Is China up to its old trick in the finance industry?

Foreigners bring in money, but get little control in an industry that''s going through a profitability crisis.

The CSRC has just issued the formal version of laws through which foreign companies can access China's brokerage, investment banking and fund management industry. Much of it was predicted, and the memoranda of understanding that foreign financial institutions such as CLSA and BNP have signed with Chinese partners can now be translated into contracts.

The superlatives about China's 'potential' don't bear repeating, but that is exactly what justifies the moves made so far.

Yet the capital markets in this country are going through a profit squeeze. Brokerage fees have been capped at 3% although everyone in the industry is actually offering far less than that, forcing the proportion obtained from brokerages fees further and further down. These fees constitute the single biggest element of profits for China's securities houses, much bigger than own account trading which has taken a drubbing in the sagging markets of the last year and underwriting fees, since the number of companies going to the market has dropped sharply in the poor pricing climate.

The sheer number of brokerages has created fierce competition and mergers are not occurring sufficiently fast since many of the houses are subject to fierce personal and provincial loyalties.

The fund management industry is potentially - that word again - another very promising area. The reasons for this are simple: The government's plan is to radically increase the size of this industry under pressure to generate sufficient returns to pay for its out-of- control pensions and social welfare bill.

Another structural problem is the government's on-again, off-again state share sell-off. Any time the government looks serious about this, the markets tanks. The overhang of hitherto non-sellable state shares terrifies investors since the proportion of tradable shares is just one third of the total outstanding.

Added to this are the restrictions faced by foreign investors. They can take only minority positions, even when WTO rules are fully implemented - initially 33% for fund management companies and securities companies, rising to 49% by 2004 for the former, but no increase in ownership for the latter.

And their scope of business will not include the brokering or own-account trading of the main share class, A-shares, although they may underwrite stocks and bonds.

In addition, access to fund management will be made less attractive by regulations that stipulate that 80% of a fund's cash has to be in government bonds, while 20% has to in listed state owned enterprises.

Investment banking activities will be hurt by the very small of number of exciting private companies that are allowed to access the capital markets - 95% of listed companies are state-owned and heavily backed by their respective provincial governments and personal connections.

From the Chinese point of view there are also some factors which could militate against a hearty union.

The new entities will formed as limited liability companies, which precludes the possibility of a listing on the stock markets, where poor standards of regulation and rampant speculation enables companies to raise large sums while having to offer little in terms of profitability and transparency. This means the obsolescence of 1979 Joint Venture law and the confirmation of the 1993 Companies Law.

The Joint Venture Law although set up to protect Chinese interests, such as having the right of first refusal in the event of the foreign partner wanting to sell out, also had some flexible points. For example, in spite of equity limitations, foreign companies could obtain a disproportionate amount of the profits, based on their higher inputs of capital and technology. Under the limited liability structure, revenue sharing will be strictly proportional to the equity stake.

Also, the Chinese companies that do accept foreign investment will no longer be able to earn brokerage commission from A share trading or income from proprietary A and B share trading.

Finally, the approval-granting body seems to be the China Securities Regulatory Commission, according to the regulations, yet there is no mention of MOFTEC, the ministry of foreign trade and economic cooperation. Usually, the industry regulator cooperates with MOFTEC in granting approval, and it could be problematic if MOFTEC which could be losing some bureaucratic turf war but later reappears on the scene to complicate the approval process for foreign companies.

"China's obsession with tight control over the approval process is very clear in the new regulations, since many of the regulations are extremely vague and provide a lot of discretion to government ministers," concludes Walter Hutchens, a professor at the business school of the university of Maryland and China capital markets specialist.

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