CHINA UNIFORMLAW NET

THE CHALLENGE OF GLOBALIZATION AND CHINA’S SECURITIES EXPERIMENT (6)

V.  ANALYSIS AND CONCLUSION

As pointed out by the World Bank, a securities market can be very useful to developing countries like China. [1]  In a free economy, it can effectively allocate resources through competition driven by the supply and demand of capital resources.  As the securities market develops and strengthens, it can benefit other parts of financial sectors as well as the wider economy. [2] However, if the mechanism of securities market is distorted, it may not be so useful.

No country’s securities market develops isolated from its external environment – the national and even international economy.  In China, the core of development of the securities markets is the reform of the State-owned enterprises (SOEs) which so far remain pillar of China’s national economy., and internationalization of China’s securities are is also closely related to this reform.  The SOEs are also of huge importance in China’s securities markets, because, as satirized by a Chinese scholar, China is the only country in the world which has securities markets where 95 percent of listed companies therein are State-owned enterprise. [3] Therefore the sound performance of those SOEs is crucial to the performance of the securities market itself.  

In this section I will address the following matters concerning the development of the securities market and its external environment, and draw conclusions accordingly.

A.   Reforming SOEs through Transforming them into Stock Companies: A dream? A Game?

To reform its cumbersome SOEs, China has tried several approaches.   In the early 1990s, concurrently with the drafting and passage of the Corporation Law, the government launched a new approach – “corporatization”.  One aspect of this approach is to transform SOEs into Joint Stock companies to be listed in stock exchanges.   As a programmatic document of the Communist Party of China (CPC) stated, “The joint stock system is a form of capital organization of modern enterprises, which is favorable for separating ownership from management and raising the efficiency of operation of enterprises and capital. ” [4] From the government’s view, this approach present several benefits. [5] First, it expands the fund-raising channel for SOEs.  Second, SOEs can transform their operational mechanisms in compliance with the requirements of modern enterprises.  And third, it helps to allocate financial resources to benefit SOEs. [6] These optimistic predictions, if not complete day dreams, at least turn out to be one-side wishes in some sense.

The major problem is that, for many of those transformed joint stock companies, if not most, their names fall short of the reality.  They have merely the corporate structures of western stock companies, but are still being run in the old way of administrative control. [7]  For many SOEs, the main benefit from the transformation into joint stock company, is not the opportunities to “restructure itself into a modern enterprises”, but rather to raise capital to alleviate financial difficulties. [8] In order to obtain approval from the CSRC, they disclose false figures of profits or even forge financial reports. [9] Therefore many SOEs, especially the relatively small ones, are not reliable for investors.

Another significant problem is that, China’s investors have little sense of responsibility as shareholders.  Popular interest in purchasing stock has been overwhelmingly motivated by the prospect of rapid appreciation in market value, rather than by long-term fundamental analysis.  It is a well-known fact that 99% of private investors are oriented towards speculative profits.  Investors rarely inquire into the stock issuer's economic condition, operations, or future prospects, apparently assuming that the government will not allow an enterprise to fail.  Dividends do not enter into the analysis.  Attention is directed solely to short-term fluctuations in price.   A report by Guangzhou East Market Research Firms indicated that, in a poll about shareholders sense of Guangzhou, about 50.6% of those investors stated that they had little or no knowledge of the operation of their companies. 43.7% stated that they never had the sense of a shareholder. [10]

The above mentioned facts indicate that, partly, the results of “corporatization” are ironically beyond the government’s expectation. 

B.  Road Ahead: Relinquish State Dominance and Government Control of Economy

So far the officially proclaimed guideline of China’ SOEs reform is “separating State ownership for corporate management”, with the intention to preserve state dominance and government control in the whole economic. [11] The government hopes to build a management team to operate SOEs.  According to the blueprint on SOEs reform issued by the ruling party, the SOE managers should not only be ideologically and politically qualified, law-abiding, have a deep sense of responsibility, but also be familiar with the business they engage in, be armed with modern knowledge of business management and even finance, science and technology, and laws. [12] It seems that they are seeking angels falling to the earth (specifically China) from heaven.  However, in many cases the quality of the persons they appointed fell far short. [13]  With the withdrawal of the State from management of enterprises, the State supervision upon the management withdraws as well.  Some managers have treated State assets like their own private property.  Corruption is thus produced.  For instance, in the Shenzhen East Development Corp. case, one manager embezzled about 17 million RMB through forged sales contracts, then leave the company and disappeared. [14] In the Guangdong Huilai First Construction Ltd. case, the general manager of the company repeatedly misappropriated the funds of the company for seven years since 1987, and he received no punishment until 1995. [15] The words of a local government official tell the truth of the quality of some SOEs’ management teams, “[m]any state factories have become an empire, with the general manager as the emperor who is accountable to nobody.” [16]

All these ridiculous but understandable problems stem from one thing, the ambigutiy of State-enterprise property relationship.  Clear ownership rights are fundamental to a society.  It can provide important incentives to use assets productively. As Demsetz stated, “property rights derive their significance from the fact that they help a man form those expectations which he can reasonably hold in dealing with others. Without those expectations, people are unable to predict whether they will have a given set of assets at their disposal and are thus less likely to make the most efficient use of those assets. At a minimum, then, a system must parcel out some (or most) of the constituent rights of ownership into a bundle of rights which are clearly defined and legally protected.” [17]  However, clear ownership by itself is not enough.  In terms of ownership in an enterprise, an enterprise has what are known as “residual risk holders”.   In order for these risk holders to be willing to accept risk, they must (1) be compensated for holding that risk by being the owner (and therefore having control over the enterprise's operations and profit and loss distribution) or (2) be able to escape the risk by selling the right to hold it. If either of these two conditions exists, the owners of the enterprise are likely to behave efficiently. [18]

Under Chinese definition of ownership rights of SOEs, the State legally owns all the assets of SOEs, and SOE managers are entrusted by the State to operate the enterprise. [19] One can reasonably conclude that this formula can never achieve success.  First, the managers have no or little incentive to behave efficiently and to make profits for the enterprise because under China’s current employment system a manager’s compensation has nothing to do with his performance in managing the company.  Second, the managers have no or little responsibility for the failure or loss of profit of the company because the current system does not pursue a manager’s personal liability in case of failure of a company.  The managers must be subject to effective external supervisions.    In a free economy the shareholders are responsible for selecting managers of a company and those managers are accountable to them.  This formula, however, does not currently work in China, partly because the State is not equipped to supervise the management of every company, and partly because private shareholders otherwise than the State are somehow consciously excluded from supervising management.

The key to solving this dilemma is to gradually privatize the SOEs and relinquish government control over them.   In a private ownership based society, the misappropriation of corporate assets seldom happens, and the corporate managers have both the financial and personal incentive to behave efficiently to operate the corporate business.  The Chinese government and the ruling party CPC has realized that the privatization approach might be their last but nevertheless the best resort to solve the SOE problems.   On the 4^th Plenum of the 15^th CPC Central Committee on September 22, 1999, the CPC issued the Decisions on Major Issues Concerning the Reform and Development of State-Owned Enterprise, which, though does not appear the word “privatization”, has implied the Party’s strong interest in this regard.   According to the Decisions, 1) the State will control only those industries relating to national security, public utility and those industries that are naturally monopolized, while withdrawing from other commercial industries; 2) the development of non-public ownership, such as private business is strongly encouraged; 3)small and medium-sized SOEs will be enlivened through merger, leasing, or sales to private persons; and 4) failed SOEs must be diminished through bankruptcy and closing.  [20] Chinese economists predicated that in the long run the State will definitely withdraw from 80 to 90 percent of the national economy. [21]

In Chinese leaders’ eyes, the issuing of stocks is a good way to legally and effectively restructure the SOEs  and gradually transfer the SOEs to the control of shareholders.   With respect to this approach, the government must permit State shares and Legal person shares to be tradable, and allow non-state institutions to raise acquisition of SOEs if they pay a good price.  It is believed that with more and more private joint stock companies and transformed entering into the securities market, the market will finally boom as expected by the government.

C.  Conclusion: Toward A More Global Securities Market

Placing a sound and fast growing economy as the core for the realization of its international strategy, China is determined to develop a well-run capital market.  Recently, in response to the sluggish securities market, Chinese securities authorities has taking gradual, yet significant toward building a more global market.  In my opinion, more bold reforms are still needed in the following respect.

First of all, based on above analysis, one cannot escape to draw the conclusion that the State dominance in the securities market should be relinquished and government control should be loosen.  Currently stock shares are classified by the identity of the shareholders and the shares holder by the State or State owned companies are not on the market and their transfer are absolutely restricted between State agencies and State owned companies. [22] Thus, a majority of the shares issued are excluded from the secondary market.   In order to enhance the liquidity of the securities market and therefore increase the efficiency of resource allocation, the government should let the State shares and Legal Person Shares to be tradable in either stock exchanges or OTC markets, opening the aforesaid shares to individual holders.  In addition, the government should avoid excessive administrative control over joint stock companies and vigorously encourage nonstate shareholders to exercise their rights.

Another significant reform expected should be the merger of A shares and B shares market, thus eliminating the existing opportunities for arbitraging between types, to the ultimate detriment of the Chinese issuers.  If the merger is done, it will then become possible for both foreign and domestic investor to purchase both kinds of shares.  It has been said that the merger of the two markets will only take place when the capital account become convertible and the RMB can be limitedly exchanged or purchased by foreigners.  This is not a big issue given the fact that China has a huge international financial reserve,[23] only second to Japan.  For the merger Chinese regulators should not worry too much, because China now is enthusiastic in attracting foreign investment and foreign portfolio investment is only another form of investment.  

China also should provide a more sustainable legal framework which is largely deregulation-oriented.  The existing Securities Law is more restrictive than necessary. [24] Moreover, transparency in the legal system is definitely essential , not only to meet the WTO requirements, but also to stimulate the creativity of market participants and eventually to the healthy development of the securities market. 

Considering its short period of re-emergence and regardless the present problems, China’s securities has been somewhat successful in attracting capital and restructuring State owned enterprises.  To achieve its goals of making its stock exchanges one of the major international financial centers, China must take bold steps toward internationalization and privation and to embrace a mature and efficient regulatory system compatible with major international market standards.   If China does, it will present the world with a huge but attractive securities market.