China's Capital Markets:
Is the Global Financial Center of Gravity Moving East?

By Judi Kilachand and Alfonso Cortes, Asia Society

October 12, 2006

Many superlatives are used to describe China's growing economic clout. Not limited to just outsourcing and low cost manufacturing, China has also adopted the mantle of roles that used to belong to the U.S., such as net creditor and the largest recipient of foreign direct investment. Recently, there have also been signs that the exchanges in mainland China and Hong Kong have started to make in-roads on New York's and London's dominance in global capital markets. Due to a combination of more stringent accounting requirements to list in New York and the need to raise capital closer to home, an increasing number of Chinese companies have opted to list domestically instead of in the West. Is this the start of a trend or an isolated group of events? Will the increase in China's capital markets conflict or complement activity in Europe and the U.S.?

To help clarify these issues, Asia Society, a global educational organization, and O'Melveny & Myers, an international law firm, co-hosted their fifth annual China's Financial Markets conference in New York on October 12, 2006, which featured an international group of twenty-two leading economists, bankers, regulators, and legal experts in China's financial community. This group of professionals examined developments over the past year in China's banking system, capital markets, overseas listings, and M&A environment.

Setting the tone for the conference, keynote speaker, Catherine Kinney, President and Co-COO, NYSE Group, touched on the growing impact of China's capital markets, and its resulting effect on equity markets in the U.S. New York's status as a global financial center has suffered a decline in recent years, partly due to the additional requirements of Sarbanes-Oxley, the lack of convergence in international accounting regimes, and the growth in capital markets overseas. In 2005, of the top 25 global IPOs, only two were registered in the U.S. and all of the top ten were conducted abroad. But Ms. Kinney noted that global requirements for capital are vast and growing dramatically worldwide, and with deep liquidity and a broad investor pool, the U.S. is in an advantageous position to help overseas companies looking to list in the short run. In the long run, overseas markets, including China's, should develop and become more complementary with a U.S. listing.

Based on best practices that NYSE has dealt with across the globe, Ms. Kinney cited four steps to speed and strengthen the development, evolution, and health of China's equity markets: (1) facilitating transparent access—for issuers, investors and intermediaries—to China's capital markets; (2) promoting an equity culture; (3) providing tax incentives for capital formation that encourage risk-taking, venture capital and entrepreneurship; and (4) creating a regulatory system with clear and certain rules, and an enforcement mechanism that is consistent and fair.

Despite the impressive transactions that China has listed domestically in the last few years, the market cap of Chinese companies listed in overseas markets is still larger than the market cap of the companies listed on the Shanghai and Shenzen exchanges. China's capital markets still have a long way to go, but in the relatively brief history of its exchanges, however, China has already taken several bold steps towards making up the distance.

China's Domestic Capital Markets

Richard McGregor, China Bureau Chief of the Financial Times, opened the panel on China's capital markets by looking at China's market reform. One of the biggest issues that China's domestic equity markets have grappled with is that two-thirds of the shares among its listed companies are owned by the state and are non-tradable. China initiated G-share reform—named for Gu Gai, Chinese for "share reform"—to unwind state ownership of those non-tradable shares.

Chairman of China Equities at J.P. Morgan, Jing Ulrich, explained that G-share reform began two years ago and that 85% of the companies have started the process. One earlier issue when G-share reform began was how to appropriately compensate shareholders for the potential price drop their stock would suffer once the government unwound its holdings. Eventually the state decided to give shareholders three additional shares for every ten shares held. The biggest issue, however, has been the improvement in corporate governance and transparency, which the government and regulatory agencies continue to pursue.

Ms. Ulrich also commented that up until very recently, banks have been the predominant provider of capital. Banks have financed 99% of the external capital to the Chinese corporate sector, whereas capital market fund raising accounted for only 1%. It is hoped that with the gradual growth of the domestic bond market, banks will face more competition from alternative sources of funding. Equity culture in China is currently close to non-existent, but is still an improvement from a few years ago. She added that if capital flows were allowed to enter and leave China, it would significantly stimulate the development of China's equity culture, given the transforming role that foreign capital can have in China's equity market. Along with the $9 billion in quotas granted to Qualified Foreign Institutional Investors (QFII) and the $12 billion in quotas granted to Qualified Domestic Institutional Investors (QDII), as capital is allowed to enter and leave China more freely, as transparency increases, and as information flow improves, a new class of investors could emerge in China's equity market.

Continuing the discussion of G-share reform, Qingyuan Li, a Senior Researcher and a former Director of China Securities Regulatory Commission (CSRC), called the G-share reform a success, because it has eliminated the biggest systemic obstacle of China's capital markets. She said that a market needs an efficient pricing mechanism to be effective, but with all of the demand focused only on the 30% of shares that are tradable, pricing cannot reflect the real investment value of the listed company. Ms. Ulrich added that the top Chinese companies used to seek overseas listings. But after G-share reform, they are now listing on the Hong Kong and Shanghai exchanges, giving Chinese investors on the mainland access to these leading Chinese companies for the first time.

Commenting on China's debt market, John Chambers, Managing Director of Standard & Poors, said that the bond market is dominated by government debt and central bank bills. The corporate bond market is dominated by financial institution issuance, so China does not have a corporate bond market similar to the one in the States. With the reforms in place, however, China's bond market is expected to grow both in nominal terms and in relationship to bank lending and GDP. The speed at which the corporate bond market will grow will be a function of different factors: The most important is the liberalization of interest rates in China. If those interest rates are administratively controlled, then it will be less easy to model. Other key issues include deepening reform on corporate governance, the ability to obtain reliable credit information, prompt dissemination of bond price information, a deepening of the repo market, and having non-financial issuers stand on their own without a bank guarantee. China does have a yield curve, but with interest rates administratively set, it is not providing the same sort of mechanism to properly allocate investment.

Overseas Listings by Chinese Companies

Senior Fellow at the Institute for International Economics, Nicholas Lardy, began the session on overseas listings by exploring whether the U.S. market will continue to have the dominant role it has had in the past.

According to Shanghai-based Kurt Berney, Partner at O'Melveny & Myers, 2006 and 2007 will see a high degree of market activity. Although there is rapid growth in China, a low base from which to grow, strong government spending, and large inherent domestic demand, in terms of dollars, about $45 billion will be raised in overseas listings. Clean energy companies, consumers, and some technological companies will likely list in the U.S. instead of Hong Kong, since they have comparables that trade in the U.S. or will have a more attractive valuation. Furthermore, technological companies have not achieved the desired valuation in Hong Kong. Hong Kong investors, however, appear more cognizant and accepting of inherent China risks—political risks, regulatory risks, the CSRC and whether their approval will be required for offshore listings.

Robert Delamater, a Partner with law firm Sullivan & Cromwell, believes that the cost benefit analysis that Chinese issuers are engaged in has changed in significant ways over the past decade. Most of the focus has been on the cost and the perceived increased cost of listing in the U.S. There are the hard costs of the section 404 internal control audit, the perception of greater litigation risk, and there are suggestions that underwriting spreads are higher in the U.S. market. There is also a general retreat around the world of listings overseas. As an example, Mr. Delamater cited that foreign listings on the Tokyo stock exchange have fallen by 80% since the early 1990s. European listings outside of the Euro zone are more greatly scrutinized, and there are also fewer "vanity" listings in New York for firms to prove themselves, though Mr. Berney believes that a New York listing still makes a strong case for a company's branding and marketing purposes. Nonetheless, there is a growing awareness among institutional investors of a growing comfort with the home market, and a perception among issuers and investors that Hong Kong is a readily accessible market. Why list anywhere outside of your home market?

Addressing the issue of Chinese and overseas markets, Hong Kong-based banker, George Taylor, Executive Director of Global Capital Markets at Morgan Stanley, noted that the additional pool of capital that one can obtain through a U.S. listing has become significantly smaller. At the same time, the pool of capital from China, including substantial on-shore Chinese capital, is making its way to the Hong Kong market, as well as its debt and retail market. As a result, the benefits of listing in the U.S. are much less than the costs of moving oneself from domestic Hong Kong capital. This year China's IPOs will comprise 25% of global IPOs—as big as the Nasdaq and the NYSE put together—and the Hong Kong IPO market will be the biggest in the world this year. Mr. Taylor added that the fees for Chinese deals are much less, however, and a lot more painful to execute. Banks make very little money out of IPOs and there is also regulatory risk: one change in CSRC policy can make a project pipeline disappear. However, how this will affect the relative attraction of U.S. versus Chinese markets on investors remains to be seen.

Other panelists were also forthright with their views on U.S. performance. Stefanie Starna, a Partner with Deloitte Touche Tohmatsu, sees the U.S. IPO market decreasing over the next few years. She also emphasized that for non-U.S. firms to compete effectively, they will require the appropriate analyst coverage and appropriate investor relations to give them the visibility they need in the market, without which they would face a sharp disadvantage against U.S. competitors.

For the markets in China going forward, Mr. Taylor summarized it as such: in twenty years' time, the vast majority of fund raising will be done on-shore via Shanghai and Hong Kong. They will still need time to further develop, and the regulatory environment will have to become tighter. China needs to increase the ability of international investors to participate in the market and allow international banks to underwrite in China. In the process, international banks could also bring in the best practices that China will need to continue to compete on the world's financial stage.

The key question many are asking today is, Will the growth and stature of China's financial markets mark the end of Western dominance in the global capital arena? One general theme throughout the conference was that the sudden increase in China's capital market activity does not necessarily have to conflict with other international markets. Indeed, perhaps even more important is not who will lead the world's capital market in the future, but rather what kind of opportunities will emerge in this changing environment.

(As printed in Euromoney's China Financial Markets Review 2007)