| DEC nds~~~~trnd China's hybrid capital markets Chinas capital markets have taken offsince their emergence in the early 1990s. But they are losing steam because Chinas experimental system, a hybrid of mar- ket forces operating within a planned economy, is at odds with itself If its cap- ital markets are to thrive, China will need to complete its macroeconomic house- cleaning, intervene less in its securities markets, and regulate more effectively. China's fast-growing economy has sparked an assigns quotas for primary issues of debt and CHINA'S CAPIDTAL almost insatiable demand for capital, driving equity securities) and state investmenit plans. MARKETS HAVE Beijing to permit the rapid opening and build- In addition, the economy still retains other ing of its capital markets. Since they emerged basic pillars of a nonmarket regime: interest DONE REMAIRtKABLY in the early 1990s China's capital markets have rate controls, a risk-free environment for state grown dramatically, outstripping longer-estab- enterprises, and a banking system that lends WELL-BUT T14EY lished emerging markets. By June 1996 market largely on the basis of the credit plan and that HAVE THE capitalization in China, at $72.5 billion, was is unaccustomed to managing interest rate POTENTIAL TO DO approaching the ranks of mid-size markets risks, liquidity, or asset liability. such as Chile ($72.7 billion), Indonesia ($79.2 The Chinese government still views the EVEN BETTEFI billion), and the Philippines ($80.0 billion). country's capital markets essentially as a vehi- For its size, however, China remains behind cle for resource mobilization. A large portiotn most major emerging economies, implying of bond issues is still distributed through that its capital markets have much room for quota allocations and are nontradable. T he further growth (figure 1). New international value added of well-functioning capital mar- equity issues by Chinese firms were close to $1 kets lies in their ability not only to act as a pri- billion in the first half of 1996 alone, and new mary vehicle of resource mobilization bhut also overseas bond issues amounted to $1.7 billion. to effectively channel-flexibly and at short Both figures exceeded the total for all of 1995. notice-large volumes of market savings among alternative uses, thereby spurring cco- Distortions in development nomic modernization and industrial growth. Despite rapid growth, China's capital markets The domestic bond market are still struggling to perform their funda- mental funcrions: increasing the efficiency of The Chinese bond market has grown consid- resource allocation, aiding the pricing of risks erably since 1994, when the government and returns, and providing a vehicle for risk agreed to restrictions on financing its deficit management. Why? The development of through central bank borrowings and had to China's capital markets is constrained by the rely instead on recourse to the bond market. framework of the aggregate credit plan (which But the bond market is still in transition. FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY OF THE WORLD BANK NO. 22 OCTOBER 1996 Figure 1. Market capitalization in selected shares remain in state hands. The extent to which developing countries, June 1996 shareholders can influence corporate governance Billions of U.S. dollars Market cap/GDP (percent) is correspondingly limited. Using the stock mar- 200 120 ket as a mechanism for merger or takeover 100 threats is rare, and the sale of government shares 50 | | | l / \ / \ to private shareholders is still not permitted. 80 CO 60 Recommendations 50 | | | | | 1lil 40 What should be done? Beijing must first decide 20 whether it is prepared to release the constraints on C * C C C C C C C llr | its capital markets. Interest rates need to be freed & b < .R .g t S g g g to serve as a pricing mechanism. Credit and investment plans must play a smaller role in cap- ital allocation. Banks need to be transformed into Source: IFC. Emerging Markets Database. GDP figures based on IMF data. institutions whose lending is based on evaluations of risk and creditworthiness, rather than on cred- Bond issuance is viewed mainly as an alterna- it plan quotas. And state enterprises must be tive revenue mobilizing system and an extension forced to face the real risks and returns of the mar- Beijing must decide of the budgetary process in that it offers addi- ketplace-through a binding budget constraint. whether it is tional financing options under the credit plan. The sequencing of reforms is also important. Coupon rates are set on the basis of the admin- Abandoning the credit plan before indirect prepared to release istratively determined deposit rate and do not instruments of monetary control are in place or the constraints on reflect secondary market yields. Since the default decontrolling all interest rates at once could its capital markets risk of state enterprises is considered to be rela- result in economic chaos. Several steps must be tively low, bond pricing does not adequately taken before interest rates are deregulated and reflect risk differentials. In these circumstances the credit plan is cut back: the link between bond market activity and * The government must coordinate its mone- underlying real sector developments is con- tary and fiscal policies more smoothly. strained, and the bond market cannot act as an * Commercial bank lending must be insulated efficient allocation mechanism for capital or as a from government policies so that banks are pricing mechanism for risk. exposed to market-based financial management. At the same time banks must begin acquiring Equity markets the capacity to manage interest rate risk and to remedy the current mismatch between their China's equity markets evolved more rapidly assets and liabilities. than the government had anticipated, as enter- Deregulation of interest rates could then prises sought new ways to raise capital. begin with short-term and money market rates. Government regulation of capital market activi- The first step would be to establish a better- ties therefore evolved after the fact. Officially, defined short-term benchmark interest rate and equity markets are regarded as a controlled interest rate term structure. experiment. The government has retained a high Recommendations for freeing up capital mar- degree of control over the listing of new enter- kets fall into five broad areas: the primary mar- prises, which is done as part of the credit plan. It ket, the secondary market, institutional also closely monitors the authorization of new investors, foreign investment, and the regulato- exchanges and the degree and direction of ry framework. growth permitted to the fledgling market. The primary aim of listing firms is to raise Improve the primary market capital for investment. The portion of shares list- The first and most critical area for attention is ed is typically small, since 75-80 percent of the primary market for bonds and equities. First, the government needs to allow securities to be gradually abandoned in favor of systems that per- issued if companies and their underwriters mit risk sharing between enterprises and their choose to take the risk of going to the market, underwriters, such as "best effort" or auction and the issuer must be permitted to set the methods. The selection of underwriters should prices. The role of credit rating agencies in issue be left to issuing enterprises, and underwriters and pricing decisions should be expanded. should be allowed to bid competitively for terms. Quotas in securities issues should be phased out. The length of time from the initial offer to the Next, the government must assess its own opening of trade should be reduced, and the short- and long-term financing requirements bunching of new issues should be avoided. and its cash flows. Until 1996 virtually all debt was issued in the first few months of each year. Reduce secondary market volatility For its term financing requirements the govern- The second area for action is the trading of secu- ment should announce its issue calendar for the rities, or the operation of secondary markets. In year, thereby improving its own liquidity man- the bond market the problem of poor liquidity agement and that of wholesale buyers. This requires greater standardization of bond instru- announcement will also further the develop- ments, targeting of issues toward wholesale ment of benchmark yields. Government and investors, and more even spacing of issues institutional liquidity management would also throughout the year according to a prean- be promoted by regular issues of short-term debt nounced schedule. Constraints on the operation -- and by central bank issues of short-term paper, of the money market also must be addressed. The High volatility is as required. If an auction process is difficult to government is establishing a centralized deposito- the main problem adopt on a large scale, the coupon at issue ry for all government bond issues, a response to should be related to current secondary market the regional segmentation in bond markets. in the secondary yields rather than to deposit rates. The key problem in the secondary market for market Electronic registration and title transfer should equities is high volatility. Many of the measures be adopted as the standard for wholesale issues, recommended to strengthen the primary market and the issue period should be progressively will also ease this problem. In addition, daily shortened. The government could then gradually price limits should be reintroduced, a capital expand the recendy introduced auction system, gains or turnover tax should be levied on share auctioning part of its bills and selling the rest trading to reduce speculation, and better regula- noncompetitively at the auction or average bid tions on disclosure should be imposed. New price. A savings bond issue should be designed for guidelines for press responsibility, an emphasis retail investors, available on demand at any time on the payment of cash dividends, and regula- of the year. This issue would spread retail sales tions preventing front-running and market over the year. The primary bond market needs a manipulation could also help. Most important, strong, wholesale investor base, which will permit the government must be more alert to the effects shortening the offer period and facilitate the of its announcements, which can send markets eventual adoption of an auction system. Efforts soaring or plunging. should be made to gauge wholesale investors' As in bond markets, regional market segmenta- demands for bonds and preferences in maturities, tion is another limitation. Dual listings on recog- and bonds should then be targeted to this group. nized exchanges and the opening of new trading To improve primary equities markets, the centers would encourage competition between the decision to issue new equities should reside with exchanges and increase liquidity in the medium the risk-bearing enterprise, subject to compliance term. The new central regulatory authority, China with rules established by the exchanges and the Securities Regulatory Commission (CSRC), will central regulatory authority. When a new issue is eventually be able to supervise regional exchanges, launched, share allotment among potential buy- but it first must establish its own regional offices. ers in cases of excess demand should be decided by the price auction system with which China Encourage institutional investors has begun to experiment. The current "firm The development of an institutional investor commitment" underwriting system should be base requires attention to both the uscs and sources of investment funds. To achieve greater Figure 2. Spreads between Shanghai flexibility in the uses of funds, the government and Shenzhen A and B shares should encourage the spread of contractual sav- Discount of B shares to A shares (percent) ings institutions (the new insurance law is a step Shanghai forward) and spur competition in the insurance 400 industry by separating the subsidiaries of the 300 People's Insurance Company of China from the 200 parent. To augment the sources of funds, the 00 government should introduce a multipillared, (at least) partially funded social insurance and oQ2-92 Q3 Q4 Ql-93 Q2 Q3 Q4 QI-94 Q2 Q3 pension system, allow housing funds to offer Discount of B shares to A shares (percent) more attractive returns, and clarify the regulato- 250' Sh hen ry framework for mutual funds. 200 Promote foreign investment e 0 To facilitate the orderly flows of foreign invest- ment in its securities markets, China must 0 encourage foreign portfolio equity investment 0 and reduce fiscal incentives favoring Q2-93 Q3-93 Q4-93 Q -94 Q2-94 Q3-94 adruefcn foreign Source: Calculations based on data from the Shanghai and Shenzhen Old habits need to direct investment. It should continue to broaden exchanges. be shed and overseas listings and encourage dual listings (with Hong Kong, for example) to ensure adequate liq- ticipants-from securities dealers and intermedi- regulationls uidity. The distinction between A and B shares aries to institutional investors. The authorities overhiauled if capital (A shares are sold exclusively to domestic should continue the process begun by the recent- markets are to fuel investors and B shares to overseas investors), ly promulgated Commercial Banking Law to the growth of which generates pricing distortions, should be clearly separate bank and nonbank activities. replaced by less discriminatory safeguards against In sum, China's capital markets are evolving China's industries volatility in capital flows (figure 2). Restrictions rapidly. But old habits need to be shed and regu- and infrastructure against foreign participation in the domestic lations overhauled if capital markets are to fuel the debt securities market should remain, however, growth of China's industries and infrastructure. until the domestic bond market is stronger. -Anjali Kumar, Kwang Jun, and Leilynne Lau Coordinate regulation reading Supervision of capital markets must be better F iritegrated. A first step is to transfer all central Claessens, Stijn, and Sudashan Gooptu, eds. 1993. oversight responsibilities for securities brokers, Portfolio Investment in Developing Countries. World Bank dealers, and underwriters from the central bank to Discussion Paper 228. Washington, D.C. the CSRC. Right now the central bank supervises Eun, Cheol, Stijn Claessens, and Kwang Jun. 1995. licensing and financial soundness and the CSRC "Pricing Externalities in the World Financial Markets: supervises trading. The recent decision to give the Theory and Policy Implications." Pacific-Basin Finance CSRC regulatory jurisdiction over regional trad- Journal 3 (1): 31-55 ing is a step in the right direction, away from the World Bank. 1995a. "China: The Emerging Capital overlapping regulatory regimes of central and Market." Washington, D.C. local authorities. The regulatory framework must . 1995b. The Emerging Asian Bond Market. deal clearly with all types of securities market par- Washington, D.C. This DECnote was prepared by Anjali Kumar, Kwang Jun, and Leilynne Lau in the International Economics Department of the World Bank. DECnotes transmit key development trends to Bank Group managers and staff. They are drawn from the work of individual Bank researchers and do not necessarily represent the views of the World Bank and its member countries-and therefore should not be attrib- uted to the World Bank or its affiliates. DECnotes are produced by the Research Advisory Staff. We welcome your questions and com- ments; please e-mail them to the authors or to Evelyn Alfaro, RAD. Prepared for World Bank staff