dongwei su chinese stock markets a research handbook 2003

8/11/2019 Dongwei Su Chinese Stock Markets a Research Handbook 2003

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H I N E S E

J ) T 0 C K

A R K E T S

A R e s e a r ch H a n d b o o k

T>ongweiSu


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C H j p % S E

S T 0 C K

M A R K E T S


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C) H

t J C %

S E

Is) T 0 C K

:M) A R K E T S

A Research H and boo k

v >

(Dongwei

Su

Department of Finance

JiNan University, China

*

World

Scientific

New Jersey London Singapore

Hong Kong


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Published by

W orld Scientific Publishing Co . Pte. Ltd.

5 Toh Tuck Link, Singapore 596224

USA office:

Suite 202 , 1060 Main Street, River Edg e, NJ 07661

UK office:

57 Shelton Street, Covent Garden, London WC 2H 9H E

Library of Congress Cataloging-in-Publication Data

Su, Dongwei.

Chinese stock m arkets : a research handbook / Dongwei Su.

p.

cm.

Includes bibliographical references and index.

ISBN 9810245122 (alk. paper)

1.

Stock exch ang es-Ch ina. 2. Stock s-Chin a. 3. Securities-Ch ina. I. Title.

HG5782 .S8 2003

332.64'251-dc21 2002033184

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

Copyright 2003 by W orld Scientific Publishing C o. Pte. Ltd.

All rightsreserved.Thisbook,or parts thereof, may not be reproduced in any form or by any means,

electronic or mechanical, including photocopying, recording or any information storage and retrieval

system now know n or to beinvented, without written permission from the Publisher.

For photocopying of material in this volume, please pay a copying fee through the Copyright

Clearance Cen ter, Inc., 222 Rosewood Drive, Danvers, MA 01 923 , USA . In this case permission to

photocopy is not required from the publisher.

Printed in Singapore by World Scientific Printers (S) Pte Ltd


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to Jinyu Su, Yuande Lin and Dongyang Su

V


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Vl l l

Preface

emerging markets?

(2) Are Chinese stock m arke ts volatile? Does stock -ma rket re tu rn

volatility change over tim e? How frequent are "big surp rises" in

Chinese stock m arkets ? W ha t are the causes for these "big sur

prises"

?

(3) What explains differences in prices and expected returns between

the classes of shares that can be bought by Chinese citizens and for

eign investors? Is the time-series variability in the spread between

domestic and foreign share returns consistent with differences in

risk exposures and expected risk premiums?

(4) W hy are dom estic shares mo re volatile th an foreign shares? How

are the variation in volatil i ty-related expected intensity of informa

tion flows and the amount of informed trading related to informa

tion correlates, such as the number of investors, change in profits,

and firm size?

(5) Was the extraordinarily large IPO underpricing caused by bribery

and insider trading, high level of government policy uncertainty, or

government 's desire to encourage wide public participation in the

equ ity m ark ets? W h at explains th e cross-sectional differences in

underpricing? Why the degree of underpricing is much smaller for

foreign-lis ted IPOs? Why do Chinese IPOs perform much worse in

the long-run than those in other countries?

(6) What are the critical differences in firm characteristics (liquidity,

leverage, and investment opportunities) between firms that issue

new shares after their IP O s and those th at d o no t? Am ong t he

firms that do issue new equities after their IPOs, do agency costs,

political costs and information asymmetry affect their choices of

different financing m eth od s? How can we exp lain th e varia tion

in ab no rm al ann ou nce m ent da y re tu rn s across different financing

methods?

(7) Is accounting information value-relevant in the Chinese stock mar

kets? Why do investors over-react to earnings release in domestic

markets? To what extent have analysts ' earnings forecasts affected

the market valuation of s tocks?

(8) What are some of the debates on privatization and reform of s tate

enterprises? W ha t was Ch ina's past experience? How can lis ted-

companies deal with owner and manager relationships and organize

efficient corporate governance structure? Will China jump into the


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Preface

IX

sea of private enterprise or remain suspended in a trance-like s tate

under the notion that market socialism will solve its problems?

Chinese Stock Ma rkets: A Research Hand book is the first to provide a

comprehensive study of the aforementioned issues in a technical manner

drawing upon rigorous theoretical and quantitative analyses. A salient fea

ture of this handbook is i ts breadth of coverage. While individual chapters

may be narrow but deep in scope, the handbook as a whole encompasses

diverse subjects and cuts across a number of f ields in f inance-investments ,

f inancial markets and institutions, international f inance, r isk management,

cor po rate finance, and corpo rate governance. T he han db oo k is intend ed

as a specially compiled research monograph and a benchmark of reference

which, I hope, will be of considerable use to academia, practit ioners , and

policy-makers interested in issues surrounding state enterprise reform and

equity market development in China.

This handbook has nine chapters . Every one except the f irs t two chap

ters brings together a set of rigorous academic research studies on issues

that enhance the existing body of knowledge in emerging markets . These

chapters typically begin with a discussion of the economics and finance

theory underlying the application, outline issues in econometric implemen

ta t io n ( including measurem ent issues) , and then deta i l im po rtant empir ical

findings. Ea ch chap ter engages read ers in a carefully designed top ic in

volving replication and extension of cutting-edge research in a coherent

framework.

This handbook has benefited from the comments and insights of a large

number of people, particularly my dissertation advisors at Ohio State Uni

versity. N um erou s colleagues an d friends have also prov ided co nst ruc tive

and challenging suggestions. I owe special th an ks to Yu ande Lin, wh o

read each chapter with great care and offered many terrific suggestions.

I take pleasure to thank the following people in numerous ways: Torben

Andersen (Northwestern Univers i ty) , James Ang (Flor ida Sta te Univer

sity) , Warren Bailey (Cornel l Univers i ty) , Prasad Bidakota (Kansas Sta te

University), David Brasington (Tulane University), Zhiwu Chen (Yale Uni

versity), Gregory Chow (Princeton University), Georgio DeSantis (Univer

sity of Southern California), Xinghai Fang (Shanghai Stock Exchange),

Yue Fang (University of Oregon), John Fernald (Board of Governors of

the Federal Reserve System), Belton Fleisher (Ohio State University), Yan

He (San Francisco State University), Gary Jefferson (Brandies University),


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X

Preface

Pok-sang Lam (Ohio State University), David Li (Hong Kong University of

Science &: Techn ology), J. Ho usto n McC ulloch (O hio Sta te U niv ersity ),

Barry Naughton (University of California at San Diego), Masao Ogaki

(Ohio State University), Min Qi (Kent State University), Bruce Reynolds

(Cornell University and Union College), Jay Ritter (University of Florida),

Alan Viard (Federal Reserve Bank at Dallas) , Xin Zhang (China Securi

ties Regulatory Commission) and Zhenlong Zheng (Xiamen University and

University of California at Los Angeles).

The experience of transforming a manuscript into final book form is

due in large part to the dedication, thoroughness, and highest professional

standards of the publishing team in World Scientific. In particular, it is a

pleasure for me to thank my editor, Joy Quek, for her meticulous work and

great professionalism.

DS


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C o n t e n t s

Preface vii

C h a p t e r 1 D e v e l o p m e n t o f C h i n e s e S t o c k M a r k e t s 1

1.1 Intro du ctio n 1

1.2 Settin g th e Scene: Sh ang hai an d Shen zhen in the Earl y

Reform Period 3

1.3 T he Es tablish m ent of Secondary M arke ts 5

1.4 T he Pa rticip atio n of Inte rna tion al Investors 11

1.5 T he Role of M utu al Fun ds and O ther Insti tutio nal Investors . . 19

1.6 After th e Fifteenth N ation al Con gress: Increasing Re versa l to

Capitalism 22

1.7 Prob lem s and Dilemm as 26

C h a p t e r 2 S t r u c t u r a l a n d I n s t i t u t i o n a l C h a r a c t e r i s t i c s 3 3


2.2 Re gula tory Framew ork 35

2.2.1 O rganiza tions in Ch arge 35

2.2.2 Securities Laws an d Re gu lation s 38

2.2.2.1 P.R .C. Com pany Law 39

2.2.2.2 P.R .C. Securities Law 41

2.3 Ow nership s truc ture 44

2.4 Lis ting Stan dard s and Proced ures 49

2.4.1 Re qu irem ents for Stock Listings 49

2.4.1.1 A Shares 49

2.4.1.2 B-S hare s 50

xi


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xii Contents

2.4.1.3 O ve rse as 'L istin g of Foreign Shares 53

2.4.1.4 Red Ch ip Listing 54

2.4.2 Pr oc ed ure s for Stock Listin g 55

2.5 M arket M icrostru cture 58

2.5.1 Re gis tratio n of Stock Dea lers 58

2.5.2 Ge neral Rules for Tra din g 59

2.5.3 Takeover of Listed Co m pan ies 64

2.5.4 Settlem ent, Clearing and Pay m ent System 66

2.5.5 Accou nting System 67

2.5.6 Ta xes an d Fees 70

2.5.7 Suspension and Term inat ion of Lis ted Com panies . . . 72

C h a p t e r 3 R i s k , R e t u r n a n d R e g u l a t i o n i n C h i n e s e

S t o c k M a r k e t s 7 5

3.1 Intro du ction 75

3.2 Stock-M arket R etu rn and Volatil i ty P at te rn 76

3.3 D ay of th e W eek Effect 82

3.3.1 An alysis of Va riance A ppro ach 82

3.3.2 Moving Average A ppro ach 83

3.4 M ark et Efficiency H yp oth esis 86

3.4.1 Ra nd om Walk Hy pothesis 86

3.4.2 Co integ ration -Ba sed M arke t Efficiency 90

3.5 GA RC H Mo dels 93

3.5.1 M odel Specification 94

3.5.2 Character iz ing Variance in Chinese Stock M arkets . . . 94

3.5.2.1 No rmal D istr ibutio n 95

3.5.2.2 Stan dardiz ed t-distr ib utio n 95

3.5.2.3 Stab le D istrib utio n 96

3.5.3 W orld Versus Local Fa ctor s in Vo latility 96

3.6 Es tim atio n and Em pirical Resu lts 97

3.6.1 Model Com parison 98

3.6.2 Pa ram ete r Es tim ates 102

3.7 Gov ernmen t Reg ulation and M arket Volatil ity 105

3.8 Volatili ty A sym m etry and Spill-over I l l

3.8.1 A Pa rtia l Ad justme nt Mo del with As ym me tries 113

3.8 .2 Asymm etric Behavior on Return s and Volat il ity . . . . 116

3.8.3 Stock -M arket Vo latility Spill-over Betw een M ain lan d

Ch ina and Hong Kong 118


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Contents xiii

3.9 Su m m ary 121

C h a p t e r 4 O w n e r s h i p R e s t r i c t i o n s a n d F o r e i g n

S h a r e s D i s c o u n t 1 2 3

4.1 Introdu ction 123

4.2 Ow nership Res trictions in Chinese Stock M arke ts 125

4.3 A Price Discrim ination Mo del 135

4.3.1 M odeling Ow nership Res trictions 135

4.3.2 Inve stors ' M axim ization Pro blem s 137

4.3.3 Firm s ' M aximizat ion Problem s 141

4.3.4 Corn er Solutions for Dom estic Fir m s' Max imiza tion

Problems 144

4.3.5 Relaxing Ow nership Res trictions 146

4.4 An Int erte m po ral Ca pital Asset Pricing M odel 148

4.4.1 Stock Pric e an d R etu rn Dy nam ics 148

4.4.2 Inte rtem po ral M axim ization by Do me stic Investors . . . 149

4.4 .3 In te r tempora l Maximiza tion by Fore ign Investors . . . . 151

4.5 Tes table Imp lications From th e M odels 154

4.6 Em pirical Res ults 156

4.6.1 E stim atin g Be tas 156

4.6.2 Erro rs-in-V ariable s an d Tests for B-s hare Pr em iu m s . . 159

4.6.3 Id ios yn cra tic V arian ce Effect an d Fi rm Size Effect . . . 164

4.7 Su m m ary 165

C h a p t e r 5 E x c e s s V o l a t i l it y i n D o m e s t i c S h a r e M a r k e t s 1 6 9


5.2 A Modified M ixture of D istr ibu tion Ap proach 170

5.3 Es tim ation : Generalized M etho d of M om ents 173

5.4 D at a Ad justm ents 175

5.5 Em pirical Resu lts 193

5.6 Cross -Sectional An alysis 200

5.7 Tim e-Series An alysis 209

5.8 Su m ma ry 210

C h a p t e r 6 T h e U n d e r p r i c i n g o f I n i t i a l P u b l i c O f f er in g s 2 1 5


6.2 T h e New -issue an d Offering Pro ces s 217

6.3 T he Role of Finan cial Variables in th e Pricing of IP O s 221


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x iv

Contents

6.3.1 T he Chinese D at a 221

6.3.2 A Be nch m ark Regression 224

6.4 T he Adv erse-Selection M odels 227

6.5 T he Signaling M odels 235

6.5.1 Em piric al Im plicatio ns from th e Signaling M odels . . . 235

6.5.2 Co rrelation Between IP O R etu rns and IP O Proce eds . . 238

6.5.3 Co rrelations Am ong IP O Un derpricing and Issuer 's In

tr insic Value, Fractional Ownership and Project Variance 240

6.5.4 IP O Un derpricing and SEO s 241

6.6 Bribe ry and Lo ttery Hy pothe ses of IP O Un derpricing 246

6.6.1 Bribe ry Hy pothesis: U nderpricing of Chinese IP O s are

Gifts to Pu blic Officials or Favo red Pu rch ase rs 246

6.6.2 Lo ttery Hy pothesis: L otte ry M echanism in Share Allo

cation Co ntrib utes to High IP O Un derpricing 249

6.7 Un derpricing of Foreign-Share IP O s 251

6.8 Lon g-run Performan ce of IP O s 256

6.9 Sum ma ry 260

C h a p t e r 7 C o r p o r a t e G o v e r n a n c e a n d P o s t - I P O F i n a n c i n g 2 6 7

7.1 Share hold ers ' Behavior and C orp ora te Go vernance 268

7.1 .1 Organiza t iona l S t ruc ture and Board Compos i tion . . . . 269

7.1.2 T h e Role of Go vernm ent 270

7.1.3 Ow nership Co nce ntration an d Fi rm s' Performance . . . 274

7.2 Political Co sts and Agency Costs of Eq uity Finan cing 277

7.2.1 T he Failure of M anag em ent Resp onsibili ty Co ntra ct Sys

tem 278

7.2.2 Co ope rative Shareholding System 279

7.3 Choices of Po st- IP O Finan cing 285

7.3.1 Soft Bu dget Co nstra ints an d Th e Role of De bt 285

7.3.2 Co sts of Eq uity 289

7.4 Th e Information Con tent of Different Financing Choices . . . . 295

7.5 Ins titutio nal Trans forma tion to Imp rove C orp ora te Gov ernance 299

7.5.1 Priv atiza tion 299

7.5.2 D enation alization 301

7.5.3 Dive rsification 302

7.6 Sum ma ry 304


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Contents

xv

C h a p t e r 8 A c c o u n t i n g I n f o r m a t i o n a n d S t o c k P e r f o r m a n c e 3 0 7

8.1 Intro du ction 307

8.2 Roles of Fin anc ial Disclosure for Perform ance Ev alua tion . . . 309

8.3 Co rpora te Disclosures M ade by Lis ted Chinese Com panies . . . 312

8.3.1 A Brief H istory of Ac cou nting Develop men t 312

8.3.2 Finan cial Re portin g Prac tices 314

8.3.3 Ca pital M arket Infrastru cture 318

8.4 Stock Re turn s Aro und Ea rning s Releases 320

8.4.1 Informa tion Co ntent Analysis 321

8.4.2 Earn ings A nno unce m ents and Stock Price Rea ctions in

China 322

8.5 W hy Do mestic Investors Ov er-react to Earn ings Release? . . . 331

8.5.1 Go vernm ent and M anag em ent as Informed Investors . . 331

8.5.2 Inv esto rs ' Sen tim ents 332

8.5.3 M arket Valuation and Tra nsp arenc y 333

C h a p t e r 9 I n t e r n a t i o n a l i z a t i o n o f C h i n e s e S t o c k M a r k e t s 3 3 5

9.1 Foreign Investm ent in Dom estic B-Share M arket 335

9.1.1 M arket M icrostru cture Issues 336

9.1.2 Risk s Involved 338

9.2 Ov erseas Listing of Ch inese Stocks 339

9.2.1 Cros s-Listing of H-S hares 340

9.2.2 Red Ch ips Rising 345

9.2.3 Overseas Lis ting in the U.S. , U.K. and Singapore . . . . 347

9.3 Con cerns T ha t Em erged 352

9.3.1 M arket Segm entation an d Foreign Exc hang e Co ntrol . . 354

9.3.2 A Lack of Foreign Pa rticip atio n and Co m petition in Fi

nancial M arkets 357

9.4 Ch ina Moving Tow ard W orld Ca pital M arket: Strategic Issues

and O ption s 359

9.4.1 En ha nc ing th e Inte rest of Ov erseas Investo rs 359

9.4.2 Im prov ing the Role of Fin anc ial Interm edia ries 361

9.4.3 Introd ucing Insu rance Ca pita l to Securities M arket . . . 363

9.4.4 Streng thenin g Ch ina Investm ent Fun ds 365

9.4.5 Reforming Pen sion Sys tem 369

9.5 Liberalization of Ca pital M ovem ents 370

9.5.1 W ha t th e Th eory Says 371

9.5.2 Ch ina's Exp erience 373


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xvi Contents

9.5.3 Policy Issues 376

A p p e n d i x A S e c u r i ti e s L a w 3 8 1

A .l Introdu ction 381

A.2 T he Role of th e Stock M arket 383

A.3 Re gulatin g th e Chinese Stock M arket 384

A.4 Ca pita l Form ation 387

A.5 Securities Trad ing and Information Disclosure 388

A.6 Ac quisitions 390

A.7 M arket Infrastru cture 392

A.8 Investor Pro tectio n 395

A.9 Ov erseas M arkets 397

A.10 T h e Role of Law yers 398

A.11 Sum ma ry 398

A p p e n d i x B S u m m a r y o f P . R . C . T a x e s 4 0 1

A p p e n d i x C M a j o r E v e n t s i n C h i n e s e S t o c k M a r k e t s 4 0 5

Bibliography 415

Index 425


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C ha p t e r 1

D ev e lop m en t of C h ines e S tock

M a r k e t s

1 . 1 In troduc t ion

China has experienced unprecedented growth in Gross Domestic Product

(G D P) from 1987 to th e presen t, growing at an average rat e of 9.5% per

year (see Fig ure 1.1). Its economy tod ay is m ore th an four time s as large

when the reforms were first introduced in 1979. The reform has affected

all sectors of the economy and has lifted a enormous number of people out

of s tarvation and into the consumer middle class . The commercialization

of the Chinese economy has also opened it up to foreign direct investment.

The continuous market development has been impressive by any standards.

Prior to 1978, the entire financial system in China was controlled by

sta te owned ban ks. Investm ents were channeled thro ug h direct grants

from the state budgetary funds or from government allocated bank credits .

Therefore, China's move towards market economy with modern financial

market was a remarkable breakthrough in terms of ways of rais ing much

needed capital for economic development.

In 1990, th ere w ere no stock m ark ets. As of O ctob er 31 , 1999, 930 com

panies were listed in the Shanghai Securities Exchange (SHSE) and Shen

zhen Securities Exchange (SZSE), with a market capitalization of US$340

billion or abou t 30% of GD P, approxim ately th e same as th at of Sing apore,

Th ailan d, Malaysia and Indonesia put togeth er. Th ere were 38 million

individual s tockholders , second in number only to the U.S. . In addition,

there are 43 H-shares and 42 Red Chips lis ted in the Hong Kong stock

excha nge, wit h a m arke t c apitaliz ation exceeding US$86 billion, or 17% of

th e Hong Kong m arket capitalization. W ith the retur n of Hong Kong in

1


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2

Developmen t of Chinese Stock Ma rkets

R e a l G D P G r o w t h

Percfn

1987 :

Fig. 1.1 Real G D P Gr ow th

1997, the mainland inherited a world class financial center, with developed

and mature banking and securit ies markets. Because China continues to

have a high savings rate of 36% of GDP and a high current account surplus,

much domestic savings have been pumped into domestic capital markets.

Bank assets and securit ies market capitalization ( including equity and bond

m ark ets) accou nted for 139% and 4 1 % of G D P in 1999, respectively.

Considerable achievements have also been made in the legal and regula

tory framework for domestic capital markets. In addition to the enactment

of the banking and central bank legislation, and the

PRC Company Law,

the latest piece of law is the

PRC Securities Law.

Fur thermore, pr ivate

enterprises are now permitted to go public in China, and more state-owned

corporations are allowed to raise funds in international capital markets.

Because these f irms have to adhere to more str ingent accounting standards

and disclosure requirements, they usually have better corporate governance

practices and are more responsive to market needs. Needlessly to say, such


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Setting the Scene: Shanghai and Shenzhen in the Early Reform Period 3

commercialization and corporatization better prepare Chinese firms to meet

global challenge and com petitio n. It is increasingly recognized th a t sto ck

markets will play an important role in China's transition towards a market

economy with modern financial system and create tremendous amount of

investment opportunities for domestic and international investors .

1 .2 Se t t in g th e Scen e : Sha ngh ai and Sh en zh en in th e Ear ly

R e f o r m P e r i o d

The development of the s tock markets is one of the most important el

em ent s of C hi na 's reform in th e financial syste m . Before 1949, Sh ang hai

was a major banking and financial center with a stock market similar in size

to that of Tokyo and considerably larger than that of Hong Kong. Fluctu

ations in the Shanghai stock exchange over the period 1919-1949 had a lot

of influence on other world-class financial markets. In fact, Shanghai was

the world's third largest after New York and London.

For approximately three decades after the Communist Party took power

in 1949, th e governm ent strictly co ntrolled virtu ally all chan nels of invest

ment. All investments made by enterprises were either from direct grants

from the state budgetary funds or from government allocated bank cred

its. Shanghai 's previous role as an international f inancial and commercial

center was reduced to a domestic Chinese industrial center. During those

three decades, the entire Chinese financial system was dominated by the

state-owned banks, such as the People 's Bank of China (PBOC), a few spe

cialized banks and their local branches. The official process that allocated

investments across regions and industrial sectors was often bureaucratic,

and in many cases, caused inefficient use of resources.

Before the economic reform was embarked, Shenzhen was just a small

remote town close to Hong Kong in southern C hina. W hen C hina began

its open-door economic policy, Shenzhen became one of four Special Eco

nomic Zones (SEZs), receiving a lot of preferential policies from the central

government and attracting a consistent f low of investment from Hong Kong

and abroad. After many years of economic development, Shenzhen became

one of th e m ajor m etro po litan cities in Ch ina. Its pop ula tion is close to

3 million and ha s one of th e highest skilled work forces in Ch ina . B oth

Shanghai and Shenzhen has established themselves as sound investment

places for domestic and international investors.


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4

Developm ent of Chinese Stock Markets

As the structural reform in China continued, the central government

experienced a decline in fiscal revenues. Th is pro m pte d th e Min istry of

Fin an ce (M O F) to sell bo nd s to cover its bud get deficit. T he issua nce of

long-term treasury bonds in 1981 was the government 's f irs t experiment

in raising capital and signified the official re-opening of China's securities

markets . The dis tr ibut ion of t reasury bond issues was through mandatory

purchase quotas divided among local governments, enterprises and individ

uals .

1

Since the early 1980s, China's financial sector experienced major in

stitutional changes. The PBOC ceased its commercial banking functions

and turned into China's central bank. Four major subsidiaries of PBOC,

namely, the Industrial and Commercial Bank of China, the Agricultural

Bank of China, the Peoples Construction Bank of China, and the Bank of

China were turned into commercial s tate banks, and a number of urban and

rural credit unions were established as subsidiaries of the four commercial

sta te ban ks. As the central bank , the PB O C controls the money supply,

determines interest rate, and handles foreign exchange reserves through

its division, th e Sta te A dm inistratio n of Exch ange Control. Com mercial

state banks passed on PBOC's policy and replaced the government budget

funds as th e main financial channels for ente rprise inve stm ents . In add i

t ion, China Internat ional Trus t and Inves tment Corporat ion (CITIC) and

its subsidiaries were established throughout the 1980s and became the ma

jor consulting firm and investment bank in China. CITIC invested and lent

funds raised from international financial institutions, such as the World

Bank and Internat ional Finance Corporat ion. The whole banking sys tem

was decentralized, and inter-ban k com petition was encouraged . However,

interest rat e remained und er gov ernm ent 's control. M on etary and credit

policy continued to take the form of a credit plan that was implemented

by PBOC through a set of credit quotas for each commercial s tate bank.

All levels of government still constantly intervene the daily businesses of

virtually all financial institutions.

During the early reform period, government saving has dropped sharply

in response to deteriorating financial position of state-owned enterprises.

However, household saving has increased very rapidly in response to the

1

Al thoug h the re was no second ary ma rket to t r ade t r easu ry bo nds a t th a t t im e, the

issuance of bonds paved the way for fur ther fund rais ing act ivi t ies by s tate-owned and

private enterprises, eventually leading to the f irst publicly issued stock for Beijing's

T ianq iao Depar tment S to re in 1984 .


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The Establishment of Secondary Markets

5

new op po rtun ities created by trans ition . Individ ual incomes were higher,

but there was a lack of alternative f inancial instruments. Individuals were

forced to either hold cash or deposit in the state banks where interests were

controlled at levels lower th an th e mark et rate . N aug hton (1987) found th at

total household saving, including both in-kind and financial saving, jumped

rapidly from 7% of household income in 1978 to 17% in 1982, and have

continued to increase steadily since. Even more crucially, financial saving

triple d, increasing from 2.3% of househo ld incom e in 1978, to an average of

6.8% in the years 1980-83. As of 1995, households were generating 70% of

domestic saving, over 25% of GDP. There was 2194 billion yuan in deposits

in banks, accounting for 38% of the GDP.

In response to the changes in savings pattern, China's f inancial reform

deepened as more competition was introduced into the banking system.

In 1981, th e central government began to issue trea su ry b on ds to f inance

deficits . Shortly thereafter , the authorities permitted the issuance of other

types of bonds-including various provincial and local government bonds

and enterprise bonds. Enterprise bonds were str ictly controlled in order to

avoid conflicts w ith th e priorities set in the cred it pla n. As of th e end of

1989,

the total issue of securities amounted to 166 billion

yuan,

of which

99%

were bonds.

In 1984, as China began to experiment further economic reform, the

issuance of bonds paved the way for s tock issues as alternative methods

of raising cap ital. T he first real ste p was tak en in 1984, w hen 11 st at e-

owned enterprises (SOEs) became shareholding corporations. This led to

the first publicly issued stocks by Feile Acoustics in November 1984, with

10,000 shares at 50 renminbi yuan per share. Two months later , Yenchung

Industr ia l Corporat ion and Beij ing Tianqiao Depar tment Store both issued

shares to the pub lic. However, the re was no over-the-counter m arket in

China and virtually no trading of s tocks and bonds before 1986.

1 .3 T h e E s t a b l i s h m e n t o f S e c o n d a r y M a r k e t s

The secondary markets for securities s tarted when over-the-counter (OTC)

markets were set up in Shanghai, Beijing, Tianjin, Shenyang, Harbin and

Guangzhou to t rade corporate bonds and shares in 1986. At that t ime, the


23/453

6

Developm ent of Chinese Stock Markets

markets dealt exclusively with bond trading.

2

The turnover was thin and

the liquidity was low because the public had very little knowledge of the

concept of equity markets . Despite that, Shanghai quickly emerged as the

major bond trading center in the nation. By the end of 1987, eight trading

counters had been opened in Shanghai. Four professional brokerage houses,

namely, the International Securities Corporations, the Haitung Securities

Corporation, the Shenyin Securities Corporation, and the Chenshing Secu

rit ies Corporation, were established in late 1980s. They helped government

issue bonds and firms issue stocks.

On December 19, 1990, the first government-approved securities market,

Shanghai Securities Exchange (SHSE), was established to allow investors

and enterprises to participate in s tock trading. I t adopted a non-profit cor

porate membership sys tem and deal t with spot t ransact ions , not including

derivative securities. It recruited members nationwide so that it might serve

as a nationwide securities transaction center. Most of the lis ted companies

on SHSE are based locally in th e Shan ghai area. T he establish me nt of SHSE

not only marked the beginning of organized securities sales, but also her

alded the firs t use of com puters in s tock and bo nd tra din g in Ch ina, there by

putting an end to all paper transactions by offering investors the improved

efficiency of computer-aided investing. Quickly after trading started, SHSE

was doing so well that their was excess demand over supply of securities

which led to dramatic increases in share prices. A few issues skyrocketed

to more than 800 percent t imes their original issuing price. Public interest

on stocks was, to say the least, piqued.

3

In 1987, th e Shenzhen D evelopment b ank b egan to issue shares to t he

public. In the next three years, five more issues were floated and actively

trad ed in th e O T C market in Shenzhen. Th e unique role of Shenzhen

in the Chinese economy led to the formal establishment of the Shenzhen

Securities Exchange (SZSE) in July 1991. Most of the companies lis ted

on SZSE were based in industrial and commercial cities in inland China.

SZSE was subject to identical regulation and trading procedures as the

SHSE with respect to debt and equity issues. For example, both securities

2

Because of a ve ry smal l number of shares out s t anding in a few corpora t ions , s tock

t ransac t ions only represented 1%, 2%, and 1% of to ta l s ecur i t i e s t ransac t ions in 1986,

1987, and 1988, respectively.

3

As early as the c los ing month of 1990, more than 400,000 res idents in Shanghai had

take n pa r t in secur i t i e s t rad ing (Fang, 1991) .


24/453

The Establishment of Secondary Markets 7

exchange operate under an auction market environment without specialis ts

or m arket-m akers . Th e highest auth orit y of bo th securities exchanges is

the general meeting of members and the board of directors , which consists

of the chairman, vice-chairman, president and three managing directors .

A supervisory comm ittee oversees the day- to-day trading op erat ion. Th e

president is the legal representative who controls daily operation of the

exchange.

In 1992, th e SHSE and SZSE further s tand ardize d their tran sac tion s

through a sophisticated over-the-counter computer network known as the

Securi t ies Trading Automated Quotat ion System (STAQS), based on the

U.S. N A S D A Q .

4

Under this network, brokerage houses located throughout

th e cou ntry could pu rchase and sell s tocks and bon ds on behalf of investors ,

just l ike how the NASDAQ market worked in the U.S. . Trading is continu

ously conducted by an order-driven computerized matching system. Buy or

sell orders are put into the central computer either through the terminals

on th e floor or th e rem ote term ina ls at the brok er's office. T he bid and

offer prices and other transaction information are shown on every terminal

and transmitted through a satelli te system to all the member brokers na

t ionwide.

5

In that year, "share fever" really took hold. The trading volume

increased tenfold and the SHSE index quadrupled.

The business scope for SHSE and SZSE includes providing place and

facilities for trading and managing the settlement and delivery for all listed

stocks. The main duties of the exchanges include: (1) to formulate trading

rules; (2) to publish the trading information; (3) to report business and

management to relevant authorities; (4) to take technical and temporary

measures to suspend or s top the trading; (5) to deal with supervision; and

(6) to supervise lis ted companies and corporate members.

There are mainly two types of s tocks traded in SHSE and SZSE: A-

shares, which are bought and sold only by Chinese investors; and B-shares,

which are restricted to foreign investors.

6

Th ere is a com plication in B-

4

The sys tem provided members wi th rea l - t ime pr i ce quota t ions , d i rec t and indi rec t read

ing faci l i t ies , c learance and set t lement , t rading informat ion, f inancia l news and other

re la ted services .

5

Rea l - t ime qu ota t ion s from SHSE an d SZS E can now be p icked up anyw here on th e

m ain lan d , even in T i be t . Some 800 l is t ed com panie s , la rge and sm al l , can be b ou gh t

and sold by Chinese cit izens in any of the offices of the 700 brokerage firms that dot

China ' s towns and c i t i e s .

6

While the domes t i c share marke t has a t t rac ted the in te res t of more than a few loca l


25/453

8 Developm ent of Chinese Stock Markets

shares trading since foreign exchange is under s tr ict control by the State

A dm inistra tion of Ex chang e Co ntrols . Subsc riptions, dividen ds, and cash

distributions to foreign shareholders are paid in foreign currencies (in U.S.

dollar at SHSE and in Hong Kong dollar at SZSE), based on the same-day

official exchange rate. Besides A- and B-shares, a company can issue shares

traded in foreign exchanges (subject to relevant authorities ' approval, of

course). The following is a list of China-related equity shares:

A -Shares: Th ey are sha res solely available to dom estic C hinese

investors . A-shares are denominated in the Chinese currency, ren

minbi (RM B), subscribed for and trad ed in RM B by dom estic in

vestors. A-shares can be further classified into four categories ac

cording to the ownership: s ta te shares (held by the governm ent

or its agencies), legal-person shares (held by other companies or

institutions), employee shares, and individual shares (held by the

public) . Currently, shares held by the general public are the only

shares that can be traded on the exchanges, although a few em

ployee and legal-person shares are traded on STAQ. By the end of

1998, there were 842 lis ted A-shares in SHSE a nd SZSE with a to ta l

market capitalization of RMB 1,950.6 billion, equivalent to

24.43%

of GDP;

B-Shares: These securities have exactly the same ownership and

dividend rights as do A-shares but can be purchased (and held)

only by holders of foreign passports (including by those who hold a

Hong Kong passport) . The separat ion of A- and B-share markets

reflects the central government's policy of restricting the foreign

control of vital SOEs and its desire to prevent manipulation of

Ch ina's fledgling stock m arkets from ab road. M aintainin g a distinct

stock market for foreign investors in which they participate using

their own currency also helps prevent the devaluation of renminbi

from excessive sales. As of December 1998, there were 103 Chinese

companies selling B-shares worth U.S.$4.37 billion

H-Shares: Th ese are the s tocks of SOE s incorp orated in mainla nd

but l is ted on the Hong Kong Stock Exchange (HKSE). H-share

specula tors , s t a t e t reasury b i l l s represent the mos t v iab le inves tment a l t e rna t ive for the

average r i sk-averse Chinese inves tor . As a resu l t , China ' s bond marke t s have deve loped

rapid ly s ince SHSE and SZSE were es tab l i shed . The annua l ra t e of i s suance has r i s en

dr am at ic al ly from 19 bi l lion yuan (US$2 .3 bi l lion) in 1991 to mo re tha n 190 bi ll ion

yuan (US$22.9 bil l ion) in 1996.


26/453

The Establishment of Secondary Markets

9

issuers are subject to more stringent disclosure rules than A-share

issuers . H-shares are denominated in Hong Kong dollars and can

be traded by any investor. By the end of 1998, 43 firms had issued

H-shares.

Red C hips: Similar to H-sh ares, red chips are listed on th e HK SE .

Red chip issuers are typically companies controlled by mainland

government or SOE s but incorpo rated in Hong Ko ng. T he Hong

Kong entity is usually a shell corporation of the mainland coun

terpart and is capitalized through the public offering. It is usually

able to purchase assets located on the mainland through what is

know n as an "asset injection". T h e m ana ge rs of m any red chip

companies have excellent polit ical connections with the mainland

centra l adminis tra t ion.

L-Sh ares and N-S hares: Th ese are th e stocks of Chine se enterp rises

th at have chosen to list on either the Lon don Stock Exch ange (LSE)

or New York Stock Exchange (NYSE), respectively

7

N-shares are shares in Chinese companies that trade in the form

of American Depository Receipts (ADRs), especially those listed

on the NYSE. These companies are the best managed and most

profitable companies in China.

8

Table 1.1 and Figure 1.2 present ownership structure based on different

share types in Chinese stock markets .

As Tables 1.2, 1.3, and 1.4 and Figures 1.3 and 1.4 indicate, the amount

of capital raised, trading volume, turnover ratio and the total market cap

italization of the Chinese stock markets have increased significantly over

t ime. By th e end of 1998, the re were 842 com panies listed in the SHS E

and SZSE with market capitalization of RMB1,950.6 bill ion, equivalent to

24.43% of GDP. There were 1,011 listed securities including equity shares

(A- and B-shares), securities investment funds, government bonds (for both

spot and repo trading), corporate bonds, and corporate convertible bonds.

China's listed companies had issued a total of 74.61 billion shares in the

7

The f i r s t N-share l i s t ed on the NYSE was Br i l l i ance China Automot ive Hold ings , which

wen t publ ic in 1992. O ne L-share ex is ts on th e LSE , and is join t ly l i s ted in Hon g Ko ng.

8

Nine Chinese companies a re l i s t ed on the NYSE: Be i j ing Yanhua Pe t rochemica l Co. ;

China Eas te rn Ai r l ines Corp . ; China Southern Ai r l ines ; Guangshen Ra i lway Co. ; Hua-

neng Power In te rna t iona l Co. ; J i l in Chemica l Indus t r i a l Co. ; Shandong Huaneng Power

Dev e lopm ent ; Yan ahou Coa l Mining Co. ; and Shang ha i Pe t roc hem ica l Co. . An othe r

19 N-shares a re t rad ed over - the -counte r .


27/453

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64/453


65/453

48

Structural and Institutional Cha racteristics

Tab le 2 .2 Ow nersh ip of Shares on the Shangh a i and Shenzhen Secur i t i e s Exc han ges

1992

1993

1994

1995

1996

1997

Government

63.1%

59.9%

51.3%

56.7%

49.2%

45.7%

Percentage of Shares Held by

Legal Entities

9.9%

10.7%

18.0%

14.9%

17.5%

20.8%

Domestic

Individuals

21.0%

22.4%

9.8%

14.0%

17.6%

17.0%

Overseas Funds

& Individuals

5%

7%

20.9%

14.5%

15.8%

16.5%

jority stake in any listed company. Table 2.2 presents ownership of shares

on the Shanghai and Shenzhen Securities Exchanges. As shown on the ta

ble, of the o uts tan din g sh ares for any firm, only 30% can actually be tra de d

in Shanghai or Shenzhen. Government agencies own a large proportion of

to ta l stock, 46% in 1997, down from 63 % in 1992. T h e categ ory of legal

entities refers to legally co ns titut ed au ton om ou s org aniz ation s. It is cru

cial that in the Chinese case these legal entit ies are generally not mutual

funds, pension funds, or insurance companies, but are generally holding

companies established by government agencies as a management tool for

government-owned stocks. Thus, most Chinese observers consider them as

secondary government ownership of shares. Shares classified as government

of legal-entity owned are no t allowed to circulate on th e exch ange . T hu s,

approximately two-thirds of total share value on the securities exchanges

did not circulate.

6

8

I t should be noted tha t a f t e r the F i f t eenth Na t iona l Congress , re s t ruc tur ing of SOEs

involved a m uch mo re rapid ra te of ow nersh ip convers ion, increased pr iv at iz at io n, an d

much grea te r use of jo in t s tock corp ora t io ns . Go vernm ent l imi ta t ion s requi r ing th a t

the s t a t e main ta in major i ty or cont ro l l ing in te res t s were repea led .


66/453

Listing Standards and Procedures

49

2 .4 L i s t in g S t a n d a r d s a n d P r o c e d u r e s

2 .4 .1 Req uirements for Stock Listings

Options available to a company for a stock exchange listing include:

Dom estic listing of A-shares;

Dom estic listing of B-shares;

Ov erseas listing of Foreign Inve stm ent Shares;

Re d-chip listing which can take various forms.

A company could list its domestic investment shares (in the form of A-

share s) or foreign inve stme nt shares (in the form of B-sha res) in Sha ng hai or

Shenzhen or its foreign investment shares on exchanges which have signed

a Memorandum of Understanding with the CSRC or under take a red-chip

listing. The relevant laws and regulations governing stock listings are the

Adm inistration of the Issuing and Trading of Shares Ten tative Regulations,

P.R.C. Com pany Law, and P.R.C. Securities La w.

2.4.1.1

A Shares

A-shares are different from other categories of domestic investment shares

such as state-owned shares. A-shares are domestic investment shares issued

by Chinese companies which are l isted on the SHSE and SZSE. A-shares

may only be subscribed by and traded among Chinese cit izens and/or en

t i t ies.

Under the

Adm inistration of the Issuing and Tra ding of Shares Tentative

Regulations prom ulga ted on April 22, 1993, before listing on th e SH SE or

SZSE, a shareholding company (also referred to as a joint stock limited

com pany) m ust first be established. Th e proced ure and requirem ents for

establishing a shareholding co mpa ny a re set out in th e Company Law. Note

that the minimum amount of registered capital is

renminbi

10 million which

has to be paid up in cash at the time of filing application and supported

by capital verification certificates.

A shareholding company must comply with the following criteria in

order to apply for listing:

The shares must be issued to the public (as opposed to a private

placement) ;


67/453

50

Structural and Institutional Chara cteristics

T he to ta l sha re ca pital after a public offering m ust not be less th a n

renminbi

50 m illion;

The amount of share capital subscribed by sponsors must be at

least renminbi 30 million and m ust represe nt a t least 35% of th e

total share capital issued;

At least

25%

of th e shares must be issued to the public an d not m ore

th an 10% of this am oun t m ay be subscribed by the staff a nd work

ers. For Chinese companies with an issued share capital totaling a

nominal value of more than

renminbi

400 million, the perce ntag e

of shares issued to the public must account for not less than 10%

of the total shares of the company;

There must be more than 1,000 individual shareholders holding

shares with a nominal value of over

renminbi

1,000 and the total

nominal value of shares held by those individuals must be at least

renminbi

10 m illion;

Ex ce pt for a newly-formed com pan y limited by sha res, th e Chin ese

company must have made profits in each of the last three years;

If a shareholding is established by restru cturin g an existing e nter

prise, the existing enterprise must have a three-year track record of

earning profits;

Any other conditions imposed by the CSRC. (See the P.R.C. Se

curities Law.)

T h e

Securities Law

st ipulates that Chinese companies proposing to is

sue and l ist their A-shares must f irst be approved by the CSRC. The CSRC

must make a decision within three months from the date on which an ap

plication is received. The stock exchange from which a company is seeking

a listing is required to verify applications and make a final decision within

six m onth s from t h e da te on which an application is received. T he com

pany and the stock exchange should arrange for the procedure regarding

the listing of the shares once an application is approved. The Securities Law

also sets out general regulation on securities trading, continuing disclosure,

insider dealing and other prohibited trading acts on A shares.

2.4.1.2 B-Shares

Foreign investment shares may be l isted as B-shares on the SHSE or SZSE.

The term "B-shares", "domestically l isted foreign investment shares" and


68/453


51

"special renmOT& z-denominated sha res" all refer to th e sam e th in g- or di na ry

shares of Chinese shareholding companies tha t are deno m inated in

renminbi

but traded in foreign currencies, such as U.S. dollars, on a Chinese securities

exchan ge. B-sha res can only be subscribed by and tra de d am ong foreign

legal and natural persons and other enti t ies, legal and natural persons from

Hong Kong, Macau and Taiwan, and Chinese cit izens who are resident

abroad.

The regulatory framework surrounding the issue of B-shares was sim

plified by the State Council in December 1995 by the introduction of Pro

visions on Listing of Foreign Investment Shares Inside China by a Share

holding Company

on December 25, 1995 and the

Provisions on Listing of

Foreign Investment Shares Inside China by a Shareholding Com pany: Im

plementing Rules on May 3, 1996. These provisions clarified the procedures

involved in applying for approval to issue B-shares. They also set out the

application procedures and approval requirements for companies seeking

to issue B-shares in order to increase their sha re cap ital . T he provisions

contain important matters such as information disclosure, and the trading

of B-shares by stock brokers and agents.

The key contents of the provisions on B-Share listings include the fol

lowing:

The CSRC is responsible for the regulation and supervision of the

issuing and trading of B-shares and related activities in relation to

B-shares;

In addition to the directors, supervisors and m anag ers of a B -share

company, other senior management personnel, including a share

holding company's chief financial officer, secretary and other exec

utives specified in the company's articles of association, owe duties

of good faith and diligence to the company;

Chinese citizens residing outside mainland Ch ina may purcha se B-

shares;

Th e derivative forms of B-shares, including w arra nts and dep ository

receipts, may be circulated and traded outside China.

The B-Share listing implementing rules set out further detailed provi

sions governing the issue and trading of B-shares. They expand upon the

application procedures set out in the B-share listing provisions to gain ap

proval for the issuance of B-shares and l ist the documents to be submitted

to the CSRC in support of an application. The key contents of the B-share


69/453

52


listing implementing rules are as follows:

An over-allotment option (commonly known as a "Greenshoe") may

be granted by a Chinese shareholding company to the underwriters .

W ith the approval of th e CSR C, a comp any m ay set aside up to 15%

of th e tota l am oun t of the proposed B-share issue which con stitute s

th e option . Such reserved shares will be considered as pa rt of th e

issue;

T he distr ibu tio n period for B-sh ares may not exceed 90 day s;

T he governing law of the un derw riting agreement mu st be Chinese

laws;

W ith in 15 days after the closing d at e of th e initial sha re di stribu

tion, the lead underwriter must submit to the CSRC a distr ibution

report and a list of the 10 largest holders of its B-shares, and details

of their holdings. The distr ibution report must contain details of

the distr ibution process;

Domestic brokerage houses are required to report to the CSRC

details of the number of B-shares held by them as a result of par

ticipating in the underwriting of a B-share issue;

In addition to appo inting Chinese accounting and aud iting firms, B-

share companies may also appoint foreign accounting and auditing

firms that comply with the Chinese regulations to audit or review

their f inancial s tatements;

B-share companies must give prior notice to their auditors of dis

missal or non-renewal of appointment and the auditors are entit led

to present their views on any matter concerning the company's

financial s ituation before the company's shareholders in the an

nual meeting. The P.R.C. Securities Law (Article 213) s tates that

shares of Chinese companies designated for subscription and trad

ing by foreign investors (B-shares an H-shares) are governed by

measures separately formulated by the State Council .

B shares are subject to a s tr ict annu al qu ota system. Each year, the

State Council decides the amount of B-share quota in U.S. dollars for that

year. For example, the quota was US$1 billion in 1993. The B-share listing

provisions did not s tipulate l is ting venue. In practice, the Shanghai Securi

ties Exchange attracted bigger and more reputable companies to lis t their

shares.


70/453


53

2.4.1.3 Overseas' Listing of Foreign Shares

All foreign listings must be approved by the CSRC and the foreign stock

exchange (and regulatory authority, such as the SEC in the case of a U.S.

listing ). Foreign shares (such as H-shares) m ust be issued in registered

form and denominated in renminbi even though they are traded in foreign

currenc ies. De pos itory receipts issued over H-sh ares are also tre at ed as

foreign shares.

Before a Chinese company can undertake an overseas listing at a desired

overseas exchange by means of a direct listing, the overseas exchange has to

sign a Memorandum of Understanding (MoU) with the CSRC. The MoU

deals with cross-border regulatory issues such as supervision, disclosure

requirements and securit ies enforcement.

In addition to complying with the requirements prescribed by the stock

exchange on which the shares are listed, a company seeking to list overseas

must also comply with the Articles of Association of Com panies Seeking

a Listing Ou tside the P.R.C. Prerequisite Clauses issued by the Securities

Office of the Restructuring Commission and effective as of September 19,

1994,

P.R.C. Company Law, and P.R.C. Securities Law. Key contents of

the Prerequisite Clauses include the following:

State enterprises to be restructured into shareholding companies

may have fewer than five promoters;

T he period betw een an overseas listing and a subse quen t issue m ay

be less than 12 months;

A 45-day w ritte n notice is required to convene sha reh old ers' m eet

ings;

A quorum of 50% of voting shares is required to convene a gen

eral meeting and shareholders must give a 20-day notice of their

intention to attend a general meeting;

T he articles of association are binding not only on a com pan y a nd

its shareholders, directors, supervisors and general managers, but

also on other senior officers including the chief financial officer and

secretary to the board;

Sha res issued outside C hina m ay be in th e form of w arra nts or othe r

derivatives subject to the approval of the State Council Securit ies

Com mission. An over-allotment optio n of up to 15% of th e t ot al

issue may be granted by an issuer to the underwriters;

Div idend s on overseas foreign share s should b e declared in renminbi


71/453

54 Structural and Institutional Cha racteristics

and paid in foreign currency;

The register of holders of foreign invested shares listed outside

China may be kept abroad and maintained by an agent.

Cooperation between Hong Kong and mainland stock market regulators

sta rted in 1993 when th e issuance of H-shares on Hang Seng Stock Ex chan ge

was first pro po sed. By 1994 Hon g Kong was able to u p da te its legislation on

listing requirements of PRC issuers. In November 1994, legislators added to

Chapter 19 of Hong Kong Stock Exchange Ordinance a sub-clause known

as Chapter 19a, which was solely devoted to PRC issuers. Once listed on

the Hang Seng Stock Exchange, a PRC issuer is subject to all relevant Hong

Kong laws and requirements , including the Hong Kong code on takeovers

and mergers .

2.4.1.4 Red Chip Listing

Red-chip companies are those incorporated in Hong Kong and lis ted on the

Hong Kong Stock Exchange but with controlling shareholders from main

land Chinese entities. In the early stage of development in Chinese stock

markets, some companies had successfully bypassed the official listing chan

nels and gotten listed either through a backdoor listing or by acquiring a

Hong Kong "shell" company. After the CSRC was established, mainland

and Hong Kong regulators s tarted to cooperate and coordinate on red chip

issues. Both sides agreed that before granting lis ting to a mainland Chi

nese company, each side would inform the other of the nature of the listing,

comp any ty pe and other related information. Now adays red chip compa

nies are generally diversified conglomerates which have grown rapidly by

the injection of assets from their parent companies in mainland China.

Red-chip companies include China Telecom, Beijing Enterprises Holdings,

China Everbright, Shanghai Industrial Holdings, China Resources Enter

prises and the "window-companies" or "International Trust and Investment

Corporations (ITICs)" of provincial governments.

Until very recently, red-chip companies did not, strictly speaking, fall

within the supervision of main land Chinese auth orities . Therefore, th ey

were able to conduct restructuring and raise funds from overseas for new

investme nts easily. In J un e 1997, th e CSRC in conjunction w ith th e Sta te

Council introduced the Notice on Further Strengthening the Adm inistration

of the Listing and Issuing of Shares Overseas (also called the "Red Chip

No tice"). T he purpos e of the Red Chip Notice was to protect dom estic


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Listing Standards and Procedures 55

assets from being channeled overseas and from being sold off indirectly to

overseas investors at a discount. Th is is accomplished by pu rpo rtin g to

more str ingent requirements for reporting to, and obtaining approval from,

Chinese authorit ies. The Red Chip Notice targets both l isted and unlisted

companies registered outside mainland China.

The main content of the Red Chip Notice is as follows:

If a foreign listed com pan y is registered and co ntrolled by C hinese

shareholders and is undertaking a spin-off listing or additional issue

of shares, i t is subject to the supervision of the CSRC and the

major i ty shareholder must repor t to the CSRC.

Domestic shareholders that have held foreign and domestic assets

for three years or more who seek to inject their assets to a red chip

company may do so provided that prior consent is obtained from

the local provincial government or relevant department of the State

Council. Domestic assets held for less than three years may not be

used in connection with foreign share issues unless there are special

ci rcumstances that the CSRC deems to be appropr iate .

Consent on restructuring and subsequent equity offerings must be

obtained from the provincial government or relevant State Council

depar tment and a repor t must be made to the CSRC for examina

tion and final approval.

Acq uisit ion, sha re swap or othe r me tho ds of injecting assets into a

foreign Chinese holding company require similar relevant consent

f rom the CSRC.

7

2.4 .2 Procedures for Stock Listing

Although the capital markets in China has developed rapidly over the past

seven years, the central government st i l l commands considerable authority

over many structural aspects of market operations. A key element of this

authority is the l ist ing requirements and procedures which the CSRC con

trols. Together with the State Planning Commission, the State Council ,

the State Commission for Restructuring the Economy, and the Ministry of

Finance, the CSRC sets an annual quota for the total value of shares to

be brought to market. Once the quota has been established, a share of the

7

The CSRC has made i t c l ea r publ i c ly tha t i t s cons iders as se t in jec t ions as an unautho

rized sale of state assets , and approvals will only be issued in special cases.


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56


total allowance is allocated to each province, which then make their own

selections am ong local com panies who have applied for stock issues. T he

decision of th e provincial a uth orit ies rests ma inly on two factors: th e size of

the share-capital quota allocated to them and whether or not the company

is in a "key industry" which the government has chosen to promote. Hav

ing been selected, the selected enterprises are recommended to the CSRC

which will then review the selections made by individual provinces for final

approval.

This heavily-regulated method of selecting firms that go public has been

criticized by many experts as not being in the best interest of the public

investors . Critics point out that SOEs with capable management and fun

damentally sound balance sheets might be passed over in favor of other less

commercially viable f irms which happen to be in the government 's latest

key indu stry category. Altho ugh companies to be lis ted are required to

have earned annual profits of 10% per year for the past three years prior to

their initial public offerings and are supposedly the most promising SOEs,

those receive permission to issue shares are actually part of the slowest-

growing sector of the economy-a sector which accounts for only about 30%

of the cou ntry 's indu strial ou tp ut . Nevertheless, the CSR C has found its

control over the supply of shares useful in influencing market conditions

and investor sentiment. For example, when key market indices have gone

up sharply in June 1996, authorities began voicing their concern over the

formation of a bubb le in s tock valuation s. W hen their wa rnings did not

serve to s low the market 's r ise towards new highs, the CSRC announced it

would double the issue volume in 1997, allowing 30 billion renminbi (US$3.6

billion) worth of A and B -shares to be placed. By increasing th e sup ply

of s tock available for purchase, the CSRC hoped to soak up the specula

t ive demand rampaging in the market , thereby promoting a more s table

investing environment.

T he re are two steps involved in selecting an issuer for A share s. T h e

first stage involves provision of share issue quotas by the CSRC to each

provincial government, autonomous zone, municipality directly controlled

by the central government, and municipality with a separate economic plan.

Factors taken into consideration when allocating share issue quotas include

(1) the development of the economy of a particular province or a specific in

dustry, which is typically a result of the macroeconomic conditions at that

time; (2) applications by prospective A-share issuers to the local municipal

government or the relevant industrial department of the State Council; (3)


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Listing Standards and Procedures 57

recommendation by local municipal government or the relevant industrial

depar tment of the Sta te Council to the CSRC; (4) prel iminary examina

tion by the relevant departments of the CSRC; (5) opinion of the relevant

ministry which governs the industry in which the prospective A-share is

suer has made the petition; and (6) issues exceeding US$30 million must

be approved directly by the State Council .

T he second s tage involves gainin g initial approval from t h e relevant local

government or State Council ministry, submission of formal application

materials to the CSRC, review and approval by the issuing department

of the CSRC, and examination by the issuing examination committee of

the CSRC. Once the issuing examinat ion committee approves the A-share

issue, the CSRC decides the specific timing of the IPOs and will issue a

formal approval certificate.

The selection and approval process for B-share issuers is pretty much the

same as that for A-shares. The selection process involves recommendation

by the local municipal government or relevant industrial department of the

Sta te C ouncil and pre-selection by the CSR C. Th e approval process involves

initial exam ination by local mu nicipal government or the relevant ind ustria l

department of the State Council , submission of application materials to the

internat ional bus iness depar tment of the CSRC, examinat ion and approval

by the internat ional bus iness depar tment of the CSRC, and examinat ion

by the issuing examination committee of the CSRC.

All foreign listings must be approved by the CSRC and the foreign

stock exchanges on which listings are sought before any listing application

is made. In the past, Chinese companies have been approved by the CSRC

in batch es. T he latest ( the 5th) batch of Chinese comp anies when th is

book is w ritten included Wenzhou Infrastructu re, Ning bo Port , Zhejiang

Tourism, Hebei Expressway, Shandong Expressway, Guangdong Agricul

ture, Heilongjiang Agriculture, and Beijing Capital Airport.

In addition to the CSRC approval, any Chinese company seeking to

list its shares on an overseas stock exchange may have to receive approvals

from the State Council , the State Assets Bureau, the Ministry of State

Land and Resources, the State Development and Planning Commission, the

State Economic and Trade Commission, the prospective issuer 's supervising

ministry, and the overseas stock exchange on which the securities will be

lis ted. Typically the issuers ' advisors will undertake the preparation work

for the public offering before all of the aforementioned approvals have been

issued.


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A Chinese company seeking to issue and list foreign investment shares

outside China must complete a three s tage procedure. The firs t s tage in

volves mak ing an app lication to the local mun icipal government or th e m in

istry or department-in-charge of the relevant industry, which will review the

application and if the company is deemed appropriate, i ts application will

be sent to the CSRC. The second stage will involve a selection process

conducted by the CSRC in consultation with the relevant local municipal

governments or ministry or department-in-charge. A short l is t of success

ful com panies will be notified and th en released to th e public. T h e final

stage comprises the examination and approval by the CSRC during which

the CSRC will review prescribed documents in accordance with applicable

securities laws and regulations.

2 .5 M a r k e t M i c r o s t r u c t u r e

2.5 .1 Registration of Stock Dea lers

One of the most successful pieces of reform recently enacted by the State

Council included regulations to establish standards within the brokerage

industry. In addition to formally prohibiting insider trading and requiring

that all companies publicly disclose news which could affect share prices,

th e Manage men t Regu lations for Securities Industry imp osed th e following

provisions on all securities firms dealing with A-shares trading:

5% of all profits mu st be kept as reserves or m arg in s.

Adequate r isk-monitoring systems must be developed.

No m ore tha n 80% of a firm's as sets can be held in stocks.

Tw o-th irds of a securities firm's ma nag ers mus t be certified b y th e

CSRC.

No securities firm can buy m ore th an 20% of the o uts tan din g float

of a listed company during any given trading day.

Regulations for securities firms doing business in B-shares and H-shares

have also been issued recently. An imp ort an t p art of th e regu lation is

to require companies that have already lis ted their B-shares to undergo

an annual f inancial auditing based on International Accounting Standards

(IAS). Under these regulations, both foreign and domestic brokerage firms

must meet the following criteria to do business in China:


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59

Stock broke rs mu st have assets of at least 50 million

renminbi

(or

U.S.

$6.0 million).

T he y mus t have suitable trad ing sites and an extensive network of

sales and research staff.

Ov erseas brokers mu st be licensed by the C SRC every two years.

Dom estic brokers mu st be authorized by the Sta te A dm inistr ation

of Foreign Exchange (SAFE) to do business involving foreign cur

rency transact ions .

In addition to regulating the market by imposing rules on brokerage

houses, securities authorities have recently launched a crack-down on il

legal practices by investors , particu larly at the Shenzhen exchange. Th e

CSRC now officially prohibits the ownership of B-shares by P.R.C. citizens,

a l though many continue to mask such purchases by routing them through

a series of accou nts at different b an ks. In a further a tt em p t to prev ent

the rampant speculat ion in A-share markets , the PBOC has prohibi ted a l l

forms of margin trading.

8

2 . 5 . 2 General Rules for Trading

Securities that have been approved for listing and trading must be quoted

and traded on stock exchanges, and trading must be conducted by a public,

centralized post at competing prices. Securities firms cannot provide loans

or lend securities to th eir cu sto m ers . Officers a nd em ployees of stock ex

changes, securities firms, securities registration and clearing companies, and

securities regulatory authorities may not engage in s tock trading, whether

directly or indirectly.

9

Similarly, professionals who issue documents in con

nection with a share issue (e.g., audit reports, legal opinions, and so forth)

may not purchase or sell shares during and six months after the offering

period.

A company applying to list its shares must first be approved by the

CSRC, and the CSRC may authorize the s tock exchanges to verify and

8

U nd er th e cur ren t P .R .C . l aw, margin t rad ing is a c r imina l offense pu ni sh able as em

bezz lem ent . Al tho ugh t he Ch inese secur i t i e s indu s t ry i s no t rea lly governed by c r im ina l

l aw a t present , th i s ru l ing is pa r t i cu la r ly h a rsh as the embezz lem ent of mo re tha n 20 ,000

renminbi (US$2,400) ca r r ies the de a th pen a l ty .

9

T h e

P.R.C. Securities Law may

appear draconian to have imposed such a res t r i c t ion ,

but in fact s imi lar regulat ions had appeared in var ious regulat ions enacted in 1993.


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approve applications for l is ting of shares in accordance with s tatutory con

dition s and pro ced ures . T he stock exchanges will verify and decide on

applications and will , within s ix months after the applications have been

received, arrange for the shares in successful applications to be listed. The

government may encourage new listings of qualified enterprises in key in

du stria l sectors it deems ap pr op riat e. If a listed com pan y ceases to m eet

the conditions for listing prescribed in the

P.R.

C.

Company Law,

the lis ting

of its shares will be suspended or terminated. Furthermore, the CSRC may

autho rize the s tock exchanges to suspen d or term ina te lis tings in accordan ce

with the law.

After a company is listed in a stock exchange, it is required to prepare

and annou nce interim repo rts and ann ual rep orts . If a major event not

known to investors has occurred that may have serious impact on the price

of shares of a listed company, the listed company must immediately sub

mit a report to the CSRC and the relevant s tock exchange detailing the

occurrence of the event. Examples of major events include:

a ma jor change in th e com pany s business policies or scope of busi

ness;

a decision by th e com pan y on a ma jor inv estm ent or asset pu rcha se;

or

conclusion of a m ate rial con tract t h a t m ay have a m ajor effect on

the companys assets, liabilities, rights, interests or business results.

There is an exception under which a listed company having sufficient

reason to believe that the disclosure may harm its interests and that non

disclosure will not lead to major fluctuations in the share price, is not

required to make disclosure subject to the consent of the relevant stock

exchange.

T h e

P.R.C. Securities Law

s tr ictly prohibits people with knowledge of

inside information on securities trading from carrying out securities trans

actions by making use of that information.

10

No person w ith knowledge

of inside information on securities trading, and no person who has illegally

1 0

The te rm " ins ide in format ion" means in format ion , no t known to the pub l ic , tha t

rela tes to th e co m pa ny s busines s or f inancial affairs or th a t m ay have a ma jor effect

on the pr ice of th e com pan ys secur i t ies . T he desc r ipt ion "people wi th knowledge of

inside information on secur i t ies t rading" refers to : (1) d irectors , supervisors , managers ,

de pu t y man ager s and o ther sen io r mana gem ent per sonnel of a l i sted com pany ; (2 )

shareholders holding 5% or more of the shares in a company; (3) people who are able

to obtain company information concerning the t rading of i ts secur i t ies by vir tue of their


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Market Microstructure

61

obtained inside information, can purchase or sell securities of the relevant

company, divulge such information or counsel another person to purchase

or sell such securities.

Under the present

Securities Law,

the actual knowledge of inside in

formation is irrelevant in determining whether a person is a "person with

knowledge of inside inform ation" . In oth er words, a perso n is deem ed a

"person with knowledge of inside information" by virtue of the positions

and offices the person holds, and the duties and functions the person per

forms, in listed companies, professional intermediary firms and securities

regu latory auth orit ies . However, thi s inte rpre tatio n of th e definit ion cre

ates an anomalous result when applied to the ar t icle of the

Securities Law

that imposes an absolute prohibit ion on sale and purchase of securit ies by

a "person with knowledge of inside information". Th us , a person who is

able to obtain company information concerning the trading of i ts securit ies

by vir tue of the posit ion held in the company but who has not actually

obtained such information is prohibited to purchase or sell securities of the

company. I t is doubtful w hether th is anoma lous result is indeed intende d

by the legislators.

11

Apart from the prohibit ion on insider dealings, the P.R.C. Securities

Law

also proh ibits ma rket m anip ulation activit ies, the m aking of false state

ments in the trading of securit ies, and activit ies amounting to deception of

clients. Fu rthe r , the new law proh ibits state-owned a nd state-controlled

enterprises from engaging in share speculation.

Because the SHSE and SZSE are located in the same t ime zone, t rading

takes place in more or less the same hours, with only little differences in

each othe r 's ope ning, mid-session and closing tim es. Th e official tr ad in g

hours of the SHSE are from 9:30 AM to 11:30 AM and 13:00 PM to 15:00

PM for stock trading; 10:15 AM to 11:45 AM and 13:00 PM to 15:30 PM

pos i t ions in the com pany ; (4) pe rsonn e l of the CS RC and o ther regu la tory bod ies ; and

(5) re levant personnel of profess ional intermediary f i rms and securi t ies regis t ra t ion and

clear ing ins t i tut ions who part ic ipate in or oversee securi t ies t rading.

u

A t presen t , inside r dea l ing ac t iv i t i e s a re regula ted by the Provisional Measures on the

Prohibition of Dec eptive Secu rities Dealing Activities

( the

Deceptive D ealing Mea

sures)

of 1993. Al l f i rms and individuals are prohibi ted from engaging in the issue and

trading of securi t ies by making use of ins ide informat ion wi th a view to making profi ts

or avoiding losses . Actual knowledge and use of ins ide informat ion must be present for

an act of ins ider deal ing to occur . The Deceptive Dealing Measures does not con tain

an absolute prohibi t ion on sale and purchase of securi t ies in terms as broadly def ined

as those of

theP.R.C. Securities Law.


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for treasury bond; and 13:00 PM to 15:30 PM for treasury bond futures.

Trading holidays include January 1, the New Year 's Day; Chinese lunar

New Year 's week-long holidays; May 1, the International Labor Day; and

October 1-2, the National Day holidays. The official trading hours of the

SZSE are from 9:30 AM to 11:30 AM and 13:00 PM to 15:00 PM. The

SZSE has the same holiday schedule as the SHSE.

The trading cost is approximately 1.05% of the total value of the trans

action on the SHSE. This includes a brokerage fee of 0.7% of the gross

consideration (with a minimum trading fee of renminbi 5), a transfer fee

of 0.1 % of face value (minim um US $1), sta m p d ut y of 0.3% of the gross

consideration, and a clearing fee of US$4 per execution for individuals and

corporations (US$8 for custodians). There is no registration fee. The trad

ing cost is 1.00% of the total value of the transaction on the SZSE, a bit

less than the SHSE.

According to China's securities regulations, the lis ted securities in the

SHSE and SZSE must be t rade d thro ugh t he centra lized com peti t ive m ethod .

The securities exchanges are entit led to formulate trading rules which be

come effective after approv ed by th e S tat e Coun cil 's . Un der thes e rules,

investors who want to participate in the centralized competitive trading

must follow the procedure of opening accounts , entrustment, conclusions,

clearing and delivery, and transfer of accounts.

12

To trade in the SHSE and SZSE one must open separate securities

and cash accounts . At the end of a trade, adjustments on the amount of

securities and cash will be made in those accou nts . Investors must apply

for accounts directly through the registration department of the securities

exchanges or their securities dealers. However, both domestic and foreign

investors may entrust domestic and foreign securities dealers or agencies to

open an account of

renminbi

special share. The capital account is issued

for deposit of cash, clearing and receiving dividend. It must be opened by

th e investo rs at th e selected securities dea ler 's business place. T he ca sh

in the account is deposited in a bank by the dealers as current deposit ,

and the interests will be automatically put in the account. Investors have

a magnetic card and a deposit card for their securities account and cash

1 2

The method of non-cent ra l i zed compet i t ive t rad ing re fe rs to the process under which

inves tors t rade thei r securi t ies through buying and sel l ing, bid or auct ion in the rec

ognized marke t s out s ide the exchanges . Non-cent ra l i zed compet i t ive t rad ing marke t s

include securi t ies dealer ' s bus iness counters , local securi t ies exchange centre and secu

ri t ies offering price system.


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Market Micro structure

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account.

In buy ing and selling secu rities, th e comm ission principa l (inve stor) shall

fill in th e comm ission shee t. T he com mission sheet is printe d by th e dealers

according to the requirements set forth by the exchanges. The commission

sheet shall list the name of the commission principal, shareholder 's code

number, the date and time of commission, the kind of securities, the volume

and face price, the commission price, effective date, etc.. The commission

may be m ade throu gh writ ten form, by telephone, fax, cable, etc. . In

Shanghai and Shenzhen, securities dealers are prohibited from accepting

the full commission which delegates the dealers with the power to decide

the kind, volume and price of the traded securities. Securities dealers are

also prohibited from accepting the commission of trust trading.

Although both the SHSE and SZSE use computer systems to reach con

clusion through centralized competitive price, they have some differences

carrying out orders. On the SHSE, the representatives of the dealers, who

sit in the exchange hall , are the actual operators who make the conclusion

throu gh the comp uter system. On the SZSE, despi te th at th ere are rep

resentatives of the dealers who sit in the exchange, the actual operators

are the dealers themselves who may enter the orders from their business

dongwei su chinese stock markets a research handbook 2003

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