Securities Regulation in China

Securities Regulation in China

by William Gamble

Securities regulation in China doesn’t work. It never will. The problem is not legal. It is economic. The incentives are wrong.

In a democratic market system the regulators have an encompassing interest. Their function is to represent everyone, including investors, citizens and voters. If they are successful in keeping securities fraud to a minimum, their political masters get reelected and the regulators keep their jobs. If the regulators allow fraud to run rampant, the press discovers and publicize the scandals. Regulators lose their jobs and their political masters do not get reelected. The regulator’s have no economic interest in the market they regulate. Their financial interest is in keeping the market free of fraud.

In China the system is the reverse. The Chinese Securities Regulatory Commission (CSRC) reports to the State Council, the executive branch of the government like democracies. The problem is that the State Council is not a disinterested party. They are the principal owners and managers of most of the enterprises. Their interest is narrow. As owners, their incentive is to raise capital at the lowest possible cost. Negative information of any kind will increase the risk of the investment. Higher risk requires a greater rate of return. If the enterprises are completely moribund, capital may not be available at any cost. Therefore, the principal owners and managers have enormous incentives to suppress negative information. The State Council has the motivation to insure that the mission of the CSRC to increase transparency is thwarted. Since the CSRC reports to the State Council, and since the State Council reports to no one, it is not hard for the State council to get its way.

The incentives in China are not unique. All principal owners and managers have similar incentives. In many large corporations shareholder relations has been raised to a high art form. For example, at Coca-Cola the department has such prominence that it is located on the same floor as the CEO.

Raising capital at the lowest rate is part of the job of management. They can, and often do, spin information to encourage investment. The definition of accuracy is often a matter of perspective. Exactly what is considered full and fair disclosure is the subject of frequent litigation. Why is China different? If there is some fraud perpetrated on all markets, why would the Chinese markets be particularly susceptible?

For markets to work properly, the government must create an efficient legal infrastructure. For a legal infrastructure to be an effective regulator of a securities market, it must represent investors and limit the power of insiders including principal owners, mangers, brokers, fund managers and promoters. It must insure that accurate information is available on a constant basis to buyers and sellers. Without accurate information, the market cannot operate efficiently. Governments have devised four types of laws to insure that investors are protected.

First and most obvious is the creation of the regulator, the policeman of the markets. These commissions are usually part of the executive branch of the government. For example both the SEC in the US and the CSRC in China report to the executive organ of government. The problem for all policemen is to keep them honest. Integrity can be encouraged in two ways. The regulator must be independent and its discretion must be limited.

For example, national banks in many countries used to either be part of, or report to the finance ministry. Finance ministries were controlled by politicians. It should not come as a surprise that the national banks would pump money into the economy and stimulate growth before elections. Of course, the extra cash would also stimulate inflation. When national banks became independent, their monetary policies became far more responsible.

The same problem exists for the CSRC. As long as the regulator reports to an organ of government, the State Council, with a direct economic interest in its mission, it will be subject to arbitrary interference. In the alternative, a regulator’s independence could suffer from simple neglect. If a regulator does not have the money to do its job, the appearance of a competent watchdog can be maintained, but the reality would have no teeth.

The more discretion a regulator has, the higher the probability of corruption ¹. Unfortunately, China has adopted a “merit” review coupled with a provincial quota system. Under this system, national authorities formulate a yearly quota of companies, that can be listed on the stock market. The quotas are allocated to provincial or ministerial authorities, who choose and then approve the candidates. The applications are then submitted for review and approval by the CSRC. Final approval must come from the State Council.²

In a free market, only firms with the best prospects or the best profits are selected by an underwriter. In China, the system guarantees the reverse. Local governments and ministries are most likely to chose firms that are: failing and require new capital, firms that provide the most number of jobs for local industries, firms with large unfunded pension obligations, or firms with the best prospects for funneling money to local officials. The process also devolves power from the central government. It insures a close relationship between local managers and local officials (where there is a difference), which increases the opportunities for fraud and collusion.

Second, governments can give individual investors the right to sue companies and managers directly. This has several advantages. It gives manager additional incentive to provide markets with accurate timely information. It prevents collusion between the regulator and the manager. Such collusion would not totally insulate either party from judicial scrutiny. It provides an strong economic incentive for investors and their attorneys to monitor the accuracy of information provided by companies. Finally, it avoids problems associated with adequate funding and staffing of the regulator.

In China no such right exists. Although the Securities Law seems to provide the right, there are two problems. First, a Chinese court has ruled that there is no direct connection between and individual plaintiff’s loss and the false disclosures.³ Even if the courts were inclined to grant a right of action, the Securities Law suggests that any damages awarded belong to the state. So potential plaintiffs have no economic incentive to even bring the suit. Nor would it ever be in the interests of the State Council, local government officials or managers to give investors that right. Investing such power in individual citizens and investors would be an enormous limitation on the ability of government as owner to act in anyway that it sees fit. Since the incentive to change is lacking, it is doubtful, that there will ever be change.

Even worse, there is a powerful disincentive. In his excellent book, “The Chinese”⁴, Jasper Becker relates the story of a successful attorney, Yang Weilin. Yang was representing one of the partners in a joint venture, a routine commercial dispute. Yang found witnesses who could exonerate his client, but before the case came to court Yang was seized and thrown in prison. He later learned that his client was given a seven year prison sentence. The witnesses either changed their stories or disappeared. Apparently the party on the other side of the dispute, had far better political connections. Other lawyers learned the lesson. “If Yang can be imprisoned like this in Beijing, imagine what it is like in the rest of the country and how nervous everyone is about taking a defense case.”⁵

Third, governments can limit the power of enterprises to disseminate false information by ensuring that accurate information is freely available. Markets are all about choice. Before making an investment choice, an investor must have as much information as possible. Even in an ideal world, individuals interpret the same information in different ways. For an investor to have all of the information, markets must encourage a free financial press and free access to the internet. It is the job of the financial press to look behind the numbers and ferret out the information. They are a powerful force, who, in addition to regulators and individual investors, constantly check on the veracity of managers.

In China freedom of speech is not available and the financial press is restricted. Allowing the a free press to limit the government’s ability to control information would be a major limit on its power at all levels. A power the government would be loath to give up. Without the power to restrict information, the government would not have the ability to control the market value of its property. Since state property is worth a great deal to the State Council, they are not going to subject themselves to legal limits.

Sometimes the control of the financial press can give the appearance of honesty. “The Caijing Zazhi is a well-respected monthly financial journal. It has ties to the Stock Exchange Executive Council (SEEC), a state-backed financial think tank. Caijing's October 2000 cover story, titled "Inside story of funds: A research report on the conduct of funds," enumerates a laundry list of misconduct”⁶ The existence of the article suggest the power of a free press to expose wrong doing and to alert investors. The reality is that the government is reasserting its authority over an errant stock market and manipulating what it considers to be speculative excess. “The Caijing article suggests that the government is intent on seizing this artificial bull by the horns and wrestling it out of China's financial arena”⁷

Fourth, governments can use the power of competition. Again, in its most basic form competition is about choice. It is a potent tool to limit fraud and abuse by enterprise managers and government. Competition gives investors a choice of investment. Their incentive is to choose only those companies that represent the best investment. In order to judge the quality of the investment, investors need accurate information. It is in their best interest to choose only companies that gave full and fair disclosure. If companies either disseminated incorrect information or no information, they would be suspected of having something to hide. In Game Theory, this is what is called a cascade. All companies are forced to disclose, because if they do not investors automatically assume that their silence indicates severe problems.

Competition is also an effective regulator of the financial press. Competition between information providers insures that there are intense incentives to get and sell the most accurate information. Markets are quick to learn which provider is giving accurate information and who is not.

It is not only competition for information within the financial press. The conflicts of interests of analysts and financial reporters in the US were recently exposed ⁸ as helping to manipulate stock prices. Competition between companies, between all information providers, between government agencies, and between different branches and levels of government all help to insure that information is both true and available.

Competition does not exist in China because competition from private companies and private information providers would be threat to the economic and political interests of the government and the State Council. Therefore, they are discouraged and curtailed. Governmental agencies all have the same constituency, so there is no incentive to provide a different solution or come up with different information. Rather the reverse, there is a great disincentive to providing unappreciated truths. Whistle blowing even in a democracy is a dangerous enterprise. In China is could lead to a prison term. Disagreeable information about the ill health of any company or sector is either hoarded, used for individual gain or ignored.

The effect of the Chinese government’s need to protect its investment is obvious throughout the market. “About a third of the 1,000 listed companies are considered absolute dogs, with another third reckoned to be indifferent performers”⁹ Potentially profitable private companies like many fledgling Chinese internet companies are limited by rules limiting foreign ownership of dotcoms and imposing onerous self-censorship requirements.¹⁰

The Caijing Zazhi article referred to above, concerned the fledgling fund management industry which was rocked by charges of systematic market manipulation and profiteering. The information was contained in a report which was “leaked” from the Shanghai Stock Exchange. The report, contained sensational allegations of how fund managers and their associates would meet in secrecy to make illicit deals to boost each other portfolios. Mangers met in a stuffy sauna room, naked, to prevent the possibility of a record or disclosure.¹¹

The price of the Minyuan Modern Agricultural Company rose 700% based on falsified reports approved by the five directors. After the scandal broke, the five directors disappeared. The CSRC began an investigation, but the company refused to help stating that it was under no obligation. As it turns out two of the largest shareholders of Minyuan had ties to Deng Xiaoping, his son, Deng Pufang and his son-in-law Wu Jianchang. Suspiciously, the investigations proceeded only after Deng’s death in February 1997.¹²

To clean up the mess Anthony Neoh, a Hong Kong lawyer and former chairman of the Hong Kong Securities and Futures Commission (SFC), was invited by Premier Zhu Rongji in late 1998 to serve as the chief adviser to the CSRC . Mr. Neoh wrote a nine point plan to help reform the market¹³. They are as follows:

1. Developing a complete mergers & acquisitions regime.

2. Rationalizing the many classes of stock market shares.

3. Rationalizing China‘s Company Law.

4. Rigorously applying accounting and auditing standards.

5. Giving the private sector a level playing field with the state sector.

6. Expanding the institutional investor base.

7. Integrating financial services and developing new financial products.

8. Developing legal structures to enable investors, including minority shareholders, to protect themselves.

9. Developing a strong, coordinated regulatory structure in the financial services.

Each of these points are well taken. They are absolutely necessary for an efficient stock market. They also have absolutely no possibility of coming into existence.

1. Mergers and acquisitions require above all accurate information so that the target can be properly valued. Besides, the most important asset of any Chinese company is its political connections. Almost by definition these connections are both secret and transitory. They can be swept away by one of the myriad “campaigns against spiritual pollution”, which result from a power struggle. Without accurate information on the target company’s assets, no company in its collective right mind would purchase another.

2. The classes of stock (A shares and B shares) were designed to get foreign money, but limit their influence on the primary market that was designed to channel savings into moribund state enterprises. Why would a government that designed such a scheme wish to change it?

3. At the end of the day, a corporation is nothing more than a sheet of paper on file with a government clerk. What gives them life is a plethora of laws protecting private property, lawyers willing to protect those rights and an independent judiciary willing to enforce those rights. Since private property in China is merely tolerated, commercial lawyers persecuted and courts are not independent, what need is there for reforming a companies law?

4. Rigorously applying accounting standards would reveal that all of the banks are insolvent and most of the companies are bankrupt. Since the government owns most of the bankrupt companies and does not have the money to payback the loans, why would they have any interest in applying rigorous accounting standards?

5. Economic power is usually synonymous with political power. Giving the private sector a level playing field would mean giving up power. Something the leadership, (or any leadership) in Beijing is loath to do. The economic situation in China will eventually become so bad that the Communist Party will have to give up power. Hopefully, the Communists will relinquish their power peacefully. However, the government in China has proved often in its fifty years of rule, that it willing to impose immense suffering to maintain that power.

6. In order to expand the institutional investor base, the government would have to attract foreign investors and foreign fund managers. Attracting foreign investors would require that legal rights and information be benchmarked to international standards. Bench marking to international standards would require an overhaul of the legal system. Overhauling the legal system would require a diminution of the power of the parochial cadres, the communist party and the State Council. A real limit on the power of the party and the government would require a multiparty democracy. Since the State Council, the communist party and local cadres are unlikely to let go of their unrestricted power to control the value of their property through manipulation of the market and the legal system, I doubt that international investors will be all that interested.

7. Integrating financial services and developing new financial products probably will not happen, because it would encourage competition between different financial industries. Competition would mean an infringement of power of the various ministries that controlled respective industries. Such an infringement would not be tolerated. Even if it did occur it would probably make the situation worse. Until there is real reform and the government is taken out of the process, the new products would still be based on the same junk. Markets require new products as different ways of allocating or laying off risk. If almost all of the companies are owned and controlled by the government, the principal risk is basically political not economic. It is also rather uniform. So the financial product most necessary to the Chinese market would be something that hedges against arbitrary state interference and manipulation. Without market forces, there is to my knowledge no method of calculating, no Black-Scholes model to place a value on such a product. Therefore the value of such products, like the action of the government itself, would be totally arbitrary.

8. Developing legal structures to protect minority shareholders would require lawyers who would be free from persecution. An independent judiciary free from any political pressure. It would also require a method of enforcement to create a strong disincentive to violate rights. The probability of enforcement is slight. Even if a litigant is successful, the odds that they can collect on the judgement are small. In 1997 “the Worker’s Daily had described how in Hunan province, where verdicts in 100,000 civil and commercial disputes remained unenforced, frustrated litigants has taken the law into their own hands.”¹⁴

9. It will be impossible to develop a strong coordinated regulatory structure in the financial services until the incentives of the government change. When the government no longer has a direct economic interest in the value of the companies listed on the stock market, it will no longer have an incentive to manipulate the system to lower the cost of capital.

But the problem is much wider. “Fresh efforts at judicial reform have brought about no substantial improvement because the political philosophy underpinning state power has not changed”¹⁵ “Genuine reform is unlikely to occur until there is a change in the status of the Party and its officials. As long as the law is not applied equally, as long as the 60 million Party members who run the administration and staff the judiciary and police apparatus feel themselves to be above the law, any legal system is bound to fail.”¹⁶