China needs its domestic capital market

By Fang Xinghai

Financial Times

Published: April 15 2005

No other big country has relied as heavily as China on overseas capital markets for its local companies to raise capital. This is now at the point that it is severely hampering development of China's domestic capital market. Data compiled by the Shanghai Stock Exchange's research centre show that the combined tradeable market capitalisation of China's two stock exchanges at the end of 2004 was only Y1,200bn, while that of overseas listed Chinese companies exceeded Y2,200bn. Furthermore, this trend - I call it the outsourcing of China's capital market services - is poised to accelerate amid the continuing subdued performance of the domestic stock market.

In today's interlinked world, outsourcing is not necessarily a bad thing; China itself is a main outsourcing destination for manufacturing. But for such a large country, relying mainly on overseas capital markets for economic growth entails some potentially dangerous outcomes:

First, domestic capital markets will not grow. In China's case, all its large and competitive companies are listed overseas. The immediate consequence is a dearth of high quality companies on the domestic stock market, which largely explains why the market keeps declining even amid rapid economic growth. With a weak domestic capital market, large companies can still secure financial services overseas but China's vast number of small and medium-sized companies are mostly deprived of such services.

Second, access to overseas capital markets will be at best unreliable for China. For example, isolated corporate or geopolitical incidents can scare foreign investors away from Chinese companies, leading to their temporary exclusion from overseas markets. This is an unacceptable risk to China's economic growth.

Third, massive outsourcing means overseas markets will largely determine Chinese asset prices. A wholesale under-valuation is then almost unavoidable. Already, shares in Chinese companies listed overseas are trading at a discount of 30-50 per cent to those of similar companies on the domestic market. The discounts have recently narrowed due to the Chinese stock market's decline but have persisted since the early 1990s. This means that not only are Chinese companies listing overseas sold cheaply but foreign companies coming to China to acquire assets buy cheaply.

Wen Jiabao, China's premier, recently reiterated his commitment to a vibrant domestic capital market and also acknowledged institutional defects in the market due to insufficient experience. I applaud the premier's foresight and courage, but urge the government to show the same foresight and courage in capital market reform as it showed in banking reform. The likely cost would be a fraction of the cost of banking reform. Yet, the impact of successful capital market reform is surely more potent than restoring the health of one or two state-owned banks.

In my view, there are three essential steps to reforming China's capital market. First, the government should use its vast state-owned assets to narrow the "value gap" in the stock market - for example, by selling some of its non-tradeable, state-owned shares at a discount to holders of tradeable stocks. Once the value gap is closed, other urgently needed reforms can proceed quickly, such as removing the distinction between tradeable and non-tradeable shares and introducing a fully market-based, share-issuing system.

The second step is to accelerate the opening of capital markets to foreign participation by expanding the quotas for foreign investors to buy Chinese shares and relaxing restrictions on foreign joint ventures in securities firms and fund management companies. It would be better to keep the capital market at home by allowing the entry of foreign companies than to drive the market overseas by excluding them.

Finally, the pace of listing large domestic companies overseas should be slowed before key institutional shortcomings are corrected in China's capital market. Also, the ban on investing abroad by the country's National Social Security Fund and insurance companies is best maintained for now, to avoid irreversible damage to the development of the domestic capital market.

I welcome the capital market reforms announced by the government in the last week, which are in the direction outlined above. The right vision for China is to focus on building a vibrant domestic capital market. Companies and investors get the best capital market services from their home market. Outsourcing is a supplement, not a replacement.

The writer is deputy chief executive officer of the Shanghai Stock Exchange; these are his personal views