The International Capital Markets Review: China


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. According to the World Bank's latest statistics, China (even excluding Hong Kong) has become the world's second-largest stock market, tailing only the United States.2 For the first half of 2020, despite covid-19 wreaking havoc on the world's economy, Refinitiv has reported that Chinese companies raised US$32.1 billion in equity capital markets, accounting for a record 49.8 per cent of worldwide equity offerings.3 Furthermore, China's US$13.5 trillion domestic bond market has already been recognised as the world's second-largest.4 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 People's Republic of China (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 (the 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, the most notable of which 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) in China's domestic capital market: for instance, foreign issuers have always been barred from offering shares in China and although the reform and opening up in recent years have lifted many restrictions, many others still remain; 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 China 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 circumventing 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 toolkits 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 opening 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 this 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.

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 2019 to 6.1 per cent for the full year, the lowest growth rate since 1990. China therefore already faced the prospect of a macroeconomic challenge in 2019 and beyond and this has subsequently been compounded by the combined impact of its trade dispute with the United States, weakening domestic demand, high levels of off-balance sheet borrowing by local governments and now the unprecedented disruptive challenge of covid-19. As a response, the Chinese central government has even scrapped its GDP growth target for 2020, the first time since records began, implying a step back from the ambitious policy target of doubling 2010's GDP by 2020. The build-up of economic and geopolitical pressure has pushed the acceleration of change to a new level 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, the wave of policy changes to further reform and open up the capital markets has been greatly accelerated. The Star Market of SSE, which is meant to fund and support companies in innovative industries, has been brought from the original concept to an open business at world-class speed. In November 2019, the State Council blueprinted a series of removal of restrictions on foreign investment to financial institutions, including the restrictions on business scope for foreign-invested banks, securities companies and fund management companies, and the ownership caps on securities companies, securities investment fund management companies, futures companies and life insurance companies. In September 2019, China issued Type A licences to Deutsche Bank and BNP Paribas, allowing them to act as lead underwriters for corporate debt issued by non-financial institutions. In May 2020, the People's Bank of China (PBOC) and the State Administration of Foreign Exchange (SAFE) jointly issued a rule to remove the long-standing quota limits for qualified foreign institutional investors (QFIIs) and yuan-denominated renminbi qualified foreign institutional investors (RQFIIs). 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. Furthermore, it should be noted that since the reforms and opening up are nearly all government-led and centralised rather than market-driven, some, or perhaps many, of the top-down initiatives may face turbulent times ahead.

i Developments affecting debt and equity offerings

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. As at 22 July 2020, the one-year anniversary of the Star Market, there had been 140 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 United States rather than at home. Coming as 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. The Star Market is expected to create 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. These features are expected 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 exchangesThe Star Market
Listing systemApproval-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 factorsRegistration-based: scales back regulators' scope in reviewing applications while putting greater onus on companies to disclose material information
IPO valuationUnofficial 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 aggressiveNo such cap
Profitability requirementsRequired for all companiesRequired only for companies with a market capitalisation of under 1.5 billion yuan
Corporate structureMust be domestic companies; strict same share, same rightRed-chip structure allowed; dual-class voting acceptable
Investor criteriaOpen to institutional investors and retail investorsOpen 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 limitTrading band of 44 per cent on debut, with 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 participationNot applicableSponsors must purchase up to 5 per cent of the shares on offer with their own capital and stay invested for at least two years

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.

One year after its debut, with a total market capitalisation surpassing 1.7 trillion yuan, and its gains doubling those of the Nasdaq 100 index thus far this year (as evidenced by the newly launched Star Market 50 Component Index (the Star 50)) and even burning bright in covid-19 gloom, the Star Market has scored highly in terms of its first strategic goal. Despite the fact that more companies have been failing their pre-IPO investors by dropping below their offering prices, the easing of a number of persistent issues with the listing criteria inherited from the old regime should ensure that a modest success is not an exaggerated prospect for the Star Market's second goal. Nonetheless, although the market may look promising, it still has its detractors and faces a number of challenges, including the following.

First, volatility: on the first day of trading, shares of the 25 companies all surged tremendously, from already high offering prices to end the opening day having made sizzling gains ranging from 84 per cent to an eye-watering 400 per cent – amounting to average gains of 140 per cent by the time the market closed. However, according to the latest trading data, all the 172 Star Market listed companies have seen their stock prices peak and of these 159 are trading at 20 per cent lower than their peak price (among these latter companies, 34 are even trading 50 per cent lower). Retail participation has been relatively high, leading to much speculative activity, which 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 particular 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 engendered caution. Although a lot of measures have been taken with a view to stabilising the Star Market, whether they will work according to 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 rejected or cancelled registration applications of three companies after review and approvals by the SSE, and many companies have been told to postpone applications or registrations, with the supervision bodies seeking to discourage 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 QFIIs and RQFIIs, and of the more-than 300 foreign institutions with QFII licences, little more than a handful have subscribed to the IPOs of the firms listed on the Star Market. The reason for this could be the tiny size of the current Star Market, or the wait-and-see attitude of cautious and sophisticated institutional investors (wary that the high valuation of Star-listed firms usually means high volatility) may also have deterred cautious foreign investors that favour value-investing strategies, analysts have said.

Much remains to be seen but probably not until the market expands and trading fever has cooled down. The fact that most applicants (with the exception of a few high flyers – including Ant Group, which recently passed the SSE review) are not high-profile market leaders raises doubts as to whether the Star Market may ultimately prove to be another ChiNext. Broadly speaking, to ease such doubts, it is expected that the regulators will 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.

Elimination of foreign ownership restrictions on certain financial institutions

Following the Chinese government's previously stated intention to implement a long-awaited easing of foreign investment restrictions on financial firms, and accelerated by the 'phase one' trade deal reached between China and the United States in November 2019, the State Council has responded to opinion and removed a series of restrictions on foreign investment by financial institutions, including restrictions on the business scope of foreign-invested banks, securities companies and fund management companies, and ownership caps on securities companies, securities investment fund management companies, futures companies and life insurance companies. In June 2020, the National Reform and Development Commission issued the latest foreign investment negative list and the ownership caps for securities companies, securities investment fund management companies, futures companies and life insurance companies have been eliminated.

Foreign heavyweight market participants have since flocked into the unrestricted sectors, with investment banks such as HSBC, UBS AG, JPMorgan, Credit Suisse and Nomura already taking majority control of their previous Chinese joint ventures, and Allianz having been approved to set up the first wholly foreign-owned insurance unit. Countries around the world establish ownership limits on companies and industries representing strategic or national interests; however, these limitations 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. Furthermore, while welcome, all the policy changes to foster a greater degree of openness could have been implemented more rapidly than they actually have been.

Improvement in trading suspensions

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 dropped dramatically to single digits in the past couple of years. The seeming change in trading behaviour is by no means spontaneous: the Chinese authorities have been making significant improvements in this area in recent 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 those 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 for 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, is commendable.

Further toughening of 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, which range as high as 10 per cent and above, and suggests that some substandard companies that should not be listed nonetheless remain on Chinese exchanges. 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 rule5 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 relisting.

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, the PBOC and the SAFE launched a new round of reform of the QFII and RQFII regime. Key amendments introduced under the new policies 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 SAFE first announced the removal of investment quota limits for QFIIs and RQFIIs completely. This was followed by new legislation jointly introduced by the PBOC and the SAFE in May 2020 to officially scrap the long-standing quota limits. Since then, QFIIs and RQFIIs no longer need to apply for investment quotas from the SAFE. Instead, 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 have also been eliminated.

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 the quotas. According to the market data before removal of the quota limits, neither of the QFII or RQFII quotas had been fully applied. 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 Shanghai-London Stock Connect

In addition 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 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 the Hong Kong Stock Exchange.

Although bearing the same badge of Stock Connect, Shanghai-London Stock Connect works fundamentally differently 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 Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect are shares listed on the counterpart's market, whereas the trading targets under Shanghai-London Stock Connect are depositary receipts listed on the local stock exchange.

However, the launch of Shanghai-London Stock Connect is recognised as being more 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, in part because of 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 the 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 2019 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 China's 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

At the National People's Congress in May 2020, the government lifted its 2020 budget deficit target to 3.6 per cent of GDP from last year's 2.8 per cent and announced a further tax cut of 500 billion yuan in 2020. The government has also announced cuts in the rate of value added tax 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 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 the 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 because of the implicit government guarantee. The deposit insurance system guarantees accounts with deposits of up to 500,000 yuan. In July 2019, the CBIRC issue a new rule setting clear limits on the business areas in which bad debt managers could operate, including both provincial level bad debt managers and 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. Given the relative clarity of the new rules for disposition of NPLs, we believe 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. In November 2019, MSCI completed the final phase of the weight increase of yuan-traded shares: it increased the inclusion factor of all China A Large Cap shares from 15 per cent to 20 per cent in the MSCI Indexes, notably in the MSCI Emerging Markets Index and the MSCI ACWI Index, coinciding with the recent index review, effective as of 27 November 2019 and it also added China A Mid Cap shares to the MSCI Indexes, including eligible ChiNext shares, with a 20 per cent inclusion factor. In June 2020, FTSE Russell (the trading name of Financial Times Stock Exchange International, the British provider of stock market indices and data services) announced it had successfully completed the first phase of inclusion of China A Shares into its global equity indexes following the September 2018 reclassification of China A Shares to Secondary Emerging market status. The first phase, which was implemented across four separate tranches beginning in June 2019, added 25 per cent of the investable market cap of 1,051 small, medium, and large cap China A Shares to the FTSE Emerging All Cap Index. China A Shares now constitute approximately 6 per cent of the FTSE Emerging Index.

Reacting in part to the opening-up policies of the Chinese government, on 1 April 2019, Bloomberg added Chinese yuan-denominated government and policy bank securities to the Bloomberg Barclays Global Aggregate Index. 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, 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 borrowing and lending 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 delivery versus payment basis.

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. Time and tide wait for no man. More people at different levels in China are finally, if not belatedly, reaching a consensus that the market-oriented reform of this sophisticated market can no longer afford to be hampered by established interest groups or inertia.



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

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