Executive Summary

• After two years of subdued performance, China's stock markets recorded impressive growth during the first nine months of 2000, with the Shanghai and Shenzhen composite indices shot up by 40% and 47% respectively. In line with the surge in share prices, combined market capitalization of the two exchanges also edged up by 58% to RMB4.18 trillion. The strong rebound was mainly due to the implementation of government measures since mid-1999 to promote the stock market, as well as reports of other pending market reform initiatives.
  
  
• To revitalize the stock market as a source of capital, the government had stepped up efforts to boost market liquidity over the past year. Through allowing more institutional investors such as the SOEs and insurance companies to buy A-shares, the government hopes to increase the pool of investible capital in the stock market. The central bank also lifted a ban prohibiting banks from financing stock investment by securities companies, hoping to induce more active trading in the local bourses.
  
  
• Steps were also taken to limit unnecessary market volatility at the time of the IPO of new shares. To discourage investors from cashing in shares to fund the subscription of new issuance, the government issued a new listing rule which linked the right to subscribe to new issues to investors' share holdings on hand. The CSRC also tightened the rules on setting the prices of new shares to avoid the practice of under pricing which caused the wide fluctuations in the values of newly listed shares.
  
  
• As part of an effort to overhaul the country's securities exchanges, the government also unveiled a plan to establish a second board in Shenzhen to provide an additional fund raising channel for the country's emerging technology and high-growth enterprises. By picking Shenzhen as the venue for the second board, the authorities also hope to compensate for the lost revenue to Shenzhen that may result from the absorption of the city's securities exchange with its Shanghai counterpart, and clear a main hurdle for the planned merger of the two exchanges.
  
  
• Apart from providing a new source of enterprise capital, the reform of the stock market also forms an important part of China's broader plan to improve the efficiency of the SOEs. Increased private sector equity participation in China's state enterprise system would provide a means of disciplining the management of the enterprises. With improved efficiency of state firms and a more robust stock market, the government would be able to sell part of its stakes in the SOEs and use the proceeds to fund the country's growing welfare payments.
  
  
• After two years of subdued performance, China's stock markets recorded impressive growth in 2000. During the first nine months of this year, the Shanghai and Shenzhen composite indices shot up by 40% and 47% respectively, outperforming other major stock markets in the world. By end-September, total market turnover of the stock exchanges in Shanghai and Shenzhen reached RMB4.9 trillion, exceeding the RMB3.1 trillion recorded in the full year of 1999. In line with the surge in share prices, combined market capitalization of the two exchanges also edged up by 58% to RMB4.18 trillion (US$ 505 billion) during the first nine months of this year.

The rebound of the stock market was partly due to a strong recovery of the economy this year. Supported by faster expansion of domestic demand, which more than offset the moderation of export growth, real gross domestic product (GDP) increased strongly by 8.2% year-on-year during the first three quarters of this year, up from 7.1% in 1999. Meanwhile, government measures introduced since mid-1999 to promote the stock market, as well as reports of other pending market reform initiatives have also boosted investors' confidence and further fuelled the stock market rally.

REFORM MEASURES

Market liquidity

Since the government tightened its control over stock investment in mid-1997 as part of an effort to curb excessive speculation, liquidity of China's stock markets had shrunk. As an indication of market liquidity, the ratio of average daily turnover to market capitalization of the country's two stock exchanges fell from 0.72% in 1997 to 0.49% in 1998 and 1999. In line with the fall in liquidity, funds raised from China's stock markets declined from the peak of RMB129.4 billion in 1997, to RMB83.7 billion in 1998, before inching back to RMB94.5 billion in 1999.

To revitalize the stock market as a source of capital, the China Securities Regulatory Commission (CSRC) had stepped up efforts to boost market liquidity over the past year. In July 1999, the CSRC lifted the ban prohibiting state-owned enterprises (SOEs) from participating in stock investment and allowed them to use their retained earnings to buy the A-shares issued in initial public offerings (IPO) by companies with share capitalization exceeded RMB400 million. Further in September 1999, the ban on stock purchase in the secondary market by SOEs was also lifted. Beginning August 2000, SOEs are allowed to invest in the IPO of all companies including those with less than RMB400 million in capital.

Apart from the SOEs, insurance companies are also allowed, for the first time, to invest indirectly in the stock market. Beginning October 1999, domestic insurance companies could invest a portion of their premium receipts in mutual funds for an amount up to 15% of their total assets. As mutual funds in China invest about 80% of their funds in A-shares, the insurance premium will eventually find its way in the stock market. Meanwhile, the CSRC is also reportedly considering the possibility of permitting foreign investors to participate in the A-share market through the setting up of a qualified foreign institutional investor (QFII) scheme. By allowing more institutional investors, such as the SOEs and insurance companies, and even foreign investors to buy A-shares, the government hopes to increase the pool of investible capital in the stock market.

Meanwhile, the government has also taken measures to increase the access of securities companies to bank funds. In September 1999, the central bank lifted a ban prohibiting banks from financing stock investment. Since then, selected brokerages and fund management companies are allowed to borrow from banks in the interbank market for a maximum tenor of 7 days, or through the treasury bill repurchase market for tenors between 7 days and one year, to fund their stock investment. Beginning February 2000, securities firms with over RMB500 million capitalization are further allowed to use their stock holdings as collateral to borrow short-term bank loans. Through enhancing the liquidity of securities companies, the government hopes to induce more active trading in the local bourses.

Market stability

Along with the implementation of measures to boost liquidity, steps were also taken to limit unnecessary market volatility. Volatility in China's stock market is particularly notable at the time of the debut of new shares. As shares on offer in IPO are usually priced at very attractive levels, investors are often lured to cash in their share holdings on hand and use the proceeds to fund the subscription of the new issuance. This introduces unnecessary volatility in the prices of the shares being dumped. By the time the new shares are listed and experience substantial price appreciation, as they always do, investors would sell their new share holdings to take profit, causing wide fluctuations in their prices. The swing is particularly dramatic if large portions of the newly listed shares are allotted to institutional investors who would usually offload their holdings in bulk amount when they take profit.

To ease the unnecessary volatility at the time of the IPO of new shares, the government has unveiled a number of measures this year to stabilize the stock market. Under a new listing rule issued by the CSRC in February 2000, investors holding every RMB10,000 worth of A-shares or other A-share vehicles, such as convertible bonds and mutual fund investment, are given a reserved right to subscribe to 1,000 other new shares on offer in IPO. With the right to subscribe to new issues linked to share holdings on hand, there will be an incentive for investors to hold onto their shares for a longer time.

Further in September, the CSRC tightened the rules on setting the prices of new shares. Under the new rules, the issue price of shares on offer in IPO has to be based on the estimated response of potential investors, and has to be verified as fairly set by notaries. The requirement is aimed at avoiding the practice of under pricing which caused the wide fluctuations in the values of newly listed shares. Guidelines were also issued to limit priority placements of shares on offer in IPO to legal persons, including state-owned enterprises, collectively-owned enterprises and domestic and joint venture enterprises accorded such status. Through reducing the proportion of shares allotted to these institutional investors, the government hopes to make the dumping of newly listed shares in bulk amount less rampant after their debut.

Other structural reforms

Apart from boosting market liquidity and limiting volatility, the government has also taken bold steps to overhaul the country's securities exchanges. In September 1999, China unveiled a plan to establish a second board for the country's stock market in Shenzhen. Proposed regulations of the second board have already been presented to the CSRC for consideration and would be submitted to the Standing Committee of the National People's Congress for approval within this year. The establishment of a second board is aimed at providing a fund raising channel for the country's emerging technology and high-growth enterprises, many of which were established only in recent years and thus lack proven profit track record to secure bank finance.

By picking Shenzhen as the venue for setting up the second board, the authorities also hope to pave a smoother path for the proposed merger of China's two securities exchanges, which involves the transfer of stocks listed in Shenzhen to Shanghai. The objective of the proposed merger is to bring together all listed companies under a single regulatory framework so that the authorities could better utilize the exchanges' technical resources to improve stock trading efficiency in the country. However, as the absorption of Shenzhen Securities Exchange by its Shanghai counterpart would mean a loss of stamp duty revenue to Shenzhen, the city's government had not been particularly enthusiastic about the plan. The establishment of a second board in Shenzhen would, however, partly compensate for the lost revenue and clear a main hurdle for the proposed merger.

WHAT CAN BE ACCOMPLISHED?

New source of enterprise capital

Through increasing market liquidity while limiting unnecessary volatility, the government hopes that more domestic savings would be channeled to the stock market to fund the longer-term investment of the state-owned enterprises (SOEs). Meanwhile, the establishment of a second board is in line with the direction set out in the Tenth Five-Year Plan approved by the fifth Plenary Session of the 15th Chinese Communist Party Central Committee in October 2000. One of the objectives of the Plan is to increase the government's financial support to the private- and individually-run businesses, especially small- and medium-sized science and technology-based enterprises (SMEs).

Means of disciplining state enterprises

Apart from providing a new source of capital for the SOEs and the SMEs, the reform of the stock market also forms an important part of China's broader plan to improve the efficiency of the state enterprises. Increased private sector equity participation in China's state enterprise system would provide a means of disciplining the management and production of the enterprises. Being held accountable to private shareholders, senior managers would be obliged to improve the efficiency of the enterprises to boost earnings, so that the value of the owners' stakes in the company will increase over time. Failure to do so could lead to termination of the managers' employment with the company.

Source for funding welfare payments

With improved efficiency of state firms and a more robust stock market, the government would also be able to sell part of its stakes in the state-owned enterprises and use the proceeds to meet the country's social welfare needs. As a result of the speeding up of enterprise reform, the number of registered jobless workers in the country's urban areas had increased from 5.7 million in 1997 to 6.8 million at the end of August 2000. Meanwhile, the number of senior citizens aged above 60 years had also grown from 112 million in 1995 to the current 128 million, accounted for 10% of the country's population.

Without a better-funded social security system to meet the welfare needs of the growing population of the jobless and the aged, China would face a rise in social discontent that could destabilize the country. In this respect, plans were already unveiled by the government to use the proceeds from the sale of state-held shares to fund a national social security system, the National Social Security Fund (NSSF), to complement the country's current cash-starved pension scheme administered by the local government. According to latest estimates, the pension obligations not funded by the current scheme amounted to a massive RMB1.8 trillion.

CONCLUSION

Despite the rapid growth over the past decade, total capitalization of China's stock market accounts for only 32% of the country's GDP in 1999 compared to Hong Kong's 380%, suggesting vast potential for further development. As part of a broader program to reform the enterprise system, the government had unveiled a series of measures over the past year, which aimed at stimulating the stock market. The reform of the stock market would not only provide a funding source for the state firms, but also the fledging small- and medium-sized science and technology-based enterprises. As a result of the ongoing reform of the stock market, private sector equity participation in China's state enterprise system is expected to increase, and the pressure for Chinese enterprises to improve transparency, efficiency, and profitability would also grow. The resulting change in China's ways of doing business would not only benefit the development of the stock market but also the long-term growth of the economy.

CHINA MAJOR ECONOMIC INDICATORS