by Wang Wei (CRI)

With its economy having grown at a dazzling two-digit rate for years, China is now the focus of global attention for its ever-increasing wealth and growing attraction of international investment. The markets are sending encouraging signals: the Chinese stock markets, excluding the Hong Kong exchange, have seen their benchmark indices jump by over 50% over the past year up until May 2006. The prospect of a bullish stock market, if not already a reality, has led to optimistic sentiments throughout the country's financial industry and among the vast majority of investors, most of whom are still domestic players.

Led by its moves towards a more flexible forex regime which began last July, the Chinese government has also slightly loosened its restrictions on the foreign exchange market. It has given the green light to begin opening the forward market in the country by introducing forex swap transactions among other derivatives.

The bond markets? Before the inception of the reform and opening-up initiative, there was no bond market at all in China. Some may argue that the situation remains the same today – a bond market in the strictest sense is still absent in the country, as compared to what exists in developed nations that have had mature and well-functioning bond markets in place for many years. It's important however to take a look at what has happened. Ever sine 1991 when China first opened its corporate bond market, issuance has surged, with the balance of bond issues soaring to 7.26 trillion yuan at the end of 2005.

There is no doubt that financial markets play a key role in an economy's healthy and sustainable development. In China's case, its financial sector is the weakest part of its over-all core economy, if not its Achilles'heel. In the talks with the WTO on its entry into the global trade organization, China found that opening the financial sector was among the most-argued terms. Grappling with the specter of high non-performing loans (NPLs), the four major state-backed commercial banks needed some time to cushion the impacts from exposure to foreign competition. Indeed, the government has done its job well by prudently allowing foreigners to buy stakes in these troubled banks while keeping the controlling shares in its own hands. At the same time, improving corporate governance across the banking sector has also been stressed and will continue to highlight the agenda for the industry's reform.

When it comes to reforming the financial sector, it's not exaggerating to describe the task as extremely complex. A probe into the major tasks that the Chinese government, especially its financial authorities, and the industry faces will give us a clear picture of what has been achieved and what still needs to be done.

The Stock Market

To revitalize stock markets that had suffered from a bearish period over several years, the Chinese authorities began a long-awaited reform campaign in May of last year. Before the reforms, liquidity had been a bottleneck for China's burgeoning stock markets. Its stock market history began fifteen years ago when the government allowed some selected state-run enterprises to raise funds from the stock markets in Shanghai and Shenzhen. Periodic booms in the early years didn't eradicate the fledging equity market's innate problems. With most of the shares of the listed companies kept in the hands of the state and barred from being freely traded on the market, the Chinese stock markets had very low liquidity. Last year's share-swap campaign was designed to correct this. How has it worked? So far, so good.

Of the 868 listed companies, around 70% have completed their share-swap scheme, at an average swap ratio of 10:3 between tradable shares and non-tradable shares. As a result, the price-earnings ratio, or PER, (a key indicator of a share's performance) has lowered by a considerable margin and all the shares on the market will become tradable once the campaign concludes as scheduled. The upshot has been so favorable that upbeat sentiments on the market now point to a bullish period ahead. 

To attract foreign investors to channel their money into the recovering stock markets, Chinese authorities have launched the Qualified Foreign Institutional Investor (QFII) pilot program in 2003, allowing foreign institutional investors to engage in the securities business on the Chinese mainland. This year, China's forex authority, the State Administration of Foreign Exchange (SAFE), awarded investment quotas totaling 1.25 billion U.S. dollars to QFIIs.  To date, 40 foreign investment institutions have been approved as QFIIs, including UBS, Deutsche Bank, and Citigroup Global Markets. As this article was being written, the SAFE was granting additional investment quotas totaling 325 million U.S. dollars to Nikko Asset Management Co. Ltd and BNP Paribas, two QFIIs approved by the Chinese authorities.

QFIIs are permitted to invest their money not only in the shares floating on the mainland stock markets, but also in bonds and funds that are springing up around the country. Along with QFIIs, the Chinese government also introduced a QDII scheme to boost the market. Different from QFIIs, QDIIs are made up of domestic institutional investors. In a new wave of investing mania, various domestic securities investment funds, insurance companies, pension funds and banks are flooding into the stock market to lower their liquidity and to profit from the ongoing boom.

The Bond Market

As for the other major source of financing in the corporate world, the bond market, China has also advanced its reforms in spite of drawbacks stemming from defects in the market structure. Though the total balance of bond issues by the end of 2005 hit 7.26 trillion yuan, an increase of 40.61% from the previous year, the issues thus far have mainly been made up of government and quasi government bonds. In fact, the quasi government bonds have been largely issued by the nation's three policy making banks - the National Development Bank, the Export-Import Bank of China and the Agricultural Development Bank of China. In comparison, corporate bonds and commercial notes (a novel short-term financing instrument in China) represent only a very small slice of the total issuance, accounting for approximately less than 6%. And up until the end of 2005, only a limited number of the most creditworthy enterprises and some infrastructure projects have been allowed to issue long-term corporate bonds to raise money.

In short, the Chinese government has made noticeable progresses in fostering the domestic inter-bank bond market and has introduced a number of new financial instruments. However, the corporate bonds called for to raise funds for the vast majority of enterprises, especially small and medium-sized enterprises (SMEs) hungry for money, have lagged behind. 

In a move to increase efficiency and liquidity in the market, the Chinese government is reportedly considering consolidating the inter-bank bond market and the stock market. Though the key to creating an effective bond market is implementing policy changes to abolish current restrictions on fundraisers and favor innovative derivatives. Under existing rules, SMEs are more or less excluded from the bond market, and foreign issuers, investors and brokers also encounter barriers in their bid to tap into the Chinese bond market.

The Forex Regime and Forex Market

The forex regime is another area where the Chinese government has been carrying out reforms to achieve far-reaching affects in its financial system and the economy as a whole. The Yuan's peg to the U.S. dollar and the tight control on the capital account (C/A) have played a positive role in the republic's history under its particular financial circumstances, even helping the nation's fragile banking system to fend off the overwhelming impact caused by financial turmoil which hit East and Southeast Asia in the 1990s. In that scenario, the Chinese currency's inconvertibility indeed served as a financial Great Wall to keep out greedy predators that had sacked Thailand and South Korea among other Asian victims.

Things change. As China's trade surpluses with its partners in Europe and America continue rising to a new series of highs, and its forex reserves, mainly in U.S. dollars, continues to pile up, a more flexible yuan has become an increasingly pressing issue to China and the rest of the world economy.  Other than pressures from foreign governments who have been pushed harder by angry domestic manufacturer's lobbying groups, the Chinese government itself has felt the heat due to deep-seated defects in its forex control system in place for decades.

The Chinese government has taken some action, recognized to be small but positive steps by most of the stakeholders on this matter. The Yuan's value has risen from around 8.2 to 8.02 to 1 U.S. dollar as of May 24th, and ever briefly breached the psychologically important 8.0 barrier on May 15th of this year. Seeing this progress, foreign governments seem to have lowered their tone in criticizing China's yuan policy, though bargaining on yuan revaluation will certainly continue as long as the international imbalance exists and the politics in foreign countries remains intertwined with domestic financial regulation.

In 2005 China broadened the forward market to introduce currency swap transactions and related derivatives. Early this year the central bank announced that it would bring in market markers for its currency transactions and over-the-counter transactions on the inter-bank forex market. More importantly, all the moves signal a trend toward the liberalization of capital accounts on a progressive basis. This will plug China's domestic capital market into overseas markets, which will, in turn, offer more investment opportunities for Chinese investors.

China boasts a large amount of domestic savings, topping 14 trillion yuan at the end of 2005, according to the statistics from the central bank. This represents a 100% increase from the figure in August 2001. Before the forex reform, the holding of foreign currencies by Chinese residents was strictly limited. From May of this year, domestic institutional investors are allowed to hold at least 500,000 U.S. dollars in their forex account, while residents now enjoy a purchase quota of 20,000 U.S. dollars or other foreign currencies of equivalent value each year. It is predicted that restrictions on investments in foreign currencies will be further loosened for the sake of reducing the opportunity costs of holding foreign money.

However, the government's actions haven't produced all results as planned. The government aimed to stimulate residents to buy and invest in foreign currencies and to ease the pressure from its soaring forex reserves. The reality is that Chinese residents prefer to put their money in banks or to buy Chinese T-bonds despite the lower deposit interest rates and low yield of T-bonds. The dearth of satisfactory foreign currency products on the market and residents' tendency to rely on banks to manage their money may explain their preference.  On the other hand, those who invest their forex assets in domestic B-shares have found the return on investment unsatisfactory.

As for institutional investors, entry into the forex market may turn out to be a cure for over-liquidity or a good investing alternative in face of a fledging but poorly functioning domestic market. On April 14th of this year, the nation's central bank, the People's Bank of China, announced that qualified domestic banks are now allowed to convert RMB deposits from domestic institutions and residents into foreign currencies, which then can be invested in overseas fixed-income products. Similarly, mutual funds, securities brokers, and qualified insurers have been given the green-light to proceed with investments in forex assets.

Transforming the System

An efficient capital market should provide sufficient financing sources for both government spending and corporate expenditures.  China's stock markets are still struggling for greater efficiency and higher return on investment to attract money from increasingly sophisticated domestic investors. The bond markets are dominated by the central bank's notes, as well as policy and treasury bonds, with corporate bonds accounting for only 2% of the total market value. An underdeveloped capital market has caused great deficiencies in the financing process and chances are this will jeopardize overall economic development.

As players on the financial market that absorb most of the nation's domestic savings, Chinese banks still suffer from high non-performing loans and poor corporate governance practices. The health of the banking system is crucial to the stability of the whole financial sector. How to optimize the banks' asset quality, reshape their ownership structure, and improve internal controls to reduce risks have stood out as the most pressing problems for the industry and government regulators. As foreign stakes in its banking sector have increased while controlling stakes still remain in its hands, the Chinese government should take more aggressive steps to improve corporate governance, particularly in terms of risk control and reduction, and to encourage more innovation to fully implement its role in the financial system.

Banks have played an increasingly important role in financing government expenditures and state-owned or state-backed enterprises' spendings. While the bank's money goes to various government-backed projects and poorly-performing state-owned enterprises, expansion of those private businesses has been hindered to a certain degree as they have less or no access to bank loans. Bad loans lent to the booming housing sector have accumulated to an alarming level, according to some economists at home and abroad, indicating possible market bubbles. This poses a great threat to China's banking system. Without access to bank loans and excluded from state enterprise-dominated stock markets, small and medium-seized businesses have had to turn to alternative financing sources, if any.

At this point, the reform of the stock and bond markets will not only serve to heal their own maladies but will also help cure the banking industry as a whole. More efficient stock and bond markets will better serve to finance businesses that were used to borrowing money from banks. Hence, pressure on the banking system will decrease and banks will be able to function more efficiently by diversifying their products and services and more effectively managing their operating risks.

Apart from the stock markets, the bond markets should be further pushed to provide more regular and less-risky financing channels. First of all, at some point the bond market should be opened to SMEs for them to raise funds at lower costs and with more predicable risks. Secondly, to meet the growing demand of government-sponsored infrastructure projects for money, municipal bonds should be introduced to turn governments, particularly at local levels, away from bank loans and provide them with a more reliable source of funds.

Financial markets are also a place where investors provide money for income. From 1979, when China first began its reform and opening-up campaign, to 2005, its gross domestic product, or GDP, (a broad gauge of a country's economic performance) had grown at an annualized rate of 9.5%. However, due to the lack of investment products, ordinary Chinese citizens haven't enjoyed as many benefits of the nation's tremendous economic growth over the past two decades as they should have. According to a survey conducted by the National Bureau of Statistics of China in 2002, bank deposits represented around 70% of financial assets held by Chinese households. Another study by the Boston Consulting Group showed that cash and bank deposits accounted for 71% of assets in wealthy households in China, while the world's average stood at 34.6%. This is a clear signal that the capital market should be transformed to give Chinese residents more opportunities to invest their money effectively.

The stock market, the bond market, and the banking system, as well as the forex markets, are the four main areas China needs to focus on in its bid to transform its capital market. The government has been prudently and confidently pushing its reforms forward in the financial sector in a fundamentally satisfactory fashion. However, as past experience indicates, a divide-and-rule strategy may not work as well as a consolidated one.

(Photo: Baidu)