China Financial System
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Papers on share-holder protections.
Two papers in James R. Barth et al., ed.,
China’s Emerging Financial Markets:
Challenges and Opportunities. Springer
2009.
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Introduction
Theory discussion
The emergence of investor protection
The central government’s changing
vested interests in the stock market
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The emergence and development of a capital market
requires more than the spontaneous actions of fundseekers and investors. Rule s and laws are needed to
reduce transaction costs so as to make the market
viable.
During in the early 1990s, China’s stock market
developed under a weak legal framework that
provided little protection for investors.
Starting from the late 1990s, China’s central
government began to gradually extend more and
more legal protection to shareholders.
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The Case of lawsuits in China’s stock market
China’s legal tradition focuses on
administrative and criminal sanctions but not
on civil liabilities.
 The legal developments in China’s stock
market have therefore been a consequence of
the complex interactions between the
government on one hand and private shares
on the other.
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The rules and laws governing the operation of a
capital market are not neutral with respect to the
interests of fund-seekers and investors, because
they define the opportunity sets opened to fundseekers and investors and change their liability
profiles.
As a result, the nature of the legal coverage for
investors has been considered a key determinant
of financial market development.
The general hypothesis is that in countries where
investor rights are better protected, investors are
more willing to finance firms, and financial
markets in those countries grow more rapidly.
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The previous literature has emphasized the role
of a country’s legal heritage in influencing the
level of legal protection offered to investors.
 La Porte et al., Legal determinants of external
finance, Journal of Finance, 1997
 La Porte, et al., Law and Finance, Journal of
Political Economy, 1998.
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The growth of China’s stock market.
The development of a stock market
needs to be supported by rules and
regulations. The rules and regulations
would have different implications for
the rights enjoyed by shareholders.
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From the inception of China’s stock market in the
late 1980s to January 2002, when the Supreme
People’s Court (SPC) issued a judicial
interpretation that opened the door for private
securities litigations, shareholder rights in China
were protected through administrative sanctions
and criminal punishments.
Since the early 2000s, significant changes have
occurred within the legal framework in which
private shareholders in China are granted private
securities litigation (PSL) as a weapon to defend
their interests, though their hands are still tied by
several impeding legal procedures.
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Event
A
PBC Branch in Shanghai issued its first regulation on issuance of stock
B
State Council issued a regulation in May 1992 that categorize the shares of a
shareholding enterprises into three types:
C
China’s first Company Law was promulgated, which became effective on January
1, 1994.
D
Criminal Law was amended to criminalize securities fraud
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The first private securities litigation case was brought against for false
information disclosure
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CSRC issued “Standard on Corporate Governance For Listed Companies”
G
The revised Company Law allows the shareholder to take a derivative action in
certain circumstances, and the amended Securities Law specifies civil remedies
for a number of additional violations such as inside trading
H
The revised Company Law and Securities Law became effective.
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The introduction of the independent
director system under which independent
directors are required to express opinions
on the fairness of important corporate
decisions to minority shareholders.
Shareholders in China actually do not
enjoy the real “private” litigation rights.
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Alongside the growth of China’s stock
market, shareholders have gained more and
more shareholder rights in 2002 the private
right of actions to bring their cases to courts.
This is particularly extraordinary given
China’s legal tradition of deemphasizing civil
action.
So how have such significant changes come
into being?
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Shareholders in China were usually less
educated people who had never been
organized. Although they voiced their
anger and demanded compensation when
their interest were hurt, they did not have a
clear idea or vision of how to defend their
rights through legal means.
Other statements
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Investors will be more willing to finance firms,
and financial markets will flourish if investors
enjoy better legal protection.
The positive relationship between shareholder
protection and stock market suggests that the
government’s incentive to develop the stock
market should be an important determinant of
its incentive to provide shareholding protection,
with a higher incentive to grant shareholding
rights if there is a strong desire to develop the
stock market.
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The roles of SOEs in the Chinese Economy
Employment, social safety net
The strategy of using bank loans to finance
SOEs became no longer viable in the late
1990s when a majority of the SOEs were
experiencing financial losses.
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The losses of SOEs not only created a burden on the
governments’ coffers but also led to the accumulation of
enormous nonperforming loans (NPLs) in the banking
sector.
As public listing is an integral part of this reform strategy,
China’s stock market has since taken on an important
role in the economy.
Consistent with the changing role of the stock market,
the government gradually proceeded to relax the
restrictive regulations that had been imposed on both
the supply and demand sides of share trading.
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Policy steps
In January 2004, the government issued a
document to promote the development of
capital markets, which stated that explicitly
“developing capital market is a task of strategic
importance linked to the fulfilling of the
strategic goal of quadrupling China’s GDP
within the first two decades of the century”.
 Given the strategic importance of the stock
market, the government has the incentive to
grant protection to shareholders.
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Legal protection to shareholders helps to
reduce corporate misdeeds and thus
increase corporate value.
Evidence: strong investor protection laws is
associated with higher corporate
valuations. The provision of shareholder
protection is beneficial for shareholders
because this will increase their wealth.
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Claessens, S., Djankov., Fan, J. and Lang, L.,
Expropriation of minority shareholders in East
Asia, Journal of Finance, 57 (2002).
 LLSV., Investor protection and corporate value,
Journal of Finance, 57 (2002), 1147-1170.
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Since the inception of China’s stock market,
the government has maintained ownership of
about two-thirds of the total equity, either held
by government agencies, or held by legal
entities. The government, therefore, is the
largest shareholder of the listed firms, who are
supposed to be benefited from the higher
corporate valuation.
The government did not allow the state-owned
shares to be traded freely due to the fear of
losing state control over the listed firms.
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The state stock sell-off program would significantly
increase the supply of stocks in the A-share market, but the
market responded with a dramatic downturn that marked
the beginning of a bear market that eventually lasted four
years.
The period 2001-2005 in which China’s government had
provided stronger and stronger legal protections to
shareholders.
How to restore investors’ confidence to support the listings
of SOEs and the sell-off of state-owned stock?
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Providing strong legal protection to minority
shareholders will increase the risks faced by
controlling shareholders when they expropriate the
minority shareholders and thus is detrimental to
the interests of the controlling shareholders.
 China’s listed companies were mainly spin-offs
from SOEs with the parent groups serving as their
largest shareholders.
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When a profitable arm of an SOE was carved out,
package financially, and floated by the local
government, the listed firm was expected to
channel funds back to support the parent
company’s unprofitable business units or nonbusiness units.
 Many controlling shareholders therefore, treat the
listed company as a vehicle of fund-raising and
resource tunneling.
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There are two main avenues used by controlling
shareholders to expropriate minority shareholders.
 The first one is false information disclosure by listed
companies in relation to equity issues.
 The second avenue for expropriation is through
tunneling related-party transactions: obtaining soft
loans from the listed companies; using listed
companies as guarantors for bank loans ……
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A gradual privatization process, however, has been
taking place in China since the mid-1990s, which
resulted in a significant reduction in the
percentage of listed firms owned by the
government.
 The privatization venue is the one-to-one transfer
market where state-owned stocks are transferred
to other owners with approval from the
government.
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The emergence of more and more private listed
firms in the mid-2000s helped to cut the direct links
between the government and the listed firms, and
lessen the conflicts of interests of the government,
which served as the controlling shareholder on the
one hand and the regulator on the other.
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What will be the future course of legal developments
in China’s stock market?
 First, the privatization process will continue on
several fronts, which will diminish the government’s
need to protect its own enterprises.
 For instance, the state share reduction program in
April 2005. Under this new program, holders of stateowned shares were required to compensate holders
of tradable shares as a pre-condition for floating the
non-tradable shares on the stock exchanges.
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Second, the benefits of a well-functioning stock
market to promote economic growth will ensure
that the government will have a strong incentive to
develop and improve the functioning of the stock
market.
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Green ., S. The privatization two-step at China’s listed firms.
London School of Economics, Chatham House Asia Program
China Project Working Paper No.3, 2004.
Allen. F., Qian, J., and Qian. M.J. (2005) Law, finance, and
economic growth in China. Journal of Financial Economics,
77(1), 57-116.
Yu, Qiao, Bin Du, and Qian Sun, “Earnings management at
rights issues thresholds: evidence from China,” Journal of
Banking and Finance, 30(12), 3453-3468.
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Shleifer A., and Vishney, R.W., (1997). The survey of
corporate governance, Journal of Finance 52(2), 737783.
 Johnson, S., McMillan, J., and Woodruff, C. (2002),
Property rights and finance, American Economic
Review 92, 1335-1356.
 Pistor, K. and Xu, C.G. (2005), Governing stock
markets in transition economies lessons from China.
American Economic Review, 7(1), 184-210.
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