China's Financial Markets: The Same Old OLD Problems

In China and the World Financial markets 18701-1939: Modern Lessons from Historical Globalization by William Goetzmann, Audrey Ukhov and Ning Zhu, the authors use a historical narrative of China's financial markets to show how China can improve its modern financial markets (h/t to The Economist, and good luck finding the article if you don't have access to an academic library database). The authors identify two "key financial motivations," and argue that they are necessary to the health of a capital market which contributes to the health of the global capital market: diversification, and corporate governance. The bad news is that China is still restricting diversification and corporate governance, and the authors argue that both of these contributed heavily to the downfall of Imperial China. The good news is that China is making huge strides to correct its problems these two areas, and preventing a modern collapse of China's financial markets.

Diversification
The authors identify a beneficial result of diversification from R. Stulz's paper Globalization of Equity Markets and the Cost of Capital:

The general conclusions reached by these and other researchers studying world capital market liberalizations is that the cost of capital drops as outside investors are given access to local investment projects. There are obviously positive features of this drop in the cost of capital--capital projects previously unattractive because of low rates of return become attractive. Lower interest rates can be an extraordinary boom to the economy ... However, the other side of the coin is that, in the competition for control of domestic assets, the undiversified local investor is at a relative disadvantage.

While Chinese investors were heavily invested in private enterprise in the late 19th and early 20th century, they were not major investors in government projects or in Chinese sovereign debt. The authors argue that this was because of a lack of a liquid capital market for Chinese, and little to no diversification into international finance by Chinese investors preventing steadier returns.

The Economist article cited to earlier heralds the opening of the Shanghai Stock Market to the world. On August 6th, China changed its securities laws to allow foreign companies to list on Shanghai's stock market. This will increase diversification by allowing Chinese to diversify their investments into foreign companies, and allow foreign companies a new source of capital. The article argues by way of Goetzmann et al, that by diversifying into foreign companies Chinese investors should have lower portfolio risk there by allowing them to allocate more capital to the riskier Chinese shares. Thus, theoretically, more capital and less risk for everybody.

Goetzmann et al, offer a few more suggestions for how to improve diversification in the Chinese market, but this is a great start.

Corporate Governance
A sentence from Goetzmann et al's article is just as applicable today as it was a century ago:

[T]he trajectory of Chinese financial history is the relative ineffectiveness of legal protection and governance structures for enterprise in China, compared to the extraordinary protections negotiated by foreign investors.

They argue that 100 years ago there were two major obstacles to effective legal protection and governance structures: 1) "stake-holders of various kinds--from local gentry to provincial government officials--wielded considereable power and influence over commercial enterprise;" and 2) concessions extracted from the Chinese government "included near-complete autonomy from Chinese law and taxation, and freedom from local competition--even the right in some cases to issue a separate currency. The first is still prevalent, especially considering the size and power of many SOEs. The second "created severe political problems," and China has been wise in recently eliminating similar concessions today. According to the authors, the best expression of when corporate governance is set within the proper legal framework is when there is equal protection of property rights for both foreign and domestic investors.

The good news is that China is working towards limiting the power and influence of stake-holders through its own version of Sarbanes-Oxley, the Standard Basic for Enterprise Internal Control. This was covered more extensively with plenty of links in a previous post. The gist is that corporate governance standards should be fixed in law when the Standard Basic becomes effective on July 1, 2009.

Conclusion
Apparently history repeated itself with the two same problems surfacing each time capital markets have risen in China. However, this should not come as a surprise. As the authors of the article make clear, these same problems existed in just about every capital market including Japan and the US. The difference is that the chaos in China during and after the fall of the Qing dynasty prevented its capital markets from making extensive reforms. Fortunately China is implementing extensive reforms now to prevent the instability that Goetzmann et al argue "led ultimately to a rejection of the international financial system." However, they also argue that the reforms can't be implemented too quickly, or else foreign investors will again have too great of an advantage in China resulting in dire human and political consequences. I'll leave you with their final words:

Given the potential for further integration versus the threat of reversal of recent gains, the lessons of history at this crucial juncture may be doubly important."