China's stock market: a marriage of capitalism and socialism.

• Author: Wong, Sonia M.L.

The rise of China's stock market during the 1990s was nothing short of breathtaking. For more than 30 years after 1949, China was a centrally planned economy in which virtually all enterprises were state owned or collectively owned. Investments were centrally planned and funded by government fiscal grants as well as by loans from the state-owned monobank system as dictated by the government's central credit plan.

In the late 1980s, as part of enterprise reforms that took place during China's gradual transition to a market economy, local governments in China started experimenting with selling shares of collectively owned enterprises directly to domestic individuals in order to raise equity capital. Curbed trading of enterprise shares soon began and was quickly followed by over-the-counter (OTC) trading in more organized but still informal exchanges. In 1991, two stock exchanges, one created by the Shanghai municipal government and the other by the Shenzhen municipal government, were launched, with the central government's formal approval. Between 1992 and 2003, the market raised a total of 796.79 billion yuan of equity capital. At the end of 2003, China's stock market had 1,287 listed enterprises and more than 70 million investor accounts (CSRC 2004).

Table 1 summarizes the growth of the Chinese stock market since its inception. The market experienced tremendous growth with total (negotiable) market capitalization increasing from 353.1 (86.16) billion yuan at the end of 1993 to 4,245.77 (1,317.85) billion yuan at the end of 2003. (1) Along with the growth in market capitalization, the market also enjoyed a high level of liquidity, with trading volume increasing from 68.13 billion yuan in 1992 to 6,082.67 billion yuan in 2000. The two exchanges now boast a modem infrastructure with a computerized automated trading system, a high-speed nationwide satellite communications system backed by digital data networks, a paperless depository, and an efficient clearing and settlement system. (2) In about a decade, China built a respectable stock market from scratch.

Stock market development in China took off in the early 1990s, roughly at the same time as it did in other transitional economies (Pistor, Raiser, and Gelfer 2000). But China's stock market is performing better than the markets of most other transitional economies, when comparisons are made using standard measures of stock market performance, including the number of listed firms, market capitalization, liquidity, and fundraising capacity (Pistor and Xu 2005: 191). (3) By the end of 2000, while many stock markets in transitional economies were plagued by low market capitalization and low liquidity, China's total stock market capitalization had swelled to more than US$507 billion. That made China's stock market capitalization the second largest in Asia, after Japan's.

China's stock market had three unique features that made its rapid development unique and interesting. First, the government used it largely as a fundraising vehicle for funding state-owned enterprises (SOEs). (4) As a result, most listed enterprises were state controlled, with only one-third of the enterprises' equity capital sold to private shareholders during initial public offerings (IPOs). The other two-thirds of the equity capital raised was held either by state asset management agencies or by SOEs themselves. In an effort to prevent the loss of state control over listed enterprises, the government forbade trading of state-owned shares on China's two exchanges, and the shares could be transferred only after approval from state asset management authorities had been obtained, which made these shares effectively nontradable. The transfer of state-owned shares to private shareholders was rare in the 1990s. At the end of the 1990s, more than 90 percent of the enterprises listed on China's two stock exchanges remained state controlled, with state-owned entities as their controlling shareholders. The rapidity of the development of China's stock market seems to suggest that a stock market (which is regarded as the incarnation of capitalism) can coexist with state ownership (which is regarded as the defining institution of socialism) and does not necessarily require the presence of private enterprise.

Second, China's stock market developed under a repressed financial regime. Financial repression was created through a combination of capital controls on international capital flows and administrative measures imposed by the central government to dampen potential competition among different financial assets (e.g., bank deposits, enterprise stocks, enterprise bonds, and various kinds of government bonds) within the domestic financial sector. (5) While the capital controls helped to prevent capital from flowing out of the country, the competition-mitigating administrative controls sought to avoid the driving up of returns on various financial assets and thus to allow the government to maintain a source of cheap capital for financing SOEs' investments (Li 1994; Li 2001; Gordon and Li 2003).

Financial repression, which generates artificially low returns on financial assets, inevitably creates excessive demand for valuable financial resources and hence results in nonprice rationing of those financial resources to preferred claimants (McKinnon 1973; Shaw 1973). Financial repression is therefore a disguised form of investment planning. In theory, this form of investment planning was to be gradually phased out with the emergence of a stock market that provided a forum for direct transactions between investors and fund seekers. However, China's central government imposed a host of administrative controls aimed at preserving its monopoly over the uses of funds long after the emergence of the stock market, thus grafting the socialistic investment planning institution onto the stock market. Such a unique institutional structure is intriguing for studies on financial repression as well as the functioning of stock markets. Furthermore, the traditional economics literature generally views financial repression as an obstacle that limits financial market development, because, under a repressive financial regime, holders of financial assets are not rewarded for real growth in their portfolios (McKinnon 1973; Shaw 1973). The rapid growth of China's stock market during its first decade seems to offer an interesting alternative case study.

Third, China's stock market was developed under a weak legal framework that offered shareholders little protection. On the widely used indicators for shareholder rights protection developed by La Porta et al. (1998), China scored 3, compared with the average score of 3.61 for all other transitional economies (Pistor and Xu 2005: 191). (6) The actual protection for shareholders in China, however, is lower than what the index suggests because of the weak legal enforcement in China (Tenev and Zhang 2002; Allen, Qian, and Qian 2005; Pistor and Xu 2005). The development of China's stock market therefore presents a puzzling case for economists and financial analysts who hold that legal shareholder protection is a prerequisite for the development of a functioning capital market (Shleifer and Vishny 1997; La Porta et al. 1997, 1998; Pistor and Xu 2005).

This article attempts to explain how China was able to develop a large, active, and technologically advanced stock market in the 1990s while maintaining its salient socialistic institutions of state ownership and monopolistic control over financial intermediation, and offering shareholders only weak legal protection. I argue that the marriage of socialism and capitalism took place when China's poorly regulated stock market was becoming a venue whereby local governments and SOEs issued shares to capture economic rents created by financial repression, and traders bought and sold shares based on speculative motives rather than investment value. I show how the development of China's stock market in the 1990s was in fact driven primarily by these rent-seeking and speculative activities rather than by value-driven transactions between investors and fund seekers.

In the early 2000s, China's central government introduced a series of reform measures for privatizing listed enterprises, removing restrictive barriers in the financial sector, and improving legal protection for shareholders. Those measures are all consistent with the standard prescriptions for fostering the development of a well-functioning stock market. However, they have met with little enthusiasm and have triggered a bear market. The composite index of the Shanghai Stock Exchange slid from around 2,250 points in mid-2001 to around 1,300 points in December 2004, a plunge of 42 percent. In January 2005, the central government decided to slash the stamp tax by half, reducing it to 0.1 percent in an apparent attempt to boost the failing stock market. The stock market, however, remained weak. As recently as March 2006, the composite index was still hovering around 1,300. I conclude this article with a discussion of the impacts of recent reforms as well as the likely evolution of China's stock market in the future.

Institutional Development of China's Stock Market

The origin of China's stock market can be traced to a fall in the central government's revenues in the early 1980s, which necessitated finding new sources of capital to fund SOEs' capital expenditures. Since the introduction of economic reforms in 1978, the central government's revenues declined steadily relative to gross domestic product (GDP), falling from 31.2 percent in 1978 to 15.8 percent in 1989. (7) Mired in a deficit of 17.06 billion yuan (about 5 percent of national income) in 1979, the government did not achieve a small surplus until 1985. (8)

During this period, private household savings surged, with deposits in state-owned banks increasing from 21.06 billion yuan in 1978 to 121.47 billion yuan in 1984. (9) In...