In this article we will discuss about the corporate governance in China. Learn about:- 1. Emergence of Corporate Governance in China 2. Financial Reform and the Establishment of Capital Markets 3. The Establishment and Development of Stock Markets 4. Foreign Investment in the Chinese Stock Markets 5. SOE Reform and Corporatisation and Few Other Details.
- Emergence of Corporate Governance in China
- Financial Reform and the Establishment of Capital Markets
- The Establishment and Development of Stock Markets
- Foreign Investment in the Chinese Stock Markets
- SOE Reform and Corporatisation
- The Approval System for an Equity Issue
- The Procedure and Methods for an Equity Issue
- The Pricing of the IPO
- The Role of the Underwriters and the Costs of an Equity Issue
- The Implications for Corporate Governance of Going Public
- The Institutional Shareholders
- Capital Structure
- Financial Reform and the Capital Structure of Chinese Firms
In 1990, China became the first communist nation in the world to have a Stock Exchange with the formal establishment of the SHSE. Five Chinese companies became the first batch of firms listed on the official Exchange. This was a result of China’s determination to establish a market-oriented economic system through economic reform and openness to the world, though doing so in a gradual evolutionary manner.
The general principle guiding this gradualist approach to reform in China is that every new institutional change should be first implemented in one geographical area or industry sector, before being later put into wider application when the paramount leaders believe it is good for the rest of the economy.
This top-down approach has been criticised by many but, at least until now, the Chinese economy appears to be performing well in comparison to other transitional economies, many of which have experienced serious difficulties and which look likely to experience further difficulties in the future.
As part of the overall programme of Chinese economic reform, the reform of the financial system had four main objectives:
1. To provide additional finance channels through which the Government might raise capital for investment projects.
2. To address bad loans/banking problem inherited from the central planning era.
3. To address the issues of control and ownership as the Chinese authorities hoped to establish a ‘modern enterprise system’, which ‘clarified property rights, designated authorities and responsibilities, separated government and enterprise functions, and established scientific management’. The authorities believed that the introduction of a joint stock system, and more specifically the corporatisation of the SOEs, was the main vehicle to achieve this objective.
4. To build an institution that can undertake the role of financial intermediation, which is essential to a market economy.
2. Financial Reform and the Establishment of Capital Markets:
Fiscal Constraints and Financial Reform:
The revitalisation and evolution of the financial markets in China can be regarded as a microcosm of the overall picture of economic reform in China. With the Introduction of economic reform, the planners of the Chinese economy felt that the fostering and development of competitive commodity markets were constrained by the fact that economic resources were limited due to the lack of capital markets.
All resources were allocated by the planners through a State investment mechanism. To satisfy the new demands for goods and services, the State had to finance new investment projects either through administratively-guided bank loans, or through funds directly from the public reserves.
But the State found that it was increasingly difficult to do the latter as fiscal revenues were declining as a result of decentralisation. New sources of capital needed to be found to finance the capital-thirsty sectors, as was common in many developing economies.
3. The Establishment and Development of Stock Markets:
Demirguc-Kunt and Levine (1996) suggest that, although economic growth in developing counties initially relies on banking finance, stock markets play a more and more important role in corporate finance as the economies grow. Stock Exchanges did exist in China before the establishment of the People’s Republic in 1949, though on a very small scale.
The emergence of a joint-stock system and Stock Exchanges in ‘Old China’ was in part due to the introduction of Western management technology, and in part due to the natural need for broad financial channels. Capitalists favour the pooling of capital so that a larger scale of production can be financed.
But soon after the establishment of the People’s Republic, the Stock Exchange in Shanghai, and other in small scale. The emergence or a joint-stock system was intrinsically contradictory to socialist ideas. Thereafter, anyone advocating the idea of a Stock Exchange was liable to serious punishment.
With the advent of greater freedom in decision-making since reform, some pioneering non-State firms, such as the collectively- owned firms, began to seek equity from ‘private’ investors, usually the firms’ employees. Beijing Tiaopqiao Department Store was the first one in China to issue ‘equity’ to its employees. The motivation for this was to finance business expansion, and to link the performance of the firm with that of its employees.
But the ‘shares’ may be better understood as a bond-type security—the firm promised a guaranteed rate of return over five years and redemption of the initial investment at the five-year maturity date. The shares were also not transferable before the maturity date.
More importantly, there was no voting right associated with each share, and the firm did not set up a Board of Directors. Notwithstanding, the simplicity of the ‘shares’, and their variation from the accepted definition, the issue was still significant in that it was an attempt to raise capital from private sources in the name of ‘shares’ and to introduce an incentive scheme other than the then- prevalent bonus scheme. A more standard share issue was made by Shanghai Feile Co.
Though not transferable, the Feile shares had all the other usual features of shares—residual claim rights, infinite maturity, and voting rights. The importance of these two pioneering firms was that they made people tolerate, and then accept, the concepts of the shareholding system. The policy-makers silently watched everything without significant obstruction.
Increasingly other firms followed suit to issue equity or bond- type securities. But the lack of transferability increased the liquidity risk, thus higher returns were required by the Investors, with consequently higher capital costs to the issuing firms. To tackle the problem, some local non-banking financial institutions in Shanghai set up a trading room to facilitate the trading of shares. This was the embryo of the SHSE.
The SHSE was formally organised on 19 December, 1990. There were just simple rules to guide the transactions of shares issued by the five companies listed initially, a number which rose to eight by the end of the year. All the transactions were dealt with by manual bookkeeping. On July 3 of the following year, SZSE was established, initially for the trading of the stocks of only two companies.
The operations of the two Stock Exchanges are now carried out independently and separately—listing and trading of shares are exclusively for shares listed on each exchange. Once a company has chosen to list and trade its shares on one Exchange, it must stay listed on that Exchange and no cross-listing and trading are allowed- a different practice from that in many major Stock Exchanges around the world.
Up until 1998, the two Exchanges belonged to their respective municipalities (i.e. Shanghai and Shenzhen), though they were national Stock Exchanges in that they provided listing and trading services to companies from all over the country. However, in 1997, the State Council, under Premier Zhou Rongji, decided to take control over the two Exchanges from the municipalities, and placed them directly under the control of the China Securities Regulatory Commission (CSRC), making them truly national exchanges.
The official explanation for the take -over was that it would make the Exchanges serve better the needs of the nation, but it was rumoured that the real reason was the perceived collusion between the Exchanges and some institutions (including listed companies and investment houses) which, with the connivance of the municipal authorities, violated official regulations by manipulating shares prices.
Currently, the two Exchanges trade not only shares, but also Treasury bills (T bills) or bonds, corporate bonds and funds. All transactions are carried out by a continuous auction mechanism, and information regarding all the deals is scriptless and stored in central computers in the Exchanges.
In term of the efficiency of making transactions, they are as modern as any other major Exchange around the world, though there is much room for improvement in the observation of regulations by the market participants. Advanced financial products, such as stock options and stock market index options, are not yet allowed to be traded.
From 1990 to 2000, the number of Chinese listed companies increased from 10 to 1,121- that is, an annual rate of growth of 53.2 per cent. Total capital raised from the various investors summed to RMB 749.91 bn by the end of August 2001. The largest (IPO) was that of China Petroleum Chemical Corporation (Sinopec), which raised US $6 bn from international capital markets.
4. Foreign Investment in the Chinese Stock Markets:
China has been among the largest recipient countries of foreign investment since the implementation of its open-door policy. But, nearly all the investments have been in the form of FDI. There has been comparatively little indirect investment via the stock markets, yet this provides greater liquidity for potential Investors. B-shares fulfill two needs- they enable firms to raise foreign capital, and they allow foreign investors to make alternative investments with higher liquidity.
To facilitate the inflow of foreign capital in the stock market, an issuer of B-shares must, besides satisfying the requirements stated in the securities regulations, meet the following conditions:
1. It must have obtained approval from the relevant authorities for its use of foreign investment, or for its conversion into a foreign-funded enterprise.
2. It must have a stable source of adequate foreign exchange income, and the total amount of its annual foreign exchange income must be sufficient to pay the annual dividends.
3. The proportion of B-shares to the total number of shares must not exceed the ceiling determined by the relevant authority. The aggregate amount of shares to be issued is fixed in each year, and the total number of firms allowed to issue foreign shares is also limited.
Currently, there are 102 companies with B-shares listed on SHSE and SZSE, which have raised total capital amounting to US $4.93 bn (RMB 41.16 bn, or 5.5 per cent of the total equity capital raised since the establishment of stock markets) by September 2001. The capitalisation and turnover of the B-share markets are only 2.2 and 3.2 per cent respectively of the corresponding figures for the stock markets in aggregate.
The B-share markets thus play an insignificant role in capital-raising compared with the more important A share markets, and the intended liquidity benefits are limited by the fact that trading can only takes place on the B-share markets, and is limited to foreign investors.
5. SOE Reform and Corporatisation:
A more important motivation for the authorities to implement financial reform was to resolve the problem of a lack of incentives in manufacturing production. This had been easily resolved in the agricultural sector, by simply allocating farmland to individual households, though this policy did entail some costs particularly linked to the loss of scale economies.
But it did ease, in just a couple of years, the problem of food shortages that had troubled China for decades. Such a solution was not feasible in the industrial sectors, as dividing the means of production was not a sensible way of linking the output to individual workers. This is a problem which has taxed practitioners and theorists not only in centrally- planned economies, but also in the West.
The problem is understandably more severe in centrally- planned economies, in that there are no clearly-defined ultimate owners who can monitor the performance of the firms, nor are there competitive capital and commodity markets to punish poorly- performed firms through bankruptcy or take-over.
The economic performance of the SOEs was improved during early 1980s by the introduction of the bonus system. This was based on the belief by the authorities that the poor performance was caused by the lack of an appropriate incentive mechanism to individual employees, including top management.
But soon the authorities found that the bonus system produced a ratchet effect—all decisions to increase the bonus were welcomed, but to punish firms or individual workers for poor performance by reducing or removing bonuses was simply not politically possible.
Contact responsibility systems were introduced in most large and medium-sized State industrial enterprises during 1986-97. The system officially intended to place (governmental) ownership at arm’s length to enterprise management, so allowing more decision-making space to the latter. In the contract, the firm hands over an agreed amount of annual profit and tax for which they have contracted, to be permitted to retain a proportion of any surplus it achieved above the contracted level.
Also, the firm guaranteed to invest to increase asset values and to develop technology by an agreed amount, using retained profits during the period of the contract. But substantial collusion soon emerged between the Directors of the companies, and the Heads of the supervising government departments, leading to widespread corruption. The Directors found that it was easier and quicker to reward them by simply transferring the firms’ assets to their own firms.
The lesson was that it is not feasible for the authorities simply to relinquish control to the firms’ managers in an attempt to improve performance. Rather a new relationship between the State, as owner, and the firm needed to be developed.
Consequently, in 1993, the National People’s Congress passed a resolution to establish a Modem Enterprise System, indicating a commitment to long-lasting progress towards a market economy. It was evident that the policy-makers in China clearly understood that a clear-cut system of property rights was required as a prerequisite for widening the finance channels and permitting the introduction of non-State capital into the SOEs.
This, in turn, required the new institutional arrangement of a joint-stock system. With the endorsement by the Fourteenth National Congress of the Chinese Communist Party in 1993, the corporatisation of the SOEs and their listing on the Stock Markets was carried out very quickly, only three years after small-scale experiments had been carried out on collectively owned enterprises (COEs) and selected SOEs.
The key features of this initiative were the approval of diversified forms of ownership by State, private and foreign investors, which would compete on equal terms in the marketplace, and the introduction of a framework for the modern corporate governance of State-owned firms.
The resolution was broadened and accelerated after the Fifteenth National Congress in the autumn of 1997, when it was announced that smaller State-owned enterprises would be effectively privatised by converting them into various forms of non-State and non-collective ownership, especially stock cooperative companies owned by their employees. For the large and medium-sized SOEs, the favoured organisational structure was the corporation.
‘Corporatisation’ involves the setting up of an independent legal entity, with the State as owner. Corporatisation usually involves commercialisation of activities so that public enterprise operations are ‘governed by commercial law private enterprises. The original capital must be audited and registered, and the owners of the capital must be identified.
In cases where the assets belong to different State agencies, the assets still need to be attributed accordingly. For example- if the assets of a firm are invested jointly by the Provincial Government and the Municipal Government, then the assets must be so recorded, and representatives must be assigned from the respective owners, even though both are State agencies.
A typical process of corporatisation may be summarised as follows:
1. Asset assessment and verification- This work is carried out by chartered accounting firms.
2. Identification of owners and allocation of ownership- For historical reasons, firms may have received finance from different State investors, through different channels, and for different objectives. There may be disputes about the classification of some capital. For example, some debt capital previously issued by State banks might be classified more properly as equity capital.
3. Choice of company form- According to the 1994 Company Law, the enterprise may choose to be either a limited liability company, or a joint stock company.
4. Establishment of the Board of Directors- If the enterprise does choose to become a joint stock company, then the first general shareholder meeting will be required to approve the company charter and the appointment of the Directors.
5. Appointment of Senior Managers- The Board of Directors appoints the Chief Executive Officer (CEO), and approves the CEO’s nominations for deputy CEO and other senior managers.
6. The new company begins business.
The corporatisation of firms which had previously been solely- owned leads to a new corporate structure, as well as to the formation of a new financing vehicle as many firms choose to get listed and raise new capital from the stock market. Further, the corporatisation of SOEs and other firms introduces a governance structure within which multiple owners jointly share finance and control, a phenomenon never seen before in China’s planned economy.
Each owner needs to both cooperate and compete with the other owners to ensure both the protection of their investment, and a good financial return. The separation of ownership and control renders the situation more complex, especially in the case of an economy in continuous transition, where old practices and laws are being abolished and new ones established.
Experience shows that constructing a workable system of ownership rights is a complex problem, even in mature and developed markets, and has been the subject of heated debate in many countries.
Going Public and the IPO:
The primary aim of corporatisation for a firm is to raise funds for their business by going public. In China, the policy-makers have an additional objective, namely the transformation of the governance structure of the firm by introducing monitoring by the capital markets. Furthermore, an implicit motive of the policy-makers is to privatise at least some of the previous SOEs.
6. The Approval System for an Equity Issue:
The system of approval for equity issue in China shows traces of its origins in a planned economic system, but has also been marked by the continual adjustment of regulations and the adoption of new laws. The approval of a share issue to the public involves a two-stage quota system.
At the first stage, the aggregate amount of new shares to be issued each year is determined by a quota set by the State Planning Committee, the Central Bank and the CSRC. The quotas are then distributed to Individual Provinces or Ministries that own key SOEs. In the years 1993-97, the quotas were RMB5, 5.5, 15, and 30 bn shares, respectively.
At the second stage, each Province or Ministry chooses the firms in the light of certain stated criteria. These criteria reflect the central Security Regulatory Authorities’ perceived regional development needs, and provincial differences in production structure and industrial base. Within each regional quota, the local Security Regulatory Authorities invite enterprises to request a listing, and make a selection based on criteria which combine good performance as well as sector development objectives.
Infrastructure enterprises, especially those specialising in electricity and water supply, have often been given priority for approval. The local Securities Regulatory body then forwards the applications of the chosen firms to the CSRC for final approval, though this is usually a routine matter.
To ensure the quality of the firms to be listed, the CSRC introduced a series of new directives in 1995, which put forth several additional requirements that firms would need to meet before a formal listing, even though their applications might already have been approved.
a. The first directive required that all issuing firms operate for one year before formally issuing shares to the public, so that their performance might be monitored during this ‘probationary period’.
b. The second was that, during this period, all directors, senior managers and supervisors needed to pass examinations organised by the CSRC in order to test their capability and knowledge of management, and their understanding of relevant laws, regulations and policies.
c. The third was that the issuing firms should provide their supervising department with profitability forecasts for all the projects which were to be financed by the capital raised.
d. The fourth was that the underwriters should coach the issuing firms for one year on the matter of issue procedure, to ensure a successful issue.
The approval system has been widely criticised for the intrinsic drawbacks in the selection and application process of issuing firms. First, the requirement that IPO reports be verified by local governments is likely to promote interventions from governments, and to blur the relationship between the administration and the enterprises. Second, the whole process of approval takes a long time to conclude.
As a result, firms that have obtained approval usually hurried to a formal listing regardless of market conditions. Finally, and most seriously, the exclusive and non-transparent policy implemented by the CSRC and its associated administrative organisations was the source of widespread corruption as firms pursued approval to raise much-needed capital.
The firms were either forced to offer bribes to secure the success of their applications, or to construct fraudulent profitability figures, or both. The system was also biased toward the SOEs, and good firms with other ownership structures found it difficult to compete on an equal basis.
This undermined one of the basic functions of capital markets as a means of resource allocation. In March 1999, the Issue quota system was abolished, though any unfulfilled quotas set earlier remained valid until they were used up. A new approval procedure was introduced which was based on a ‘verification system’.
According to the new regulations, any firm that is able to achieve certain pre-determined standards can apply for listing on the Stock Exchanges. These standards relate to the applying firm’s business line. Its financial strength, quality and prospects, the minimum number of shares to be issued, and the offer price.
Listing is authorised by a scrutiny committee consisting of professionals and experts. The transition from an administrative approval system with annual quotas, to a verification system reflects progress towards a market economy system.
However, there is still a strong element of administrative intervention, and much still needs to be done before the system is similar to that in the West, where the financial authorities only ensure that the disclosed information is genuine and the offer price is set by the firm itself according to market conditions.
7. The Procedure and Methods for an Equity Issue:
On the more technical aspects of issue, there are a number of steps a firm must take after it has been selected for an Initial Public Offering, but before market trading begins.
Some typical steps include:
1. The setting of offer prices by the lead underwriter, according to the regulations of the CSRC;
2. The publication of a prospectus in newspapers, and the selection of underwriters;
3. The purchase of application forms by prospective investors; and
4. The choice of application method. The firm needs to choose one of three major application methods, as will be discussed in more detail later;
5. The delivery of shares to the lottery winners, after payment has been made.
The choice of application method is central, in that it affects the chances of success of individual investors and hence the eventual distribution of share ownership. All three methods involve a lottery mechanism as the primary means of share allocation, but the mechanism has undergone several substantial changes over the years.
Before October 1992, the Security Regulatory Authorities designed a lottery system based on a preannounced fixed number of application forms. Each retail investor was allowed to purchase a limited number of lottery forms from the Central Bank or its subsidiaries. The lottery winners were entitled to a certain number of shares per winning form. With the number of lottery forms pre-determined, the odds of winning the lottery was known to investors.
But the frantic demand for shares by investors made the forms the passport to an instant gain, and this led, not surprisingly, to the corruption of people who had easy access to the forms. In recognition of the problem, the CSRC introduced, in December 1992 and August 1993, two new lottery mechanisms to replace the old one. One mechanism was based on an unlimited number of application forms.
The issue agency sold as many lottery forms at a low cost as investors were willing to buy. The other lottery mechanism was based on savings deposit certificates. Investors were required to deposit a certain quantity of funds into a special saving account when submitting an application for shares and these funds could not be withdrawn until the lottery was completed.
Deposits in these special savings accounts earned relatively low interest. Both new methods imposed a cost on speculative applications by investors. Under all the lottery mechanisms, the IPO price is determined before the publication of the prospectus.
In April 1994, two new auction mechanisms were introduced. Under the first auction mechanism, an issuer set an initial price and investors were required to bid for the price and quantity. The final offer price was set at the level where the accumulated quantities demanded by investors equalled the total number of new shares available. But soon the authorities found the new methods problematic.
The former method, when oversubscribed, would give rise to a high offer price and subsequently to a negative return during the first trading days. Resentful investors put pressure on the authorities to abolish the methods after the IPOs of a mere three firms. Under the second auction mechanism, the IPO price was fixed and investors were invited to bid for the quantity of shares.
In case of oversubscription, all investors were guaranteed a certain amount of shares and the remaining shares were distributed in proportion to investors’ bids. The latter method led to a widely- dispersed distribution of shareholdings—in several cases. Investors were offered only tens of shares. This Increased transaction costs for the small investors—they had to pay a minimum commission for the transfer of a mere 10 shares.
Since then, and based on past experience, the CSRC has introduced three new methods, all with predetermined and announced offer prices. All three methods require investors to set aside full deposits according to the number of shares for which they are bidding, and the offer price. Each investor is then given a series number, and waits for the results of the lottery.
The winners receive their shares, whilst the unsuccessful investors are refunded their money within eight days of the lottery. The proceeds raised in the IPO are then transferred to the account of the issuing firm. Each investor can bid for a maximum of 1 per cent of the total number of shares.
The differences between the three methods mainly concern the agency through which the bidding takes place. In the first method, the bidding is affected through the national securities trading network. This is very sophisticated, even in comparison with developed markets, and this method has become increasingly popular as it is highly efficient in both cost and security terms.
The second method is carried out through local issue agencies, which take both the deposit and issue certificates with series numbers to investors. The lottery is carried out in a local public place, with official notaries as witnesses. The agencies keep the deposits, and distribute the share certificates to the successful shareholders.
The advantage of the second method is that it can attract new local investors to join share-trading activities. The third method is similar to the second one in that the IPO is affected though local agencies but the difference is that, after the lottery, the unsuccessful bidders have to leave their funds in the banks for 3-6 months.
8. The Pricing of the IPO:
The pricing of an IPO is a critical step as it directly affects both the wealth distribution between the initial and the outside owners, and also the success of the equity issue. Thus IPO pricing is a matter which not only involves the issuing firm and the underwriters, but also regulatory bodies around the world. Prior to the establishment of the Chinese stock markets, most equity was issued at face value.
From the early 1990s to March 1999, the offer price was set under the strict regulation of the CSRC. If the price was set too low, then the State-owned assets were depleted. If too high, then there was a crash of the post-issue stock markets. The benchmark for pricing was the price-earnings (P/E) ratio, though with some adjustment and variation.
In the early 1990s, the CSRC required that all offer prices should be determined solely by a P/E ratio of 13. But earnings could be calculated arbitrarily by the issuing firms; hence they could justify a range of offer prices using the set P/E ratio. From 1994 onwards, the CSRC maintained the P/E ratio as a benchmark, but insisted that earnings per share should be calculated on the basis of past accounting profit figures together with a prediction of future profitability.
And the CSRC permitted a range of P/E ratios between 15 and 20. This rigid offer pricing thus ignored other important aspects of asset pricing, such as industrial characteristics, firm size, and the potential for future growth.
In March 1999, the CSRC amended the regulations on IPO pricing to a more market-oriented approach. Thereafter, the issuing company and the underwriter had to submit an IPO pricing report to the CSRC, and the offer price had to be agreed by the CSRC. But the firm was allowed to consider factors other than the P/E ratio in setting the offer price.
The pricing reports of new IPOs should thus include industry analysis, company analysis, and an analysis of current market conditions such as the share prices of comparable companies. The offer price should reflect these factors, and be agreed initially by the issuing firm and the lead underwriter. After reviewing the report, the CSRC sets a narrow price range within which the issuing firm can make adjustments according to market conditions.
The effect of the new rules is that the average P/E ratio of companies listed after March 1999 has increased substantially, from the previous range of 15-20 to around 30. Once an offer price has been set, it is announced in the prospectus, together with the numbers of shares available to the public, and cannot then be changed.
It is noteworthy to point out that an IPO price celling is not unique to China. In the United States, the SEC regulations specify that new offer prices should reflect a maximum P/E ratio of 200, and prices are usually filed two weeks in advance of the actual offering, although they can be adjusted in some cases.
9. The Role of the Underwriters and the Costs of an Equity Issue:
The underwriters play a key role in the success of an IPO. There are broadly two possible arrangements which can be made between the issuing company and the underwriters: one based on a ‘firm commitment’ and the other on ‘best effort’. Under the former, the underwriter guarantees a minimum level of proceeds from the IPO, based on an agreed offer price and number of shares, and regardless of how many shares are sold.
If not all the shares are sold, then the underwriter will take over the remaining shares at a price a little lower than the market price. But if demand is higher than anticipated, the underwriter can issue a further 15 per cent of shares and earn extra commission. The alternative is the ‘best effort’ arrangement, under which the underwriter helps the issuing firm to issue the shares, but does not guarantee a full sale.
The issuing firms may then find that some shares cannot be sold to the public, and that the proceeds raised may be smaller than anticipated. Clearly the ‘firm commitment’ arrangement is safer for the issuing firm, but riskier for the underwriter.
In China, there are a number of features related to the role of underwriters in the IPO process which should be stressed. First, all IPOs are made under a ‘firm commitment’ arrangement. This is not a problem for the underwriters, as almost all IPOs have been oversubscribed and the shares have performed well afterwards. But the underwriters are not permitted to issue additional shares, even when there is substantial demand.
Second, there is little competition for underwriting business, unlike in the West, since all Provinces and major cities in China have set up their own securities companies, which are owned either by the Provincial or the Municipal Government and which undertakes both IPOs and any subsequent SEO by local firms.
As a consequence, the choice of underwriter in China is usually made according to the issuing firm’s geographic location—the issuing firm will only employ the local securities company, either because of their relationship or because of pressure from the local government.
According to the CSRC, the underwriting costs include the commissions paid to the underwriters, to the accounting firms for auditing, asset assessment and verification, and profit-forecasting, and to the lawyers for legal consultations. The costs of document preparation, printing, dissemination, prospectus publication, and advertisement are not listed as issue fees.
The underwriting fees, which constitute the largest part of the total direct costs of IPOs, are strictly regulated by the CSRC.
The standard charge is linked to the issuing method.
For an IPO through the national trading network, the fee is –
(i) 1.5-3 per cent of proceeds, when the proceeds are smaller than RMB200 mn;
(ii) 1.5-2.5 per cent of proceeds, when the proceeds are between RMB200 and 300 mn;
(iii) 1.5-2 per cent of proceeds, when the proceeds are between RMB300 and 400 mn; and
(iv) A maximum fee of RMB9 mn for an IPO with proceeds of more than RMB400 mn.
For an issue through a local agency, the maximum commission per share is limited to 0.1 RMB, and the total commission to RMB5 mn.
Interestingly, the underwriters in China also are responsible for some duties both during the IPO and after the issue, which are not common in the West. One of them is to provide a one-year training programme to the issuing firm prior to formal listing.
This is to ensure, according to the CSRC, that the company to be listed is well prepared to meet the requirements of publicly listed companies (e.g. information disclosure, accounting standards, general meetings, and Boards of Directors). The effects of such an arrangement are uncertain, since there is not much for the underwriters to do when everything has already been arranged by the local government.
10. The Implications for Corporate Governance of Going Public:
The IPO and the process of going public are not merely means of raising finance, but also entail a change of governance structure and mechanism. In particular, management is exposed to new discipline from the market, as intended by the decision-makers, and listed companies are subject to regulations on information disclosure, to public criticism, and to fluctuations of stock prices.
A further implication is the impact of the initial ownership structure upon the underpricing of the IPO. The underpricing of the IPO may be used to achieve multiple objectives. It may be used to signal the quality of the firm, to increase liquidity, or to maintain control over the firm as a dispersed outside shareholding makes take-over harder.
The Government has introduced a variety of share categories, so that ownership of the SOEs is dispersed between the Government itself, other SOEs, the firms’ own employees the domestic public and foreign investors
11. The Institutional Shareholders:
Many domestic institutions hold significant numbers of the shares traded on the Stock Exchanges. According to China Securities News, the numbers of shares held by domestic Institutional Investors in China’s two A-share markets had risen 26.5 per cent from 282,000 at the end of 1999 to 356,700 by the end of July 2001.
Of this total, the shares owned by the institutional investors on SZSE grew from 107,200 to 129,100, an increase of 20.4 per cent. Those on the SHSE surged 30.2 per cent from 174,800 to 227,600. The increased number of institutional investors in China has been accompanied by a rise in shareholder activism.
In developed economies, institutional shareholdings predominate. In the United Kingdom, for example- institutional shareholdings increased steadily from less than one-third of the total in 1963, to two-thirds in 1993. It has been suggested that the active participation of institutional investors in the corporate governance mechanism can improve corporate performance, both due to the significant investment of funds and the input of professional knowledge.
Whilst the appropriate role of institutional shareholders is still under debate in China, many regard institutional shareholdings as a way of establishing sound corporate governance.
One role is to stabilise the highly volatile stock markets, as institutional investors are hoped to be strategic investors pursuing long-term returns rather than short-term profits, thus reducing short-term trading activities and mitigating substantial fluctuations in stock prices. A second role is that a large shareholding and the possession of investment expertise enable the institutions to play an active part in corporate governance.
But the role of institutional investors is questionable if they themselves are State-owned or State holding companies- by what mechanism can they monitor the managers of companies that they don’t own?
As Coffee (1991) pointed out-
“The problem of who will guard the guardian is a timeless one, but it is particularly complicated when the proposed guardian is the institutional investor. Not only do the same problems of agency cost arise at the institutional investors level, but there are persuasive reasons for believing that some institutional investors are less accountable to their ‘owners’ than are corporate managements to their shareholders. Put simply, the usual mechanisms of corporate accountability are either unavailable or largely compromised at the institutional level.”
The traditional view of debt is that it serves as an alternative form of capital financing to equity. However, the development of debt theory sheds light on this understanding of debt. The first financial reforms of China involved the adjustment of firms’ capital structure. Indeed, it can be argued that the path of economic reform in China can be viewed in terms of the adjustment of laws and policies with regard to debt and equity, both in the aggregate economy and in firms.
On one hand, the pressure to make interest and principal repayments on debt forced the decision-makers to seek equity investment from non-State investors when facing fiscal constraints. On the other hand, the relinquishment of control over the firms to the non-State equity investors raised concerns about the socialist characteristics of the Chinese economy.
Concern about the debt burden was justifiable. As Miller (1998) has pointed out, the importance of capital structure can be observed directly from the South Korean and Japanese experience. Both economies are still struggling to solve the problems of debt accumulated from their over-dependence on debt during their periods of economic takeoff.
The huge debts of the banks as a result of State policy towards the non-performing corporate groups constitute serious threats to their success. Given similar policy in China towards the market economy, it is natural to be concerned about the capital structure of listed companies in China.
In a centrally planned economy, the distinction between debt and equity in a State-owned firm is not significant—since the State provides all the capital that the firm needs. At the macro level, the State borrows debt from households in the form of family savings, to complement other important sources of capital including fiscal revenue.
The economy is organised like one huge company. The function of the firm is as a production unit, rather than as a self- sustained entity, and the cost of capital is not a matter of concern. Investment thirst and soft budget constraints are common.
Since 1992, the large-scale corporatisation of the SOEs has further reduced the debt level for two reasons. The first is that most of the new capital injected into SOEs has taken the form of equity, instead of debt or grants. The State is the provider of some of this new capital, but the ownership is clearly registered and traced. The second reason is the participation of investors other than the State, including individuals, foreign investors, COEs, and TVEs.
These new investment sources have not only provided equity capital for the firms, but have also reduced the debt level. According to the SHSE Annual Report (2000), many firms repay a part of their previous debt with the proceeds raised during their IPO.
The Monitoring Role of Banks:
A stylised fact about the capital structure of Chinese firms is that the vast majority of corporate debt is privately placed debt in the form of bank loans. The total amount was RMB 9,773 bn in 1999, and priority was given to State-owned or State-controlled firms who received over 70 per cent of total bank loans.
Public corporate debt markets are not well developed in China. Publicly-placed debt, with merely twelve corporate bonds, only amounted to RMB 17.9 bn with a market value of RMB 15.3 bn. This accounts for just 6 per cent of the stock market in terms of total capital raised, and 0.6 per cent in terms of stock market capitalisation.
The theory of corporate governance regards debt as a governance mechanism in that it provides additional monitoring over management. Furthermore, the placement structure of debt has implications for governance. Privately-placed debt, usually bank loans, enables the debt-holders (the banks) to monitor the corporations more directly and collectively than in the case of publicly-placed debt, where the scattered debt-holders do not have the same power over their loans.
The Chinese Government has been trying to adopt the Anglo- American model of corporate governance, which is characterised by the protection of minority shareholders and the prohibition of shareholding by banks. Yet the Government also introduced a ‘main bank system’, based on the idealised Japanese model, in its financial reform package of 1996. This system is supposed to provide the participating main bank with a more comprehensive capability to monitor the performance of the enterprise.
According to the Interim Regulations for the Administration of the Main Bank, the firm is obliged to disclose information to the banks about the firm’s major business and financial activities, and to accept monitoring from the main bank. The bank has the right to audit all the dealings between the firm and other banking institutions, and to punish the firm if there are any activities by the firm breaching the terms of establishment of main banking relations.
For its part, the bank is supposed to give priority to the firm with regard to the provision of reasonable loans as well as other financial services. Officially, the idea was to promote a major monitoring role for the designated main banks to restrain the ‘Inside control’ behaviour within large SOEs, and to develop a stable bank-centred financial environment for the enterprises to become modern corporations and to show better performance.
However, the realisation of the above objectives for the ‘main bank system’ was hampered by the fact that the choice of main bank is made by the firm’s supervising Government department. The direct monitoring effect of the main bank is thus weakened by the intervention of the Supervising department.
It would be premature to conclude that the ‘main bank system’ will not function effectively in China, and there are obvious, differences between the Chinese and Japanese realities. However, the Japanese model has been the subject of criticism on the grounds that banks have provided loans to their related firms for low-return projects, which this has led to a decade-long recession which shows no prospect of an end in near future.