I INTRODUCTION

China’s capital markets have gone through decades of development since economic normalisation. It was not initially an attractive financing option for most private Chinese enterprises. The Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) were established in the 1991 as arms of the central government to solve the capital shortage problems of state-owned enterprise (SOEs) and sell shares to outside investors, thereby raising the value of the government’s stake in these companies. However, China’s capital markets have sped past various milestones. As of December 2018, China (excluding Hong Kong) had the world’s third-largest stock market with a combined aggregate market capitalisation of US$6.3 trillion. For all of 2018, according to Refinitiv Chinese issuers raised US$55.65 billion in global equity capital markets, accounting for 8.7 per cent of overall issuance. In the meantime, China’s US$12.5 trillion domestic bond market is currently the world’s third-largest by securities outstanding, behind only those of the United States and Japan. Having grown to be among the largest markets in the world in just over two decades, China’s capital markets are usually cited as a counterexample to the significance of law for financial market development. However, a thorough examination of the development of China’s capital markets will reveal that the law is actually critical to sustaining growth. Just as the experience of China suggests, law and market growth exhibit a bidirectional rather than a unidirectional causal relationship, and the course of development is more like ‘growth-law-further growth’.

The legislation of the capital markets includes several fundamental laws, and most importantly the Company Law of the PRC and the judicial interpretations of that Law made by the Supreme Court of the PRC (together, the Company Law), and the Securities Law of the PRC (Securities Law), followed by a fiddly series of rules promulgated by central government (including the State Council and its delegated departments). Laws and regulations of the capital markets in China, originally borrowed largely from the legislation of developed economies, have the skeleton of a regulatory set-up supervising equity market (mainly shares), fixed income products (mainly government bonds, central bank bills, financial bonds and corporate bonds), derivatives (including futures, yuan interest rate swap and share index futures), securitisation products (mostly asset-backed securities (ABS)) and foreign exchange in a broader sense.

The laws and regulations have many distinctly Chinese characteristics, inevitably, among which the most notable is a structurally inward-looking feature, which is evident in two ways in particular:

  1. restricted access to and unequal treatment of foreign participants (issuers, investors and intermediaries) into China’s domestic capital market: for instance, foreign issuers have always been barred from offering shares in the PRC; and
  2. the regulatory regimes concern not just the domestic capital market but also share and bond issuance of ‘red-chip’ companies. Red-chip (which is market-created business jargon rather than a legal term) generally refers to a corporate structure in which business interests are mainly within the PRC but are owned by holding companies established overseas, which are in turn controlled by Chinese citizens or state-owned bodies. Since shares and bonds issued by red-chip companies are sold to international investors rather than within China, and the companies are only listed on overseas exchanges, if they are listed at all, the government should not have bothered about regulating this kind of operation too much, if at all. However, owing to the government’s near-paranoid prejudice against foreign ownership, the red-chip structure is seen more as a way of getting round government supervision, and thus is subject to a series of complicated and less-transparent requirements.

Only the central government is involved in the legislation of the capital market. Within central government, the regulatory bodies are mainly the People’s Bank of China, which is China’s central bank, and two commissions: the China Securities Regulatory Commission, which regulates the securities industry, and the China Banking and Insurance Regulatory Commission (CBIRC), which regulates the banking and insurance industries. However, there are also a few departments and self-regulatory industry organisations delegated with certain administrative functions. Under the motto ‘Stability conquers all’, the Chinese regulators place great emphasis on maintaining the stability of the capital markets by intervening and reasserting control over both the primary and secondary markets. Inevitably, people cast doubt on the effects of this intervention. For instance, it is widely believed that policies pursued by the government in search of new sources of growth are at least partly to blame for the creation of the bubble that burst in the summer of 2015; in addition, the noisy but fruitless introduction of issuance of Chinese depository receipts in 2018 without any official admission, denial or reasons given revived the debate about whether the policy tool kits of government are able to accommodate the growth of capital markets so as to support a sustainable economy. On the other hand, since the economic open-up, China has relied to date on a reasonably successful approach involving limited experiments and pilot programmes as test cases for reform, and only expanding them after careful and deep assessment. With significant international developments occurring at an ever-faster pace, whether such a cautious and incremental approach will continue to serve China’s capital markets well requires careful consideration. A broad reform agenda that encourages development of deeper, more liquid capital markets with greater choice of investment products is critical to sustaining China’s growth as traditional drivers weaken, whether in terms of external trade, domestic infrastructure investment or appetite for risk on the part of global investors. At the end of the day, what is paramount is domestic capital market reform primarily for the benefit of the Chinese economy and its citizens and consumers, including minimising malfeasance, transitioning from over-reliance on retail participation to more professional investors, and proper supervision of financial market participants, including over technology firms.

II THE YEAR IN REVIEW

In the past, China’s financial model was based to a large degree on state-owned banks lending to SOEs, which in turn exported products to developed markets or financed domestic infrastructure projects. This cycle was ultimately funded by China’s large base of domestic deposits, which are the result of high savings rates, a lack of alternative investment options and the relative security of bank deposits. While this financial model is undoubtedly successful in an export-driven economy in the early stages of development, in recent years rising geopolitical tensions, an easing of gross domestic product (GDP) growth and a build-up of debt have created pressure to build a financial infrastructure that is both flexible and robust. China’s growth slowed in 2018 to 6.6 per cent for the full year, the lowest growth rate since 1990. A recent paper by economists at the Brookings Institution suggests growth rates were consistently overstated between 2008 and 2016, and that the actual 2018 GDP might be 10.8 trillion renminbi, which lies below the official figure of 90 trillion renminbi.2 China’s macroeconomic challenge in 2019 and beyond is meeting the combined impact of its trade dispute with the US, weakening domestic demand and high levels of off-balance sheet borrowing by local governments. The 6.4 per cent growth rate in the fourth quarter of 2018 was the lowest since the global financial crisis of 2008, and the previous two quarters also showed sharp deceleration. Nonetheless, over the next two years China is likely to use all the policy tools it has at its disposal to achieve the minimum annual growth target in order to meet its policy target to double 2010’s GDP by 2020. The build up of growth pressure has also accelerated the pace of change in China’s capital markets which, if trade earnings are squeezed, can serve as an alternative growth driver by mobilising domestic and foreign savings to create wealth through investment in new businesses and technologies. The worsening of China’s geopolitical environment in many respects underlines the importance and urgency of continued reform in its capital markets.

In the past year, a wave of policy changes to further reform and open up the capital markets has been accelerated. The Star Market of SSE, which is meant to fund and support companies in innovative industries, has been brought from being a concept to being an open business at world-class speed. In August 2018, when the CBIRC announced the elimination of limits on foreign ownership of Chinese financial institutions, removing ownership caps that were part of the previous ruling. In January 2019, the China Securities Regulatory Commission (CSRC) published draft rules combining its two long-standing inbound investment schemes, the qualified foreign institutional investor (QFII) and the yuan-denominated renminbi (RMB) qualified foreign institutional investor (RQFII) into one, together with the removal of quantitative criteria that hampered inbound investment. In the same month, the People’s Bank of China (PBOC) announced it would allow Standard & Poor’s (S&P) Beijing subsidiary to conduct credit rating activities domestically and to register for bond rating services in China’s interbank market. In May 2019, the CBIRC announced plans to remove limits on ownership in local insurance companies by foreign institutions and reduce size requirements for foreign banks that operate onshore. More recently, in September 2019, China’s foreign exchange regulator – the State Administration of Foreign Exchange (SAFE) – announced the removal of investment quota limits for QFII and RQFII. These examples hint at the potential for China’s capital markets to transform themselves and adapt to the requirements of a growing economy and an ever-more sophisticated populace. In the meantime, we should point out that, since nearly all reforms and open-ups are government-led and centralised rather than market-driven, some, or perhaps many, of the top-down initiatives may have to face bumps or even failures.

i Developments affecting debt and equity offerings

The debut of the Star Market

On 22 July 2019, the new Science and Technology Innovation Board of the SSE, called the Star Market by Chinese authorities, was officially launched, with the first batch of 25 companies listed on the same day. Considering the idea for this new Board was only first unveiled by President Xi Jinping in November 2018 and the birth of the Star Market only took a few months, the implementing speed of the CSRC and the SSE is spectacular by China’s standard, as is the ambition and momentum of China to bid for tech superpowers and the reform of its equity markets. At the time of writing, there were 34 companies listed on the Star Market, with more than 100 applicants waiting in the pipeline.

Often dubbed Nasdaq-style, the Star Market is intended to catch up with its United States counterpart eventually. The idea behind the Star Market is to encourage investment in domestic tech innovators, ensuring they have resources to develop and also incentives to list at home. It also will make those companies easy for mainland investors to trade in after complaints that Chinese megastars like Alibaba chose to list in the US rather than at home. Coming as the US-China trade tensions have spread to the technology sector, threatening huge homegrown stars like Huawei and others, the new market is of strategic importance to China. Beyond the ambition to rev up China’s emergence as a research powerhouse while the country battles accusations of intellectual property theft and technology sanctions from the United States, the Star Market looks set to broaden companies’ access to private capital. It is also a test case for capital market reforms: changes to initial public offerings (IPOs) and trading mechanisms could be rolled out to China’s main boards if they succeed. Moreover, the Board could push China’s industries up the value chain by channelling funds to homegrown businesses developing innovative capabilities.

Broadening access to private capital

As China pins mounting hopes on innovation to drive higher-quality growth and technological breakthroughs, the Star Market’s creation is timely. It may enable not just high-tech start-ups to raise cash, but also venture capital and private equity funds to exit their investments and redeploy capital. Altogether, the Board could encourage private capital investments in the technology scene. The implications go further. A stock market that better serves China’s real economy can potentially improve capital allocation in a country that has been criticised for handing out state subsidies and other forms of aid. We see the Star Market creating room for the government to reduce support, which should strengthen the economy’s efficiency and longer-term resilience.

Deepening capital market reforms

China’s equity markets, although massive, remain uninviting for some investors and high-quality companies looking to list. Among their concerns are strict practices that rein in market forces and impede efficiency. These include an approval-based system for IPOs, a profitability requirement for listing candidates, an unofficial but widely observed cap on IPO valuations and daily price limits for stocks. China has pledged to reform its capital markets, and the Star Market could be a pivotal testing ground. It marks several firsts (some major breakthroughs are illustrated in the table below) in the country as it shifts to a registration-based IPO system and accepts unprofitable companies. We expect these features to give market forces greater sway and make IPOs faster and more transparent. Some of these features could also be applied to other domestic exchanges in the future.

Select differences between major A-share exchanges and the Star Market
Major A-share exchanges The Star Market

Listing system

Approval-based: gives regulators the power to approve, hold back or reject listing applications based on their assessments of companies’ prospects, market conditions and a host of other factors

Registration-based: scales back regulators’ scope in reviewing applications while putting greater onus on companies to disclose material information

IPO valuation

Unofficial valuation cap of 23x price-to-earnings ratio (trailing earnings): the industry widely follows this implicit rule, taking its cue from regulators’ need for more disclosures if issuers price new shares at multiples that are considered aggressive

No such cap

Profitability requirements

Required for all companies

Required only for companies with a market capitalisation of under 1.5 billion yuan

Corporate structure

Must be domestic companies; strict same share, same right

Red-chip structure allowed; dual-class voting acceptable

Investor criteria

Open to institutional investors and retail investors

Open to institutional investors and retail investors with at least 500,000 yuan in their trading accounts plus at least two years of equity trading experience

Daily price limit

44 per cent trading band on debut, 10 per cent trading band thereafter (with exceptions)

No daily limits for the first five days of trading for newly listed stocks, 20 per cent trading band thereafter

IPO sponsor participation

Not applicable

Sponsors must purchase up to 5 per cent of the shares on offer with their own capital and stay invested for at least two years

We believe this reflects China’s commitment to making its capital markets more open and competitive. For Shanghai especially, the Board could aid its bid to become a global financial centre. Beyond pulling in capital, the Board is likely to inject dynamism into the financial ecosystem, whether by promoting venture capital activity or by spurring the launch of mutual funds targeting investments in technology firms. A successful Board could even entice Chinese companies listed overseas to also list onshore.

Promoting industry upgrade

The Star Market could be a critical prong of China’s plan to move its industries up the value chain, as tellingly shown by the first line-ups on the new market, including chipmakers, AI companies, biotech firms, electric car battery makers and suppliers for high-speed railways. China’s economic rebalancing and technological survival would depend heavily on its ongoing transition from a cheap maker of low-end goods to a developer of high-tech and high-margin products. For companies with convincing strengths in innovation, the Board is a prime channel of financing that could ramp up their growth and help them, and China, compete on a global scale.

However promising the market may be, it still has its detractors. First, volatility: on the first day of trading, shares of the 25 companies all surged tremendously from their already high offering prices, ending the opening day with sizzling gains ranging from 84 per cent to an eye-watering 400 per cent, gaining 140 per cent on average by the time the market closed. However, according to the latest trading data, of the 25 companies listed on the opening day, 21 have dropped from such closing prices, with one of them, Jingchen Holding (688099.SH), having nearly halved. Retail participation has been relatively high, leading to much speculative activity that has caused many to call China’s stock markets a casino. Worries of a rapid boom and bust loom especially large. Chinese retail investors have historically shown outsized interest in new bourses and listings, driven in part by confidence in the IPO approval process and a belief that capped IPO valuations spawn easy returns later. ChiNext in Shenzhen, for example, had surged on investor exuberance shortly after its debut in 2009, only to sink when interest waned. Understandably, market excitement around the sci-tech board has stoked caution. Although a lot of measures aimed at stabilising the Star Market have been taken, whether they would work to go with the plan is anybody’s guess.

Second, the policy changes introduced have been implemented more slowly or somewhat nominally than some market practitioners would like. Although it is subject to the a disclosure-based registration system rather than the approval system, the registration with the CSRC is still essentially a de facto approval. The CSRC has twice rejected registration applications of two companies after review and approvals by the SSE, and has been told to postpone the registrations of some companies with the intention of discouraging them from going ahead. Moreover, trading still cannot be instantly settled but is on T+1 basis, and price fluctuation beyond the 20 per cent range would still trigger automatic trading halt for a day.

Third, the Star Market has seen limited participation from foreign investors, despite their notable presence on the main board. At present, foreign investors can only access Star-listed firms through QFII and RQFII, while among the more-than 300 foreign institutions with QFII licences, only six had subscribed to the IPOs of the firms listed on the Star Market. The reasons could be the tiny size of the current Star Market, or the wait-and-see attitude of cautious and sophisticated institutional investors – namely, that high valuation usually means high volatility – of Star-listed firms may have also deterred cautious foreign investors that adopt value-investing strategies, analysts have said.

Much remains to be seen until the market expands and trading fever cools down. The fact that most applicants are not high-profile market leaders casts doubt on whether the Star Market may be another ChiNext eventually. Broadly speaking, to ease such doubts, we expect regulators to be mindful of the overall quality of companies listed, especially in the near term as they work to cement market confidence in the new Board.

Easing of foreign ownership restrictions on financial firms

On 28 July 2018, the National Reform and Development Commission (NDRC) announced on its website the lifting of foreign ownership caps on brokerages, life insurers and commercial banks. This came as welcome news, although details remain that require clarification. The changes include a previously announced decision to allow 51 per cent foreign ownership of brokerages and life insurers, and the removal of the cap entirely by 2021. Rules limiting a single foreign financial institution’s ownership in a Chinese commercial bank to 20 per cent were abolished, along with a rule limiting investment by multiple overseas financial institutions to 25 per cent. In addition, the NDRC cut the negative list for foreign investment from 63 industries to 48, easing or lifting ownership caps on businesses including ship and aircraft manufacturing, power grids and crop breeding (excluding wheat and corn). Foreign ownership for passenger car manufacturing will be removed by 2022, together with ownership limits on passenger rail transport and shipping, according to the announcement. Countries around the world use ownership limits for companies and industries representing strategic or national interests. However, they tend to be overused and retained long after the original reasons have become obsolete. For all these reasons, we believe the use of ownership limits should be minimised to the extent possible. As ownership caps are eased or removed in selective industries, it will ease investing in some industries, including finance.

It has been more than a year since the regulatory authorities approved the first majority stake in a domestic financial firm by an international bank, and licences for some international rating agencies and bank card payment firms were still pending to date. UBS was the first international bank to be allowed to take a majority position in its Chinese joint venture, UBS Securities Co, in November 2018, a year after the initial announcement. In March 2019, the CSRC accepted applications for 51 per cent stakes in joint ventures for JP Morgan Securities (China) Company Limited and Nomura Orient International Securities Co Limited; in April, Credit Suisse also had its application accepted. As of April 2019, Fitch Ratings was still waiting approval despite having opened a wholly owned office in Beijing, Fitch Bohua, in November 2018 in advance of obtaining a licence. Bank card payment firms Visa and Mastercard were also awaiting approval to process renminbi payments a year after both companies submitted applications in early 2018. All the welcome policy changes to greater openness could have been implemented more rapidly than they really have been.

Improvement in trading suspension

During the past year, there has been a visible improvement in trading suspensions, which hovered for many years in the 150 to 200 range. These had dramatically dropped to single digits by the end of 2018. The seeming change of trading behaviour is by no means spontaneous: the Chinese authorities have been making significant improvements in this area over the past few years. This contrasts with 2015 when, during the height of market volatility in the summer, on some days trading in over half the stocks was suspended. This exacerbated market anxiety, which spilled into other products domestically, as well as markets globally. Suspensions cause problems for the obvious reason that a suspended stock cannot be bought or sold. For fund managers, widespread suspensions can be a major hindrance to meeting fund redemption obligations. While it can be recognised that a listed company has a right to suspend trading of its shares under specific conditions so that investors have time to digest the significance and implications of such conditions, it is particularly important to investors to know that the liquidity of the shares they hold is reliable. The rights and interests of investors and the liquidity of the market should prevail over the rights and interests of listed companies. Many have been advocating for the continued discouragement of trading suspensions except under exceptional circumstances and set out in transparently applied rules to safeguard market liquidity. On 6 November 2018, the CSRC issued the Guiding Opinions on Improving the Suspension and Resumption of Trading of Shares of Listed Companies, which was followed by the SSE and SZSE each issuing a consultation on reducing the types of events under which a listed company may request a trading suspension and the maximum period of such suspensions. Although the final SSE and SZSE Guidelines issued on 28 December 2018 keep the maximum suspension period to 10 dealing days despite requests to shorten it further to five dealing days, it is encouraging to see that the circumstances under which a listed company can suspend trading of its shares are limited. The focus of the exchanges and Chinese regulators on these concerns, as reflected by the number of trading suspensions falling to single digits by the end of 2018, is commendable.

Further toughening of the delisting rules

Clear rules and consistent implementation of a process for delisting illiquid and substandard companies – those that no longer meet the listing requirements – are crucial. From 1995 to 2016, China delisted only 0.8 per cent of total listings. Since the first of these in 2001, China’s A-share market has only seen 57 firms leave the market despite the reform of the delisting rules in 2014. This is a small number compared to global rates that range as high as 10 per cent and above, and suggests that some substandard companies remain listed on Chinese exchanges that should not be. The authorities recognised the shortcomings of the delisting process, and in 2015 the CSRC introduced new rules that require a greater level of information disclosure and delisting for illegal acts and fraudulent issuance. On 21 March 2016, authorities delisted ST Boyuan from the SSE because of illegal disclosure of important information. This was encouraging, and the market widely looked forward to the continued consistent application of the new approach.

On 27 July 2018, the CSRC amended its delisting rule (Several Opinions of the China Securities Regulatory Commission on Reforming, Improving and Strictly Implementing the Delisting System for Listed Companies) after months of public consultation. The amendment states that listed companies involved in fraudulent issuance, violations of major information disclosure or other major illegal activities concerning national security, public safety, ecological safety, production safety, or public health and safety, the stock exchange shall move to suspend or terminate the listing of the company’s shares. Another major revision states that the securities regulator can suspend or terminate the listing when illegal activities are found. This compares to the previous version in which companies carrying out significant legal violations would first suspend trading and then withdraw from the market. Accordingly, the two exchanges have also introduced detailed rules for delisting from them, stipulating that companies will be ousted from the market if any evidence is found of fraudulent IPOs, cheating in financial disclosures or law violations.

In November 2018, supplementary delisting rules were introduced as a follow-up measure after Shenzhen-listed Changsheng Bio-technology falsified data on rabies vaccines, drawing the attention of President Xi Jinping. The new delisting rules ban companies found guilty of financial fraud in their IPOs from re-listing forever. Companies that are delisted for other reasons need to trade in the over-the-counter (OTC) market before they can apply for re-listing.

The idea of toughening the delisting rules is to shut the door behind uncompetitive companies on the one hand while opening the door to attract listings in the new technology and new economy sectors through the Star Market on the other, collectively to create a healthier flow of listed companies. However, with the open-door initiative having been postponed, the voice of the shutting door appears to have gone quiet, too.

Reforms of QFII and RQFII programmes

Foreign investors are not able to invest in domestic listed companies except by participating in QFII or RQFII programmes, unless they seek to be the strategic investor of a listed company as defined by the CSRC’s Measures for the Administration of Strategic Investment in Listed Companies by Foreign Investors, which must seek to purchase at least 10 per cent of a listed company’s outstanding shares at one time but will be subject to a 30 per cent cap of ownership in the same listed company. In addition, until recently, China’s bond markets were generally restricted for foreign investors before the expansion of the QFII and RQFII schemes to allow foreign investors to invest in Chinese bonds.

Since the QFII regime was introduced in 2002, followed by the launch of the RQFII regime in Hong Kong in 2011, China has taken a step-by-step approach towards opening its capital markets to foreign investors. Recently, the CSRC has launched a new round of opening up the financial sector by seeking public comment from 31 January 2019 on the combined and amended Administrative Measures for Domestic Securities Investments by Qualified Foreign Institutional Investors, the Measures for the Pilot Programme of Domestic Securities Investment by RMB-Qualified Foreign Institutional Investors and their supporting rules. Key amendments of these new rules include, among others:

  1. a combination of the two regimes;
  2. a relaxation of the entry criteria;
  3. the expansion of the scope of investment;
  4. the optimisation of custodian management; and
  5. the strengthening of ongoing monitoring.

Most significantly, the investment scope of RQFIIs and QFIIs is expected to expand significantly from the currently limited assets categories such as:

  1. stocks and bonds traded on the SSE and SZSE;
  2. securities investment funds;
  3. stock index futures and fixed income products traded in the interbank market for inclusion of shares quoted on China’s OTC market;
  4. depository receipts;
  5. commodity futures and options;
  6. private securities investment funds;
  7. financial futures for hedging purposes;
  8. bond repos; and
  9. foreign exchange derivatives.

Added to these measures, on 10 September 2019, the State Administration of Foreign Exchange (SAFE) announced the removal of investment quota limits for QFIIs and RQFIIs completely. As a result of this announcement, QFIIs and RQFIIs will no longer be required to apply for any investment quotas from SAFE. Instead, it is expected that a new QFII or RQFII only needs to make a SAFE registration with assistance from its onshore custodian. The SAFE registration will be used to open onshore cash accounts and accommodate the remittance and repatriation of funds onshore. Furthermore, aggregate investment quota limits that apply to a specific foreign country or region will also be removed. Although SAFE’s announcement did not specify when the removal of investment quota limits will take effect, it did state that it would amend the relevant rules and regulations as soon as possible to implement its decision, which has already been approved by China’s State Council.

These qualified institutional investor reforms, rather significant on their face, are consistent with the financial market opening-up reforms to further simplify management and facilitate operation, and governmental officials have said that they will further expand the new landscape for opening up the capital markets. However, in reality they may make little difference, because the programmes under which the caps operated were already becoming somewhat redundant. For instance, the quotas that have been removed had been in no danger of being breached for at least a decade, despite the fact that China had kept on expanding such quotas. According to the recent data, foreign institutions had applied for QFII investments worth US$111.3 billion, only 37 per cent of the total quota, while applications for RQFII were worth 693.3 billion yuan, just one-third of the 1.99 trillion yuan quota. Both equity and bond foreign investors had been relying more heavily on other cross-border channels with better arrangements in place, especially the Stock Connect and Bond Connect programmes, to allow easier access to trade in China. It was not the quotas that were constraining them from investing more through QFII and RQFII. From this perspective, the reforms are more importantly symbolically. The ease of access and scrapping of the quotas alone may not bring significant liquidity into domestic financial markets.

Launch of the Shanghai-London Stock Connect

Added to the market openness mechanism of Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect, on 17 June 2019 the CSRC and the Financial Conduct Authority of the United Kingdom released a joint announcement of their approval in principle of the establishment of the Shanghai-London Stock Connect. On the same day, the London Stock Exchange held the launch ceremony for the westbound business of Shanghai-London Stock Connect and the listing of global depositary receipts (GDRs) issued by Huatai Securities Co, Ltd (Huatai), a company listed on both the SSE and Hong Kong Stock Exchange.

Although bearing the same badge of Stock Connect, Shanghai-London Stock Connect works fundamentally different from the two mechanisms already in place. First, while the previous two mechanisms, belonging to a secondary market trading scheme, allow investors on one side to trade stocks listed on the other side, Shanghai-London Stock Connect works to allow eligible companies listed on the two stock exchanges to issue, list and trade depositary receipts on the counterpart’s stock market in accordance with the corresponding laws and regulations, and so is a scheme that covers both the primary market and secondary market. Second, the trading targets under the Shanghai-Hong Kong Stock Connect and the Shenzhen-Hong Kong Stock Connect are shares listed on the counterpart’s market, whereas the trading targets under the Shanghai-London Stock Connect are depositary receipts listed on the local stock exchange.

However, the launch of Shanghai-London Stock Connect is recognised more to be of symbolic importance, and it probably is not a game changer for the Chinese or UK stock markets. It is believed that the link will probably be largely illiquid at the beginning, due in part to unresolved compatibility issues. For example, Shanghai has a 10 per cent daily trading limit while London has none. So far, just one company, Huatai, is using the connect. HSBC Holdings PLC has previously said it would consider a Chinese listing. A comparable programme in Germany, which allowed Chinese companies to issue depositary receipts in Frankfurt, met with a lacklustre response in October 2018. More than half a year later, appliance giant Qingdao Haier Co Ltd remains the only company to have done so, and trading volumes have been low.

ii Developments affecting derivatives, securitisations and other structured products

Innovations within the securitisation market

Securitisations were introduced by several central government departments in China in 2005 through the Credit Asset Securitisation (CAS), a pilot programme, but was suspended in 2008 following the onset of the global financial crisis amid concerns relating to securitised assets. The CAS framework, normally used by banking and non-banking financial institutions, was restarted in 2012 with an initial quota of 50 billion yuan. This has since been increased to 500 billion yuan, pursuant to an announcement by the State Council on 13 May 2015. Despite the explosive growth of ABS issuances in China, existing laws permit only a limited class of investors to subscribe to ABS issuances adopting the special purpose trust (SPT) structure; this closed group mainly consists of domestic banks, insurance companies, securities companies and mutual funds. When credit assets originated by a commercial bank are repackaged into ABS sold to other commercial banks on the interbank bond market, there is no true transfer of risk. The situation is more akin to an exchange of risk within the banking industry, with no real offloading of risk to the capital markets.

Several innovations have been seen in the Chinese securitisation markets. These include a programme of securitisation of non-performing loans (NPLs) and trust structure asset-backed notes issued by corporates in the interbank market; this is similar to the SPT structure under the CAS framework. This is a welcome development, since corporate issuers now have access to the more liquid interbank market. In addition, for the first time in several years, collateralised loan obligation issuances by banks (which merely moved corporate loan assets from one bank balance sheet to another) have accounted for a smaller share of ABS issuances, relative to other forms of securitisation. This is also a healthy development. On the other hand, existing regulations do not permit direct foreign investment into an onshore trust holding securitised assets. In addition, existing routes for foreign investors to access domestic ABS issuances are very restrictive. Since 2016, trust structure asset-backed notes (ABNs) have allowed corporates to access the more liquid China interbank securitisation market. Assets backing the notes are entrusted to a newly established SPT under the Trust Law. Specifically, the ring-fencing protection provided by the ABN trust structure is similar to that provided under the CAS scheme, which is regulated by the PBOC and CBIRC and which until recently was accessible only to bank and non-bank financial institutions. In addition, elsewhere in the Chinese domestic securitisation market, over the 2017 to 2018 period the securitisation of NPLs, and the development of commercial mortgage-backed securities, quasi-real estate investment trust framework and supply chain finance ABS, especially in the context of the rapid development of the PRC e-commerce market, are especially noteworthy.

iii Cases and dispute settlement

In the past, the most effective legal remedy for misconduct or wrongdoing in the capital markets has always been to seek government intervention rather than private dispute resolution. During the past year, the CSRC has broken several records regarding the amounts of fines for misconduct in the secondary market (i.e., a record 1.8 billion yuan fine for a case of manipulation of a stock price was soon surpassed by a 5.5 billion yuan fine for another similar case). However, for wrongdoings before IPOs, the CSRC’s punishment is still not much more than a slap on the wrist, especially considering that delisting rules might not be implemented in the way they are written. The legal remedies available to investors are also extremely limited. Under current Chinese securities and civil procedure laws, they may not sue a company and its intermediaries for fraud, and there is no effective mechanism for class action litigation for investors to take collective action. The lack of effective deterrents and the failure to provide effective protection for investors in China are in sharp contrast to the efficient investor protection mechanism in developed economies.

iv Relevant tax and insolvency law

Plan for significant tax cut

In November 2018, the Ministry of Finance and State Administration of Taxation jointly confirmed a three-year waiver of the value added tax (VAT) and corporate income tax on interest income received by overseas institutions from investing in Chinese bonds. At the National People’s Congress in March 2019, the government lifted its 2019 budget deficit target to 2.8 per cent of GDP from last year’s 2.6 per cent, and cut business and personal taxes by 1.3 trillion renminbi, which is more than the 1.1 trillion renminbi seen in 2018’s tax cuts. The government has also announced cuts in the VAT rate for manufacturing firms from 16 to 13 per cent, and has reduced the rate for transport and construction firms from 10 to 9 per cent. The calculation is that reducing the tax burden of households will mean that they become more confident in their consumption, and that the lower operating costs of businesses will make them more attractive to invest in. The demand impact may thus lead to more organic growth and less reliance on stimulus.

Latest developments in the insolvency laws

Slowing growth has led to an increasing bankruptcy caseload for China’s court system, which is spilling over into foreign jurisdictions, including the Special Administrative Region of Hong Kong. In 2019, Shenzhen set up a bankruptcy court to handle cross-border cases, aimed at helping officials in Guangdong trace assets of bankrupt businesses in the mainland that have been transferred to Hong Kong. In 2018, according to the Supreme People’s Court, nearly 7,000 bankruptcy cases were settled, more than the 6,257 bankruptcies seen in 2017. As early as 2016, anticipating larger bankruptcy caseloads, a number of provincial-level courts and governments announced plans for measures to help bankruptcy processes move more smoothly, efficiently and transparently. Although their approaches vary, measures being taken include simplifying the proceedings in minor and uncontested cases, establishing a special bankruptcy division within the courts and setting up information-sharing mechanisms. It remains to be seen how these measures will be implemented in practice, and what their impact will be on bankruptcy and reorganisation practices in China.

In August 2017, the CBIRC (then China Banking Regulatory Commission) told the fifth session of the 12th National People’s Congress that it was preparing rules on bankruptcy risk management. The new rules were to push forward legal protection for close-out netting, the primary means of mitigating credit risks associated with OTC derivatives, according to the CBIRC, which said it would work with the International Swaps and Derivatives Association to establish a close-out netting arrangement for Chinese commercial banks. This reform, along with the introduction of a deposit insurance guarantee scheme in 2015, would provide additional clarity about investors’ place in the credit structure of Chinese banks, which has been unclear due to the implicit government guarantee. The deposit insurance system guarantees accounts with deposits of up to 500,000 renminbi. In February 2019, the CBIRC released draft rules for industry comment setting clear limits on the business areas in which bad debt managers could operate, including provincial level bad debt managers as well as the four dedicated NPL managers set up in 1999. The rules would allow the institutions to acquire, manage, operate and dispose of NPLs and engage in debt restructuring, debt-to-equity swaps and bankruptcy management, but prohibit the use of repo agreements that would allow banks to sell bad loans for future repurchase. In our opinion, given the relative clarity of the new rules for disposition of NPLs, regulators should consider allowing foreign financial firms to purchase NPLs directly from commercial banks.

v Role of exchanges, central counterparties and rating agencies

There have no significant changes to the role of the exchanges, central counterparties and rating agencies in China during the past year.

vi Other strategic considerations

On the equities side, the global index provider Morgan Stanley Capital Investment (MSCI) announced in February 2019 that it would quadruple the weighting of Chinese mainland A-shares in its global benchmarks and add 168 mid-cap and 27 small-cap securities listed on the ChiNext Index. It plans to raise its inclusion factor of yuan-traded shares from 5 to 20 per cent in three stages from May to November 2019. Upon completion, Chinese stocks will account for a 3.3 per cent weighting in the pro forma MSCI Emerging Stocks Index. FTSE Russell (the trading name of Financial Times Stock Exchange International, the British provider of stock market indices and data services) announced in September 2018 that it would add shares to its FTSE Emerging Index in three phases from June 2019 to March 2020. A-shares are projected to account for 0.57 per cent of the FTSE Global All Cap Index after the completion of the first of the three phases.

Reacting in part to the opening-up policies of the Chinese government, Bloomberg confirmed in January 2019 that Chinese renminbi-denominated government and policy bank securities would be added to the Bloomberg Barclays Global Aggregate Index starting in April 2019 and phased in over a 20-month period. The S&P Dow Jones Indices started to include eligible A-shares from September 2019, based on shares that are accessible via the northbound Stock Connect channels.

As flows increase, so too will the diversity of global investors participating in China’s capital markets. However, we notice that despite the aforementioned reforms that have led to the index inclusions, there remain practical barriers that impede attracting more global institutional investors to China’s equity capital markets. The following are all critical for the further strengthening and globalisation of China’s equity market:

  1. adopting global standards for matters such as an effective closing auction mechanism;
  2. the development of an efficient stock borrow loan mechanism for hedging;
  3. the ability to offer QFII and RQFII investors the ability to sell through multiple brokers for best execution;
  4. improvements to the block trading mechanism; and
  5. the settlement of securities on a DVP basis.

III OUTLOOK AND CONCLUSIONS

China’s capital markets, already among the largest in the world, are playing a key role as the country becomes a consumption-driven economy, seeking to break through the middle-income trap as it deals with an ageing society and the threat of slower economic growth. As external pressures keep building, China’s rise is no longer seen as an unqualified gain to the global system: in some quarters, it is perceived as a threat. China is also hampered by a economy that is slowing down from its double-digit growth performance in the 2000s, and concerns about rising debt levels of local governments and non-performing loan ratios at China’s banks, both of which may be under-reported. The worsening of China’s geopolitical and economic environment in many respects underlines the importance and urgency of continued reform in its capital markets, which if trade earnings are squeezed can serve as an alternative growth driver by mobilising domestic and foreign savings to create wealth through investment in new businesses and technologies. There is no single easy way out, but rather a constellation of interrelated actions leading to a larger goal. With so much at stake, it is anybody’s guess how this will be achieved well, mainly from the top down. Maybe it is the time to reflect on the nature of the capital market: after all, it is, first and foremost, a market.


Footnotes

1 Lei (Raymond) Shi is a partner at Tian Yuan Law Firm.

2 Wei Chen, Xiliu Chen, Chang-Tai Hsieh, and Zheng (Michael) Song, ‘A forensic examination of China’s national accounts’, 7 March 2019, Brookings Paper on Economic Activity, Spring 2019 Edition, Brookings Institution. https://www.brookings.edu/bpea-articles/a-forensic-examination-of-chinas-national-accounts/.