Capital freedom in China as viewed from the evolution of the stock market.

• Author: Chen, Zhiwu

Since reforms started in 1978, China has made commendable progress in achieving capital freedom and individual liberty. Prior to 1978, private enterprises with more than eight employees were prohibited and there were no capital markets. Private entrepreneurs were labeled "capitalist tails," and political movements were launched frequently to "cut the capitalist tails." For several decades, Chinese citizens could only obtain employment and economic means from government organizations and state-owned enterprises, which strictly limited individual liberty. Today there are more than 10 million privately owned enterprises, making up more than 80 percent of each year's employment growth. As a result of less regulation and more room for entrepreneurship, it is relatively easy to register and start a business. Public equity offering opportunities and bank financing are also increasingly available to private firms as well. Chinese, young and old, can choose among jobs provided by government organizations, SOEs, private businesses, and foreign-owned firms. As capital freedom has increased, the rise of the individual and liberty is one of the highlights achieved in China's development over the past 35 years.

There are, however, many challenges ahead to further increases in capital freedom in China. These challenges are inevitably due to China's gradualist reform approach in which pragmatic economic reforms have been allowed and adopted without correcting the philosophical foundation of the country's political, economic, and legal system. SOEs, government, and Marxist ideology still dominate the economy, politics, and business--although market forces and private ownership are a significant part of the Chinese society and still on the rise. In particular, political power is not formally checked or balanced and neither is the monopoly position of SOEs, which has allowed government agencies and SOEs to reenergize and expand their power to cut into capital freedom as they desire. There has not been a formal debate or reform to define and limit the scope of government. Taxation has been increasing at more than twice the speed of GDP growth. Thus, unless and until political reforms take place and functioning cheek-and-balance institutions are put in place formally, SOEs and government power present immediate threats to the precious but still limited degree of capital freedom and individual liberty in China.

In this article, I use China's capital markets, more specifically its stock market, to illustrate why the lack of a formal rejection of Marxist economics, as well as the lack of political reforms, has internalized forces and contradictions in the Chinese society that have the potential to reverse the many positive achievements of the last 35 years. At a minimum, such forces will continue to make it difficult for the rule of law and for justice and equity to progress further.

Today China has a sizable capital market, with more than 2,400 listed companies on the two stock exchanges with a total market capitalization of more than RMB 21 trillion (almost 50 percent of China's GDP). (1) More than 300 securities and trust companies are licensed to provide investment banking and stock brokerage services through more than 2,500 branch offices in cities large and small. This extensive network of brokers has attracted more than 200 million stock and mutual fund accounts. China today has among the most robust securities market infrastructures in the world, when measured in terms of both trading capacity afforded by the electronic systems and potential investor reach facilitated by the vast physical distribution channels. The physical infrastructure and distribution network present the Chinese economy with a potentially great financing capacity.

The gap between stock market potential and reality is, however, still quite wide. While China's physical infrastructure for capital markets is impressive by many measures, the institutional infrastructure necessary for investors to be willing to part with their money is largely missing or not functioning in its intended way. As a result, recent efforts by the government to push up stock prices have led to continuous disappointment. Investors are not rushing back to buy stocks, and the stock market is not showing enthusiasm.

China's stock market development started during the 1860s, was interrupted several times by wars and ideology, and reemerged in the late 1980s. In this article, I compare the stock market under the current regime with its past under the Qing dynasty and during the Republican years before 1949. Discussion centers around several key questions: (1) In the absence of necessary impersonal legal and regulatory institutions, what arrangements did China come up with to induce public investors to join stock trading? (2) What was done to overcome the confidence and trust barriers? (3) With the government being the largest shareholder in most publicly listed companies today, how does that impede legal development and limit capital freedom? Answering these questions will help us understand the cultural roots of the Chinese government's large role in the economy, in addition to the Marxist political economy roots. What we will see is a constant struggle between the traditional Chinese preferences for informal or relationship-based rules of business transactions and the stock market's dependence on formal structures of contracting and governance. That struggle in the capital market mirrors closely the struggle by the larger Chinese society with the process of modernization.

The Origin of China's Stock Market: 1860s to 1911

China is known to have invented paper money during the Song dynasty, 960-1279 (see von Glahn 2005). However, China did not venture into innovations in securities trading until the late 19th century. The move to adopt joint-stock companies with limited liability and initiate a stock market was largely a consequence of the "Self-Strengthening Movement" following the defeat to Britain and France in the Opium Wars (1839-42 and 1858-60). The wars revealed that China was far behind in military technology and that in order to win over the West and regain national pride, China must catch up with Western military and industrial technologies (Feuerwerker 1958). However, adopting such technologies and developing the necessary manufacturing infrastructure required large sums of capital. Yet, at the time, the Qing government was financially constrained. The state would not have the needed resources to take on the projects directly. The financing challenge was therefore daunting.

As one of the leading voices at the time, Xue Fucheng (1838-94) commented,

The essence of the joint-stock corporation is to make a nation rich and powerful.... If a country does not pursue joint-stock companies, its industry cannot prosper nor can its commerce.... Where foreign firms are present, there are corporations raising capital from hundreds or even...