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Capital Market Reform in a Modern Financial System

        2018-11-30

Capital Market Reform in a Modern Financial System[1]

 

Hong Lei

CF40 Council Member

Chairman of the Asset Management Association of China

 

 

Abstract: This article is a short version of ‘Capital Market Reform in a Modern Financial System’, a sub-report of the 2018 Jingshan Report. Short-term speculations and herd behaviors have long prevailed in China’s capital market. Rapid capital inflow and outflow have prevented the formation of long-term capital. Consequently, there is a severe deficiency in the generation of innovation capital, and many small- and medium- sized and start-up firms are unable to secure enough equity investment. How to reform the capital market to address these issues? The authors propose the following three suggestions. First, attach more importance to legislation, and build a comprehensive system of capital market laws and regulations; second, promote the synergy between institutional regulation and functional regulation, establish a modern governance system of the capital market. Third, undertake tax reforms on the capital market.

 

Innovation capital formation is the cornerstone of the modern financial system

 

The modernness of the financial system is reflected in its capacity to mobilize and allocate financial resources commensurate with the level of economic development. For China, production factors such as land, natural resources and labor have been nearly fully utilized. The future supply of these production factors is faced with resource, environmental and social constraints, thus it can no longer support an input-intensive model that emphasizes quantitative growth. China therefore must shift toward a model that optimizes the economic structure and promotes technological innovation, in order to increase the total factor productivity (TFP) and achieve sustainable growth. From this point of view, the core function of a modern financial system should be aligned with the needs of economic upgrading and innovation, and to create a financial resource allocation system that facilitates the formation of innovation capital.

 

Based on the development trajectories of major economies, there are two main pathways for innovation-led growth. One is the incremental innovation. Countries following this approach are represented by Germany and Japan. These countries seek to continuously lower production cost and increase efficiency in their respective areas of comparative advantage through internal knowledge accumulation and the absorption of imported technologies. The other is disruptive innovation. Countries using this approach are represented by the U.S. These countries make completely new inventions which push further the production frontier and bring about supply-side revolution. Correspondingly, there are two basic models of financial system. The first mainly consists of financial intermediaries and relies mostly on bank credit. The second is a financial market system dominated by direct financing. Theoretical and empirical studies have both shown that indirect financing is more compatible with incremental innovation, and direct financing is compatible with original, disruptive innovation. Due to the high uncertainty of innovation, innovation advantage and an innovation-led development model can only be formed if sufficient risk-tolerant capital is devoted to innovation. International experience suggests that the more advanced a country’s equity financing system, the higher its capacity for innovation capital formation and its ability to promote technological advancement and innovation-led development.

 

China’s capital market lacks the capacity to form innovation capital. The market system and institutional environment need improvement.

 

Short-term speculations and herd behaviors have long prevailed in China’s capital market. Rapid capital inflow and outflow have prevented the formation of long-term capital. Consequently, there is a severe deficiency in the generation of innovation capital, and many small- and medium- sized and start-up firms are unable to secure enough equity investment. The root causes of these problems are as follows -

 

First, under the current legal framework for the capital markets e.g. the Securities Law, a market-based pricing mechanism and a market bargaining system have yet to take shape. There is still a long way to go before the market mechanism plays a decisive role. In terms of pricing, a mechanism based on full information disclosure and free market bargaining has yet to be established in order to form fair market values. Under current rules, the issuance of securities is subject to an approval process and the securities firms are required to assume the role of “sponsors”. Although to some extent, this system gives the market players the freedom to recommend and choose securities, the regulator retains the power to conduct compliance and suitability examinations, and the securities must meet the substantive requirements of regulators. Among these requirements, a key criterion is the issuer’s ability to achieve sustained profitability. In other words, the regulator is making judgements for investors about the investment value of the securities. Meanwhile, the price earnings ratios (P/E ratio) of new issuances are limited by the industry average, and are not the outcome of the bargaining between issuers and investors. Moreover, out of concern for market stability, the regulator still keeps tight control over the amount of securities that can be issued and the pace of issuance.

 

At the same time, bargaining between buyers and sellers based on their expertise and creditability is lacking. The scarcity of resources has pushed these market players from bargaining against each other into working together against the regulators. During the issuance process, the issuers and intermediaries only comply in appearance with the requirement for truthful, accurate, and complete information disclosure. While in reality, they often cook the books. Fraudulent behavior exists in abundance in practice, and accounting and law firms often collude to make untruthful, untimely and inaccurate disclosure.

 

The Securities Law of China and other regulations focus more on regulating the conduct of industry actors by means of strict substantive approval process and attempt to maintain the order of market credibility through the enforcement of law and the government's administrative power. Out of the trust of and the reliance on the authority, investors often take government approval of issuance as an affirmation of the authenticity of the disclosed documents and the qualification of the securities. They attribute investment risks to the government, which in turn encourages opportunism among institutions and individuals. In practice, cases of private equity pre-IPO investment, tunneling, market manipulation, and insider dealing occur frequently. Market manipulation has shifted from being the action of individual investors to collusions between major shareholders and listing companies. Such phenomena that hurt investors and cripple the very foundation of the capital market persists, because despite the opposing interests between investors and listing firms, securities/futures institutions and listing firms, and security/futures institutions and other intermediary institutions, there is a lack of market selection mechanism and administrative or legislative sanction mechanism that could restrain dishonest behaviors. Such mechanisms include institutionalizing delisting, imposing stern administrative or criminal sanctions, and offering legal aid to investors.

 

Second, corporate governance mechanism for publicly listed firms which centers on shareholders, as established by the Company Law, has major defects. Corporate governance is the outcome of balancing the interests and contentions of multiple actors including the shareholders, the board, and the management. Because shareholder general meetings are recognized by the Company Law as having the absolute say in the matter of listed companies, the principle of majority voting when the presence of controlling shareholders is common for publicly listed firms further turns “shareholder-centrism” into “controlling shareholder-centrism”. Corporate decisions typically reflect the key interests of the controlling shareholders. In other words, the inadequate protection of the interests of the minority shareholders has become the main agency problem of listed firms in China. Listed firms tend to view corporate governance mechanism as regulatory compliance requirements, without realizing its importance in boosting long-term firm value and ensuing all parties’ interests are protected. Control of key decisions regarding the long-term development of the listed firm and the interests of all investors such as firm development strategy, major investment decisions and profit-sharing arrangements has fallen into the hands of the main shareholders. The power of the board to make independent, professional decisions on the behalf of all the shareholders is significantly weakened, and the modern corporate governance mechanism could not function properly. As a result, behaviors infringing upon the interest of listed firms are left unchecked, which include complete sell-down, “pledge-style” offloading, and cutting the holding with manipulative behaviors by main shareholders, as well as reinventions such as joint establishment of buyout funds by listed firm and private equity, and integration of industrial and financial capital. Listed firms suffer a loss of credibility with all the shareholders and external investors.

 

Third, poor regulation in both institutional and functional dimensions hinders the effectiveness of capital market regulation. Existing financial regulation has major issues regarding two relationships: the first is the relationship between financial regulation and financial development, and the second is the relationship between institution-oriented regulation and function-oriented regulation. In terms of objectives and responsibilities, financial regulatory bodies play the dual role of regulator and guardian, which is inherently conflicting. Within a system of highly centralized economic decision-making, financial regulatory bodies have the political duty to serve economic development goals by facilitating the rapid development of the financial sector. They also have the market duty to promote the stable and prudent operation of financial institutions and prevent systemic financial risk. As economic situations and short-term macroeconomic goals change, the political duty of the financial regulatory bodies often undergoes vast adjustments, thereby affecting the stability and consistency of their market duty. In a complex political decision-making process, decisions to promote market development usually end up deviating from the market neutrality principle. The inability of regulatory policies to change accordingly therefore creates room for regulatory arbitrage, which in turn leads to intensified speculation behaviors. As for the relationship between institution-oriented regulation and function-oriented regulation, existing regulation duties are divided following the principle of institution-oriented regulation. Function-oriented regulation is subordinate to institution-oriented regulation and plays a rather limited role at the latter's periphery. Function-oriented regulation is in severe shortage in the entire financial system. For example, shadow banking as an outgrowth of the traditional banking system is able to slip from the grasp of function-oriented regulation of credit business. Similarly, securities issuance (which falls within the scope of financing business), when showing up as asset management, is no longer regulated as financing business, while investment business in the guise of insurance products is no longer regulated as asset management business, and so on and so forth. Within the existing regulatory system, both regulatory bodies and institutions in the sector have a strong tendency for institutional departmentalism and an urge to expand.

 

Forth, an administrativized regulatory regime cannot achieve the level of specialization required. In addition, inadequate self-regulation inhibits capital market vitality. As capital market activities become increasingly specialized and complex, financial regulatory bodies should become specialized too so they could make timely and flexible response to the quick changes in the capital market. The China Securities Regulatory Commission (CSRC) at its inception aimed at becoming a specialized institution regulating the securities market. However, as it develops, it is increasingly turning into a government department with a lack of expertise-based and flexible decision-making mechanism and highly-qualified professionals. Although there are many self-regulation organizations such as industry associations and bourses, and the Securities Law and the Fund Law grant industry associations similar self-regulation duties, the size of these associations are generally rather moderate. Their self-regulating functions are also woefully inadequate.

 

Fifth, capital market function of the buy-side is deficient, and an organic ecosystem has yet to be formed. In advanced markets, asset management institutions carry out professional investment with the assets entrusted to them. They are the most important buyers in the capital market. In the Chinese capital market, phenomena that go against the very nature of asset management and weaken the investment function are abundant in the asset management business. For example, multiple asset management plans are in fact for the financing of a single project, ending up as a channel for bank funds to go off the balance sheet for arbitrage purpose. Many bank wealth management funds and insurance funds enter the stock market illegally through trust plans and asset management plans. Asset management has largely been turned into a tool for financial arbitrage, distorting the development of the industry. The characteristics of public funds as an investment vehicle are weakened. The functions of value investing and long-term investing are not realized. The underlying causes of the aforementioned problem are as follows. First, the asset management industry has failed to fully implement the requirements of trust relationship. Consequently, contract relationship collides with trust relationship, and financing activities disrupt investment activities. Second, asset management industry has yet to develop a multi-layered, integral system that offers products ranging from asset allocation among major categories, professional investment vehicles, to underlying assets management. It is therefore unable to satisfy the intertemporal asset allocation needs for pension funds, wealth management funds and insurance funds, as well as the continuous financing needs for the growth of the real economy.

 

Sixth, there is no sound tax system that facilitates the formation of long-term capital. Taxation system that encourages the formation of long-term capital has long been absent in China’s capital market. Value-added tax puts cost constraints on investment vehicles, not only increasing the friction and reducing the efficiency of market transactions, but also exerting a significant inhibitive effect on the reinvestment activities of long-term capital. Private equity, pension, insurance and public funds are main sources of long-term capital. Without the protection of neutral tax and the support of preferential tax treatments for long-term investment, market willingness to invest will for certain decrease and the capacity for long-term capital formation weakens, which will in turn impair the innovation capacity of the real economy and put China in a more disadvantaged position in the financial competition against other powers.

 

Policy suggestions for developing a modern capital market

 

First, elevate the position of legislation and construct a general legal framework for the capital market. Make systemic amendments to the financial laws and regulations including the Banking Law, the Securities Law, the Trust Law, the Securities Investment Fund Law, and the Insurance Law based on the fundamental function and risk attribute of different financial activities. Financial legislation and regulation should focus on the nature and risk of the operations when formulating the operation standards and seek to manage the risk of mixed operation at the capital level through institution-oriented regulation and that at the product and operation level through function-oriented regulation. Establish unified standards for fiduciary duties for the whole market to ensure that the sellers fulfill their obligations and the buyers take responsibilities for their own decisions, so that fair and reasonable pricing for financial assets can be achieved though market-based games of players, rather than reliance on the credibility of shareholders and originators. Further refine the Company Law so that the focus of corporate governance is shifted from centering on shareholder’s general meeting to centering on board meeting, the independence of the board is improved, and the interests of public investors are better protected.

 

Second, promote the synergy between institution-oriented regulation and function-oriented regulation and establish a modern industry governance system. Establish a regulatory framework featuring “one bank, one commission, and multiple associations” to implement institution-oriented regulation and function-oriented regulation. “One bank” refers to the central bank which is responsible for monetary policy and macroprudential supervision with a key focus on preventing systemic risks. “One commission” refers to the combination of three commissions into a financial regulation commission that oversees different financial institutions including banks, securities institutions, insurance companies, and funds, with the goal of enhancing financial institution prudence through full-range, vertical supervision. “Multiple associations” refer to multiple industry associations legally authorized to serve as industry self-regulation organizations, for example, banking industry association, securities industry association, funds industry association, futures industry association, insurance industry association, etcetera. Each carries out self-regulation in accordance with the industry they belong to and fully perform industry associations’ function of social governance. By establishing uniform standards and reduce room for regulatory arbitrage, these associations can uphold market efficiency and fair competition.

 

Third, reform tax system for the capital market. At the level of financial products, substitute value-added tax and individual income tax with capital gains tax, so that various investment vehicles can enjoy the benefits of tax neutrality. Give long-term investment activities preferential treatments in the form of deferred taxation so as to encourage more capital to take risk and gain returns through long-term investment. Promote the development of specialized investment institutions and strengthen the competitiveness of the capital market internationally. Study and push forward estate tax, gift tax, and tax exemption schemes for donations in order to encourage idle funds to invest in angel and venture capital and boost the formation of early-stage innovation capital.



[1] Hong Lei is head of the research team for this report. Other members include Cheng Xin, Zhang Xuanchuan, Deng Huanle, Han Bing, Liang Shuang, Fei Wenying, Li Zhongli, Lin Yuchen and Jin Keyu. The views expressed in this report are those of the authors’ own and do not reflect the views of the organizations they are affiliated with.

 
 
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