While China’s stock exchanges have developed faster than their global counterparts, with which they compare favourably in terms of size, they still play a less important part in economic life than other forms of investment financing.
For them to assume a greater role, the authorities will need not just to deepen capital market reform but also to reinforce the institutional framework within which the exchanges operate. If they succeed, China’s expanded stock markets can contribute not just to the country’s own enhanced economic development by reducing the cost of capital and increasing investment efficiency, but also to the size and diversity of global capital markets, benefiting us all.
Fixed investment in China is largely financed by regular bank loans and the shadow banking system, not by the stock market, as in other financially developed countries. In 2012, credit was 128% of GDP, compared to 48% in the US; the bond market provided credit equivalent to 41% of GDP (243% in the US); and stock markets had an aggregate market capitalisation of only 44% (US 118%). These figures also demonstrate the predominance of stocks over bonds in investment finance – the reverse of the situation in countries like the US.
Economists largely agree that stock markets allocate capital to firms more efficiently than other forms of finance, provided that stock prices accurately reflect profitability. If we accept this hypothesis, than it makes sense to implement reforms that will allow China’s stock markets to play an expanded role in the economy.
But are these markets fit for purpose? Not yet, but they are getting there. In China, criticisms of the stock markets routinely repeat the charge, first made in 2001, that they are “casinos” dominated by players with insider information and that they do not fairly reflect the value of companies. Recent research suggests that this is far less the case than in the past, though improvements are still needed.
In a paper published on 8 July 2014, three researchers at New York University show that the capital market reforms conducted so far have already resulted in significant advances. Their research shows that the informativeness of stock prices has improved since the establishment of market reforms around the time of China’s entry to the WTO at the end of 2001 and even that it now compares favourably with that in the USA.
Importantly, investment efficiency rose in line with price informativeness. While cross-sectional return patterns are similar to those in the US, China’s stock markets exhibit low correlation with other large economies, indicating (along with the current depressed state of the indices) that there are profitable opportunities for foreign investors seeking high potential returns and geographical diversification.
As described in the preceding article in this series, China’s leaders have recently decided to enact further policy measures incrementally to liberalise and expand the scope of the country’s stock markets.
The guideline on capital market reform (the “New Nine Measures”) issued on 9 May 2014 sets a target of forming a “transparent, efficient, open and inclusive, multi-layer capital market system” by 2020. Investor protection will be increased, as will be investors’ rights to access information, participate in the market, seek compensation and supervise. Companies engaging in fraudulent issuance are to be delisted. The issuance of private placements will no longer be subject to government approval and more types of issuer will be allowed to issue stocks, bonds and investment funds. New futures markets will be added, along with financial derivatives. Cross licensing of various kinds of investing companies may occur. Internet securities and futures investment will be regulated and digital innovation encouraged. And China’s capital markets are to be gradually opened up to foreign investors as access restrictions are removed and connectivity with foreign stock exchanges increased.
As with other measures of financial reform in earlier decades, implementation will be gradual to avoid impacts on growth and to allow for the absorption of experience. The slow, intermittent pace of change does not satisfy the international community but it does fit into the Chinese Communist Party’s prioritisation of “social stability” over competing policy objectives.
These laudable improvements are, arguably, necessary but not sufficient conditions for the full development of China’s capital markets. There is also a need to tackle systemic problems that go well beyond the markets themselves. These problems arise fundamentally from the monopoly of power by the Chinese Communist Party, a monopoly that distorts the flow of information in the system, undermines its objectivity and exerts power and influence that can circumvent the operation of the market.
For a stock market to fulfill the function of reflecting the profitability of enterprises so that the weakest can go to the wall and be absorbed by the strongest, there needs to be reliable information to which investors can react. Although Chinese companies have been obliged by law to adopt a national accounting standard congruent with the international accounting standards set by the IFRS, financial reporting, though improved, is not yet really up to the mark.
This is because state-owned enterprises (SOEs) still to some extent use state-owned accounting firms that may not be entirely free from Party influence, or else use smaller accounting houses that may be less rigorous or independent than the “Big Four” (Deloitte, Price Waterhouse Cooper, Ernst & Young and KPMG).
Due diligence by companies seeking to acquire other companies is difficult in China because of less-than-transparent accounting practices, whether deliberate or not. The stock market therefore is not a wholly effective check on bad management, as it cannot effectively enable successful firms to detect and buy out failing enterprises.
Heavy reliance on bank (and shadow bank) lending allows large SOEs to survive on transfusions of cash that are directly or indirectly provided by the state. The share price may in such cases not wholly reflect the underlying profitability of the SOE.
Another major obstacle to stock market development results – despite many conferences and reports on the subject – from shortcomings in corporate governance in China. In many countries company officials can be turfed out by shareholders if their companies are unprofitable. This cannot happen so easily in China, where such appointments are part of the Communist Party’s nomenklatura system and enterprise strategy is monitored not by shareholders but by the enterprise’s Party committee. In China, shareholders may own a sizeable chunk of an SOE, but this does not give them control or strong influence, nor does it guarantee them a reasonable return, even if the SOE is profitable.
Stock markets, like other markets, work best when there is not only a free flow of information but also an unbiased court system that provides legal recourse in both criminal and civil cases. Again, the rule of law has made enormous progress in recent decades as the number of trained lawyers and judges has increased, but the quality of law has not improved concomitantly. Communist Party leaders, especially at local level, continue to exert an influence on court decisions that undermines the rule of law.
For China’s stock markets to play their full part in the country’s further economic and social development, there needs to be wholesale reform not only of the regulatory framework directly relating to the exchanges but also entrenchment of the rule of law and the removal of Communist Party influence on business. Such politico-economic reform poses a fundamental challenge to the policy division that the Party has maintained since 1989 in which reform is allowed only in the economic, not in the political, sphere.