Located in Ningxia Province, one of the poorest areas of China, Guangxia was listed on the SZse in 1994 as a manufacturer of floppy disks and related products. After reporting poor and deteriorating performance in its original line of business and in all other diversify ing new lines of businesses for the first five years, the company released unprecedented high EPS (earnings per share of the stock) at the end of 1999, and claimed that they had mastered the techniques of CO2 fluid extraction and signed a lucrative, multiple year sales contract with a German company. Subsequently, the companys stock price shot up from RMB 14 to RMB 76 in one year and realized an annual return of 440%, highest among all listed companies in either stock exchange in 2000. After the article in Caring Magazine raising doubts about the star'company was published, CSrC launched an investigation and found that the reported earnings along with many sales records and contracts including the one with the german company, were fabricated, and the company was in fact losing money. The company's top executives were criminally charged and its auditors lost their licenses Shareholders lawsuits were eventually processed for the first time by courts around the count after much delay and a change of procedure for handling such cases was approved by the Supreme Court. The most damaging piece of evidence from this case is that, unlike Enron, Guangxia's managers did not use any sophisticated accounting and finance maneuvers to mask their losses (even by China's standards); the collective failure of internal and external monitors and regulators indicates that either these 'gatekeepers"lack basic professional skills, or proper incentives to do their job, or both The above example also reveals that the inefficiencies in the Chinese stock markets can be attributed to poor and ineffective regulation. The current process of listing companies fosters both a problem of adverse selection among firms seeking an initial public offering(IPO), and a moral hazard problem among listed firms. First, even though there has never been any explicit regulation or law against the listing of non-state owned firms, the going public process strongly favors former SOEs with connections with government officials. For example, each candidate firm must obtain listing quota/permission, disclose financial and accounting information, and is subject to a lengthy evaluation process; the whole process is inefficient due to bureaucracy, fraudulent disclosure, and lack of independent auditing. As a result, most of the listed firms are indeed former SOEs(more evidence to follow in Section IV. 4 ).Second, once listed, managers in firms with severe agency problems do not have an incentive to manage assets to grow, but rather to rely on the external capital market to raise funds(mainly through mergers and acquisitions, and seasoned offerings of
26 Located in Ningxia Province, one of the poorest areas of China, Guangxia was listed on the SZSE in 1994 as a manufacturer of floppy disks and related products. After reporting poor and deteriorating performance in its original line of business and in all other diversifying new lines of businesses for the first five years, the company released unprecedented high EPS (earnings per share of the stock) at the end of 1999, and claimed that they had mastered the techniques of CO2 fluid extraction and signed a lucrative, multiple year sales contract with a German company. Subsequently, the company’s stock price shot up from RMB 14 to RMB 76 in one year and realized an annual return of 440%, highest among all listed companies in either stock exchange in 2000. After the article in Caijing Magazine raising doubts about the ‘star’ company was published, CSRC launched an investigation and found that the reported earnings along with many sales records and contracts, including the one with the German company, were fabricated, and the company was in fact losing money. The company’s top executives were criminally charged and its auditors lost their licenses. Shareholders’ lawsuits were eventually processed for the first time by courts around the country, after much delay and a change of procedure for handling such cases was approved by the Supreme Court. The most damaging piece of evidence from this case is that, unlike Enron, Guangxia’s managers did not use any sophisticated accounting and finance maneuvers to mask their losses (even by China’s standards); the collective failure of internal and external monitors and regulators indicates that either these ‘gatekeepers” lack basic professional skills, or proper incentives to do their job, or both. The above example also reveals that the inefficiencies in the Chinese stock markets can be attributed to poor and ineffective regulation. The current process of listing companies fosters both a problem of adverse selection among firms seeking an initial public offering (IPO), and a moral hazard problem among listed firms. First, even though there has never been any explicit regulation or law against the listing of non-state owned firms, the going public process strongly favors former SOEs with connections with government officials. For example, each candidate firm must obtain listing quota/permission, disclose financial and accounting information, and is subject to a lengthy evaluation process; the whole process is inefficient due to bureaucracy, fraudulent disclosure, and lack of independent auditing. As a result, most of the listed firms are indeed former SOEs (more evidence to follow in Section IV.4). Second, once listed, managers in firms with severe agency problems do not have an incentive to manage assets to grow, but rather to rely on the external capital market to raise funds (mainly through mergers and acquisitions, and seasoned offerings of
securities)to pursue private benefits. Due to data limitations, we again present case studies to illustratetheaboveproblems(formoredetailsseehttp://finance.sina.com.cn First, the IPO experience of Hongguang Industrial Co, Ltd. with its headquarters in Chengdu(capital city of Sichuan Province), illustrates the inefficiency of the listing process. With an IPO price of RMB 6.05(on the SHSE), Hongguang raised RMB 410 million in June 1996. In its prospectus, the company claimed that it had made profits in each of the three years prior to the IPO year, its financial statements were audited by a Chinese CPa firm, and its forecasted 1997 net income(RMB 71 million)and EPS (31 fen; equivalent to 31 cents)were in line with the disclosed figures for pre-IPO years. Within one year of its public listing, the company announced that it incurred a net loss of RMB 198 million and ePs of negative 86 fen. A CSrC investigation revealed that in order to meet the criteria for an IPO, the company had not only forged its profit records for all three years prior to the IPO year, but also failed to disclose that its major production facility was so outdated that it could not maintain normal operations the company used more than 80% of its IPO proceeds to pay off its debt, in contrast to the stated purposes in the prospectus, and it actually under reported the amount of losses in 1997 by 15%. How did such a company obtain the precious IPO quota in 1996? The municipal government of Chengdu championed the companys IPO application by stating that". this high-tech enterprise will become one of the 100 modern nterprises of China.. "In reality, the listing of this financially distressed former SOE shifted the burden from the government to the investing public Second, following the scandal of Guangxia described above, Sanjiu Medical Pharmaceutical Co, Ltd(hereafter the Company ), another SZse listed company, was the target of a CSRC investigation in 2001. The Company belongs to the Sanjiu Group(hereafter the Group), the largest domestic pharmaceutical group in China, founded by Mr. Xinxian Zhao in 1985. Since then, Mr. Zhao pursued an aggressive expansion policy through acquisitions financed by bank debt, but many acquired companies performed poorly and the Group's high leverage ratio significantly constrained its ability to receive more loans and further expand The solution was the IPO/listing of the Sanjiu Company in 1999(a major subsidiary of the Group), which raised RMB 1.69 billion (around US$200 million). During the first year after its IPO, the Company paid RMB 360 million to its parent(the Group)to cover acquisitions of six companies, and this practice continued in the following two years. Essentially, the listed Company became the 'cash cow for the struggling yet still expanding parent. By May 2001, the Group and associated companies had tunneled' more than RMB 2.5 billion from the Company, which accounted for 96% of the Company's net assets, yet the
27 securities) to pursue private benefits. Due to data limitations, we again present case studies to illustrate the above problems (for more details, see http://finance.sina.com.cn). First, the IPO experience of Hongguang Industrial Co., Ltd., with its headquarters in Chengdu (capital city of Sichuan Province), illustrates the inefficiency of the listing process. With an IPO price of RMB 6.05 (on the SHSE), Hongguang raised RMB 410 million in June 1996. In its prospectus, the company claimed that it had made profits in each of the three years prior to the IPO year, its financial statements were audited by a Chinese CPA firm, and its forecasted 1997 net income (RMB 71 million) and EPS (31 fen; equivalent to 31 cents) were in line with the disclosed figures for pre-IPO years. Within one year of its public listing, the company announced that it incurred a net loss of RMB 198 million and EPS of negative 86 fen. A CSRC investigation revealed that in order to meet the criteria for an IPO, the company had not only forged its profit records for all three years prior to the IPO year, but also failed to disclose that its major production facility was so outdated that it could not maintain normal operations. The company used more than 80% of its IPO proceeds to pay off its debt, in contrast to the stated purposes in the prospectus, and it actually under reported the amount of losses in 1997 by 15%. How did such a company obtain the precious IPO quota in 1996? The municipal government of Chengdu championed the company’s IPO application by stating that “… this high-tech enterprise will become one of the 100 modern enterprises of China…” In reality, the listing of this financially distressed former SOE shifted the burden from the government to the investing public. Second, following the scandal of Guangxia described above, Sanjiu Medical & Pharmaceutical Co., Ltd (hereafter the Company), another SZSE listed company, was the target of a CSRC investigation in 2001. The Company belongs to the Sanjiu Group (hereafter the Group), the largest domestic pharmaceutical group in China, founded by Mr. Xinxian Zhao in 1985. Since then, Mr. Zhao pursued an aggressive expansion policy through acquisitions financed by bank debt, but many acquired companies performed poorly and the Group’s high leverage ratio significantly constrained its ability to receive more loans and further expand. The solution was the IPO/listing of the Sanjiu Company in 1999 (a major subsidiary of the Group), which raised RMB 1.69 billion (around US$200 million). During the first year after its IPO, the Company paid RMB 360 million to its parent (the Group) to cover acquisitions of six companies, and this practice continued in the following two years. Essentially, the listed Company became the ‘cash cow’ for the struggling yet still expanding parent. By May 2001, the Group and associated companies had ‘tunneled’ more than RMB 2.5 billion from the Company, which accounted for 96% of the Company’s net assets, yet the
Group was still in financial trouble with high debt ratios and low return on assets. The joint financial status of the Group and Company triggered lawsuits by banks, forcing repayment of loans immediately. How can such ostensible expropriation of the Company's shareholders' wealth take place? Because the Group, through direct and indirect ownership, owns 73%of the Company's stock, while Mr. Zhao was the President of the group and Chairman of the board of Directors of the Company In Section IV6 below, we propose specific measures that can be implemented to improve the efficiency of the stock markets as well as the corporate governance of listed firms Insert fi igure Finally, Figure 4 compares the performance of major stock exchanges around the world, with performance measured by the buy-and-hold return in the period 1992-2003(gross return at the end of 2003 with $1 invested in each of the valued-weighted stock indexes in the beginning of 1992). The performance of the value-weighted SHSE index(the calculation for the SZSE is very similar) is only better than that of the Nikkei Index, whose poor performance was caused by the prolonged recession of the Japanese economy in the 1990s, while underperforming the indexes of the S&P 500, NASDAQ, and the Hang Seng. Since China's economy was growing at much higher rates than the U.S. during the period(over 11% per China vs 4 5% for the u.s. in ppp terms), the fact that the ShSe index underperformed the s&p index by 120% suggests that listed firms are among the low-quality firms in China IV 2 Overview of Bond markets Table 5-B provides information on the growth of China's bond markets from 1998 to 2002 The government bond market did not grow as fast as the stock market, but did have an annual bonds reached RMB 1,933. 61 billion(or USS233 billion). The second largest component of the o growth rate of 11.7% during the time period in terms of newly issued bonds, while total outstanding bond market is called"policy financial bonds"(total outstanding amount RMB 1, 005 billion at the end of 2002). These bonds are issued by "policy banks, " which belong to the Treasury Department and the proceeds of bond issuance are invested in certain industries(e.g, infrastructure, similar to municipal bonds in the U.S. ). Compared to government-issued bonds, the size of the corporate bond market is minuscule: In terms of the amount of outstanding bonds at the end of 2001 bond market is less than one-fifteenth of the size of the government bond market nsert Table 5-b and Figures 5-A and 5-b here
28 Group was still in financial trouble with high debt ratios and low return on assets. The joint financial status of the Group and Company triggered lawsuits by banks, forcing repayment of loans immediately. How can such ostensible expropriation of the Company’s shareholders’ wealth take place? Because the Group, through direct and indirect ownership, owns 73% of the Company’s stock, while Mr. Zhao was the President of the Group and Chairman of the Board of Directors of the Company. In Section IV.6 below, we propose specific measures that can be implemented to improve the efficiency of the stock markets as well as the corporate governance of listed firms. Insert Figure 4 here. Finally, Figure 4 compares the performance of major stock exchanges around the world, with performance measured by the buy-and-hold return in the period 1992-2003 (gross return at the end of 2003 with $1 invested in each of the valued-weighted stock indexes in the beginning of 1992). The performance of the value-weighted SHSE index (the calculation for the SZSE is very similar) is only better than that of the Nikkei Index, whose poor performance was caused by the prolonged recession of the Japanese economy in the 1990s, while underperforming the indexes of the S&P 500, NASDAQ, and the Hang Seng. Since China’s economy was growing at much higher rates than the U.S. during the period (over 11% per annum for China vs. 4.5% for the U.S. in PPP terms), the fact that the SHSE index underperformed the S&P index by 120% suggests that listed firms are among the low-quality firms in China. IV.2 Overview of Bond Markets Table 5-B provides information on the growth of China’s bond markets from 1998 to 2002. The government bond market did not grow as fast as the stock market, but did have an annual growth rate of 11.7% during the time period in terms of newly issued bonds, while total outstanding bonds reached RMB 1,933.61 billion (or US$233 billion). The second largest component of the bond market is called “policy financial bonds” (total outstanding amount RMB 1,005 billion at the end of 2002). These bonds are issued by “policy banks,” which belong to the Treasury Department, and the proceeds of bond issuance are invested in certain industries (e.g., infrastructure, similar to municipal bonds in the U.S.). Compared to government-issued bonds, the size of the corporate bond market is minuscule: In terms of the amount of outstanding bonds at the end of 2001, the corporate bond market is less than one-fifteenth of the size of the government bond market. Insert Table 5-B and Figures 5-A and 5-B here
In fact, the under-development of the bond market, especially the corporate bond market, relative to that of the stock markets, is not uncommon among Asian countries. In Figures 5-A and 5- B we compare different components(bank loans to private sectors or the Hybrid Sector of China; stock market capitalization; public/government and private/corporate bond markets)of the financial markets around the world with Figure 5-a (5-B) presenting data at the end of 1995(2003). First, compared to Europe and the U.S., the size of both the government(public)and corporate(private) bond markets is smaller in Non-Japan Asia(Hong Kong, South Korea, Malaysia, Taiwan, Singapore, Indonesia, Philippines, and Thailand); even in Japan, the size of the corporate bond market is small compared with its government bond market. Second, consistent with previous evidence, the size of all four components of Chinas financial markets are small relative to other regions and countries, including bank loans made to the Hybrid Sector(private sector)in China (other countries). Moreover, the most under-developed component of Chinas financial markets is the corporate bond market (labeled"private"bond market) Perhaps the most important reason for the imbalance among different financial markets lies in investors and markets'ability to"price"the risk of investing in stocks and bonds as well as the possibility of being compensated by the risk and uncertainty of investing in these(corporate) securities(e.g, Herring and Chatusripitak 2000). On the other hand, the development of the bank loans market does not rely on sophisticated institutions, because banks have the expertise(based on their long-term relationship with firms) to evaluate even opaque and risky firms. In order to price bonds(or assign the proper interest rate), investors must have accurate estimates of the probability of default and recovery rate in the case of default. These probabilities are not available without a sound accounting/auditing system and high-quality bond-rating agencies. Another important fact is that during a firm's default the conflict of interest between the firm's bondholders and stockholders usually favor stockholders, because managers of the firm work on behalf of stockholders. This is true even in countries with strong protection of creditor rights. In emerging economies, creditor rights protection is much worse and the courts are not efficient, all of which imply that the recovery rate for bondholders during default will be very low. Finally, the lack of institutional investors makes matters worse, in that these investors are better at monitoring firms' managers than dispersed ( small) bondholders On the other hand, we already mentioned that stock markets in emerging countries, such as in China, are not efficient in that prices do not necessarily reflect fundamentals of firms. So why are investors willing to take the chance of investing in stocks? One reason is the stock market's ability
29 In fact, the under-development of the bond market, especially the corporate bond market, relative to that of the stock markets, is not uncommon among Asian countries. In Figures 5-A and 5- B we compare different components (bank loans to private sectors or the Hybrid Sector of China; stock market capitalization; public/government and private/corporate bond markets) of the financial markets around the world with Figure 5-A (5-B) presenting data at the end of 1995 (2003). First, compared to Europe and the U.S., the size of both the government (public) and corporate (private) bond markets is smaller in Non-Japan Asia (Hong Kong, South Korea, Malaysia, Taiwan, Singapore, Indonesia, Philippines, and Thailand); even in Japan, the size of the corporate bond market is small compared with its government bond market. Second, consistent with previous evidence, the size of all four components of China’s financial markets are small relative to other regions and countries, including bank loans made to the Hybrid Sector (private sector) in China (other countries). Moreover, the most under-developed component of China’s financial markets is the corporate bond market (labeled “private” bond market). Perhaps the most important reason for the imbalance among different financial markets lies in investors and markets’ ability to “price” the risk of investing in stocks and bonds as well as the possibility of being compensated by the risk and uncertainty of investing in these (corporate) securities (e.g., Herring and Chatusripitak 2000). On the other hand, the development of the bank loans market does not rely on sophisticated institutions, because banks have the expertise (based on their long-term relationship with firms) to evaluate even opaque and risky firms. In order to price bonds (or assign the proper interest rate), investors must have accurate estimates of the probability of default and recovery rate in the case of default. These probabilities are not available without a sound accounting/auditing system and high-quality bond-rating agencies. Another important fact is that during a firm’s default, the conflict of interest between the firm’s bondholders and stockholders usually favor stockholders, because managers of the firm work on behalf of stockholders. This is true even in countries with strong protection of creditor rights. In emerging economies, creditor rights protection is much worse and the courts are not efficient, all of which imply that the recovery rate for bondholders during default will be very low. Finally, the lack of institutional investors makes matters worse, in that these investors are better at monitoring firms’ managers than dispersed (small) bondholders. On the other hand, we already mentioned that stock markets in emerging countries, such as in China, are not efficient in that prices do not necessarily reflect fundamentals of firms. So why are investors willing to take the chance of investing in stocks? One reason is the stock market’s ability
to provide a better arena than the bond market in fulfilling investors' motive of speculation, since stock prices fluctuate more than bond prices(when firms are not in financial distress), and there is no limit on the upside of holding stock as stockholders own the residual claim of the firms assets Thus, investors believe, despite the large amount of risk, that they can be compensated by the possibility of a"lottery-like' winning payoff As Herring and Chatusripitak(2000) point out, the lack of a well functioning bond market reduces the overall efficiency of the financial markets, which is detrimental to the economy. In the absence of an efficient bond market, the economy will lack a market-determined term structure of interest rates that accurately reflects the opportunity cost of funds at each maturity. The deficiencies in the term structure of interest rates consequently hamper the development of derivatives markets that enable firms and investors to manage risk. as well as the effectiveness of the governments macroeconomic policies. Therefore, it is imperative that China should develop its bond markets in the near future along with its legal system and related institutions T3 Fundraising through Financial Markets and International Comparison First, we briefly examine the role of financial markets in helping firms raise funds table 5- C). Both the scale and relative importance(compared with other channels of financing )of China's markets for finance from outside the firm or External Capital as it is called in the literature are not ignificant. For example, for the ratio of External Capital and GNP, the LLSV(1997a) sample average is 40%, compared to Chinas 16%(using only the floating supply or value traded part of the stock market, rather than the total market capitalization ). For the ratio of total debt(including bank loans and bonds) over GNP, the llsv sample average is 59%, compared to Chinas 35% However, if we include all debt, including bank loans, issued to all sectors including the State Sector, this ratio increases to 79%, suggesting that the majority of debt does not go through the capital markets, consistent with evidence on bank credit Insert Table 5-c here Next, we compare, at the aggregate level, external financing (i.e financing from outside the firm), in China and other major emerging economies. We also relate the aggregate financing channels with the growth of the economy during different growth periods, in order to determine whether the Chinese experience in financing is unique. First, Figure 6-A compares the development Given the small size of the publicly traded treasury bond market and lack of historical prices, we can only plot snapshots"of a partial yield curve(maturities range from one month to l year only) based on pricing data of treasury (government) bonds in the national interbank market. This is far from the standard yield curve covering interest rates on bond maturities ranging from I month to 10 years
30 to provide a better arena than the bond market in fulfilling investors’ motive of speculation, since stock prices fluctuate more than bond prices (when firms are not in financial distress), and there is no limit on the upside of holding stock as stockholders own the residual claim of the firm’s assets. Thus, investors believe, despite the large amount of risk, that they can be compensated by the possibility of a “lottery-like” winning payoff. As Herring and Chatusripitak (2000) point out, the lack of a well functioning bond market reduces the overall efficiency of the financial markets, which is detrimental to the economy. In the absence of an efficient bond market, the economy will lack a market-determined term structure of interest rates that accurately reflects the opportunity cost of funds at each maturity.16 The deficiencies in the term structure of interest rates consequently hamper the development of derivatives markets that enable firms and investors to manage risk, as well as the effectiveness of the government’s macroeconomic policies. Therefore, it is imperative that China should develop its bond markets in the near future along with its legal system and related institutions. IV.3 Fundraising through Financial Markets and International Comparison First, we briefly examine the role of financial markets in helping firms raise funds (Table 5- C). Both the scale and relative importance (compared with other channels of financing) of China’s markets for finance from outside the firm or External Capital as it is called in the literature are not significant. For example, for the ratio of External Capital and GNP, the LLSV (1997a) sample average is 40%, compared to China’s 16% (using only the floating supply or value traded part of the stock market, rather than the total market capitalization). For the ratio of total debt (including bank loans and bonds) over GNP, the LLSV sample average is 59%, compared to China’s 35%. However, if we include all debt, including bank loans, issued to all sectors including the State Sector, this ratio increases to 79%, suggesting that the majority of debt does not go through the capital markets, consistent with evidence on bank credit. Insert Table 5-C here. Next, we compare, at the aggregate level, external financing (i.e. financing from outside the firm), in China and other major emerging economies. We also relate the aggregate financing channels with the growth of the economy during different growth periods, in order to determine whether the Chinese experience in financing is unique. First, Figure 6-A compares the development 16 Given the small size of the publicly traded treasury bond market and lack of historical prices, we can only plot “snapshots” of a partial yield curve (maturities range from one month to 1 year only) based on pricing data of treasury (government) bonds in the national interbank market. This is far from the standard yield curve covering interest rates on bond maturities ranging from 1 month to 10 years