CAPITAL FREEDOM IN CHINA AS VIEWED FROM THE EVOLUTION OF THE STOCK MARKET Zhiwu chen Since reforms started in 1978. China has made commendable progress in achieving capital freedom and individual liberty. Prior to 1978, private enterprises with more than eight employees were pro- hibited and there were no capital markets. Private entrepreneurs were labeled"capitalist tails, "and political movements were launched requently to "cut the capitalist tails. For several decades, Chinese citizens could only obtain employment and economic means from government organizations and state-owned enterprises, which strictly limited individual liberty. Today there are more than 10 million pri- vately owned enterprises, making up more than 80 percent of each year's employment growth. As a result of less regulation and more room for entrepreneurship, it is relatively easy to register and start a business. Public equity offering opportunities and bank financing are also increasingly available to private firms as well. Chinese, young and old, can choose among jobs provided by government organizations SOEs, private businesses, and foreign-owned firms. As al free. dom has increased, the rise of the individual and liberty is one of the highlights achieved in Chinas development over the past 35 years There are, however, many challenges ahead to further increases in capital freedom in China. These challenges are inevitably due to ato Journal, Vol. 33, No. 3(Fall 2013). Copyright Cato Institute. All rights Chen Zhiwu is Professor of finance at the Yale school of ma He thanks William Goetzmann for the many conversations on this topic
587 Capital Freedom in China as Viewed from the Evolution of the Stock Market Zhiwu Chen Since reforms started in 1978, China has made commendable progress in achieving capital freedom and individual liberty. Prior to 1978, private enterprises with more than eight employees were prohibited and there were no capital markets. Private entrepreneurs were labeled “capitalist tails,” and political movements were launched frequently to “cut the capitalist tails.” For several decades, Chinese citizens could only obtain employment and economic means from government organizations and state-owned enterprises, which strictly limited individual liberty. Today there are more than 10 million privately owned enterprises, making up more than 80 percent of each year’s employment growth. As a result of less regulation and more room for entrepreneurship, it is relatively easy to register and start a business. Public equity offering opportunities and bank financing are also increasingly available to private firms as well. Chinese, young and old, can choose among jobs provided by government organizations, SOEs, private businesses, and foreign-owned firms. As capital freedom has increased, the rise of the individual and liberty is one of the highlights achieved in China’s development over the past 35 years. There are, however, many challenges ahead to further increases in capital freedom in China. These challenges are inevitably due to Cato Journal, Vol. 33, No. 3 (Fall 2013). Copyright © Cato Institute. All rights reserved. Chen Zhiwu is Professor of Finance at the Yale School of Management. He thanks William Goetzmann for the many conversations on this topic. 44795_Ch19_Chen:19016_Cato 8/29/13 11:37 AM Page 587
CATO JOURNAL Chinas gradualist reform approach in which pragmatic economic reforms have been allowed and adopted without correcting the philo sophical foundation of the country's political, economic, and legal system SOEs, government, and Marxist ideology still dominate the economy,politics, and business--although market forces and private ownership are a significant part of the Chinese society and still on the rise. In particular, political power is not formally checked or balanced and neither is the monopoly position of SOEs, which has allowed government agencies and SOEs to reenergize and expand their power to cut into capital freedom as they desire. There has not been a formal debate or reform to define and limit the scope of govern ment. Taxation has been increasing at more than twice the speed of GDP growth. Thus, unless and until political reforms take place and functioning check-and-balance institutions are put in place formally SOEs and government power present immediate threats to the pre- cious but still limited degree of capital freedom and individual liberty in China In this article, I use China's capital markets, more specifically its stock market, to illustrate why the lack of a formal rejection of Marxist economics, as well as the lack of political reforms, has inter- nalized forces and contradictions in the Chinese society that have the potential to reverse the many positive achievements of the last 35 years. At a minimum, such forces will continue to make it difficult for the rule of law and for justice and equity to progress further oday China has a sizable capital market, with more than 2, 400 listed companies on the two stock exchanges with a total market cap- italization of more than RMB 21 trillion(almost 50 percent of Chinas gDP). More than 300 securities and trust companies are licensed to provide investment banking and stock brokerage services through more than 2, 500 branch offices in cities large and small This extensive network of brokers has attracted more than 200 mil lion stock and mutual fund accounts. China today has among the most robust securities market infrastructures in the world, when measured in terms of both trading capacity afforded by the electronic systems and potential investor reach facilitated by the vast physical distribution channels. The physical infrastructure and distributi IThe statistics cited are all as of mid- vear 2012 and come from the Chinese SecuritiesRegulatoryCommission(www.csre.gov.cn) 58S
588 Cato Journal China’s gradualist reform approach in which pragmatic economic reforms have been allowed and adopted without correcting the philosophical foundation of the country’s political, economic, and legal system. SOEs, government, and Marxist ideology still dominate the economy, politics, and business—although market forces and private ownership are a significant part of the Chinese society and still on the rise. In particular, political power is not formally checked or balanced and neither is the monopoly position of SOEs, which has allowed government agencies and SOEs to reenergize and expand their power to cut into capital freedom as they desire. There has not been a formal debate or reform to define and limit the scope of government. Taxation has been increasing at more than twice the speed of GDP growth. Thus, unless and until political reforms take place and functioning check-and-balance institutions are put in place formally, SOEs and government power present immediate threats to the precious but still limited degree of capital freedom and individual liberty in China. In this article, I use China’s capital markets, more specifically its stock market, to illustrate why the lack of a formal rejection of Marxist economics, as well as the lack of political reforms, has internalized forces and contradictions in the Chinese society that have the potential to reverse the many positive achievements of the last 35 years. At a minimum, such forces will continue to make it difficult for the rule of law and for justice and equity to progress further. Today China has a sizable capital market, with more than 2,400 listed companies on the two stock exchanges with a total market capitalization of more than RMB 21 trillion (almost 50 percent of China’s GDP).1 More than 300 securities and trust companies are licensed to provide investment banking and stock brokerage services through more than 2,500 branch offices in cities large and small. This extensive network of brokers has attracted more than 200 million stock and mutual fund accounts. China today has among the most robust securities market infrastructures in the world, when measured in terms of both trading capacity afforded by the electronic systems and potential investor reach facilitated by the vast physical distribution channels. The physical infrastructure and distribution 1 The statistics cited are all as of mid-year 2012 and come from the Chinese Securities Regulatory Commission (www.csrc.gov.cn). 44795_Ch19_Chen:19016_Cato 8/29/13 11:37 AM Page 588
CAPITAL FREEDOM IN CHINA network present the Chinese economy with a potentially great financing capacity The gap between stock market potential and reality is, however, still quite wide. While Chinas physical infrastructure for capital mar kets is impressive by many measures, the institutional infrastructure necessary for investors to be willing to part with their money is largely issing or not functioning in its intended way. As a result, recent efforts by the government to push up stock prices have led to contin- uous disappointment. Investors are not rushing back to buy stocks and the stock market is not showing enthusiasm Chinas stock market development started during the 1860s, was terrupted several times by wars and ideology, and reemerged in the late 1980s. In this article, I compare the stock market under the cur- rent regime with its past under the Qing dynasty and during the Republican years before 1949. Discussion centers around several key questions: (1)In the absence of necessary impersonal legal and regu- latory institutions, what arrangements did China come up with to induce public investors to join stock trading?(2) What was done to overcome the confidence and trust barriers? (3)With the government being the largest shareholder in most publicly listed companies today, how does that impede legal development and limit capital freedom? Answering these questions will help us understand the cultural roots of the Chinese government's large role in the economy, in addition to the Marxist political economy roots. What we will see is a constant struggle between the traditional Chinese preferences for informal or relationship-based rules of business transactions and the stock mar- kets dependence on formal structures of contracting and gover That struggle in the capital market mirrors closely the struggle by the arger Chinese society with the process of modernization The Origin of China's Stock market: 1860s to 1911 China is known to have invented paper money during the Song dynasty, 960-1279(see von Glahn 2005). However, China did not venture into innovations in securities trading until the late 19th cen- tury. The move to adopt joint-stock companies with limited liability and initiate a stock market was largely a consequence of the"Self- Strengthening Movement" following the defeat to Britain and revealed that China was far behind in military technology and taly France in the Opium Wars(1839-42 and 1858-60). The wa 589
589 Capital Freedom in China network present the Chinese economy with a potentially great financing capacity. The gap between stock market potential and reality is, however, still quite wide. While China’s physical infrastructure for capital markets is impressive by many measures, the institutional infrastructure necessary for investors to be willing to part with their money is largely missing or not functioning in its intended way. As a result, recent efforts by the government to push up stock prices have led to continuous disappointment. Investors are not rushing back to buy stocks, and the stock market is not showing enthusiasm. China’s stock market development started during the 1860s, was interrupted several times by wars and ideology, and reemerged in the late 1980s. In this article, I compare the stock market under the current regime with its past under the Qing dynasty and during the Republican years before 1949. Discussion centers around several key questions: (1) In the absence of necessary impersonal legal and regulatory institutions, what arrangements did China come up with to induce public investors to join stock trading? (2) What was done to overcome the confidence and trust barriers? (3) With the government being the largest shareholder in most publicly listed companies today, how does that impede legal development and limit capital freedom? Answering these questions will help us understand the cultural roots of the Chinese government’s large role in the economy, in addition to the Marxist political economy roots. What we will see is a constant struggle between the traditional Chinese preferences for informal or relationship-based rules of business transactions and the stock market’s dependence on formal structures of contracting and governance. That struggle in the capital market mirrors closely the struggle by the larger Chinese society with the process of modernization. The Origin of China’s Stock Market: 1860s to 1911 China is known to have invented paper money during the Song dynasty, 960–1279 (see von Glahn 2005). However, China did not venture into innovations in securities trading until the late 19th century. The move to adopt joint-stock companies with limited liability and initiate a stock market was largely a consequence of the “SelfStrengthening Movement” following the defeat to Britain and France in the Opium Wars (1839–42 and 1858–60). The wars revealed that China was far behind in military technology and that in 44795_Ch19_Chen:19016_Cato 8/29/13 11:37 AM Page 589
CATO JOURNAL order to win over the West and regain national pride, China must catch up with Western military and industrial technologies feuerwerkEr 1958). However, adopting such technologies and developing the necessary manufacturing infrastructure require large sums of capital. Yet, at the time, the Qing government was financially constrained. The state would not have the needed resources to take on the projects directly. The financing challenge was therefore daunting As one of the leading voices at the time, Xue Fucheng (1838-94) The essence of the joint-stock corporation is to make a nation rich and powerful... If a country does not pursue joint-stock companies, its industry cannot prosper nor can Where foreign firms are present, there are corporations raising capital from hundreds or even thou sands of shareholders. Backed by plenty of financial resources, no wonder they are so powerful and hard to com- pete with.... This is truly an unprecedented historical hange in business [Li 2002: 271] In 1868, Yung Wing, the first Chinese student to graduate from an American university(Yale, 1854) proposed to Zeng Guofan, the gov ernmor-general of Liangjiang, to adopt the joint-stock corporate form and start a Chinese-owned navigation company. That idea was well received by the Qing mandarins. China was thus on its way to exper- iment with the modern corporation and make its shares tradable. But how could this be done? The modern corporation has three defining characters. First, it is a legal person, with the same ability to do business and engage in con- tracting as a real person. Second, it can issue tradable shares to any number of investors. Third, the investors face limited liability(i.e they could lose no more than their initial investment). At the heart of the modern corporation is the separation between ownership and control. Thousands of outside investors(owners)entrust their capital with the management who has actual and full control over the use of shareholder assets. To provide outside shareholders with the needed confidence, this separation has to be supported by a corresponding set of legal institutions, including investor-friendly substantive laws, an independent judiciary, and a reliable enforcement infrastructure (Black 2001, Coffee 2001). In addition, as what is exchanged between
590 Cato Journal order to win over the West and regain national pride, China must catch up with Western military and industrial technologies (Feuerwerker 1958). However, adopting such technologies and developing the necessary manufacturing infrastructure required large sums of capital. Yet, at the time, the Qing government was financially constrained. The state would not have the needed resources to take on the projects directly. The financing challenge was therefore daunting. As one of the leading voices at the time, Xue Fucheng (1838–94) commented, The essence of the joint-stock corporation is to make a nation rich and powerful. . . . If a country does not pursue joint-stock companies, its industry cannot prosper nor can its commerce. . . . Where foreign firms are present, there are corporations raising capital from hundreds or even thousands of shareholders. Backed by plenty of financial resources, no wonder they are so powerful and hard to compete with. . . . This is truly an unprecedented historical change in business [Li 2002: 271]. In 1868, Yung Wing, the first Chinese student to graduate from an American university (Yale, 1854) proposed to Zeng Guofan, the governor-general of Liangjiang, to adopt the joint-stock corporate form and start a Chinese-owned navigation company. That idea was well received by the Qing mandarins. China was thus on its way to experiment with the modern corporation and make its shares tradable. But how could this be done? The modern corporation has three defining characters. First, it is a legal person, with the same ability to do business and engage in contracting as a real person. Second, it can issue tradable shares to any number of investors. Third, the investors face limited liability (i.e., they could lose no more than their initial investment). At the heart of the modern corporation is the separation between ownership and control. Thousands of outside investors (owners) entrust their capital with the management who has actual and full control over the use of shareholder assets. To provide outside shareholders with the needed confidence, this separation has to be supported by a corresponding set of legal institutions, including investor-friendly substantive laws, an independent judiciary, and a reliable enforcement infrastructure (Black 2001, Coffee 2001). In addition, as what is exchanged between 44795_Ch19_Chen:19016_Cato 8/29/13 11:37 AM Page 590
CAPITAL FREEDOM IN CHINA the outside shareholders and the corporation is a financial contract (instead of tangible physical goods), there need to be informational institutions, such as a free press and other mass media, to facilitate he uninhibited and fast flow of information. Substantial and truthful information about the stock-issuing corporation is essential for the ccurate pricing of its shares and for the keeping of investors'trust Business organizations and economic transactions in China had relied on personal relationships for centuries. Relationships served as a signaling and commitment framework, or as informal bedrocks for trust and a basis for enforcement of contracts(implicit or explicit) Partnerships of unlimited liability were the typical form of joint own- ership, with partners from a single family, a lineage, a small number of lineages, or the same locality, usually not going beyond townsht boundaries. before the railroad network was built in the late 19t century and afterwards, the lack of mass transportation means pre- ented for centuries the inland local economies from expanding across regions, generating no pressure for business organizational changes. Capital was free but constrained to one's locality or circles of friends and kinship networks. The waterways in southeast China and along the coast could have pressured the unlimited-liability part nership structure and called for more impersonal forms of business organization. However, the emperors'orders forbidding overseas trading since the 13th century and the general anti-commercial Chinese culture stifled the possibility of inter-regional market expat sion afforded by the waterways, which served to limit the develop ment of formal institutions that are necessary for capital to b impers According to Jensen and Meckling(1976) and Easterbrook and Fischel (1989), the modem corporation is simply a"nexus of con- tracts"or a legal creation. For this"nexus of contracts"to work, there have to be supportive laws and impartial enforcement institutions with enough force. But, as of the late 19th century, China did not have the necessary legal or informational institutions for arms-length or impersonal financial contracting, let alone an institutional infra structure for public trading in financial contracts. In Chinas tradi- tion, the legal system is never separated from, or independent of, the administrative system. In addition, Chinas tradition put its emphasis on administrative and criminal sanctions. with a lack of formal devel- opment in contract, civil liability and procedural laws. Rules and ractices did not develop to enforce impersonal contracts o
591 Capital Freedom in China the outside shareholders and the corporation is a financial contract (instead of tangible physical goods), there need to be informational institutions, such as a free press and other mass media, to facilitate the uninhibited and fast flow of information. Substantial and truthful information about the stock-issuing corporation is essential for the accurate pricing of its shares and for the keeping of investors’ trust. Business organizations and economic transactions in China had relied on personal relationships for centuries. Relationships served as a signaling and commitment framework, or as informal bedrocks for trust and a basis for enforcement of contracts (implicit or explicit). Partnerships of unlimited liability were the typical form of joint ownership, with partners from a single family, a lineage, a small number of lineages, or the same locality, usually not going beyond township boundaries. Before the railroad network was built in the late 19th century and afterwards, the lack of mass transportation means prevented for centuries the inland local economies from expanding across regions, generating no pressure for business organizational changes. Capital was free but constrained to one’s locality or circles of friends and kinship networks. The waterways in southeast China and along the coast could have pressured the unlimited-liability partnership structure and called for more impersonal forms of business organization. However, the emperors’ orders forbidding overseas trading since the 13th century and the general anti-commercial Chinese culture stifled the possibility of inter-regional market expansion afforded by the waterways, which served to limit the development of formal institutions that are necessary for capital to be impersonal. According to Jensen and Meckling (1976) and Easterbrook and Fischel (1989), the modern corporation is simply a “nexus of contracts” or a legal creation. For this “nexus of contracts” to work, there have to be supportive laws and impartial enforcement institutions with enough force. But, as of the late 19th century, China did not have the necessary legal or informational institutions for arm’s-length or impersonal financial contracting, let alone an institutional infrastructure for public trading in financial contracts. In China’s tradition, the legal system is never separated from, or independent of, the administrative system. In addition, China’s tradition put its emphasis on administrative and criminal sanctions, with a lack of formal development in contract, civil liability and procedural laws. Rules and practices did not develop to enforce impersonal contracts or 44795_Ch19_Chen:19016_Cato 8/29/13 11:37 AM Page 591