1 How QFII Influence Chinese Stock Market Liberalization? Compare with Taiwan’s Experience by Chan Oi Yee , Iris MA Finance and Investment 2008
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How QFII Influence Chinese Stock Market Liberalization? Compare with Taiwans Experience
by
Chan Oi Yee , Iris MA Finance and Investment 2008
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Abstract QFII (Qualified Foreign Institutional Investors) announced in November, 2002 and formally implemented in 1st of December, 2002. It is the initial stock market liberalization policy adopted by Chinese authorizes after the accession of WTO. Stock market liberalization is a decision to allow foreign investors to purchase domestic share. In this dissertation, the major improvements on Chinese QFIIs entry criteria and investment quota are recommended from the Taiwans QFII experience. Taiwans QFII is a good example for comparison on Chinese QFII scheme because Taiwans QFII is the most successful among other emerging counties such as India and Korea. The stock market behaviour of Taiwans QFII implementation is similar to Chinas QFII implementation where both and China have high PE ratio and contain large proportion individual investors at the QFII implementation period. This dissertation is an even study on market reaction around the implementation of QFII. The author find there is no significant abnormal returns in the whole market within the short-term period, 3 months after implementation; negative abnormal returns followed the implementation. Also, there are no significant abnormal returns in the long-term period. These insignificant results implied that investors were taken a wait-and-see attitude and lack of confidence on stock market liberalization. Moreover, the findings is partly comply with the prediction of international asset pricing models , it suggested the scheme may not help much in reducing the cost of equity capital and risk premium of Chinese companies. Finally the long term impact of QFII scheme to difference aspects of Chinese securities market, such as advance investment strategy, listed companies information disclosure standards improvement, the conflict between domestic and foreign banks and the future developments of Chinese liberalization policies are declares in this dissertation as well.
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Acknowledgement This dissertation could not have been written without Ms. Thomas Kristie who not only serves as my supervisor but also encouraged and challenged me throughout my academic program. She guided my through the dissertation process, never accepting less than my best efforts. I thank her devoutly. I am also grateful for the support of my parents and of my friends, Cheryl Ha , Jacqueline Leung , Sue Yin Wong and Stephanie Wong
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Table of Contents Abstract ... Acknowledgement . Table of Contents .. Table of Abbreviations .. List of Table 1. Introduction 1.1 Background . 1.2 Objective . 1.3 Methodology ... 1.4 Structure .. 2. Literature Review 2.1 Introduction . 2.2 Definition of Emerging stock market 2.3 Definition of Stock Market Liberalization 2.4 Brief concept of International Asset Pricing Model (IAPM) .. 2.5 Short term impact Market Behaviour . 2.6 Long term Impact ... 2.6.1 long term stability and stock market performance ... 2.6.2 Emerging market development .. 2.7 Potential Risk of Liberalization . 2.8 Summary . 3. Background of Chinese Stock Market 3.1 Introduction ..... 3.2 Chinas recent development . 3.3 Brief History of Chinese Stock market 3.4 Capital Control Closed Capital . 3.5 Type of Share . 3.5.1 Non Circulating shares 3.5.2 Circulating Share .. 3.6 Type of market 3.6.1 Primary Market .. 3.6.2 Secondary Market 3.7 Problem of the Stock Market . 2 3 4 7 8
11 12 13 15
18 19 21 22 24 27 27 30 31 33
35 35 37 38 39 40 41 42 43 43 44
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3.8 Regulatory Framework ..... 3.9 China Stock Market liberalization 3.10 Summary ... 4. China's QFII scheme and Comparison with Taiwan's QFII scheme 4.1 Introduction . 4.2 QFII definition . 4.3 QFII Application and Operation procedures .. 4.4 Characteristic of QFII . 4.4.1 Avoid market fluctuation .. 4.4.2 Scope of QFII 4.4.3 Investment Sectors Control . 4.4.4 Foreign Exchange Control .. 4.5 Limitation and Risk of QFII regulation 4.5.1 Limitation on QFII investors 4.5.2 Limitation on QFII operation 4.5.3 Lack of regulation on information disclosure 4.5.4 Weakness on QFIIs shareholding control 4.5.5 Centralize of approval process ... 4.6 Reason of choosing Taiwans QFII as example 4.7 Brief history of Taiwans QFII ... 4.8 Comparison of QFII regulation between China and Taiwan . 4.9 The effect of Taiwans QFII scheme 4.9.1 Simulate Investors Confidence ... 4.9.2 Increase proportion of institutional investors in Taiwans stock market . 4.9.3 Enhance the conductivity with international market 4.10 Possible improvement of QFII regulations by looking in Taiwan s QFII development ... 4.10.1 Relaxation on entry criteria ... 4.10.2 Relaxation on capital liquidity ... 4.11 Summary ... 5. Short term Impact - Empirical Research 5.1 Introduction ... 5.2 Theoretical framework ..
47 49 51
53 53 54 57 57 58 58 59 61 61 62 65 65 66 67 69 72 78 78 78 78 79 79 79 80
82 82
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5.3 Data and Methodology .. 5.4 Empirical result and finding .. 5.4.1 Descriptive analysis 5.4.2 Regression Analysis .. 5.5 Research limitation 5.6 Summary . 6. Long term Impact 6.1 Introduction . 6.2 Investment strategy ... 6.3 Local stock market . 6.4 Local listed companies . 6.5 Local banking industry .. 6.6 Future development on financial policy .. 6.7 Summary . 7. Conclusion .. Reference . Appendix Appendix 1 -- Provisional Measures on Administration of Domestic Securities Investments of Qualified Foreign Institutional Investors (QFII) Appendix 2a -- China's Stock Index in US$ Appendix 2b Taiwan's Stock Index in US$ Appendix 3 Full Result from SPSS Appendix 4 Full Result from Sata
83 89 89 92 93 97
99 99 104 106 108 109 105 113 116
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Table of Abbreviations AAR ADRs CAR CEPA CRSC FDI FII GDP GNP HSBC IAPM IFC IPO Moftec MOC MSCI NBS NPLs PBC PE ratio QDII QFII RMB SAFE SCSPC SHA SHB SZA SZB SHSE SZSE TAIEX TWSE WTO Average Abnormal Return American Depositary Receipts Cumulative Abnormal Return Closer Economic Partnership Arrangement Securities Regulatory Commission Foreign Direct Investment Foreign Institution Investors Gross Domestic Product Gross National Product The Hongkong and Shanghai Banking Corporation Limited International Asset Pricing Model International Finance Corporation Initial Offerings Ministry of Foreign Trade and Economic Co-operation Ministry of Commerce Morgan Stanley Capital International National Bureau of Statistics Non-Performing Loans Peoples Bank of China Price Earning Ratio Qualified Domestic Institutional Investors Qualified Foreign Institutional Investors Renminbi State Administration of Foreign Exchange State Council Securities Policy Committee Shanghai A-share Shanghai B-share Shenzhen A-share Shenzhen B-share Shanghai Stock Exchange Shenzhen Stock Exchange Taiwan Capitalization Weighted Stock Index Taiwan Stock Exchange World trade Organization
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List of Table Table Table 2.2.1 History of FDI growth ... Table 3.4.1 Top ten global trading nations Table 3.5.1.1 Capital Structure of Listed Firms Table 4.5.2.1 List of Custodian Bank . Table 4.7.1 Taiwans QFII History .. Table 4.8.1 Detail of Taiwans Investment Qualification Evolvement ... Table 4.8.2 QFII Regulation Comparison Between Taiwan and China . Table 5.4.1 Description of stock market indices monthly return for four event periods (%) Table 5.4.2 Result for Panel and Linear Regression (%) Table 5.5.1 Correlations between A-share market and B-share Market Table 6.1.1 Current QFII Status .. Table 6.2.2 Top 10 Shares purchased by QFII in 2007 .. Diagram Diagram 3.8.1The Structure of CSRC ... Diagram 4.1 QFII application and operation procedures Diagram 4.6.1 Comparison of PE ration in Major Stock Market 48 56 67 20 39 41 64 70 73
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90 93 95 100 104
Chart Chart 4.1 Taiwan's Investors Distribution 1991 71
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Chart 4.2 Taiwan's Investors Distribution 2001 Chart 4.3 China's Investors Distribution 2003 .. Chart 4.3 China's Investors Distribution 2003 ..
71 72 72
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Chapter 1 Introduction
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1.1 Background In year 1979, the open policy was introduced in China which derived upon the restricted trade and inwards investment policy. It became a crucial element of the new foreign invest policy, for example the Joint Venture Law 1979 and the four Special Economic Zones (SEZs), Shenzhen , Zhuhai, Shantou and Xiamen were establish. In 1984, the Joint Venture regulations were declared and the foreign investment started to growth rapidly in the following years, 1985-1987. In later year 1992, Mr. Deng Xiaoping recalled the importance of open-door policy and the Peoples Congress of China formally replaced the planned economy by a market economy in 1993. Since the economic reform started in 1978, the economic was growth rapidly; the average economic growth rate was calculated at 9.6 percent from 1978 to 2004 (Li et al., 2007).
On December 11, 2001 China formally became a member of WTO. It is an historical turning point which brings Chinas economy into harmony with the world. Although a WTO membership is important for the integration with world economy, it brings many vital opportunities and also challenges.
For such a long period, Chinese authorities cut tariffs, liberalizes its trade, security investment and even some domestic sectors to foreign participation, which push Chinese regulated economy more further to a market economy. Since China joined WTO, hundred of laws and regulations were revised for coping with the WTO policies. To be fully integrated into world economy, all of these changes are essential for a countrys economy. The significant economy growths in China were mainly gained from the comparative advantages in capital and labor-intensive sectors, where enable resources reallocated and
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created more work opportunities.
However, there are still long ways to go before enjoining the positive effects which bring from WTO accession. While integrating into global economic system, many challenges accompany by the underdeveloped and
inexperience of Chinas traditional financial sector. On December 11, 2006, five years after WTO accession, foreigner-owned banks can freely manage renminbi (RMB) banking business as domestic banks do (Ma, 2007). Transformation of governments functions is the greatest challenge in government sector. As WTO requires their members governments to be fair, transparent and marketable, Chinese government has realized the necessary to speed up the reformation in different sectors and develop an optimistic legal, policy and financial environment.
1.2 Objective It is a popular research topic, how stock market liberalization impacts emerging stock market, in both short term and long term. Such empirical researches were usually examine on a group on emerging countries, however, lack of them focused on only one country, especially Chinas QFII and the impacts on its stock market. It possibly is an interest area to work on; therefore the gap could be filled up by providing a deep analysis on QFII regulation and the influence of QFIIs implementation in Chinese stock market.
However, QFII has already implemented for quite a long period, nearly 6 years, but it is still putting efforts on fully open up the Chinese stock market. Therefore the major objective of this dissertation is to capture the temporary influences of12
QFII on stock market occur around the implementation period and the validity of the prediction of IAPM will also examine throughout the study. Chen & Yus (2004) paper, the first paper worked on the announcement of QFII policy impact to Chinese stock market, is modified by taking a longer observation period and the implementation date is used instead of announcement date.
Before RMB can feely convert, the only way to achieve the expectation of Chinese authorizes - attract more foreign investment by adopting QFII scheme, is to improve the corporate governance of local domestic listed companies. Traditionally Chinese domestic investors are lack of advance investment technique therefore, example of foreign professional investors can use for educating local investors. For the result, the potential long term influences of QFII on China domestic listed company, investor and banking industry are also the objective in this study. In order to achieve detail recommendations, experience of Taiwan will use for judging the current QFIIs status in China, the limitations, potential development and long-term impact will be declared in this way.
1.3 Methodology Methodology is not only a method of analysis empirical findings , it is a section including research design , explaining how the research undertake, data collection methods and analysis technique and specify the methods of achieving research objective. In this research, both qualitative and quantitative research methods are adopted and case study is used for detail explanation.
According to Saunders et al. (2000) a research approach can either deductive13
or inductive. Inductive approach refers to build a theory through gathering and analyzing a group of data while deductive approach is to develop and test an existing theory or hypothesis by creating a new research strategy. It implies that, deductive approach is mostly the same as quantitative approach and inductive approach is similar to qualitative approach. Punch (1998) realized that quantitative research is a method to present facts by pooling and analysis a large group of data. On the other hand, qualitative research is basically targeted on empirical research analysis, the data can be taken in many forms and usually present in non-numerical form. Also Ghauri et al. (1995) suggested that qualitative research is usually rational, explorative and institutive. Therefore, analysis previous researchers experience is treated as an important part in the whole research.
Secondary data, which described as inductive approach, are used throughout the research. China financial market data are used to evaluate the performance of QFII and Taiwan QFIIs experience is used for identifying the improvement aspects of Chinas QFII regulation and listed companies information transparency.
In order to achieve a high quality research, a good research strategy is essential. A clear objective should keep in mind when answering each research questions (Saunders et al., 2000). Research strategy can also take in any form of experiment, survey, case study, ground theory, ethnography, action research, cross-sectional and longitudinal studies, and exploratory, descriptive and explanatory studies.
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When a holistic and in-depth investigation is needed, case study is suggested to be the best methodology (Feagin, Orum & Sjoberg, 1991). Case study is a method to analyze the phenomenon by selecting a few examples and examine the characteristics from those examples or cases. The most suitable case that can choose to study must bethe relatability of a case is more important that its gernealisability by Bassey (1981). It implied that the best case to study must have some direct relevance with the original case, just like the Chinas QFII scheme and Taiwans QFII scheme, where both of them have a similar stock market structure and performance.
1.4 Structure In Chapter 2, literature review will be used to define each key terms, emerging market, stock market liberalization and international asset pricing model. Moreover, the short-term and long-term impacts of stock market liberalization will be specified and conclude with the potential risk of stock market liberalization.
In Chapter 3, a broad view on Chinese stock market history and its current position will be described in detail. Besides that, the type of share currently trade in Chinese stock market, type of markets and the regulatory framework will also mention.
In Chapter 4, apart form the broad view of Chinas QFII scheme and Taiwans QFII scheme, comparison of these two QFII schemes will be given. Recommendations on Chinas QFII scheme which learn from Taiwans QFII scheme will make as well.15
In Chapter 5, it is the empirical experiment part, the theoretical framework research strategy will demonstrate first and following with the experiment of short term impacts of QFII onto stock market where secondary data of Chinese stock market index and Taiwans stock market index are used for examination.
In Chapter 6, long term impacts of QFII in different of aspects the Chinese economy will be described. Influences on investment strategy, stock market, and listed company will be involved. The future developments of Chinese stock market are also recommended.
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Chapter 2 Literature Review
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2.1Introduction Qualified Foreign Institution Investors (QFII) is a milestone in Chinese stock market liberalization history. It enhances the opening process of local stock market (A share market) to the rest of the world. The adoption of QFII is aiming that more investment from foreigners will be attracted and Chinese stock market will liberalize finally. Due to the new policy, more investments are attracted and more challenges of foreign capital inflow and outflow are following by. Summarize the empirical studies of previous researchers the impacts of liberalization can be described into two types, short term and long term. Apart from the final result of stock market liberalization on market, the experience of how it contributions on emerging stock markets are more relate to this research study.
This chapter will start with the definitions of emerging stock market and stock market liberalization and follow the brief idea of standard International Asset Pricing Model (IAPM). After demonstrated the definitions of those key terms, past literatures will use to explore the short term impact and long term impact. In short term impact, will mainly study on the short term market behavior and the stock market volatility at initial liberalization. With regard to long term effect, past empirical researches are divided into how liberalization influences emerging stock market stability and how it affects the development of emerging market. The contributions and limitations of all literatures will be pointed out through this research study. Finally this chapter will conclude with the potential risks of stock market liberalization.
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2.2 Definition of Emerging stock market According to International Finance Corporation (IFC) emerging stock market is the stock markets consist in the developing countries where they are low or middle income economies (Kim & Singal 2000). Moreno (2007) listed a range
of emerging stock markets such as Indonesia, Korea, Philippines, Thailand, Chain, Czech Republic, Mexico and etc. An emerging stock market usually exists in an emerging economy. As Dara (2000) said to measure the development status of a country, gross national product (GNP) are used to measure the level of income traditionally. Generally, there are common criteria exist among emerging stock markets. If a stock market belongs to emerging, this market should have begun a process to change such as growing size, turnover and sophistication. IFC, a member of the World Bank Group who publishes monthly Emerging Stock Market indexed has tracked a list of emerging markets that are particular interest to international investors, so do Morgan Stanley Capital International (MSCI). Besides the measurement mentioned above, IFC also guided that an emerging stock market should be in term of five characteristics, which are growth, changes (economics, financial and political), investability, size and liquidity.
Because of the relative small of Chinas capital market to the whole economy and the potential of fast growing, which make Chinas stock market classify as emerging. As Chinese market liquidity are increasing which allows the market earning more potential , on the other hand , the range of companies quoted are widened and the corporate sector becomes more relied upon equity financing. Moreover, foreign investors have shown more interests of the investment opportunities in China (where the rate of foreign direct investment (FDI)19
increasing year by year). According to the Ministry of Foreign Trade and Economic Co-operation (Moftec), until June of 2008 there are 14544 FDI firm in China , reduce 22.15% compare with the same time of last year. The actual FDI reached to US$ 523.88 hundred million, in the first half of 2008, rise nearly 50% from last year.
Table 2.2.1 History of FDI growth
Source : Beamish (1993)
Regarding to the majority of emerging markets think liberalization is an essential policy decision to attract more foreign investment funds. Hence, the following section will focus on emerging stock markets performance and behaviour which occurs at the initial market liberalization.
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2.3 Definition of Stock Market Liberalization As the importance of liberalization therefore definition will be demonstrate first. Stock market liberalization is specifying from a more general policy reform called Capital account liberalization. There are several meanings regarding Capital account liberalization. A general definition given by Biem and Calomitis (2001) it is a package of reforms that include global opening up and the creation of governance infrastructure such as sound law and regulation governing trading , and reliable systems of accounting information and control (Bekaert et al., 2005). Henry (2000b) narrowed definition to removing restrictions on international capital flows.
Henry (2000) also gave another definition on stock market liberalization, he thought it is a decision that made by a countrys government to allow foreigners to purchase share in that countrys stock market. It is a political decision designed to attract foreigners investments in domestic stock market. Extensively it is also treated as a study on economic, financial growth and development. Thus stock market liberalization is not just a political decision; it is an indicator on macroeconomic factors which may influence financial growth and development.
Moreover, study of Kim & Singal (1993) used an increase in issuance of share capital and stock voting open to foreigners as a detail classification for stock market liberalization. Similar to the first introduced by Henry (2000), Jayasuriya (2002) specified the stock market liberalization definition narrowly. The data is available for the identifiable ease dates. If any one of the following occurs, an official policy announcement, establishment of a country fund, or an increase21
in the IFCs Investability Index of at least 10 percent1 then this month will be counted as the market opening date. Hence, the date of liberalization is directly captures at the official policy announcement while the others alternative are indirectly capture the opening date.
Chinas QFII scheme is the first phenomena which made by Chinese government allowing the foreign investors to purchase A share in China domestic share market. The introduction of QFII scheme is really a strong evidence of Chinese stock market liberalization. Moreover, Henry (2000) suggested that standard international asset pricing model (IAPM) can be used for predicting the implication of stock market liberalization. The brief idea of will explain in the next section.
2.4 Brief concept of International Asset Pricing Model (IAPM) Standard International Asset Pricing Model is meaning the equity premium embedded in its aggregate valuation will be proportional to the variance of countrys aggregate cash flows if an emerging countrys stock market is completely segmented form the rest of the world (Henry, 2000b). Once liberalization takes place in the emerging stock market and until it is fully integrated, the equity premium and covariance of countrys aggregate cash flow with those of a world portfolio are proportionally linked. If the foreign ownership of an emerging market is restricted and partly segmented, like QFII in China, then the equilibrium of the emerging markets valuation will incorporate with the equity premium and may lie in somewhere between1
The Investability Index is constructed as the ratio of the market capitalization of stocks that
foreigners can legally hold to total market capitalization
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autarky and fully integrated premium (Bekaert and Harvey, 2000). They also showed a possible reduce on equity premium that subscribed to an emerging stock market when the local price of risk (the variance) exceeds the global price of risk (the covariance). Holding constant future cash flows, the decrease will cause a permanent fall in the total equity capital cost and the aggregate equity price index will affect as well. In Chen & Yu (2004) working paper they described this effect by the following way:
E[RM] = rf+ T Var(RM)
(1)
Where E[RM] is the expected rate of return on the aggregate domestic stock market before liberalization, rf demonstrate the domestic risk- free rate ,T is the price of risk and Var(RM) is the variance of the market return. Therefore the difference between E[RM] and rf ( E[RM] - rf ) is the aggregate risk premium. Replacing the terms in formal (1), the expect rate of return on the market after liberalization, E[R.M], should be given.
E[R.M] = rwf+ MW (E(RW)- rwf)
(2)
Here rwf is representing the world risk free rate, MW is the beta of the domestic stock market with the world stock market and E(RW) show the expected return on the world equity market.
Furthermore, if the capital markets are completely opened then the world risk free rate rwf will become the relevant interest rate. When substitute E(RW) in formal 1 , the equation will become E[Rw] = rwf+ T Var(Rw). Therefore,23
substitute into formal 2, the new equation will be look like this
E[R.M] = rwf+ MW (rwf+ T Var(RM) - rwf) = rwf+ TMW Var(RM) = rwf+ T Cov(Rw, RM)
(3)
And the equation of the difference between before and after market liberalization ( E[R.M] - E[RM] ) can be written in the following ,
E[RM] = E[R.M] - E[RM] = ( rwf - rf )+ T { Cov(Rw, RM) - Var(RM)} (4)
If
rwf < rf and Cov(Rw, RM) < Var(RM) , thus the E[RM] will be small than 0 ,
which implied that stock market liberalization reduces the equity capital cost of the liberalization country.
2.5 Short term impact Market Behavior Concerning the linkage of stock market liberalization and stock return, Kim & Singal (2000) found out critical evidence on the valuation of initial stock market liberalization. From their empirical result, suggested that stock returns increase immediately after market opening without a concomitant increase in volatility. However, they did not control the confounding event during the sample period and the decrease of stock return follow by.
Henrys (2000) study improved Kim and Singals (2000) research by using 12 emerging countries data. The empirical result gave out an average abnormal24
return of 4.7 percent per month in which the liberalization in a countrys stock markets initial implementation that experienced the real dollar terms within 8 months window in stock markets.
After controlling of co-movements with world stock markets liberalization, economic policy reform and macroeconomic fundamentals, the result in a deduction of abnormal return happened (only 3.3 percent per month over the same horizon) is still statistically significant. In addition, Henry concluded that even employing a smaller range of months, including five months, two months or even the implementation month only for estimation, all windows are still in conjunction with the statistically significant stock price revaluation. Moreover, his findings consisted with a fundamental prediction of the standard International Asset Pricing Model (IAPM).
After Henry (2000) had presented the first empirical research on how stock market liberalization influenced the equity prices in the emerging market, a relative large amount of studies also have been pointed out many challenges in this field. For example, Henry (2000b) also stated that the stock market liberalization raise up the private investment rate right after it had adopted for three years. Bekaert and Harvey (2000) thought the abnormal return may increase or decrease in the post-liberalization period but it might also be affected by the model specification. In contrast, Kim & Singal (2000) concluded the stock returns were actually fell in one year after the liberalization. Errunza (2001) also concluded that the concern of destabilizing influence of the foreign participation is largely unwarranted. However the data used in these studies were prior to the financial crisis in 1997 (Wang, 2007).25
In the study of Dvorak (2001), he did research on the correlation between local and world return as well as the impact of foreign trading with the short term volatility. He found out the foreign trading did not impact the volatility in the developed countries under the controlling of total volume in the local markets, but it dose impact the volatility in the emerging market. Moreover, Bae et al. (2002) has shown that stocks with higher investability index (i.e. more accessible to foreign investors) have higher return volatility in emerging markets (Wang, 2007).
However, the researches mention above are all observing a yield of emerging countries rather than a single country or region. Base on the cross countries analysis, the inside country factors will be ignored. Therefore, it is hard to define how a stock market opening influences the market performance and the reaction of foreign investors, such as China.
Because of the similar investors structure and the price earning ratio of Taiwan and China stock markets at the implementation moment of QFII (TWSE , SZSE and SHSE web site2), Taiwan QFIIs experience choose as an example for the comparison, and more details about two markets will be discussed in later chapter. Here, an individual study from Li (2001) will be employed to justify short term market behavior in an emerging market. In this studied, Li focused on the Taiwans experience of market opening and analyzed the stock market data one year before and after the opening event (QFII).He identified there was no significant change in the stock mean returns while volatility is2
TWSE Taiwan Stock Exchange SZSE Shenzhen Stock Exchange SHZE Shanghai Stock Exchange 26
notably reduced three months after opening Taiwan stock market. If applied this result to China, the volatility should be reduced and the stock return will be constant during implementation of QFII.
2.6 Long term Impact 2.6.1 long term stability and stock market performance Since the second oil price shock in 1979, the paradigm of liberalization became more impressive and widely spread. Its influx foreign capital led to increased volatility in these emerging markets. In opposite to other academics researches which showed little evidence to support claims of increased volatility in those volatile market, Dara (2000) argued that emerging market are always volatile. Risk can be widely spread through opening the emerging stock markets and the volatility also can be eliminated by the presence of foreign investors. Aside from the foreign investors, local investors also play an important role in determining the emerging market volatility and the level of asset price (Bae et al, 2002). Nevertheless, Richards (1996) found out there is an insignificant linkage between liberalization and increased volatility. He estimated the volatility from two periods, 1972 to 1992 and 1992 to 1995 (foreign institutional investors played a significant role in emerging markets). Monthly data were collected from nine markets while weekly data were gathered from 16 markets started at the end of 1988 until the end of September 1995. Finally, he concluded that the volatilities were not much different between periods and there was little evidence indicated the volatility would rise in both short and long term return while large scale foreign investments became a major player in these markets.
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Actually volatility does not rise in emerging market, but people usually think stock market liberalize will cause volatility increase, the reason is here. Levine & Zervos (1998a,b), they are the first to ask whether stock markets are key to economic growth . In this study, the measure of stock market liquidity, size, volatility and integration with world capital markets were used to test whether correlated with the current and future rate of economic growth, capital accumulation, productivity improvements, and saving rates, the data of 47 countries from 1976 to 1993 were used. The testing result indicated that
there is a positive and significant relation between stock market liquidity and long term growth, where a small and liquid market will usually have high turnover and small value traded. Additionally, this finding implied importance of the liquidity of stock market tends to be risen following the liberalization of international capital control.
In order to test further the studies from both Dara (2000) and Richards (1996), Kim & Singal (2000) chose 20 countries as sample from the IFCs (1996) emerging markets database, which is similar in other studies. They exposed the stock markets opening do increases the stock price while no positive changes in stock return volatility. Stock price increase may also indicate the demand for domestic securities raise and oblique the domestic firms can access foreign capital at lower cost. However, greater volatility may reduce investors interest in holding stocks as higher risk premium may face, consequently, the cost of capital will either higher or lower than investment. Since policy makers impossibly to react the unexpected market forces without considering economy, therefore, guidance on growth control is essential. Kim
& Singal (2000) revealed that there is no upward pressure on inflation will28
affect the efficiency gains and the inflation rates, on average, will fall after stock market liberalization. An appreciate exchange rate may help the country to retain its competitive position in the global marketplace, especially for the export- orientated economies countries. The government in such countries may always need to worry about the inadequate on investment opportunities for absorbing massive inflow of money. Hence, too much capital inflow will cause inflation.
On the other hand Dara (2000) mentioned that the first time of an industrial countries portfolio mangers invest in emerging market, they may react to expose more comparatively volatile in the market other than increase volatility in such market. The 1994 Mexican currency crisis and the East Asian financial turmoil both raise the interests of many academics and politicians to look into the desirability of free flow of capital for emerging economies where Chile and China were successfully restrained on capital flows. Even popular economists such as Joseph Stiglitz of the World Bank and Panl Krugman of MIT have championed capital control as a way of coping with financial crisis (Kim & Singal, 2000). Hence made people link financial turmoil, crises and increase volatility together. Moreover, these assumptions of financial turmoil also the increase of volatility and foreign investors are lack of evidence to support, because financial crisis may not is the result of volatility increase.
Additionally, the movement of hot money, it is an important and difficult issue need to be concern. Hot money is the international flow of funds which highly sensitive to the changes of interest rate, expectation of future economic growth and returns on securities held (Hu, 2004). Even a small shock to the economy29
will cause a serious volatilization on inflow of funds and consequently destabilize the domestic economy.
2.6.2 Emerging market development Other than the liberalization impacts on market stabilize, there are many liberalization researches focused on the economy and policy development in an emerging market. As mention in Dara (2000) there are several benefits an emerging economy can gain from the increase of foreign investors after opening stock market. The major advantage is the raise of investment opportunities for foreign investments. Also the financial instrument and the other equity market developments can be enhanced as well (Levine & Zervos, 1998a). In doing so, the cost of investment can maintain at a relatively low level and the economic growth is facilitated too. In Henry (2000) paper, the researcher selected a sample of 11 developing countries and liberalized their stock markets ; 9 out of 11 experienced a growth in private investment after the first year liberalization. In the second and third years after liberalization 10 and 8 countries respectively experienced a higher growth rate of private investment. This example do make a strong evidence on capital account liberalization has no effect on investment.
Allocate capital more efficiency is another crucial consideration. Kim & Singal (2000) pointed out that accountability management and shareholder rights, which allowed the investors to stay away from dangerous of expropriating wealth by other investors; therefore it is treasured by the foreign institutional investors. In order to achieve this more transparency on list companies information associate with more complete disclosure rules are required.30
Because of the convincing and satisfactory response to those requirements, listed companies information and corporate governance are improved, the risk of holding stock reduced and lower the cost of capital. Meanwhile Dara (2000) concluded in most emerging markets, there are significant restrictions to the information distribution and less information disclosure apply to companies with a greater time lag than those in well-developed markets. As mention in other research, Dara (2000) suggested efficient stock market development must accompany by liberalization of financial sector and it is also important to follow prudent macroeconomic policies.
Besides the impacts on the domestic economy, development of financial markets can also be seen as a risk diversification. A global diversification enables better resource allocation and fewer international risks need to bear with. As well as the integration of stock market and global diversification taken place, more advantages on steady-state welfare can be retained. In addition, Frenkel & Menkoff (2004) suggested by limited the types of financial products, information asymmetry between local and other foreign institutional investors, the integrated of emerging and international financial markets will results more and new diversify opportunities.
2.7 Potential Risk of Liberalization Although there is strong evidence on liberalization will benefit the emerging market, several legitimate concerns about the rapid market growth and potential risk need to be considered. First, the widen degree of market development and liquidity will result as volatility increase, trading frequency increase and new information will reflect in price more quickly. Thus, the31
excessive price volatility in some stock markets is required to separate from the real economies. Also the potential risk of bubbles economies, it is common in developing countries where the stock prices rise sharply in the emerging markets. Financial liberalization often lead financial crisis (Daniel & Jones ,2007).The example of Russia financial crisis, at the beginning of 1990s its price-earning ratios of listed stocks rise rapidly on several emerging market and followed a sharp drop in the late 1990s.
Because of the strong inflow of capital so the supporting services, such as the improvements and reforms of bank system, are required. Providing more
credit to market participants can encourage the foreign investors trading and attendant settlements. Consequently, excessive risks might impose when the effort to develop stock market is less- than- adequate market infrastructure (Dara, 2000). Finally, private capital flows to emerging market economies could damage the sustainability of these markets, which may lead unbalance country performance, slowing down the financial reform, and diminish influence of multilateral institutions and injudicious lending. Thus the continue expansion of capital flows and relatively huge scale can weaken external competitiveness and put pressure on monetary policy. Financial instable creates uncertainty that can seriously damage market efficiency and lead a significant economic destabilize.
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2.8 Summary Recalling to the experience of emerging market, both benefits and risks exist at the same time within the stock market opening process. The opening policy is seemed to be two-edged sword; it is not just influence foreigners only. Even it shows the opportunities of attracting foreign capital for financial economic growth but it also hasten the development of equity market. Enlargement in equity market will result as more liquid, more internationally integrated. While increasing the efficiency of the market prices, the market size, variety of market participants and information transparency can both improve and expand. Because of the protection requirements on account management from foreign institutional investor, risk of holding stock and even the cost of capital are able to reduce. Moreover, the sustainability of emerging market may be damaged by the introduction of private investment, which may lead uneven country performance as well. As a result, strong and continue capital inflow will possibly weaken the external competitiveness and put pressure on monetary policy.
The impacts of QFII may not fully demonstrate through the literature review but the liberalization experienced in emerging stock markets is still valuable and remarkable for Chinese authorizes. Also, these empirical findings may be useful in predicting the QFIIs performance in stock market and Chinese stock market future developments.
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Chapter 3 Background of Chinese Stock Market
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3.1 Introduction Accession of WTO is an important event in the Chinese history. It causes a rapid growth in Chinas economy and authorities reforms. All of these changes lead the opening of Chinese stock market to a further step. In this chapter development of Chinese stock market before QFII implemented will be drafted. Besides the history of Chinese stock market, its background such as, type of shares, market, and the regulatory framework will present in this section. Before the QFII implemented - the first policy on Chinese stock market liberalization to foreigners, there are lack of successful stock market opening policies in the past. Therefore, the history of Chinese stock markets development and liberalization process is necessary to explain the appearance of QFII scheme.
3.2 Chinas recent development In December 2001, after years of negotiations, China finally became one of the World trade Organization (WTO) members. In order to match the WTO agreement, many reforms were taken place, especially the increase in Chinese export efficiency and the widely open of its economy to foreign competitions. When its export and economy become more efficient and mature, China may disadvantage more on low cost labors losing. Aside of the changes mentioned, financial sector is another seriously influenced. Since the Chinese market opened to rest of the world, greater accession of foreign banks and insurance companies gained into Chinese market, which including the securities, fund management and also joint ventures companies. Whilst the more accession of foreign institutions, the lower entry thresholds for foreign venture capitalists will be (Suen , 2002).35
According to Burke (1999), there is a crucial advantage expose from the Chinas WTO accession which is the Chinese financial services opened to foreign investment. However, state-owned banks dominated majority of financial sector by holding large amount of non-performing loans (NPLs). When the financial sectors become more mature, the requirements on investment brokerages, risk assessor, invest advisers and other intermediary services providers will expect to strengthen.
Chinas economy continues opening up since the joined of WTO in 2001. According to the latest figure from the National Bureau of Statistics (NBS), the first quarter gross domestic product (GDP) of 2008, is 6149.1 billion RMB and there is a 10.6 percent growth at the same period of last year3. Hu (2004) mentioned an important reason that lead foreign exchange reserves increase and massive capital inflow into country. He indicated that Chinas spectacular growth performance and its status as world factory is main reason of exchange reserve and capital inflow raise. According to statistics issued by the Peoples Bank of China, Chinas official foreign exchange reserves amounted to 1528.249 billion US dollars by the end of 2007. Now China is ranked as the 3rd largest exporter and importer. In the first four months of 2008, the total imports and exports amounted 7912.6 billion US dollar and reach a 24.4 percent of growth compare with same period in 2007. Chinas foreign trade has been growing at a much faster rate then the world trade on average for over two decades. Market opening and economic growth has made China target more on foreign direct investment.
3
Gross Domestic Product (GDP) (First Quarter,2008) From http://www.stats.gov.cn 36
3.3 Brief History of Chinese Stock market Chinese securities trading emerged in Shanghai in 1984 and four years later 1988, there are four professional securities trading corporation formed in order to help business to issue their bond and/or shares. In the early 1990s the over-the-counter exchange systems: the STAQS and the National Electronic Trading System were established.
Nowadays, there are two stock exchanges in mainland China which located at Shanghai and Shenzhen. The Shanghai Securities Exchange (SHSE) was formally opened on 19th December 1990, at the end of 1994 there were 168 companies approved to listed in SHSE which is much more than in 1991, just only 8 companies (Green , 2004). Also on 3rd of July 1991, another stock exchange, Shenzhen Securities Exchange (SZSE), was formally opened. This exchange allows issuing B-shares to attract foreign funds enter China, the number of stocks listed increase quickly from only 19 at the end of 1991 to 138 by September 1994 (Green, 2004). By the end of 2007, 1,550 companies were listed in Shanghai and Shenzhen stock exchanges, with a combined market value of RMB 32.71 trillion and accounting for 140 percent of the country's GDP (Zhang, 2008).
However these two stock exchanges took a difference role within the stock market. Shanghai stock exchanges are mainly dominated by large state-owned enterprises as well as it is monitored closely by Chinese government, therefore, the stock performance in this stock exchange are usually treated as an indicator of Chinese domestic economy. In contrast, most of the manufacturing and export companies which have a close relationship37
with Hong Kong, are listing on Shenzhen stock exchange (Green, 2004). It makes Shenzhen stock exchange relatively more international base than Shanghai stock exchange.
3.4 Capital Control Closed Capital In order to measure the economic openness, Hu (2004) suggested using trade/GDP or FDI/GDP as indicator which are the same as in China Statistical Year Book 2003. Hu (2004) also found out that China ranks one of the most open among the worlds large economies. However, the openness of capital account is incompatible with that of economy.
Because of the huge capital inflows and foreign exchange reserve, which give big pressure on the countrys exchange rate regime Therefore, in July of 2005, the Peoples Bank of China, the nations central bank, announced that RMB no longer peg to US dollar and re-peg to a basket of currencies. Meanwhile, the exchange rate for US dollar to RMB reduced by 0.17 to 8.11; which means, RMB immediate appreciates 2.1 percent against US dollars (Lenard, 2005). Within the top ten global trading nations table (table 3.4.1), it is obvious showed that China is the only one who still has capital control , maintained widespread restrictions over the movement of cross-border capital. Under the Chinas closed capital account, the restrictions on inward portfolio investment are very tight.
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Table 3.4.1 Top ten global trading nations
Source: Hu (2004)
Even through China has eliminated most restriction on inward foreign direct investment, there are still have wide-ranging controls over portfolio investment such as equities, bonds, bank loans, currencies, commodities and derivative instruments. In order to deal with the obvious incompatible between Chinas closed capital account and a higher degree of country economic opening, QFII scheme established. It allows the foreign investors to invest in the domestic listed, denominated by local currency stock, such A-shares, corporate bonds, exchange trade funds and other securities. The adoption of QFII is an early step to match the openness of capital account with the economy, relaxing the capital control.
3.5 Type of Share Until now, the regulatory framework has been set up nationwide automated trading system and professional terms are formed in security market. However the market is still not consummate and partially illiquid. There is only about39
one-third of total shares were allowed to circulate and the rest of shares are non-circulating share, meaning those share cannot be traded on market freely. Even so the circulated share can be categorized into different type according to investor, issuer and currency.
3.5.1 Non Circulating shares Government Owned share, these are the shares directly owned by government and it occupies the largest amount of total stock, 46% at the end of 2001, in its capacity as sponsor of IPOs. (Naughton, 2007) Sponsor legal persons, they usually are stated owned corporations, the parents of the listed firms, in some cases, they are holding companies established to manage government shares. These two types of share are making up with a direct and indirect government control.
Private Placement of Legal Person Share, the ownership of this share type reflects the continuing interest of firms that listing sponsored in the first place. However, this type of share cannot be sold on the market, they can be only transferred through private placements, by the end of 2005, 5.3% of total share was traded in this way. Worker Share, it takes over a small proportion of non-negotiable shares and they were issued to workers within the companies, but these shares have now virtually disappeared. (Naughton, 2007)
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Table 3.5.1.1 Capital Structure of Listed Firms Percent of Total Shares 2001 I. Non Circulating Shares IA. Sponsors Shares Government-owned Sponsor Legal Person IB. Private Placement of Legal Person Shares IC. Worker Shares II. Circulating Share A- Shares B- Shares H- Shares 65.3 59.8 46.2 12.7 4.7 0.5 34.7 25.3 3.1 6.4 Source: Naughton, 2007 p. 470 2005 61.8 53.4 5.3 0.1 38.2 29.9 2.9 5.4
3.5.2 Circulating Share Circulating shares are the share traded in segmented market. A-Shares, which are the primary share type traded. It is the share that available only to Chinese citizens so it is denominated in Chinese currency. B-Shares, are denominated in foreign currency and were originally reserved for foreign investors, however, Chinese citizen may able to hold them now as well. H-Shares are shares listed by Chinese companies on Hong Kong Stock Exchange and N-Shares (American Depositary Receipts ADRs) are shares issued by Chinese companies and trade on New York Stock Exchange. In August 2005, 117 firms have issued H-shares and all but two were listed on the
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Hong Kong Stock Exchange, excepted two were listed in Singapore only. Moreover, 17 of H-shares companies have joint listing in New York or London. (Ma, 1996, Naughton, 2007). Red Chips are shares of the Chinese
enterprise but listed in Hong Kong Stock Exchange, the Chinese institutions or enterprises normally withhold the largest quantity of shares in those red chip companies. These shares are traded in Hong Kong but derive most of their profit from business in mainland China (HSBC web site)
Chinese policies markers want to collect Chinese household saving but also tap into foreign capital without exposing themselves to the possibility of destabilizing capital flow. Therefore A-shares are usually priced higher than B-shares and/or H-shares, intend to limit the investment options available to Chinese households (Chan , 2001). Because of the market inefficiencies, B-shares market does not expanded as rapidly as A-shares market. B-shares market is appearing less liquidity and inactive than A-shares market (Naughton, 2007). Nonetheless, Red Chips are more attractive to foreign investors than B-shares because it offers foreign investors more disclosure of Chinese companies through a more transparent lens of Hong Kong stock market (Chan , 2001).
3.6 Type of market Similar to other stock markets around the world, Chinese stock markets also consist of primary market, which allow companies to issue their initial offering (IPOs), and the secondary market where shareholders can trade their stocks.
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3.6.1 Primary Market Chinese companies can initially issue their shares by either internal offering or public offering. Internal offering share which is similar to the Private Placement of Legal Person Share, meaning a firm can sell its stocks only to its own employees with a discount. Same as private placement of legal person share, internal offering shares are not able to trade in any secondary market as well. Approvals from firms supervisory industrial bureau, and other government agencies, including China Securities Regulatory Commission (CSRC), State Council Securities Policy Committee (SCSPC) and the Peoples Bank of China (PBC) etc must be needed for issuing internal shares. Moreover, the annual stock issuance plans are jointly established by those departments. Every providence will be given a quota and conclude the finial decision base on firms qualification, stock market condition and new government policies (Green, 2004).
3.6.2 Secondary Market Chinese Secondary Market contains investors, market marker, organized exchange and various brokerage firms etc. In China, security investors can be divided into two main types, most of the investors are individual investors and institutional investors just consist of a small amount. Individual investors can be divided into two types, general investors and prestigious investors. The difference between general and prestigious investor is that, prestigious investor can directly access to a network computer4, at least RMB 100 000 capital stock and a monthly fee paid to brokerage firm are required (Ma 1996,
4
The network computer offers current market information from SHSE and SZSE. It is a software that perform technical analysis of the stock price movement. 43
Green, 2004).
Nowadays brokerage firms are taking an important status in Chinese stock market. Shares can only trade through brokerage firms therefore every investor needs to hold an account with brokerages firms. Ahead of any stock transaction, brokerage firm need to get hold of the corresponding stock certificate. At the present time, transactions are replaced by networked computers which allow direct connection to the broker from respective brokerage firm in stock exchange (SZSE & SHZE web site). Therefore, it is difficult to see any completed transaction by transferring the physical copy of stock certificate now.
Moreover, the Chinese stock exchange is following four operational principles: electronic trading, central settlement, no physical exchange of certificates and automatic transfer. For example, in SHSE, potential sellers can only trade on stock market after share certificates deposited. Thereafter, member of stock exchange, like a brokerage firm, can ask price on its computer and wait the potential buyers to agree with (bid price equal ask price), then trade will take place. Also the deposited certificates will be checked and ownership will transfer automatically. Even this system is complicate but it minimizes paperwork and speed up the transactions (SZSE & SHSE web site)
3.7 Problem of the Stock Market As Wang (2004) argument there are still many problems appear in Chinese stock market because the lack of advanced regulatory experience under an immature economy. Firstly, there are too many share types which confusing44
investors, except the well-know A-shares and B-shares, there are several additional share types available to foreigner, such as H-shares, N-shares, Red chips, Blue chips, and these entire shares are denominated in free exchangeable currency.
The development of Chinese stock market causes problems on the institutional investors development. Institutional investors, such as mutual funds, pension funds and insurance companies. They are the shareholders usually large in size and interest in monitoring enterprise performance. Institutional investors are also serving as patient owners with long-term interest in improving corporate governance and performance (Gleave & Kazer, 2007 and Naughton, 2007). Since the disclosure standard of China is far behind than those mature markets, the interests of institutional investors may be reduced. In additional the market is highly inefficient so the traded companies only have to provide limit information. As a result, it becomes a vicious circle.
Moreover, the Chinese stock market is thin, meaning that the supply of desirable shares is quite limited (Gleave & Kazer 2007 and Naughton, 2007).
The market contains many small-cap stocks instead of occupied by big blue-chip companies. Also most of those blue-chips are only listed on oversea exchanges which mean those blue-chips are not tradable to Chinese residents. Because the underdeveloped of Chinese retail investors and institutional investors as well as the limit share types available for Chinese citizen to invest. Hence, shares price are pushed up and lead Chinese stock market to a bubble market.
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Until 2001 Chinese disclosure and regulation standards were extremely poor which cause liquidity problems. From that time outwards information disclosure standards were improved. Nowadays, the corporate reports must be post on internet and competitive business press transparency is also improved. Regardless of these improvements, the disclosure standards and information reliability are still far behind the standard of developed economy market. (Naughton, 2007). Also the regulatory system was put focus on protecting
the right of government as the owner of the companies, in another word, the protections on minority shareholders are weak. Because of the limitations given on companies information and shareholder control, the Chinese stock market is simply affected by the change in government policy (Chen, 2003).
Furthermore, the IPOs are strictly regulated and the market is the low contestability of control in China. Since Chinese government is one of the sponsors of the IPOs and the government owned nearly two-third of the total shares (Chen, 2003, Naughton, 2007). Also the state owned and legal person shares are not able to trade in secondary markets, obviously the non-transferability of state share disallows the government to sell its shares and reinvest in other firm. On account of the ownership system is dominated by government, sometimes stock market listings have only led on to privatization, in which legal- person shares have been placed with private investors.
Finally, the two stock exchanges in China have a similar size and performing virtually same function on every aspect. The market structure is contradicting to the global trend of combining multi exchange into one single stock exchange.46
Thus, the special stock market features result as a remarkable impact on foreigners contribution to Chinese stock markets.
3.8 Regulatory Framework In China, State Council Securities Policy Committee (SCSPC) and the China Securities Regulatory Commission (CSRC) are responsible on regulating the stock market. They were established and began to intervene in the market in 1992. Because of the establishment it allows the Chinese authorities to develop stock market more actively. Besides that the measures improvements allow the supervision and regulation of stock market become more complete. Nowadays the regulatory framework has been set up and the Shanghai Stock Exchange, Shenzhen Stock Exchange, regional offices and the Securities Association of China are all under CSRCs supervision.
Since December 29, 1998 the Securities Law passed, it impacted the development of Chinese stock market seriously. After the passing of Securities Law, a series of policy regulatory and progress on regulating investor, listed companies and government behaviors were established by the Chinese authorities. At the peak time 2000, there were 1086 listed companies with a market capitalization of RMB 4800 billion approached 50 percent of GDP. However, four year later the total capitalization had fallen to 23 percent of GDP (Naughton 2007). By the end of 2007, there are 1530 listed companies in two stock exchanges and its market capitalization surpassed 50 percent of GDP. (SZSE and SHSE factbook, 2007)
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Diagram 3.8.1The Structure of CSRC
Department and Offices Regional Offices CSRC Shenzhen Stock Market Shanghai Stock Market
The Securities Association of China
Source www.szse.com.cn, Zhang(2001)
The current Security Law5 was at the 6th meeting of the Standing Committee of the Ninth National Peoples Congress on December 29, 1998. Nowadays, security law is important on maintaining and promotion the development of Chinese securities market, however, the law is insufficient in some aspects because the provisions are too general. Moreover, the law did not take the update situation into account, such as the possible securities industry challenges face after the accession of WTO.
5
Full Security Law http://www.csrc.gov.cn/n575458/n4001948/n4002075/n4002315/4059170.html
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3.9 China Stock Market liberalization In the early 1990, the establishment of B-shares market is the initial opening of Chinese stock market; it was dominated by foreign currency and available exclusively to foreigners. Since 2001 Chinese citizens were permitted to own or trade in B-shares, similar to other shares which are dominated in RMB. Opening of B-shares created two windows for Chinese capital markets; B-shares market is treated as a channel to help the small amount of Chinese State Owned Enterprises to reserve limited foreign currency ; reveal to foreign investors how did the Chinese authorizes solve the opening problems of stock market and economy , is account as another windows (Chao, 2003). Through years development in B-shares market, there are still lack of listed companies in the market and does not contribute much to the whole market capitalization. Hence, the choices of stock available to foreign investors are absolutely limited. Thus, it is a subject to argue that stock market liberalization is to opening B-shares market to its domestic investors because the policy does not create new avenue to foreign investors (Chen & Yu, 2004).
Other than B-shares, some Chinese companies will list their share in other oversea security market, aimed to gain more investment funds from foreigners, for example, the H-shares, N-share, L-shares and S-shares. Hence, H-shares are the share offered by Chinese companies and listed on Hong Kong Stock Exchange. As this share type can be trade by Hong Kong local investors and other international investors, these shares are promised to trade in Hong Kong dollars but denominate in RMB. N-shares are share issued on New York stock exchange and they are subscribed in US dollar and denominated in RMB. However many N-shares are not trade directly on stock exchange, they are49
issued by the ways of ADRs (American Depository Receipts). L-shares and S-shares are shares offered on London Stock Exchange and Singapore Stock Exchange respectively. (Green, 2004 ). However, those types of shares are the process of Chinese stock market liberalization; they are just another way for stock listing and trade.
Only consider as a real liberalization, an emerging country should open its domestic market to foreign institutional investors and complete opening finally. Many Chinese economists such as Jiao (2003) used Taiwan QFII as reference to predict the impact of Chinese QFII scheme. In1991 Taiwan was formally attempt the qualified foreign institutional investor (QFII) scheme, through the scheme qualified investors permitted to buy and trade Taiwan listed securities directly. After three main reformations over the 10 years implementation and development, Taiwan stock market achieves the expected result under QFIIs contributions and finally liberalizes its capital market.
In contrast, CSRC and Peoples Bank of China (PBC), the two regulators on Chinas financial markets, jointly established the Chinas QFII regulation and system in a decree titled, Provisional Measures on Administration of Domestic Securities Investment of Qualified Foreign Institutional Investors (QFII), in November 2002. It notified the first step of liberalization where foreign institutional investors can directly enter into Chinese stock markets.
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3.10 Summary Regarding to the accession of WTO, Chinese economy grow rapidly and its stock market show its talent to be the top in the world. However, due to the immature Chinese stock market, many problems are still questioning the direction of its markets to be fully liberalized. Therefore to achieve better result, Chinese authorizes need to put more effort on improvements in every aspects. In next chapter current status of QFII will be examine in detail and follow with a comparison of Taiwans QFII scheme.
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Chapter 4 China's QFII scheme and Comparison with Taiwan's QFII scheme
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4.1 Introduction Since the entering of World Trade Organization in 2001, QFII was initially launched in China on November 5, 2002. The Provisional Measures on Administration of Domestic Securities Investments of Qualified Foreign Institutional Investors (QFII) was issued by the Chinese Securities Regulatory Commission (CSRC) on September 11, 2006. The QFII regulation is absolutely a successful policy which initially allows foreign investors to invest and trade A-shares in Chinese history. The following chapter will discuss the basic concept of QFII regulations and recommend the future developments depending on Taiwans QFII experience.
4.2 QFII definition QFII, Qualified Foreign Institutional Investment, it is a kind of transitional policy especially designed for emerging market. Such scheme is usually used to overcome the restrictions of exchange freely, and closed-end capital policies to foreign investors. As a result, attract more foreign investments and open the capital markets gradually are the main objectives of such scheme. Emerging markets such as South Korea, India, Brazil and China Taiwan province and etc, used this scheme for market liberalization. After adopted such scheme from early 1990s in those emerging countries, stock market liberalization is accelerated in a relatively safe environment and its effectiveness was being proved (Chen, 2006). Therefore in the case of China, QFII is the ideal choice for attracting more foreign portfolio investments to enter Chinese market until renminbi (RMB) became freely convertible.
In China, a QFII is referring to a foreign fund management company, a foreign53
insurance company, a foreign securities company or other asset management companies that have been approved by the CSRC to invest in China securities markets and obtained a quota from the China State Administration of Foreign Exchange (SAFE) to remit foreign exchange into China to make securities investment. As China has constantly restricted foreign exchange control, such scheme is used to enhance the entry of foreign capital and companies into Chinese securities market. Because of the QFIIs activities and qualifications are strictly regulated, the potential interruptions cause by massive capital inflow can be minimized as well.
Besides of the main objectives - promotion of convertible capital account, Chinese authorizes want to improve the corporate governance in the market. Introduction of QFII enable traditional domestic listed companies to learn more advance management techniques from foreign professional investors, in which, encouraged domestic listed companies to repackage themselves for attracting more new investments from foreign qualified institutional investors (Li et al., 2007). In stead of benefit to domestic listed companies, domestic individual investors can also improve their risk management knowledge, investment strategy from the introduction of QFIIs.
4.3 QFII Application and Operation procedures In order to apply for QFII status, a foreign investor / candidate must assign a domestic bank or a foreign banks branch located in China to act as a custodian. The custodian need to submit all application documents, including the application forms, the most recent 3 years audited financial reports, statement on sources of funds etc, to both CSRC and SAFE on behalf of the54
foreign candidate. After the application documents are completed and sent to CSRC and SAFE, decision on the application will be made within 15 working days. In order to encourage medium and long-term investments, preference will be given to the institutions managing closed-end Chinese funds subject to the requirements of pension funds, insurance funds and mutual funds with good investment records in other markets. As soon as the foreign candidate has been approved by CSRC and become a QFII, then the candidate will receive a Securities Investment Licences from CSRC. The QFII applicant can then apply the investment quota from SAFE. This quota is the maximum amount of the foreign exchange that a QFII allows to remit in Chinese securities markets. Therefore, the total investments for QFII in Chinese securities market must not exceed this quota. Nowadays, SAFE has established the minimum investment quota of US$ 5 billion at least and raises the maximum from US$8 billion to US$ 30 billion (Gave, 2007).
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Diagram 4.1 QFII application and operation procedures
Prepare to invest in China s share market
A
Cannot InvestQualified as QFII ?
Hand in application document to CSRC
Appoint one or two domestically registered broker to conduct trading in the exchange
Open a special RMB account at anQualified as QFII
approved custodian bank
Custodian bank opens a security accountApply investment quota form SAFE
for QFII
Exchange foreign currency into RMB QFIIs broker opens a special security account for QFII
Obtain investment quota
Invest in China domestic security markets
Become QFII
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4.4 Characteristic of QFII 4.4.1 Avoid market fluctuation When opening the stock market in developing countries, there are two ways to raise foreign funds, one is indirect way and the other one is raise funds directly. The indirect way mean that the foreign funds are raised by issuing the beneficiary certificates or shareholding certificates to oversea investors and then such fund will be used for investing local security market. Hence indirect way represent the domestic stock market is opened to foreign investment funds which target the same stock market which one country. It is the method chose at the beginning of Taiwans QFII adopted (Lu, 2004). In contrast, Chinas QFII skipped this step and used a direct way. This direct way of investment allows the foreign institutional investors to operate the dealing system of Chinese securities market and compete with local investors. The reason why China used direct way is because the scale of its security market and foreign reserves are far forward then Taiwan and Korean (Xu & Qu, 2003, Lu, 2004). Under such circumstances foreign investors allow acting independently, however, market go larger and mature, the more difficult to coordinate the investors in the market and transaction activities may suffer from global economic situation.
Because of the massive capital flow follow by the introduction of QFII, high quality capital inflow control must be established, such as strong capital inflow control and complete perfect monitoring measures. Unfortunately, the stock price will be affected and volatilize by the world market easier, due to the stock market opening. Therefore the quota set in the QFII regulations limited the capital inflow and minimize the capital fluctuation.57
4.4.2 Scope of QFII The range of qualified institution investors quoted in Chinas QFII is much wider than Taiwan. At the early stage of Taiwans QFII, it just allowed the fund management institutions, insurance companies and bank to join only, alternatively, the securities company and other assets management companies were forbidden. According to the Provisional Measures on Administration of Domestic Securities Investments of Qualified Foreign Institutional Investors (QFII) , the qualified institution investors include overseas fund management institutions , insurance companies , securities and other assets management institutions which have been approved by China Securities Regulatory Commission (CSRC), those institutions mentioned are nearly all the investment institutions inside China . And the examination on qualification are more strict ,for example, the qualified institutions must not have less than US$10 billion assets management in the most recent account year ( Wang, 2008 ,Lu, 2004 & appendix 1 ).
4.4.3 Investment Sectors Control Chinas QFII offers qualified institution investors and local security investment fund quite large freedom especially on investment scope, share types and the shareholding scale etc. Usually foreign investors may want to takeover listed companies by purchasing majority stocks of the corresponding listed companies in secondary market. In order to avoid the risks of important
sectors in the country may be takeover by foreign investors, restrictions such as identifying some non-invest sectors for foreign investors and set the maximum shares which foreign investors can hold are essential. Hence, the provisional measure mentioned that except B-shares, A-shares, Government58
bonds, Convertible bonds, Corporate bonds and other financial instruments are permitted to invest in (Zhang & Zheng, 2003, Lu, 2004 and appendix 1). Also there are some areas prohibit to invest, such as, state safety sector, secret recipe of Chinese traditional medicine, fundamental telecommunication and futures industry etc. All permitted, restricted and prohibited industries sectors for foreign investment are outlined in Foreign Investment Industry Guidelines6.
Chinas QFII provisional measure clearly stated that the share held by each QFII in one listed company cannot exceed 10 percent of total outstanding share of that company and total share held by all QFII in one listed company should not exceed 20 percent of total outstanding of the company. Compare with Taiwan, it limited all foreign investment in one listed company a maximum 10 percent at the beginning of regulation set up (Zhang & Zheng, 2003, Lu, 2004 and appendix 1).
4.4.4 Foreign Exchange Control When a country opens their stock market to foreigners, the certain foreign currency has to exchange to local currency for purchasing local stocks. The foreign investors need to sell and buy the local currency to transfer profit and capital in and out of the country. Therefore the capital inflow and outflow will affect drastically to the countrys foreign market. As a result, restrictions on capital flowing are essential. Looking at the establishment of Taiwan QFII, it
For details of those industries, refer to Catalogue for the Guidance of Foreign Investment Industries (Amended in 2007) http://www.fdi.gov.cn/pub/FDI_EN/Laws/law_en_info.jsp?docid=87372
6
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also took restrictions on capital flowing. It required the foreign capital must be remittance within three months after approved and in the fowling three months capital cannot be repatriated. Moreover the gain from investments can be counted and remittance once a year. Compare to Taiwan, the restrictions in China are more conscientious. The principal and interests can be repatriated three years after its remittance of the principals. The amount of each batch of principal repatriation should not exceed 20% of the total principals, and the interval between two repatriations should not be shorter than one month (Zhang & Zheng, 2003, Lu 2004 and appendix 1). These restrictions are undoubtedly control the risks cause by international flowing capital and the dangers of larger scale maliciously capital withdraw can avoid, so long term investments from QFII are also encouraged.
Nowadays, foreign exchange restrictions has relaxed more than before but RMB is still not able to convert freely especially on the foreign currency capital account. Conversely, there are some argument on the free convertibility of RMB is necessary for A-shares market opening. Freely convert of RMB
allows large amount of foreign capital enter Chinese market, also, the incentive for foreigners to keep RMB in cash can remove as well. Many securities markets in other countries, such as India, Brazil , Korea and Taiwan etc, were also opened to foreign investments without freely convert their currency in before hand. Thus, from the other counties experiences implied that non-convertibility of RMB (Mundell ,2002 ,Chu,2007) should not influence the Chinese stock markets liberalization.
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4.5 Limitation and Risk of QFII regulation Undoubtedly, the introduction of QFII pushes the development of Chinese foreign investment legal framework to another advance situation. The sophistication investment process, confidence of the domestic individual investors in China and the quality of the domestic investment professionals, they are the factors which determine the quality of the QFII policy. In the following section limitations of QFII regulations will be discussed.
4.5.1 Limitation on QFII investors In the article 2, the qualified investors definite as those oversea fund management institutions , insurance companies , securities companies and other assets management institutions which are approved by China Securities Regulatory Commission (CSRC) and assigned investment quota by State Administration of Foreign Exchange (SAFE). Except the three types of institutions are clearly stated, the qualification of other institutions are definite vaguely in article 6. In this article, it just mentioned the requirements on financial, credit status and other aspects only. Thus, it dose not give a clear legal instruction on whether other institutions like government investment institutions and unit trust institutions are qualify as QFII. These confusions inside provisional measure implying that there are inadequacies compare to the formal legislations (Wang, 2006, Wu, 2008). While Chinese government wants to attract more mid- and long- term foreign investments, the high qualification standards, asset holding requirements and the experienced operation history , all of these limitations may block out many worthy and interested foreign investors from Chinese security market.
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4.5.2 Limitation on QFII operation Nowadays, the provisional measures restricted the qualified foreign investors to choose their custodian bank. The investors can only choose one domestic custodian bank to carry on their capital management. Until now there are only 13 custodian banks (Table 4.5.2.1)7 can do the capital custody.
Being with the lack of freedom on choosing suitable a custodian bank, the QFII cannot compare the service of each bank. In order to enjoy better service, the transaction cost of switching back will increases as well. Hence, if a QFII chose a wrong bank at the beginning, then it can just endure to the poor service provided by that bank. As a result QFII needs to bear larger risk while their accounts are completely management by one custodian bank (Hu , 2008). Furthermore, as mentioned in part 4.4.4 the capital can be repatriated 3 months after it entry Chinese market. In which risk of maliciously withdraw of capital can be prevent but also limit the liquidity of QFIIs investment on global level.
According to the analysis made by Hu (2008), he judged that QFIIs are longer acting as long term and worthy investors. Because he categories QFII into two types, sell side and buy side. The buy side QFIIs will usually use their investment quotas for self-trading or set up a Chinese fund which is management by themselves or other trustees. In contrast, the sell side QFIls, which include UBS, Deutsche Bank, Merrill Lynch, Nomura Securities and etc. They will retain some quotas for self-investment and lend most of their
7
http://www.csrc.gov.cn/n575458/n4001948/n4002030/10801331.html
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investment quotas to other investment institutions, in order to gain commission from it. Regarding to the globalize trend, invest in China, appreciation of RMB and the bull market of A-shares, many foreign investors want to entry Chinese market. Until now the investment quotas are still limited therefore renting the QFIIs quotas will give a huge amount and risk-less profit to those sell side QFIIs. Furthermore, Hu (2008) and Pettis (2003) also stated that those who rent the quotas are not long term investors, they are the investors who targeting for short term profit only and their investment funds are counted as hot money. Consequently, market stability will be easily damaged by the hot money effect. If there is a downturn happen, those hot money investors will be the first one who escapes the market. The present securities market is volatilized where there is a large group of hot money investors containing inside the market.
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Table 4.5.2.1 List of Custodian Bank Name of the Custodian No. Bank 1 Industrial and Commercial Beijing Bank of China Limited 2 3 4 Agricultural Bank of China Beijing Bank of China Limited China Construction Bank Beijing Corporation 5 Bank of Communications Shanghai Co., Ltd. 6 7 8 Hua Xia Bank Co., Limited Beijing China Everbright Bank China Merchants Bank Shenzhen Co., Limited 9 10 CITIC Industrial Bank China Minsheng Banking Beijing Corp., Ltd. 11 12 Industrial Bank Co., Ltd. Shanghai Pudong Development Bank Co., Ltd. 13 Bank of Beijing Co., Ltd. Beijing 3-Jun-08 Shanghai 10-Sep-03 Fujian 25-Apr-05 9-Jul-04 Beijing 18-Aug-04 6-Nov-02 Beijing 23-Feb-05 23-Oct-02 3-Jul-98 18-Mar-98 Beijing 29-May-98 7-Jul-98 24-Feb-98 Registration approved date Place of Qualification
Source : www.crsc.gov.cn
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4.5.3 Lack of regulation on information disclosure There is still lack of information disclosure regulations, especially on QFIIs investment aspect. The information such as, proportion of share that QFII held and the companies invested can only view on the CSRCs quarterly report and unfortunately only the top ten share-holdings will be shown. In contrast to Taiwan, they required all foreign capital flowing to be shown on stock exchange everyday. Because the size of foreign capital is relatively large, this policy can avoid any illegal investments happen and better supervision on QFIIs investment behaviors can be provided by administration departments. (Ji, 2007) As a result, general investors can access the QFIIs investment decision more easily. The comparison of Taiwans information disclosure system and Chinese one, Chinas information disclosure system of QFII is definitely far behind and incomplete.
4.5.4 Weakness on QFIIs shareholding control As declared in provisional measures the maximum investment of 10 percent in a single company and maximum 20 percent of combined shareholding of all QFII in a single company (Wang, 2006). This regulation is seem to be efficiently control the listed company takeover by foreigners, but it is just a limitation the scale of A-shares investment in secondary market only .
In fact, there are still many ways authorize foreign investors to gain shareholding in listed companies. For example the Notice on State-owned Legal Person Share Transfer to Foreign Trader made by CSRC and Ministry
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of Finance (MOF) on November, 2002 8 , and Measures for Strategic Investment by Foreign Investors upon Listed Companies9 jointly made by CSRC , SAFE, Ministry of Commerce (MOC), State Administration For Industry & Commerce and State Administration of Taxation in December , 2005, both of them allow the foreigners to buy and own different kinds of shares legally and relatively easier than through QFII. Even though foreigners cannot own majority shares through QFII scheme, foreign investors still have other opportunities to gain shareholding of domestic listed companies (Hu, 2008).
4.5.5 Centralize of approval process Throughout the QFII measures, approvals are required for every single aspect in the application and operation. The government agencies are required for the QFIIs qualification and receiving of investment license, obtaining investment quota from SAFE. Moreover, the set up of special RMB account for QFIIs investment, the choosing of custodian banks and even the capital repatriation are all restricted by central government. While the foreign investors getting approves from the governing authorizes, such as SAFE & CSRC, the more uncertainties foreign investors may face where those authorizes have absolute right on adjusting the qualitative standards and rejecting the foreign investors
For Detial of the Notice on State-owned Legal Person Share Transfer to Foreign Trader http://news.sina.com.cn/c/2002-11-04/1253794928.html Full Measures for Strategic Investment by Foreign Investors upon Listed Companies http://www.for68.com/new/2007%5C1%5Cwa23822943441221700218816-0.htm9
8
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4.6 Reasons of choosing Taiwans QFII as example Taiwans QFII experience gave China a good opportunity to learn from. Its stock market has a longer history than Chinas one, it was established in 1961. In the early of 1990, individual investors were the majority player in the market, nearly 96.6%, which is quite similar to Chinas stock markets nearly 99% are individual investors. At the moment of QFII launched, 1991 & 2002 respectively, Taiwans stock market PE ratio is about 32.05 while there is an average 30 from the two stock markets in China. However, these PE ratios are already much higher than other advanced markets, for example in 1991, the PE of London Stock Exchange and New York Stock Exchange was just 14.2 and 15.08 respectively. Moreover, as Taiwans QFII was abolished in 2003 therefore it is worthy to use as an example to investigate for improvement of Chinas QFII regulation (Lin & Chen, 2006).
Diagram 4.6.1 Comparison of PE ration in Major Stock Market
Source: Lin & Chen , 200667
Apart from the obvious similarity of high PE ratio and market structure between Taiwans and Chinese stock market during the period of QFII implemented, there are some minor reasons which make Taiwan to be a good example to compare with. Emerging market like India and Korea, both adopted similar
liberalization policies as QFII. For India, its government launched a Foreign Institution Investors (FII) scheme in 1992. The qualification criteria and investment choice, shareholding proportion are both similar to Taiwans QFII scheme. Indias FII a allows investors who are professional , good reputation and approved by the Reserve Bank of India - Indias Central Bank and the primary and secondary stock market , including share, bonds, unit trust and etc are open to foreigners. The shareholding is basically same as Taiwans QFII which limited to 10 percent for one FII and 20 percent for all FIIs (Cai2002). While Taiwans QFII is already fully liberalization its stock market, India is sill implementing FII (Indian Reserve Bank web site). Base on the smaller degree of Indias market liberalizes than Taiwans, therefore, Taiwans the successful liberalization experience is a better example.
For Korea, the process of introduce QFII scheme is similar to Taiwan as well. At the beginning of QFII introduce, Korea
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