and Policy Recommendation ................................. 160 D. Housing Funds ................................................................. 161 E. Mutual Funds ................................................................. 162 Potential Role and Benefits ........................................................ 163 Annex 6.1 Glossary On Contractual Savings Institutions ...................................... 164 Annex 6.2 Institutional Investors In Hong Kong ................................................... 166 7. CONCLUSIONS AND RECOMMENDATIONS ........................................... 171 A. Conclusions ....................... .......................................... 171 B. Recommendations ................................................................. 175 REFERENCES ................................................................. 180 STATISTICAL APPENDIX ................................................................. 192 Tables in Text Table 3.1 Government Debt Purchases: Households and Non-Households .65 Table 3.2 Treasury Bill Coupon Rate, Deposit Rates and Inflation .68 Table 3.3 Comparison of Coupon and Deposit Rates, and Secondary Market Yield 68 Table 3.4 Comparison of Coupon on Treasury Bills Sales by Purchaser: Households, Enterprises, and Financial Institutions .69 Table 3.5 Tradability of 1994 Treasury Bill Issues .69 Table 3.6 China: Spot and Futures Trading of Bonds .73 Table 3.7 Ratio of Bond Trading Value to Stock Outstanding .74 Table 3.8 Trading in Repurchase Agreements .75 Table 4.1 Concentration Ratios of Member Firms Trading on the Shanghai Stock Exchange (January, 1995) .87 Table 4.2 Concentration of Share Trading on China's Securities Exchanges 87 Table 4.3 China's Equity Markets: Underpricing of New Share issues .93 Table 4.4 IPO Underpricing World-Wide .96 Table 4.5 Trading on China's Equity Markets: Returns and Volatility .100  - iv - Table 5.1 Chinese Companies with ADR and GDR Programs (December 1994) ....... 134 Table 5.2 China Closed-End Country Funds: Discounts/Premiums ....................... 136 Table 5.3 Average Spread on Floating Rate Medium and Long-Term Bond Issues ..... 140 Table 6.1 China Underwriting Performance of the People's Insurance Company of China (1992/93) ................................................... 152 Table 6.2 China and Other Countries: Basic Equation of Social Pension System .......... 156 Table 6.3 China Projected Basic Equation of Social Pension System ......................... 161 Figures in Text Figure 1.1 Growth of Securities Issued and Outstanding (1981-1993) .......... ............... 1 Figure 1.2 Secondary Markets in China's Securities .2 Figure 1.3 Growth of the Equities Market .3 Figure 1.4 China and Other Emerging Equity Markets: A Comparison (1993) . 4 Figure 1.5 Securities Markets in China's Financial Sector. 6 Figure 1.6 Central Government Budgetary Deficit and Treasury Bond Issues .10 Figure 1.7 Contribution of Capital Markets to Real Sector Investment .13 Figure 1.8 Share of Bonds in China's Overseas Borrowing .15 Figure 1.9 Volatility in China's Securities Trading .17 Figure 3.1 China: Composition of Outstanding Debt Issues .58 Figure 3.2 Outstanding Debt Composition Disaggregated .59 Figure 3.3 China: Trading Value of Bonds .71 Figure 3.4 Ratios of Trading Volume of Debt to Debt Stock and to GDP .72 Figure 3.5 Ratios of Debt Stock Outstanding to GDP: China and Other Countries . 73 Figure 3.6 Regional Bond Yield Differentials (1990) .77 Figure 3.7 Yield Differentials between Treasury Bills on Principal Markets: 1994 (Shanghai, Wuhan and Shenzhen) .78 Figure 3.8 China: Secondary Market Yield Curve .79 Figure 3.9 China: Bond Yield, Deposit Rate and Inflation .80 Figure 3.10 Equity Index and Average Bond Yield ..81 Figure 4.1 Average Daily Trading Value of Shares .85 Figure 4.2 Shanghai Securities Exchange .88 Figure 4.3 China: A Stylized IPO Process: Post-Offer to the Beginning of Trading 91 Figure 4.4 Initial Offerings of Shanghai A and B Shares .92 Figure 4.5 Risk-Adjusted Returns to IPOs at Shanghai .94 Figure 4.6 China: Shanghai and Shenzhen Share Indices and Volume of Trade . 101 Figure 4.7 Shanghai and Shenzhen: Share Price Variance .102 Figure 4.8 Spreads between Shanghai and Shenzhen A and B Shares .106 Figure 4.9 Discounts on Shares Listed in Overseas Exchanges .107 Figure 5.1 Private Capital Flows to China .126 Figure 5.2 China and Other Emerging Markets: Participation in International Capital Flows .127 Figure 5.3 China and Mexico Inflows .128 Figure 5.4 Country Funds - Average Discount .137  - v - Figure 5.5 International Bond Issues by Chinese Borrowers: Currency, Type and Maturity ............................................... 139 Figure 5.6 China: International Syndicated Loans ............................................. 142 Figure 5.7 China: Maturities and Spreads on International Syndicated Loans ............ 143 Figure 6.1 China: Insurance Premium Growth (1986-1992) ................................. 149 Figure 6.2 China: International Comparison of Insurance Premiums (1992) ............. 149 Figure 6.3 China: Comparison of the Life and Nonlife Structure of Insurance with Selected Countries .........................................................151 Figure 6.4 China: Insurance Premiums by Line (1992) ....................................... 151 Figure 6.5 China: Compositions of the Performance of the Insurance Industry in Selected Countries ......................................................... 153 Statistical Appendix Appendix Table Al .1 China: Debt Securities Issued and Outstanding .192 Appendix Table A1.2 China: Trade in Debt Securities .196 Appendix Table A1.3 China: Securities Trading on the Shanghai Exchange in 1994 (January 1994 to January 1995) .197 Appendix Table A1.4 China: Securities Markets and the Financial Sector .198 Appendix Table Al.5 Financing of the Govermment Deficit: Contribution of Bond Issues .199 Appendix Table A1.6 China: Contribution of Securities Markets to Investment . 200 Appendix Table A1.7 China: Overseas Debt and Capital markets (1987-1993). 201 Appendix Table A2.1 China: Structure Of Securities Regulation .202 Appendix Table A2.2 Structures of Regulation in Asian Securities Markets. 203 Appendix Table A2.3 Minimum Listing Requirements of Major Stock Markets . 205 Appendix Table A3.1 China: Securities Trading by Region .207 Appendix Table A3.2 Monthly Transaction Volume in the Interbank Market. 208 Appendix Table A3.3 Assets of Financial Institutions Engaged in the Interbank Market .209 Appendix Table A4.1 China: Key Characteristics of the Equities Markets of Shanghai and Shenzhen .210 Appendix Table A4.2 China: Size and Growth of China's Equities Markets (1991-1994) .211 Appendix Table A4.3 Trading Value of Equities (1991-1994) .212 Appendix Table A4.4 China: Trading Volume of Securities Per Day (1991-94) . 213 Appendix Table A4.5 Trading Value of Inter-Linked Trading Centers (Linked to Shanghai) (January 1995) .214 Appendix Table A4.6 China: Stock Trading Centers .215 Appendix Table A4.7 Shanghai Securities Exchange: Trading Summary of Sectoral Stocks .217 Appendix Table A4.8 Initial Public Offering Quotas (1993) .218 Appendix Table A4.9 China and Other Emerging Equity Markets: Relative Size and Market Liquidity (1994) .220  - vi - Appendix Table A4. 10 China and Other Emerging Equity Markets: Growth (1989-1993) ......................................... 221 Appendix Table A4.11 China and Other Emerging Equity Markets: Volatility (1993-1994) ......................................... 222 Appendix Table A5.1 International B and H Share Offerings by Chinese Issuers ...... 223 Appendix Table A5.2 China's Overseas Share Listings (Hong Kong and New York) ......................................... 225 Appendix Table A5.3 Country Funds-Trends in Total Returns ........................... 226 Appendix Table A5.4 Credit Ratings of Chinese Borrowers ................................ 227 Appendix Table A5.5 Sovereign Rating Selected Developing Countries ................. 228 Appendix Table A5.6 China: Overseas Bond Issuing Institutions ......................... 229 Appendix B5.1 Limits on Equity Participation by Foreign Investors ................... 230 Appendix B5.2 Foreign Exchange Controls on Portfolio Investment Capital Gains and Dividends .231 Appendix B5.3 Taxation of Dividends and Capital Gains of Foreigners Investing in Emerging Markets ........................................ 232 Appendix Table A6.1 China: Insurance Premium Growth (1986-92) .................... 233 Appendix Table A6.2 China: International Comparison Of Insurance Premiums (1992) ........................................ 234 Appendix Table A6.3 China: Comparisons of Growth of Insurance Penetration ......... 235 Appendix Table A6.4 China: Comparisons of the Structure of Life and Nonlife Insurance (1992) ........................................ 236 Appendix Table A6.5 China: Comparisons of the Performance of the Insurance Industry in Selected Countries ........................................ 237 Appendix Table A6.6 China Assets and Liabilities of the People's Insurance Company (1992/93) ........................................ 238 Appendix B6.1 Investment Patterns of Contractual Savings Institutions .......... 239  CONTRIBUTORS This report is the outcome of a joint investigative study undertaken by the World Bank and the China Securities Regulatory Commission. Its results are based on the findings of a preparatory visit to China in August 1994, followed by a full-fledged investigative study in October 1994. In addition to discussions in Beijing, the team visited securities trading centers and market participants at Shanghai, Shenzhen, Wuhan, Tianjin and Hong Kong. Numerous persons have contributed to this report. The World Bank team consisted of Anjali Kumar (team leader and task manager); David Wilton, FSD, (bond markets); Dimitri Vittas, FSD, (contractual savings); Kwang Jun, IEC, (international aspects); and consultants Professor Anthony Saunders (Salomon Center, New York University; equities markets), Susan Selwyn (International Securities Consultancy, Hong Kong; securities regulation); and Sun Yan, (Columbia University; equity market data analysis). Edgardo Barandiaran and others at the World Bank's Beijing office organized the work in China, and Vikram Nehru participated in the mission. Julia Li provided major inputs to the report (on the marco framework and on equity markets) in Washington. Yan Wang provided comparative contributions. The report also benefited from the generous information and comments provided by the IMF (notably Marc Quintyn and Michael Spencer) and the excellent collaboration of the IFC (Peter Wall, Sara Ugarte, Rashad Kaldany, Ravi Vish, Jiansheng Wang, Jun Zhang, Claudia Morgenstern), in terms of sharing data and coordinating technical assistance and investigative studies. The Chinese team was led by Fu Feng Xiang, (Vice Chairman, CSRC), and Bei Duo Guang, Deputy Director of the International Department, and principal counterpart to the World Bank. Numerous other persons from the CSRC contributed, particularly, Xu Ya Ping, Nie Qing Ping, Yang Zhi Hua, Jesse Wang, Gao Xi Qing and Song Li Ping. Zhong Rongca, Wu Qing and Yan Wen organized and accompanied all the mission's meetings. Particularly valuable insights to the study were provided by Ma Zhong Zhi (SCSC) and Gao Jian, (Ministry of Finance). Particular thanks must also be extended to Liu Bo, executive vice president of the Shanghai Securities Exchange and Cavin Xue of its data departrnent; Zhang Ning, of the Shanghai Municipal Government Securities Administration Office; Xia Bin, president of the Shenzhen Securities Exchange, Lian Quan Kun, president of the Wuhan Securities Trading Center, and Vivian Gu, also of the Wuhan Securities Trading Center; and Hu Li Yun, of the Tianjin Securities Trading Center. Officials from many other agencies and institutions in China also contributed, notably, the PBC, Ministry of Finance, CMTIC, BOCOM, Pudong Development Bank, domestic securities trading firms including Guo Tai and Wan Guo, and the Chengxin securities rating agency. Background papers for the report were contributed by Zhang Bing Xun of the Securities Exchange Executive Council (SEEC), and Mr He Dexu, of the Chinese Academy of Social Sciences. The team extends its gratitude and appreciation to all the officials from the various government agencies and securities companies with whom it met. In Hong Kong, particular thanks must be extended to Andrew Sheng of the Hong Kong Monetary Authority, Iris Leung and Iris Cheung of the Hong Kong Securities Exchange, Jane Tam of the Hong Kong Securities and Futures Comrnision, and many executives at Jardine Fleming, JP Morgan, Merrill Lynch, Peregrine, Sassoon UBS, and other securities dealers. Preparation for the missions would have been difficult without the assistance of Cathy Song, and its production would not have been possible without the excellent support of Adelma Bowrin.   1. THE CONTEXT OF CAPITAL MARKET DEVELOPMIENT A. The Growth of China's Capital Markets Size and Growth 1.1 Even by Chinese standards, the growth of China's capital market has been exceptional. From 1981, when China resumed the issue of domestic debt, to 1986, the stock of outstanding debt securities increased eightfold, from Y 5 billion to Y 40 billion, and then accelerated to nearly Y 300 billion, by the end of 1993. The rate of growth of debt on issue over 1987 to 1993, at 31 percent per year, far outstripped the rate of growth of GDP, of 17 percent per year, at current prices. From 1994 debt securities issues escalated further, with Y 113 billion of new treasury bills in 1994 and Y 150 billion of planned issues for 1995. The growth of equities has been even more remarkable. Between 1989 and 1993, the value of equities issued increased from Y 3 billion to Y 30 billion; a tenfold increase in four years (Figure 1.1, and Appendix Table A1.1). The number of stocks listed grew from 14 in 1991 to 336 by the end of 1994. Market capitalization on the two exchanges exceeded Y 560 billion by the end of 1994.' Shareholding has spread rapidly among domestic investors. In October 1994, a survey of 500 households in Beijing by the Municipal Statistical Bureau showed that the average Beijing household had Y 17,551 in capital assets of which Y 12,800 was in bank savings, Y 1,271 in cash and Y 3,474 in securities. Figure 1.1 Growth of Securities Issued and Outstanding (1981-1993) Debt Securities E4uties Y I00 m Y lOOm 3,000 140 2,50 _ Issues 2,00 120 Summary descriptions of100 H shares 1,500 0 Itrain Secus COutstanding 80 D B shares 1,000 0 I A shares 40 500j n211 ARd. 2 Source: State Council Securities Committee and PBC. Summary descriptions of the development of China's securities markets may be found in RAF (1991, 1994); International Securities Consultancy (1994); Bei Duo Guang, Koontz, Lu and Xiangqian (1992), and Bowles and White (1992, 1993).  1.2 The development of secondary markets in securities began with the trading of domestic debt, in 1988. From 1989 to 1990, annual trade in debt on issue increased almost fivefold in a single year, from Y 2.2 billion to Y 10.5 billion. Within two years, by the end of 1993, annual trade in debt had further dramatically increased, to Y 105 billion. Trade in equities, first permitted officially from December 1990, accelerated even more rapidly. From Y 1.8 billion in 1990, it exceeded Y 730 billion in three years, by the end of 1993. The volume of trade has been twenty five times as high as the volume of equities on issue. In contrast, the ratio of traded debt to debt outstanding was less than one, in 1992. Thus while the primary market has clearly been dominated by debt, with equities accounting for less than a tenth of securities on issue, the value of trade in equities, by 1993, was five times as high as trade in debt (Figure 1.2, and Appendix Table A1.2).2 Figure 1.2 Secondary Markets in China's Securities Y million 0 ~ ~ ~ ~ ~~~~~~~j~~~ Equities 1987 Source: China State Securities Commitee and PBC? Diversification 1.3 Debt securities in China consisted entirely of treasury bonds until 1985, and new issues amounted to around Y 5 to 6 billion per year. Diversification in securities issued increased rapidly from 1986 until 1993. From the time of their introduction in 1986, corporate debt issues averaged around Y 8 billion per year, until 1990, accelerating to an average of Y 37 billion per year over 1992 and 1993. There was also a diversification in the variety of treasury bonds issued, by issuer, by end use and by maturity. Aggregate treasury bond issues rose, reaching almost Y 40 billion in 1992. By the end of 1992, the proportional contribution of treasury bonds to total debt was 38.5 percent, while financial bonds (issued by financial institutions) and corporate bonds (issued by state enterprises) accounted for another 6.4 percent and 43 percent respectively (Appendix Table A1.1). After 1993, the government reduced the varieties of debt issues, and new corporate bond issues declined to a virtual halt. The proportional role of treasury bills has rapidly increased again, especially with the large new issues of 1994 and 1995. 2 There was an apparent reversal of this trend in early 1995, when bond trading seemingly exceeded trading in equities fourfold (Appendix Table A1.3). However the escalation in bond trading was almost entirely in the bond futures market, due an incident of speculation on one specific security (see Chapter 3 for details). Liquidity in the underlying spot market for bonds also rose as a consequence, but by a much more limited extent.  - 3 - 1.4 In the equities market, China also introduced a bewildering variety of shares; A shares for domestic individual investors; B shares for foreign investors (but listed and traded on domestic securities exchanges); C shares for 'legal persons', ie, enterprises holding shares in other enterprises, and H and N shares for overseas investors in Hong Kong and New York. Only A and B shares are listed on the two official exchanges of Shanghai and Shenzhen, although the number of B shares listed on the two exchanges (28 and 23, in Shanghai and Shenzhen respectively) is well below the number of A shares (169 and 116). In terms of numbers of listings, B shares accounted for 15 percent of total listings. The contribution of B shares to market capitalization and trading value has been lower. At the end of 1994, B shares accounted for less than 3 percent of market capitalization at Shanghai and Shenzhen (2.4 percent and 2.6 percent respectively) and a remarkably small proportion of annual trading value (1.8 percent and 0.7 percent). C shares cannot be listed on the official exchanges, but a small number are listed and traded on China's over-the-counter electronic trading systems, STAQS (10 shares) and NETS (7 shares). Figure 13 Growthbofthe Equities Market Nos Nu%truerofUstedStocks 180 160 140 U 120 _m 300 40 -rih1I 020 fl i II 111 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 Q4 Ql Q2 Q3 1991 1992 1993 1994 1i Shanghai A Shares a Shanghai B Shares D Shenzhen A Shares Shemnzhen B Shares Mirket Capltailztion Annual Tradng Value Yb~~~~~~~~~Y Y b 450 500 400 400 035 300 3 00 250 ' ' . O _- t s-a i,I . ~~~~~~~~~~~~~~~~~~~~~~1.- 50 200 250 - 0s_ _ _ _ _ - _ . o -00 _,- _._ -, . .4 S. 5 f3A Shimes B Shares DA shares B Shares China Relative to Other Emerging Markets 1.5 Although the burgeoning of China's equities markets occurred in parallel to many other emerging markets, the size and growth of these market in China has been remarkable even by these standards. At the end of 1993', market capitalization in China, at US$42 billion, stood in a league comparable to the Philippines (US$41.5 billion), Argentina (US$44.3 billion) and Chile (US$52.4 billion). China had already outstripped some Asian countries such as Indonesia 3 Latest year for which comparable data are available (IFC Emerging Markets Data Base).  - 4 - (with a market capitalization of US$35.9 billion), although it is still some paces behind the more mature East Asian countries such as Thailand (US$123 billion), Korea (US$158 billion) and Malaysia (US$201 billion). Average daily trading value, at US$386 million, not only exceeded Indonesia, Argentina, Chile and the Philippines, but also exceeded Brazil (US$343 million) and Mexico (US$376 million). Relative to the size of the Chinese economy, however, capital markets have a limited role. Market capitalization in China stood at 7 percent of GDP at the end of 1993, lower than all the above countries, although higher than other transitional economies such as Hungary and Poland (2.4 and 3.1 percent of GDP respectively) (Figure 1.4). Figure 1.4 China and Other Emerging Equity Markets: A Comparison (1993) Number of Shares Average Daily Trading Value Kors - _ ~~~~~~~~~ ~~~Taiwan j m l M tl7Kor^; T!w MThala nd M lyiqsl Taiwan Thailand Chile Philippinesa Indonesis Indonesia Philippines Argentins Argentina Poland Hungary Chile Poland iHungary China Clhin. 0 100 200 300 400 500 600 700 0 500 1000 1500 2000 2500 (Nos.) (SUS million) Market Cap italization Tumover Ratio M Ieslhi, Taiwan Taiwan Ka r:a Korea Poland Thailand Thailand Chile M aleyaia Argentina Indonsiai Phillppines Ptilippines Indonesia Argentins Poland Hung syY Hungary Chile Ch,,a China 0 so000 100.000 150.000 200.000 2so5.oo 0 5 10 15 20 25 30 35 (USS million) Source: Calculations based on data from the IFC Emerging M arkets Data Base. Overseas Investors in China's Securities Markets 1.6 Foreign investors have been eager to participate in the sudden and rapidly accelerating securities markets of China in the early 1990s. From 1991 to 1994, a total of US$1.3 billion was invested in China through its B share listings, with each listing raising an average of US$25 million. Meanwhile, as investment in the domestic economy accelerated, Chinese enterprises sought other means to raise capital overseas. With the legalization of the overseas listing of Chinese shares in 1993, larger sums of foreign capital were raised through H share issues in Hong Kong (which at US$350 million on average, were considerably larger than B  share issues), and through the issue of shares and ADRs in New York. By the end of 1994, Chinese companies had raised an estimated total of US$3.7 billion overseas. Other exchanges have been soliciting the listings of Chinese companies, notably London, Tokyo, Singapore, Melbourne and Toronto.4 1.7 Since 1992, the Chinese have also become active in the international market in debt securities. Although the domestic bond market remains closed to foreign investors, China's new overseas bond issues have grown remarkably fast. From less than $200 million per year over 1989-91, the annual volume of new overseas bond issues grew on an unprecedented scale; to over US$2 billion per year over 1992 to 1994. In 1994, overseas bond issues reached an all- time high, at US$3.5 billion. Securities Market Institutions and Market Participants 1.8 With the growth of securities on issue, a number of formal and informal trading centers and exchanges have sprung up for the trading of securities. At the core of the market are the two securities exchanges of Shanghai and Shenzhen, which trade not only equities but also government and enterprise bonds, government bond futures, mutual funds and warrants.5 In addition, 17 regional securities trading centers trade bonds and mutual funds, and two electronic networks, STAQS and NETS, provide the means to trade 'C' or legal person shares and government bonds. The largest center for trade in government bonds is at Wuhan, and since the listing of bonds on the exchanges of Shanghai and Shenzhen was permitted, these, especially Shanghai, have grown to follow the Wuhan center in rank. Bonds are also traded in over-the-counter markets in over 40 regional centers (Appendix Table A3.1). Major trading centers have links to the trading floor in other cities; for example Shanghai has 21 centers linked by satellite and telephone to its exchange. 1.9 The rapid growth of capital markets has been accompanied by a sharp expansion in the number of market participants, in the form of investors, brokers, dealers, and underwriters of securities. Although most of the end holders of securities in China today are individuals, the bulk of trade in securities takes place between wholesale dealers and institutional owners. By January 1995, the Shanghai exchange had 541 members, of whom around 500 were estimated to be from outside Shanghai. The Shenzhen exchange had around 425 members in 1994. Many of these are members of both exchanges, and stem from the ranks of the large and rapidly growing number of China's non-bank financial institutions, and a large number of the principal brokerage houses and dealers were established as non-bank subsidiaries of banking institutions.' Yet the number of large scale institutional investors with investible funds based on contractual savings in China today is limnited. Although there are now allegedly 19 insurance companies in China, they are virtually all spun off from a single parent organization which still retains a holding company style majority or minority ownership interest in them, and competition is limited. The lack of funded pension and security systems have implied that funds are not available from such sources, which form the core clientele of capital markets in mature economies. 4 Another indication of the rapid growth of foreign investor interest in China's securities markets is that at the begimning of 1994, foreign financial institutions from 15 countries had 298 representative offices nd 98 managing offices in China from a near zero base in 1990. 5 Details are in Chapter 4 and Appendix Table A4.1. 6 China today is estimated to have over 1500 brokers, dealers, and underwriters, 400 trust nd inveslment corporations, 40 finance companies, 52 mutual funds. 19 insurance companies, and 30 leasing companies.  - 6 - B. The Role of Capital Markets in China's Economy 1. Role in the Financial Sector 1.10 Various approaches can be applied to the assessment of the role of capital markets in China's financial sector. First, through 'stock' estimates, of the size of capital markets relative to the size of other elements of thefinancial sector. In terms of assets, this implies the measure of the assets (loans) of financial institutions such as banks and credit cooperatives, relative to the assets held by securities institutions. In terms of liabilities, it implies a comparison of deposits at financial institutions with the volume of securities issued. Only very broad orders of magnitude can be estimated, because of data limitations.' The results are summarized in Figure 1.5 (details are available in Appendix Table A1.4). Figure 1.5 Securities Markets in China's Financial Sector (Y billion) Assets liabilities 4,000 3:~~~~~~~~~~~~000 3,000 2~~~~~~~~~~~~~000 2,000~~~~~~~~~~~~~20 1,000 ~ ~ ~ ~1000 - D.posh. FW- 1WKW 0 ll~~~~~~~ A.tkAio~ 0 '4 .-W&t W oA.mI,u Note. Securities outstanding data for 1994 are estimates. Source: World Bank and IM F data. 1.11 From these points of view, the role of capital markets in the financial sector today appears small but has been growing. Total assets of non-monetary financial institutions, as defined here, grew from 6 percent in 1989 to a high of 8 percent in 1992, of the financial sector's assets, declining once again to 5 percent by 1994. The pattern reflects the growth of enthusiasm for securities with the legalization of exchanges and high returns to equities from end 1990 to mid-1993. With the introduction of the 16-point program in the latter half of 1993, and the squeeze of credit to the non-bank financial institutions, their levels of activity declined. By early 1994, the decline was exacerbated by the increase in deposit rates offered on the banking sector. Data on the annual issue of securities, compared to the liabilities of the financial sector, indicate a similar pattern and similar relative size: (a 4 percent share in 1989, rising to 6 percent by 1992, and declining to 2 percent in 1993). Note however that the 7 The assets of securities institutions are not available as a separate category, but are partly subsumed under the larger category of Trust and Investment Corporations. TICs includes many, but not all, securities dealerships, and to this extent underestimate the result. But also, not all TIC business is securities business, which would overestimate the result. Until 1993, data on insurance companies was available separately. Moreover, in the present definition, Urban Credit Cooperatives are grouped with banks as they are indeed deposit-taking institutions (from individuals and collectives, although not from state enterprises), but they too participate in securities business. From 1994, data supplied by the PBC are supposed to cover all non-monetary financial institutions (See Appendix Table A1.4 for details of the numbers used). On the liabilities side, there is no separation of government securities issues and securities issued by enterprises, because of the conceptual difficulties in separating the bond issues by ownership in China.  - 7 - cumulative share of securities on issue has been increasing. Both sets of estimates however clearly reinforce the officially expressed position, that the Chinese government's approach to the growth of capital markets has been 'experimental' and is still an experiment on a small scale. The banking sector without doubt dominates resource flows to the real sectors. Another possible measure of the relative size of the emerging securities market is through alternative measures of money supply.' Recently, attention has been paid to the changing composition of China's broader monetary aggregates (M2), and the increasing importance of non-monetary components of M2 (money + quasi money) or alternatively, looking at the non-monetary components of even broader monetary aggregates, which include deposits of urban credit cooperatives, or trust and investment corporations. These measures suggest that these broader monetary aggregates have rapidly become less money-like over time. 1.12 The second and more interesting question conceming the relationship between the securities market and the financial sector is the dynamic or flow' issue of the extent to which links exist between the banking sector and securities markets, and the impacts of these links on financial sector efficiency, systemic risks, and on the support provided to the real sector. The question can be broken down into a number of components: (i) what are the institutional links between banks and securities dealerships; (ii) to what extent do they permit theflow offunds between these institutions? Are there any dangers of systemic risks because of the increased exposure of banks to securities markets? Specifically, are depositor's funds at risk?9 (iii) Can securities markets 'displace' bank lending, and if so, which provides a better vehicle of finance to the real sector? '