Deutsche Bank Research China's financial markets March 16, 2009 a future global force? As the world struggles with the financial crisis and its repercussions on the global economy, questions inevitably arise as to what and wh will drive the financial markets in future years. China is likely to be one of the key players, given its dynamic development China's financial markets have enjoyed a period of strong growth E0E since the early 1990s, even though they are still relatively small compared to those of industrial countries and some other emerging markets Regulatory bodies have followed a careful and gradual reform path and will most probably continue with this approach. Given the current turmoil in global financial markets and the experience of successful gradual reforms, this approach is likely to provide a good basis for sustainable develop- ment in the future It would be unrealistic to expect China to emerge unscathed from the global recession. The weaknesses of less financially sound banks will be exposed during the downturn. A strengthening of provisioning and the capital base will be needed in light of a potential rise in credit losses management is a crucial determinant of winners and losers. It is rtant that Chinese banks continue to strive for prudent risk management research com In ten years, china is likely to account for 13% of the banking market, over 16% of the stock market and over 5% of the bond market worl Authors wide. Even under conservative assumptions, Chinas share in global financial 656423-8057 markets is set to grow syetarn.hansakul@db.com China's future role in global finance depends on its ability to open up. +4969910-31753 Granting greater market access to foreign financials will be a vital prerequisite for steffendyck@db.com sustained development, and greater integration and regulatory convergence efforts especially with the US and the EU should be key policy objectives +4969910-31889 steffenkern@db.com The"going global"drive of chinese financial institutions marks a Editor second wave of Chinese outward investments. While the increasing Steffen Kern internationalisation of Chinese financial institutions is not a totally new phenol Technical Assistant menon activity has increased markedly since 2006. In the near term, Chinese Sabine Kaiser banks' earnings and profit outlook for 2009 to 2010 as well as regulatory Deutsche Bank Research Frankfurt am Main considerations are likely to curb their global expansion. Over the medium and nger term much will depend on how the global economic system evolves from the crisis E-mailmarketingdbr@db.com Fax:+496991031877 The Chinese state is a global investor set to grow further In recent multilateral initiatives, China has contributed to the acceptability of sovereign Norbert wi investments. While advanced economies need to maintain liberal investment conditions, China is still at a starting point of opening up to foreign investments
Authors Syetarn Hansakul +65 6423-8057 syetarn.hansakul@db.com Steffen Dyck +49 69 910-31753 steffen.dyck@db.com Steffen Kern +49 69 910-31889 steffen.kern@db.com Editor Steffen Kern Technical Assistant Sabine Kaiser Deutsche Bank Research Frankfurt am Main Germany Internet:www.dbresearch.com E-mail marketing.dbr@db.com Fax: +49 69 910-31877 Managing Director Norbert Walter given its dynamic development. !!" even though they are still relatively small compared to those of industrial countries and some other emerging markets. # Given the current turmoil in global financial markets and the experience of successful gradual reforms, this approach is likely to provide a good basis for sustainable development in the future. $ The weaknesses of less financially sound banks will be exposed during the downturn. A strengthening of provisioning and the capital base will be needed in light of a potential rise in credit losses. # It is important that Chinese banks continue to strive for prudent risk management. %& '& (& ) Even under conservative assumptions, China’s share in global financial markets is set to grow. Granting greater market access to foreign financials will be a vital prerequisite for sustained development, and greater integration and regulatory convergence efforts especially with the US and the EU should be key policy objectives. * + , While the increasing internationalisation of Chinese financial institutions is not a totally new phenolmenon activity has increased markedly since 2006. In the near term, Chinese banks’ earnings and profit outlook for 2009 to 2010 as well as regulatory considerations are likely to curb their global expansion. Over the medium and longer term much will depend on how the global economic system evolves from the crisis. * In recent multilateral initiatives, China has contributed to the acceptability of sovereign investments. While advanced economies need to maintain liberal investment conditions, China is still at a starting point of opening up to foreign investments. - . March 16, 2009 /
Deutsche Bank Research Current Issues Editorial the financial markets in future years China has on many occasio The financial crisis has thrown the banking world into turmoil. As dust settles, questions inevitably arise as to what and who will dr been identified as one of the potential key players, given its size and share in the global economy and its vigorous pursuit of economic reform for several decades. Whether the country will be in a position to meet these expectations critically depends on how deeply it will be affected by the current crisis, how well it can emerge from the turmoil, and how its markets and regulators respond to the recent experiences. We set out to explore these questions, and assess China s prospect in a series of chapters in this report. We start by looking at the existing structure and recent develop ments of China s own domestic financial markets, assessing its capability and potential. We then take a critical look at the state of Chinas banking sector and how it will be impacted by the current global financial crisis. The potential of China's domestic banking sector is also examined. We try to gauge the current extent of China's integration into the global financial markets. The opening of China's markets to outside investors and the progress and pro- spects of regulatory liberalisation are also scrutinised. Finally, we look at China s own reach around the world through different angles china's financial institutions going abroad and Chinas role as a global investor. China's financial markets will continue to evolve as guided by its domestic dynamics and needs as well as external opportunities and circumstances. It is clear that China has global ambitions on top of the potential to be a key player in the world financial markets, and the country has made great strides in recent years. The journey is still in its early stages, and there will be many pitfalls ahead. As China continues to rise, it is difficult to imagine that its level of engagement or influence on the world stage will not grow. Syetarn Hansakul Steffen Dyck Steffen Kern arch16.2009
Current Issues 2 March 16, 2009 / The financial crisis has thrown the banking world into turmoil. As the dust settles, questions inevitably arise as to what and who will drive the financial markets in future years. China has on many occasions been identified as one of the potential key players, given its size and share in the global economy and its vigorous pursuit of economic reform for several decades. Whether the country will be in a position to meet these expectations critically depends on how deeply it will be affected by the current crisis, how well it can emerge from the turmoil, and how its markets and regulators respond to the recent experiences. We set out to explore these questions, and assess China’s prospect in a series of chapters in this report. We start by looking at the existing structure and recent developments of China’s own domestic financial markets, assessing its capability and potential. We then take a critical look at the state of China’s banking sector and how it will be impacted by the current global financial crisis. The potential of China’s domestic banking sector is also examined. We try to gauge the current extent of China’s integration into the global financial markets. The opening of China’s markets to outside investors and the progress and prospects of regulatory liberalisation are also scrutinised. Finally, we look at China’s own reach around the world through different angles: China’s financial institutions going abroad and China’s role as a global investor. China’s financial markets will continue to evolve as guided by its domestic dynamics and needs as well as external opportunities and circumstances. It is clear that China has global ambitions on top of the potential to be a key player in the world financial markets, and the country has made great strides in recent years. The journey is still in its early stages, and there will be many pitfalls ahead. As China continues to rise, it is difficult to imagine that its level of engagement or influence on the world stage will not grow. Syetarn Hansakul Steffen Dyck Steffen Kern
China's financial markets-a future global force? Deutsche Bank Research Table of contents Page China s capital markets- structure and market development Chinas banking sector to be tested by the downturn Chinese financial markets in the global context-much growth, little integration Opening up Chinas financial markets- progress and prospects of regulatory liberalisation Chinese financial institutions going global The Chinese state -a global investor March 16. 2009
China's financial markets – a future global force? March 16, 2009 3 ) Page China’s capital markets – structure and market development............................................................ 4 China’s banking sector to be tested by the downturn....................................................................... 12 Chinese financial markets in the global context – much growth, little integration ............................ 18 Opening up China’s financial markets – progress and prospects of regulatory liberalisation.......... 24 Chinese financial institutions going global........................................................................................ 33 The Chinese state – a global investor .............................................................................................. 37
Deutsche Bank Research Current Issues Chinas capital markets-structure and market devel。 pment The development of China's capital markets can be divided into three phases. Between early 1978 and 1992 full-scale economic reform took place, with capital markets emerging in response to the beginning incorporation process of Chinese enterprises as the concept of privatisation took off following the introduction of the Open Door policy. In the second phase(1993-1998), the focus shifted to strengthening the capital markets in terms of institutional Financial markets in framework as well as supervisory framework. Supervision of capital son markets was consolidated, leading to the formation of the China of GDP, 2008 (latest available data) Securities Regulatory Commission(CSRC)in its current form China Regional pilot programmes were expanded nationwide. The pro- mulgation of the Securities Law marked a milestone in the third Brazil phase between 1999 and 2007, resulting in formalisation and strengthening of the legal status of China's capital markets. The India emphasis rested on refinement of the legal and regulatory system to Russia create a more transparent and efficient market. Concepts such as corporate governance and market discipline were introduced Further, a series of reforms were implemented to facilitate future development of national capital markets in terms of product Japan While substantial progress has been made and reforms are generally heading in the right direction, several areas are still subject to further work. These include, among others, corporate overnance as well as capital market infrastructure and rating 00 agencies. In order to make China s financial markets really world- class they have to become freer, more transparent and better a Private sector credit regulated. Aside from increasing the share of institutional investors a Stock market capitalisation especially in the stock market, it is necessary to raise the general level of financial literacy. By successfully implementing these reforms, China s financial markets will be in better shape to serve investors' and fund raisers needs at the same time and thus support China' s long-term growth in a more efficient manner. Non-FIs heavily on banks Structure of Chinas capital markets of total extemal financing, 2006 Compared to industrial countries, Chinas financial markets are still Bonds relatively shallow as measured in relation to nominal GDP (see 10.1 Stocks chart 1). Bank loans to the private sector account for the lion,s share ABS not least due to the recent steep decline in the stock market. However, in a BRIC comparison, China leads in terms of combined Bank financial market depth The comparatively large share of private sector credit shows that the Chinese economy remains heavily dependent on bank finance. Bank loans account for more than 80% of total financing to the non- financial sector, while equity and bond issuance plays a sub ordinated role(see chart 2 ). Aside from financial risk concentration Source: CSRC in the banking system this signals that capital markets are still derdeveloped See CSRC (2008). China Capital Markets Development Report. China Securities Regulatory Commission. March 2008 People's Bank of China(2008a). Financial Stability Report 2007 March 2008 p.28. arch16.2009
Current Issues 4 March 16, 2009 - The development of China’s capital markets can be divided into three phases1 . Between early 1978 and 1992 full-scale economic reform took place, with capital markets emerging in response to the beginning incorporation process of Chinese enterprises as the concept of privatisation took off following the introduction of the Open Door policy. In the second phase (1993-1998), the focus shifted to strengthening the capital markets in terms of institutional framework as well as supervisory framework. Supervision of capital markets was consolidated, leading to the formation of the China Securities Regulatory Commission (CSRC) in its current form. Regional pilot programmes were expanded nationwide. The promulgation of the Securities Law marked a milestone in the third phase between 1999 and 2007, resulting in formalisation and strengthening of the legal status of China’s capital markets. The emphasis rested on refinement of the legal and regulatory system to create a more transparent and efficient market. Concepts such as corporate governance and market discipline were introduced. Further, a series of reforms were implemented to facilitate future development of national capital markets in terms of product diversification. While substantial progress has been made and reforms are generally heading in the right direction, several areas are still subject to further work. These include, among others, corporate governance as well as capital market infrastructure and rating agencies. In order to make China’s financial markets really worldclass they have to become freer, more transparent and better regulated. Aside from increasing the share of institutional investors, especially in the stock market, it is necessary to raise the general level of financial literacy. By successfully implementing these reforms, China’s financial markets will be in better shape to serve investors’ and fund raisers’ needs at the same time, and thus support China’s long-term growth in a more efficient manner. Structure of China’s capital markets Compared to industrial countries, China’s financial markets are still relatively shallow as measured in relation to nominal GDP (see chart 1). Bank loans to the private sector account for the lion’s share – not least due to the recent steep decline in the stock market. However, in a BRIC comparison, China leads in terms of combined financial market depth. The comparatively large share of private sector credit shows that the Chinese economy remains heavily dependent on bank finance. Bank loans account for more than 80% of total financing to the nonfinancial sector, while equity and bond issuance plays a subordinated role (see chart 2). Aside from financial risk concentration in the banking system2 this signals that capital markets are still underdeveloped. 1 See CSRC (2008). China Capital Markets Development Report. China Securities Regulatory Commission. March 2008. 2 People’s Bank of China (2008a). Financial Stability Report 2007. March 2008, p. 28. Bank loans, 84.9 Bonds, 10.1 Stocks, 3.9 ABS, 1.1 0(1 % of total external financing, 2006 Source: CSRC ' 0 100 200 300 400 500 US Germany Japan UK Russia India Brazil China Bonds outstanding Private sector credit Stock market capitalisation 1 % of GDP*, 2008 (latest available data) Sources: BIS, Bloomberg, IMF IFS, DB Research *As shares of 2008 est. GDP
China's financial markets-a future global force? Deutsche Bank Research Brief history of Chinas bond market Bond market While some kind of financing instruments Market structure resembling bonds can be traced back to Chinas "Spring Autumn" and"Warring Although total annual issuance has surged since the early 2000s States"periods(770 B. C to 256 B.C. ) bonds in from less than RMB 1 tr to RMB 8 tr as of end-2007-China's bond modern sense became more widely used during the late 19th/early 20th century to market is still relatively small as a share of nominal GDP (35%in finance government spending and larg 2007)especially when compared to mature economies. Public infrastructure projects. Having vanished ector issuance continues to dominate People' s Bank of China following the foundation of the PRC in 1949 (PBC) and treasury bonds accounted for almost 80%of total the bond market came back to life in the early issuance in 2007 and more than 75% until September 2008. In the 1980s as economic reforms kicked off and categories "financial bonds" and " corporate bonds, entities that are enterprises had to diversify their funding sources. Treasury bonds were relaunched in linked to the state play the most important role. Policy bank bonds constitute more than 90% of total issuance of financial bonds Accordingly, commercial bank bonds make up only roughly 10% of defaults started in 1993 leading to a period of the total issuance volume Among corporate bonds, those from decline in corporate issuance. Financial bond state-owned enterprises account for more than 70% of the total until banks from 1984 on. Starting from April 1988, September 2008, almost unchanged from their 2007 share trading of treasury bonds by retail investors was permitted in seven cities and by the end of that year it had spread across the country. The Strong growth until 2008 interbank segment was established by the Total annual issuance PBC in 1997-open only for domestic in- stitutional investors. After 2000, the range of 70730 market participants was broadened to also include domestic non-financial institutions 4.22 Intemational institutions were also given per mission to issue so-called Panda bonds 050 bonds denominated in RMB. In exchange- based trading, net price bond trading was 10210620 44044058099 5 introduced in 2002 and the following years witnessed a number of new products, includin asset-backed securities by non-FIs OTC 99719981999200020012002200320042005200620072008 ading was also established in 2002 in order to RMB tr(left) 96 of GDP (right) service retail investors and SMEs Source: Chinabond The higher treasury share in 2007 can be attributed to the issuance So far no major shifts in of so-called"special T-bonds"which were used to buy USD 200 bn term structure RMB tr in foreign exchange as capital funds of China Investment (CIC) Frequency and issuance volume of PBC bonds also in creased again starting in 2007 as the effect of monetary policy tightening. However, due to a policy change towards monetary easing PBC issuance declined in late 2008 The share of bonds with maturities of less than one year has 4 traditionally been high in China's bond market. It rose from 30% in 2002 to more than 75%in 2006, but in 2007 declined sharply to less than 45%. However, in the same year the share of bonds in the one to three year range rose to 22%, which means that the term structure of the chinese bond market remains skewed towards the short end. Longer-term issuances could gain some ground in 2007, but issuance data for 2008 suggest that shares of bonds maturing up to 1Y 1-3Y within seven to ten years or after ten years are back to single-digit 3-5Y territory again 7-10Y amore than 10Y The Chinese bond market can be separated into two sections: the Source: Chinabond OTC section -which can be sub-divided into an interbank and the commercial banks'OTC market-and so-called exchange-based 3 Policy banks are: China Development Bank(CDB), Export-Import Bank of China (Eximbank), and Agricultural Development Bank of China(ADBC) China Government Securities Depository Trust Clearing Co Ltd (2008). China Bond Market Review 2007 January 2008, p 21 March 16. 2009
China's financial markets – a future global force? March 16, 2009 5 Brief history of China’s bond market While some kind of financing instruments resembling bonds can be traced back to China’s “Spring & Autumn” and “Warring States” periods (770 B.C to 256 B.C.), bonds in a modern sense became more widely used during the late 19th / early 20th century to finance government spending and large infrastructure projects. Having vanished following the foundation of the PRC in 1949, the bond market came back to life in the early 1980s as economic reforms kicked off and enterprises had to diversify their funding sources. Treasury bonds were relaunched in July 1981 and, from 1982 onwards, corporate bonds re-emerged. A wave of corporate defaults started in 1993 leading to a period of decline in corporate issuance. Financial bonds became a regular financing instrument for banks from 1984 on. Starting from April 1988, trading of treasury bonds by retail investors was permitted in seven cities and by the end of that year it had spread across the country. The interbank segment was established by the PBC in 1997 – open only for domestic institutional investors. After 2000, the range of market participants was broadened to also include domestic non-financial institutions. International institutions were also given permission to issue so-called Panda bonds – bonds denominated in RMB. In exchangebased trading, net price bond trading was introduced in 2002 and the following years witnessed a number of new products, including asset-backed securities by non-FIs. OTC trading was also established in 2002 in order to service retail investors and SMEs. Bond market Market structure Although total annual issuance has surged since the early 2000s – from less than RMB 1 tr to RMB 8 tr as of end-2007 – China’s bond market is still relatively small as a share of nominal GDP (35% in 2007) especially when compared to mature economies. Public sector issuance continues to dominate. People’s Bank of China (PBC) and treasury bonds accounted for almost 80% of total issuance in 2007 and more than 75% until September 2008. In the categories “financial bonds” and “corporate bonds”, entities that are linked to the state play the most important role. Policy bank3 bonds constitute more than 90% of total issuance of financial bonds. Accordingly, commercial bank bonds make up only roughly 10% of the total issuance volume. Among corporate bonds, those from state-owned enterprises account for more than 70% of the total until September 2008, almost unchanged from their 2007 share. The higher treasury share in 2007 can be attributed to the issuance of so-called “special T-bonds” which were used to buy USD 200 bn in foreign exchange as capital funds of China Investment Company (CIC)4 . Frequency and issuance volume of PBC bonds also increased again starting in 2007 as the effect of monetary policy tightening. However, due to a policy change towards monetary easing PBC issuance declined in late 2008. The share of bonds with maturities of less than one year has traditionally been high in China’s bond market. It rose from 30% in 2002 to more than 75% in 2006, but in 2007 declined sharply to less than 45%. However, in the same year the share of bonds in the one to three year range rose to 22%, which means that the term structure of the Chinese bond market remains skewed towards the short end. Longer-term issuances could gain some ground in 2007, but issuance data for 2008 suggest that shares of bonds maturing within seven to ten years or after ten years are back to single-digit territory again. The Chinese bond market can be separated into two sections: the OTC section – which can be sub-divided into an interbank and the commercial banks’ OTC market – and so-called exchange-based 3 Policy banks are: China Development Bank (CDB), Export-Import Bank of China (Eximbank), and Agricultural Development Bank of China (ADBC). 4 China Government Securities Depository Trust & Clearing Co. Ltd (2008). China Bond Market Review 2007. January 2008, p. 21. 0.21 0.62 0.44 0.44 0.58 0.99 1.76 2.73 4.22 5.71 7.98 7.07 0 5 10 15 20 25 30 35 0 1 2 3 4 5 6 7 8 9 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 RMB tr (left) % of GDP (right) 2 '""3 Total annual issuance Source: Chinabond 4 0 1 2 3 4 5 6 7 8 9 00 01 02 03 04 05 06 07 08 up to 1Y 1-3Y 3-5Y 5-7Y 7-10Y more than 10Y 2 RMB tr Source: Chinabond 5
Deutsche Bank Research Current Issues trading(see chart 5 below). The OTC market accounts for more tha 97% of total transaction value, with the overwhelming majority in interbank activity and followed by exchange-based trading in Shanghai and Shenzhen(2.7%). The China Government Securities Depository Trust& Clearing Co Ltd (CGSDTC)takes the functio of centralised depository and settlement for all market segments with commercial banks and Chinaclearacting as sub-custodians in the otc market and exchange-based trading respectively China bond market structure OTC Exchange Market type Market Market CGSDTC (General custodian) Custod ian Commercial ban ks (Sub-custodian (Sub-custodian rkets of market OTC market market transaction Negotiating Match-making Pricing nvestors Non-financial Non-bank institutions nstitutions participant Public sector issuance dominates Liquidity trading overview 100% Market liquidity measured by turnover ratios(calculated as trading volume divided by value of outstanding bonds)is higher for cor- porate bonds than for government bonds, making mainland China 60% an exception in emerging Asia. However, when looking at bid-ask spreads, liquidity seems to be much higher for government (i.e treasury) bonds. This has probably to do with the dominant position treasury bonds have with regard to issuance and amount outstand ing, which also translates into much higher trading volumes for 00010203040506 government bonds(approx. eight times the trading volume of UPBC corporate bonds) ■ Treasury Commercial Paper ABS/MBS Market participants Domestic commercial banks are the major players in Chinas local Bond holding structure bond market, holding close to 60% of the total amount outstanding of total (see table 7). However, their share has been declining from around 200820072006 65%in 2006, while the share of insurance companies and other Commercial banks 57.1 59.0 64. 6 market participants has risen substantially. This trend can be linked of w hich foreign 0.50.50.4 to CSRC's explicit policy of broadening the investor base and Credit cooperatives 3.1 2.7 3.6 making the bond market an alternative for institutional investors Securities funds 754.38.8 Also, demand for life insurance products has likely risen but only at companies, other non- low pace. Ongoing reform of the social security system coupled bank FI Insurance companies 11.3 9.4 10.3 3.13.96.2 Chinaclear(or China Securities Depository and Clearing Corp. Ltd ) established in Others(incl. Special 17.8 20.7 6.5 members, non-Fl custodian for China' s stock exchanges, comparable to Germanys Clearstrear Shanghai and Shenzhen stock exchange both hold 50% stakes in the company individuals) which is under supervision of CSRC Sources: Chinabond. DB Resear ADB (2008). Asia Bond Monitor 2008, November 2008 arch16.2009
Current Issues 6 March 16, 2009 trading (see chart 5 below). The OTC market accounts for more than 97% of total transaction value, with the overwhelming majority in interbank activity and followed by exchange-based trading in Shanghai and Shenzhen (2.7%). The China Government Securities Depository Trust & Clearing Co. Ltd. (CGSDTC) takes the function of centralised depository and settlement for all market segments with commercial banks and Chinaclear5 acting as sub-custodians in the OTC market and exchange-based trading, respectively. Liquidity & trading overview Market liquidity measured by turnover ratios (calculated as trading volume divided by value of outstanding bonds) is higher for corporate bonds than for government bonds, making mainland China an exception in emerging Asia6 . However, when looking at bid-ask spreads, liquidity seems to be much higher for government (i.e. treasury) bonds. This has probably to do with the dominant position treasury bonds have with regard to issuance and amount outstanding, which also translates into much higher trading volumes for government bonds (approx. eight times the trading volume of corporate bonds). Market participants Domestic commercial banks are the major players in China’s local bond market, holding close to 60% of the total amount outstanding (see table 7). However, their share has been declining from around 65% in 2006, while the share of insurance companies and other market participants has risen substantially. This trend can be linked to CSRC’s explicit policy of broadening the investor base and making the bond market an alternative for institutional investors. Also, demand for life insurance products has likely risen but only at slow pace. Ongoing reform of the social security system coupled 5 Chinaclear (or China Securities Depository and Clearing Corp. Ltd.), established in 2001, is in charge of clearing any security transaction and also covers the role of custodian for China’s stock exchanges, comparable to Germany’s Clearstream. Shanghai and Shenzhen stock exchange both hold 50% stakes in the company which is under supervision of CSRC. 6 ADB (2008). Asia Bond Monitor 2008, November 2008. Source: Chinabond CGSDTC (General custodian) OTC Market Exchange Market Exchange market Chinaclear (Sub-custodian) Individuals Non-financial institutions Bid-ask Commercial bank OTC market Institutional investors Negotiating Inter bank market Commercial banks (Sub-custodian) Individuals Non-bank institutions Match-making Market type Custodian Markets of transaction Pricing Market participants % 6 % of total 2008 2007 2006 Commercial banks 57.1 59.0 64.6 of w hich foreign 0.5 0.5 0.4 Credit cooperatives 3.1 2.7 3.6 Securities, funds companies, other nonbank FI 7.5 4.3 8.8 Insurance companies 11.3 9.4 10.3 Exchanges 3.1 3.9 6.2 Others (incl. Special members, non-FI, individuals) 17.8 20.7 6.5 Sources: Chinabond, DB Research 7 0% 20% 40% 60% 80% 100% 00 01 02 03 04 05 06 07 08 PBC Financials Treasury Corporates Commercial Paper ABS/MBS 8 Source: Chinabond 9
China's financial markets-a future global force? Deutsche Bank Research with growing sophistication and awareness on the part of market Stock market crash participants will help to increase the share of institutional investors like insurance companies 5,000 Stock market 4.000 China operates two stock exchanges, one located in Shanghai and the other one located in shenzhen Instruments traded on both 2,000 exchanges include shares(A shares and B shares), convertible bonds, warrants, closed-end mutual funds, ETFs, corporate and government bonds, and repos. Aside from B shares, all instruments 959801040 are only denominated in local currency Stock market cap, USD tr(left) China s stock market experienced a first period of strong growth SH composite index (right) between the mid-and late 1990s with the Shanghai Composite soures CEI, DB Research& Index almost quadrupling within five of fise and Starting in 2006, ars. However over the llowing five years, the index lost half China's stock markets witnessed a stellar rise and the Shanghai Composite Index doubled in both 2006 and 2007(see chart 8). In 2007, the combined market capitalisation of both exchanges in IPOs plunge in 2008 Shanghai and Shenzhen reached almost 140% of GDP, making Chinas stock market the second-largest in Asia after Japans. In a 160 global comparison, China s stock market capitalisation was the third- 140 largest. Average daily trading volume reached USD 26 bn, making it 120 one of the most actively traded markets worldwide. However, after the stock market started to correct in october 2007. market capitalisation declined to around 50% of nominal gDP as of end- 600 2008. Trading activity also dropped, reaching USD 17 bn on a daily average basis 0 The strong rise and sharp fall of the chinese stock market is also 05060708 reflected in IPO figures. Both the amounts raised as well as the USD bn(left) Number(right) number of IPOs rose sharply between 2005 and 2007. By Source: Dealogic November 2008, they had fallen below their 2005 levels(see chart 9) Stock market capitalisation in comparison 100 20 China Germany Russia 2007 ■2008 Sources: Bloomberg, DB Research 7 World Bank(2008 ). China Quarterly Update. February 2008, p. 17 8 See, for instance, Yao, Shujie and Dan Luo(2008). Chinese Stock Market Bubble Inevitable or Incidental? The University of Nottingham China Policy Institute Briefing Series No 41, August 2008 March 16. 2009
China's financial markets – a future global force? March 16, 2009 7 with growing sophistication and awareness on the part of market participants will help to increase the share of institutional investors like insurance companies. Stock market China operates two stock exchanges, one located in Shanghai and the other one located in Shenzhen. Instruments traded on both exchanges include shares (A shares and B shares), convertible bonds, warrants, closed-end mutual funds, ETFs, corporate and government bonds, and repos. Aside from B shares, all instruments are only denominated in local currency. China’s stock market experienced a first period of strong growth between the mid- and late 1990s with the Shanghai Composite Index almost quadrupling within five years. However, over the following five years, the index lost half of its value. Starting in 2006, China’s stock markets witnessed a stellar rise and the Shanghai Composite Index doubled in both 2006 and 2007 (see chart 8). In 2007, the combined market capitalisation of both exchanges in Shanghai and Shenzhen reached almost 140% of GDP, making China’s stock market the second-largest in Asia after Japan’s. In a global comparison, China’s stock market capitalisation was the thirdlargest. Average daily trading volume reached USD 26 bn, making it one of the most actively traded7 markets worldwide. However, after the stock market started to correct in October 2007, market capitalisation declined to around 50% of nominal GDP as of end- 20088 . Trading activity also dropped, reaching USD 17 bn on a daily average basis. The strong rise and sharp fall of the Chinese stock market is also reflected in IPO figures. Both the amounts raised as well as the number of IPOs rose sharply between 2005 and 2007. By November 2008, they had fallen below their 2005 levels (see chart 9). 7 World Bank (2008). China Quarterly Update. February 2008, p. 17. 8 See, for instance, Yao, Shujie and Dan Luo (2008). Chinese Stock Market Bubble: Inevitable or Incidental? The University of Nottingham China Policy Institute. Briefing Series No 41, August 2008. 0 1,000 2,000 3,000 4,000 5,000 6,000 0 1 2 3 4 5 95 98 01 04 07 Stock market cap, USD tr (left) SH composite index (right) 2 Sources: CEIC, DB Research 3 0 20 40 60 80 100 120 140 160 0 10 20 30 40 50 05 06 07 08 USD bn (left) Number (right) 8: '""3 Source: Dealogic ! 0 20 40 60 80 100 120 140 160 180 China US UK France Germany Japan Brazil Russia India 2006 2007 2008 2 % of GDP Sources: Bloomberg, DB Research "
Deutsche Bank Research Current Issues Overview of china s stock exchanges Shanghai Stock Exchange Shenzhen Stock Exchange Total end-2008 end-2007 end-2008 end-2007 end-2008 end-2007 740 1,604 p(RMB bn) 9,7252 26,983 5,7302 12,1366 32.714.1 A-shares 96875 268497 23691 5.6090 12,0567 32458.8 B-shares Avg daily turnover 2.3588 (RMB bn) 1.572.5 19735 933.5 A-sh 1.568 19608 7825 2.350.5 2.886.6 4.6 127 3.8 7.7 Sources: Shanghai Stock Exchange, Shezhen Stock Exchange, CEIC A&8 shares There are different share types in existence, although for China,s domestic stock markets so-called A-shares and B-shares are most important(see table 13). Both types are issued by companies incorporated in the People' s Republic of China(PRC), the main difference being who is entitled to trade them. Chinese nationals as well as foreign institutional investors authorised under the Qualified Foreign Institutional Investor (QFII) scheme are allowed to buy and sell A-shares that are denominated in rmB. B-shares -which are denominated in USD or HKD-were originally designed for foreign investors only, but since March 2001 domestic retail investors are also allowed to trade them Importance of A-shares in However, judging from figures regardir raising capital shares are by far the most important segment in China's stock Y of total (incl H-shares) market (see chart 12)and, since the early 2000s, the amount raised via B-shares has been virtually zero. The drop in the share of capital aised via A-shares in the period 2003-06 can be attributed to the strong growth in capital raised via H-shares issuance The little attention paid to the B-shares market over the past decade 50 can be explained by their huge discount compared to A-shares Also, it seems that the B-shares market has lost its function since it was originally designed to attract limited foreign investment, which 10 can now also be achieved via QFlls. Liquidity has been scarce over the past few years, and a possible merger of A and B-shares also 95979901030507 adds to subdued performance of the latter. However, still existing Sources: CSRC, CEIC restrictions on full convertibility of the RMB pose an obstacle to such arch16,2009
Current Issues 8 March 16, 2009 A&B shares There are different share types in existence, although for China’s domestic stock markets so-called A-shares and B-shares are most important (see table 13). Both types are issued by companies incorporated in the People’s Republic of China (PRC), the main difference being who is entitled to trade them. Chinese nationals as well as foreign institutional investors authorised under the Qualified Foreign Institutional Investor (QFII) scheme are allowed to buy and sell A-shares that are denominated in RMB. B-shares – which are denominated in USD or HKD – were originally designed for foreign investors only, but since March 2001 domestic retail investors are also allowed to trade them. However, judging from figures regarding total capital raised, Ashares are by far the most important segment in China’s stock market (see chart 12) and, since the early 2000s, the amount raised via B-shares has been virtually zero. The drop in the share of capital raised via A-shares in the period 2003-06 can be attributed to the strong growth in capital raised via H-shares issuance. The little attention paid to the B-shares market over the past decade can be explained by their huge discount compared to A-shares. Also, it seems that the B-shares market has lost its function, since it was originally designed to attract limited foreign investment, which can now also be achieved via QFIIs. Liquidity has been scarce over the past few years, and a possible merger of A and B-shares also adds to subdued performance of the latter. However, still existing restrictions on full convertibility of the RMB pose an obstacle to such a merger. Overview of China's stock exchanges end-2008 end-2007 end-2008 end-2007 end-2008 end-2007 Companies listed 864 860 740 670 1,604 1,530 Market cap. (RMB bn) 9,725.2 26,983.9 2,411.5 5,730.2 12,136.6 32,714.1 A-shares 9,687.5 26,849.7 2,369.1 5,609.0 12,056.7 32,458.8 B-shares 37.7 134.2 42.3 121.2 80.0 255.3 Avg. daily turnover (RMB bn) 1,572.5 1,973.5 786.3 933.5 2,358.8 2,907.0 A-shares 1,568.0 1,960.8 782.5 925.8 2,350.5 2,886.6 B-shares 4.6 12.7 3.8 7.7 8.4 20.4 Shanghai Stock Exchange Shenzhen Stock Exchange Total Sources: Shanghai Stock Exchange, Shenzhen Stock Exchange, CEIC 11 0 10 20 30 40 50 60 70 80 90 100 95 97 99 01 03 05 07 Importance of A-shares in raising capital % of total (incl. H-shares) Sources: CSRC, CEIC 12
China's financial markets-a future global force? Deutsche Benk Research Derivatives in China's financial markets The Chinese stock market alphabet soup Regarding derivative financial products, the Chinese govemment has taken a cautious Currency Description approach towards liberalising derivatives A-shares RMB Companies incorporated in PRC markets. First experiments with futures exchanges date back to the early 1990s, raded in Shanghai& Shenzhen tarting with grain forward contracts and Largest class of Chinese shares als futures. Treasury bond futures were Investors: Chinese nationals and foreign introduced in December 1992 and both institutional investors authorised under OFIl arkets experienced chaotic devele leading to stronger regulation from the mid- B-shares USD/HKD mpanies incorporated in PRC 1990s onwards. In general, derivatives have Traded in Shanghai(USD)& Shenzhen( HKD) itted in selected market segments vestors: prior to Mar 01 only foreigners, now nly commodities. Here, too, a lively market has developed in the past decade also domestic retail investors featuring a turnover of more than RMB 40 tr H-shares HKD Companies incorporated in PRC USD 5.8 tr/EUR 4 tr)in 2007. Stock inde Traded in Hong Kong futures are not available yet, as the China Financial Futures Exchange(CFFEX) stil N-shares USD Companies incorporated in PRC, listed and traded awaits approval from CSRC. Other on the New York Stock Exchange derivatives include warrants, currency forwards and swaps, bond forwards, and L-shares GBP Companies incorporated in PRC, listed and traded interest rate swaps. Red chips HKD Chinese companies incorporated outside PRC Often state-ow ned or state-controlled companies S-shares SGD Like H-shares but traded in Singapore Phasing-out of non-tradable shares Additionally, there is a distinction between tradable and"non- Vibrant growth in Chinas tradable "shares within the A-shares category, a distinction that futures market dates back to the early years of the Chinese stock market. Prior to April 2005, only about 1/3 of shares from listed companies were 2.500 tradable shares. The remaining 2/3 were not freely trading in the 2,000 market but held by the government or related entities. The non- tradable share reform, starting in April 2005, aimed at eliminating the difference between tradable and non -tradable shares while at the 1.000 same time, avoiding market disturbance due to the huge amount of new' supply coming to the market. Appropriate compensation was therefore a core element of the reform and usually holders of non- 0001020304050607 tradable shares compensated those of tradable shares by giving out Trading turnover, RMB tr(left) a portion of their shares at mutually agreed prices. By the end of Trading volume, m units(right) 2007, 1, 300 listed companies- accounting for 98% of total market ource: PBoC capitalisation- had either started or finished the reform process However, the amount of floating shares -i.e. shares that can be freely traded on the secondary market and are not subject to any lock-up restrictions-is still very low. As of end-2007, the free float totalled less than 30% of all the shares outstanding 9KPMG(2007, 10 CSRC (2008). China Capital Markets Devel Report. China Securities B ry Commission. March 2008, p 205 d.p.24 March 16, 2009
China's financial markets – a future global force? March 16, 2009 9 Derivatives in China’s financial markets Regarding derivative financial products, the Chinese government has taken a cautious approach towards liberalising derivatives markets. First experiments with futures exchanges date back to the early 1990s, starting with grain forward contracts and metals futures. Treasury bond futures were introduced in December 1992 and both markets experienced chaotic development leading to stronger regulation from the mid- 1990s onwards. In general, derivatives have been permitted in selected market segments, primarily commodities. Here, too, a lively market has developed in the past decade, featuring a turnover of more than RMB 40 tr (USD 5.8 tr/EUR 4 tr) in 2007. Stock index futures are not available yet, as the China Financial Futures Exchange (CFFEX) still awaits approval from CSRC. Other derivatives include warrants, currency forwards and swaps, bond forwards, and interest rate swaps. Phasing-out of non-tradable shares Additionally, there is a distinction between “tradable” and “nontradable” shares within the A-shares category, a distinction that dates back to the early years of the Chinese stock market. Prior to April 2005, only about 1/3 of shares from listed companies were tradable shares. The remaining 2/3 were not freely trading in the market but held by the government9 or related entities. The nontradable share reform, starting in April 2005, aimed at eliminating the difference between tradable and non-tradable shares while, at the same time, avoiding market disturbance due to the huge amount of “new” supply coming to the market. Appropriate compensation was therefore a core element of the reform and usually holders of nontradable shares compensated those of tradable shares by giving out a portion of their shares at mutually agreed prices10. By the end of 2007, 1,300 listed companies – accounting for 98% of total market capitalisation – had either started or finished the reform process.11 However, the amount of floating shares – i.e. shares that can be freely traded on the secondary market and are not subject to any lock-up restrictions – is still very low. As of end-2007, the free float totalled less than 30% of all the shares outstanding12 . 9 KPMG (2007), p. 4. 10 CSRC (2008). China Capital Markets Development Report. China Securities Regulatory Commission. March 2008, p. 205f. 11 Ibid., p. 208. 12 Ibid., p. 240. The Chinese stock market alphabet soup Name Currency Description A-shares RMB Companies incorporated in PRC Traded in Shanghai & Shenzhen Largest class of Chinese shares Investors: Chinese nationals and foreign institutional investors authorised under QFII B-shares USD/HKD Companies incorporated in PRC Traded in Shanghai (USD) & Shenzhen (HKD) Investors: prior to Mar 01 only foreigners, now also domestic retail investors H-shares HKD Companies incorporated in PRC Traded in Hong Kong N-shares USD Companies incorporated in PRC, listed and traded on the New York Stock Exchange L-shares GBP Companies incorporated in PRC, listed and traded on the London Stock Exchange Red chips HKD Chinese companies incorporated outside PRC listed in Hong Kong Often state-ow ned or state-controlled companies S-shares SGD Like H-shares but traded in Singapore 13 0 500 1,000 1,500 2,000 2,500 3,000 0 5 10 15 20 25 30 35 40 45 00 01 02 03 04 05 06 07 Trading turnover, RMB tr (left) Trading volume, m units (right) Source: PBoC Vibrant growth in China's futures market 14
Deutsche Bank Research Current Issues QFII Market participants The Qualified Foreign Institutional Investor In 2006. the investor structure of china s stock market was"still not (QFII)scheme was introduced in 2002. The aim was to let foreign institutional investors desirable"according to the People's Bank of China as institutional participate in local stock and bond markets in investors accounted for only 30% of the total market capitalisation order to bring more stability to the markets By As of end-2007, retail investors still had a share of more than 50% the end of 2007, 52 foreign institutions had Institutional investors generally play an important role in developing obtained a qfll licence of which 49 had been capital markets as they can help to channel (individual) savings into allocated quotas totalling USD 9.995 bn Five ovide OFIl capital markets with a medium to long-term investment horizon and custodian services are foreign banks. OFIl are lower risk for investors, due to size and risk diversification. They can allowed to invest in A-shares, bonds, and other also add to product innovation and possibly improve market and financial instruments approved by the CSRc pricing transparency Eligibility rules are established by the CSRC and include the following requirements The structure of institutional investors in the chinese stock market differs markedly from that of more developed markets. As of end oper- USD bn 2007. investment funds accounted for 52.7% of all institutional investor assets in China, followed by pension funds that had a share years of around 40%. The share of the latter group is much higher in Type Japan or Korea, while insurance companies play a much stronger role in the Us. Investment funds offer only a limited range of manager 5 ≥1 products and have only weak innovation capability. Also, particip- Insurance ation of insurance companies and social security funds is very low, which can be attributed to the low development level of the funded companies >30 social security system. Domestic private equity funds are under- Ranked≥1 developed in China, which explains why foreign players dominate in cial bank this field in China. Last but not least, the complex regulatory 100 banks environment for collective investment schemes hampers the globally by development of institutional investors as it raises costs and leads to total assets efficiency losses. Currently there are three entities-CSRC, CBRC and CIRC -in charge of regulating collective investment schemes in China This large share of retail investors and-according lack of sufficient institutional investors is widely seen as a problem. Re investors are often linked to higher volatility, as herd behaviour he qualified domestic Institutional investo prevails and people tend to act more sentiment-driven. However, (QDII) scheme was introduced in mid-2006 in there are also views that the share of"real" retail investors in China order to give approved domestic institutiona is lower than suggested by the numbers for individual stock trading investors the opportunity to invest in inter- accounts, as entities with close state linkages- like the military national, foreign-currency-denominated police, local governments, state-owned enterprises and private securities(fixed income, stocks, derivatives). he scheme had principally two goals: 1)to funds opened such accounts in order to participate in the stock funnel abundant domestic liquidity abroad and market boom". Additionally, in the case of China, relatively low 2) to stem appreciation pressure on the experience among traders and institutional investors might also currency from rising foreign exchange reser- have added to the build-up of the stock market bubble and height ves.By the end of 2007, 15 fund management ened volatility. It would therefore not be sufficient only to increase firms and 5 securities firms had been granted QDIl status with a total quota of USD 24.5 bn the share of institutional investors. An improvement in financial literacy would also be desirable People's Bank of China(2008a). China Financial Stability Report 2007. March People's Bank of China(2008b). China Financial Stability Report 2008. July 2008, Kim, Yongbeom, Hi, Irene and Mark St Giles(2003). Developing institutional investors in the People's Republic of China. World Bank Country Study Paper. September 2003, p 3ff 6 CSRC(2008). China Capital Markets Development Report. China Securities Regulatory Commission. March 2008, p. 273 China's Illusory Retail Investor 07. Online http://ww.businessweek.com/gl 07471221hm arch16,2009
Current Issues 10 March 16, 2009 QFII The Qualified Foreign Institutional Investor (QFII) scheme was introduced in 2002. The aim was to let foreign institutional investors participate in local stock and bond markets in order to bring more stability to the markets. By the end of 2007, 52 foreign institutions had obtained a QFII licence of which 49 had been allocated quotas totalling USD 9.995 bn. Five of the 13 banks permitted to provide QFII custodian services are foreign banks. QFII are allowed to invest in A-shares, bonds, and other financial instruments approved by the CSRC. Eligibility rules are established by the CSRC and include the following requirements: QDII The Qualified Domestic Institutional Investor (QDII) scheme was introduced in mid-2006 in order to give approved domestic institutional investors the opportunity to invest in international, foreign–currency-denominated securities (fixed income, stocks, derivatives). The scheme had principally two goals: 1) to funnel abundant domestic liquidity abroad and 2) to stem appreciation pressure on the currency from rising foreign exchange reserves. By the end of 2007, 15 fund management firms and 5 securities firms had been granted QDII status with a total quota of USD 24.5 bn. Market participants In 2006, the investor structure of China’s stock market was “still not desirable” according to the People’s Bank of China13 as institutional investors accounted for only 30% of the total market capitalisation. As of end-2007, retail investors still had a share of more than 50%14 . Institutional investors generally play an important role in developing capital markets as they can help to channel (individual) savings into capital markets with a medium to long-term investment horizon and lower risk for investors, due to size and risk diversification. They can also add to product innovation and possibly improve market and pricing transparency15 . The structure of institutional investors in the Chinese stock market differs markedly from that of more developed markets. As of end- 2007, investment funds accounted for 52.7% of all institutional investor assets in China, followed by pension funds that had a share of around 40%. The share of the latter group is much higher in Japan or Korea, while insurance companies play a much stronger role in the US16. Investment funds offer only a limited range of products and have only weak innovation capability. Also, participation of insurance companies and social security funds is very low, which can be attributed to the low development level of the funded social security system. Domestic private equity funds are underdeveloped in China, which explains why foreign players dominate in this field in China. Last but not least, the complex regulatory environment for collective investment schemes hampers the development of institutional investors, as it raises costs and leads to efficiency losses. Currently there are three entities – CSRC, CBRC, and CIRC – in charge of regulating collective investment schemes in China. This large share of retail investors and – accordingly – lack of sufficient institutional investors is widely seen as a problem. Retail investors are often linked to higher volatility, as herd behaviour prevails and people tend to act more sentiment-driven. However, there are also views that the share of “real” retail investors in China is lower than suggested by the numbers for individual stock trading accounts, as entities with close state linkages – like the military, police, local governments, state-owned enterprises and private funds opened such accounts in order to participate in the stock market boom17. Additionally, in the case of China, relatively low experience among traders and institutional investors might also have added to the build-up of the stock market bubble and heightened volatility. It would therefore not be sufficient only to increase the share of institutional investors. An improvement in financial literacy would also be desirable. 13 People’s Bank of China (2008a). China Financial Stability Report 2007. March 2008, p. 44. 14 People’s Bank of China (2008b). China Financial Stability Report 2008. July 2008, p. 43. 15 Kim, Yongbeom, Hi, Irene and Mark St Giles (2003). Developing institutional investors in the People’s Republic of China. World Bank Country Study Paper. September 2003, p. 3ff. 16 CSRC (2008). China Capital Markets Development Report. China Securities Regulatory Commission. March 2008, p. 273. 17 China’s Illusory Retail Investor Class. In BusinessWeek. June 7, 2007. Online: http://www.businessweek.com/globalbiz/content/jun2007/gb20070607_471221.htm ?campaign_id=rss_as Type In operation, years Paid-in capital, USD bn AuM, USD bn Fund manager > 5 - 1 Insurance companies > 30 1 10 Securities companies > 30 1 10 Commercial banks - Ranked among top- 100 banks globally by total assets 1 Source: www.fundcn.org 15