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Apply “Treatment or Life Saving Measures” On the Critically Ill Securities Industry in China?

“Treatment or lifesaving” usually is the job of medical doctors. In China, it has become a buzzword in the Chinese securities industry these day.

Is the Chinese securities industry really critically ill?

On October 22, 2004, after the market closed, the People’s Bank of China, the China Securities Regulatory Commission (CSRS), and the government of Liaoning Province collectively decided to entrust the China Cinda Asset Management Company to manage the Liaoning Securities. The Liaoning Securities reportedly had a black hole of 4 billion yuan (US$0.48 billion). The People’s Bank of China (also referred to as the Central Bank of China) has tentatively agreed to bail out Liaoning Securities. During the first half year of management in trust, Cinda will be responsible for cleaning up Liaoning Securities’ debts and liabilities, and conducting an early-stage reorganization. Once Cinda completes the trust period, Liaoning Securities will be taken over by another company.

Liaoning Securities is only one of the seven securities firms that have been taken over by the government this year. The 4 billion yuan (US$0.48 billion) deficit disclosed was the result of a recent review of all of Liaoning Securities’ debts. The true figure of the loss could be as high as 7 billion yuan (US$0.85 billion), according to people familiar with the situation.

Before this incident, the stock crisis of Xinjiang Delong Group involved as much as 50 billion yuan (US$6.04 billion) in losses. The Chinese government bailed out this publicly listed private company with both governmental guarantees and capital injection, an unprecedented move in China’s history of the securities market. The recent nose-dive of the Chinese stock market has created additional crisis for the Chinese securities industry. Without exceptions, almost every securities firm is stuck in difficult situations. Technically speaking, the Chinese securities industry is already bankrupt, with a loss of as much as 100 billion yuan (US$12.1 billion). This is certainly consistent with the technically bankrupt Chinese banking system.

Back in 2001, I had a conversation with a top Chinese official in regard to the potential crisis in China’s securities industry. Though the issues were not as serious as those in China’s banking system, the securities industry had already shown some signs of systemic deficiency. Unfortunately for some reason, I was not able to obtain accurate data to fully discuss my concerns with this official.

Lacking accurate data is still a problem today. Lately, when asked about detailed figures, some financial experts and government officials told me very frankly, “We ourselves cannot obtain the true figures. When we do research, we have to glean data from various government reports and then analyze them with our own judgment.”

From many Chinese newspapers and various public channels, I was able to compile some alarming data and information. In 2003 the Chinese securities market was entirely in the red. Some had huge losses; for example, Minsheng Securities lost 467 million yuan (US$56.4 million). Five firms reported over 1.1 billion yuan (US$0.13 billion) total loss, with each losing at least 100 million yuan. The total 2003 annual loss of China’s securities firms, excluding the loss in the businesses in trust financing, surpassed the record of 100 billion yuan (US$12.1 billion).

In August 2004, the overall deficit of China’s securities industry surged to another record level, 170 billion yuan (US$20.5 billion). In fact, the overall deficit of China’s securities industry in 2003 wiped out almost all the capital it raised, which signaled the beginning of the actual bankruptcy of the entire industry.

A little hard to believe? In the past few days, I learned from some official sources that the Chinese government approved various security firms, including Hainan China Bank, Dalian Securities, Anshan Securities, Beijing Huayang Loan Corp, Shanxi Huakang Trust, Jiamusi Securities, and Xinhua Securities, to go through bankruptcy procedures. The bankruptcy case of Dalian Securities is on trial in the People’s Intermediate Court of Dalian City. The risk of raising funds in the capital market became very high recently as a few securities giants including Southern Securities and Min Fa Securities disclosed losses of billions of yuan. According to my calculation based on incomplete public official reports, the abuse of margin in the securities industry reached over 200 billion yuan (US$24.2 billion), which translates to 2.54 trillion yuan (US$0.31 trillion) for the cost of the financial reform in China. [1] By the most conservative estimates, an additional 1.2 trillion yuan (US$0.14 trillion) injection is needed for the Chinese financial industry. Adding both items together, to pull the financial industry out of non-performing loans, the Chinese government has to set aside 3.7 trillion yuan (US$0.45 trillion)—equivalent to 2,850 yuan (US$344.2) per capita in China.

How did Chinese stockholders end up with such misfortune? Their misfortune actually began on the very first day the securities market was established in China. From that first day to October of 2004, China raised 900 billion yuan (US$108.7 billion) by issuing new stocks and collected 300 billion yuan (US$36.2 billion) of stock-related taxes, and the securities firms charged around 250 billion yuan (US$30.2 billion) in commissions. In other words, Chinese shareholders invested a total of about 1.5 trillion yuan (US$0.18 trillion) in the stock market. Yet their returns have totaled a miserable 70 billion yuan (US$8.45 billion) from the stock yields, with the gulf of difference totaling 1.4 trillion yuan (US$0.17 trillion).

From another perspective, the market capitalization of China’s entire securities market is worth 1.5 trillion yuan (US$0.18 trillion), two thirds of which are the restricted shares controlled in the Chinese government’s hands. Almost each of the 60 million shareholders has incurred significant losses. The foundation of the Chinese securities industry has almost vanished entirely. In today’s Chinese securities market, there is no trace of rule or law, only deceit, excessive speculation and gambling.

It’s no secret that nowadays illegal trading and deceit are commonplace. In June 2003, CSRC asked all stock exchanges to conduct a survey among major securities firms. It discovered that the illegal buyback of government bonds totaled 20 billion yuan (US$2.42 billion). Six months later, the authorities ordered Southern Securities to stop any bond trading and officially take over control of the company. Having discovered that Southern Securities owed 5 billion yuan (US$0.60 billion), CSRC decided on February 25, 2004, that China Securities Registration Corporation should conduct another survey on illegal buybacks of government bonds. The survey this time showed that the amount of illegal buybacks surged five times within only six months, reaching 100 billion yuan (US$12.1 billion).

The financial reports for the first half of this year revealed that the large account deficit of the securities firms was mainly attributed to a high percentage of their own portfolio existing in their portfolio configurations. Among the 40 securities firms that issued financial reports for the first half year, securities worth 29.3 billion yuan (US$3.54 billion) were owned directly by the firms themselves—a position which had changed little from the beginning of the year. These firms all suffered tremendous loss in the second quarter as both the equity and bond markets went south. In particular, Haitong Securities lost 317 million yuan (US$38.3 million) in its own portfolio. Shenyin Wanguo saw their portfolio value drop 175 million yuan (US$21.1 million). Guotai JunAn and Guangdong Securities lost 133 million yuan (US$16.1 million) and 100 million yuan (US$12.1 million), respectively.

It is estimated that the loss in these securities firms’ own portfolios outpaced their overall revenues in the first six months, with the median loss being 129 percent of their revenue. Actually the depreciation of their portfolios became the major culprit for their deficit. On the other hand, the newly promoted business of financial trust securities accounts was another area of disaster. The overall business manages 100 billion yuan (US$12.1 billion). Normally the securities firms guarantee their customers for a minimum return of 6 percent. Some even promise a 15 percent return. This means that even if the securities firms would withdraw the capital from the equity market right after the market drop in the second quarter, their loss would have reached 20 billion yuan (US$2.4 billion). Based on publicly available data, the actual loss in that business, by estimate, totals 40 billion yuan (US$4.83 billion). The securities firms in China are really on the verge of collapse. After the subsequent nose-dive of the Chinese stock market in September, that loss is likely to exceed 50 billion yuan (US$6.04 billion).

Savvy investors must be asking, “So, now you tell me that China’s securities market lacks regulations and laws and that securities firms are illegally diverting their customers’ funds. There’s something else missing in this picture. It seems that the source for a large amount of securities firms’ funds is a still mystery. Where is all the money coming from?”

The answer is actually very simple. With a series of Chinese government policies and laws, experts outside of China were misled to believe that everything in China was legalized and the financial system in China was consistent with the western system.

This is certainly not the case. In spite of the government ruling in the past few years that bank funds are prohibited from entering the securities market, due to the problems of the system, securities firms and the banking industry have been closely tied together, and a lot of funds freely flow from banks to the securities firms. From the central government to local governments, from corporations to government agencies, everyone, out of one’s own interest, has been broadly violating laws in the name of “developing the economy and maintaining the stability.”

The major avenue through which securities firms obtain the funds from banks is through the practice of short-term loans within the industry. Data shows that as of March 31, 2004, securities firms raised 222.2 billion yuan (US$26.84 billion) via the short-term loans from various banks, which covered over 80 percent of the total bank loans. The second avenue for securities firms to obtain funds from banks is re-loaning from the People’s Bank of China. In dealing with the issue of closedown and takeover of securities firms, the People’s Bank of China has been playing the role of the last “life-saver” for an extended period of time. Since 2002, the People’s Bank of China has refinanced many troubling securities firms and helped them escape from the disaster. The Chinese government has been tapping into government credit and public funds to rescue law-breaking securities firms, and through various means it is robbing the wealth of millions of ordinary Chinese. The impact of such a practice is often negative. Not only does it encourage illegal practice within securities firms and magnify the cost of China’s financial reform, but also it ultimately forces all Chinese people to share the loss. For example, the 1.5 billion yuan (US$0.18 billion) and 1.45 billion yuan (US$0.175 billion) of loans that the People’s Bank of China issued respectively to the troubled Anshan Securities and Xinhua Securities now vanished entirely with the bankruptcy of these firms. In addition, the 10 billion yuan (US$1.21 billion) of refinancing for Southern Securities and other securities firms will almost certainly not return. The reserve fund that the Chinese government allocated to take over Southern Securities alone totaled as much as 8 billion yuan. From the current situation, the possibility of getting the money is almost zero. Therefore, another 10 billion yuan (US$1.21 billion) of newly formed bad accounts has already been formed.

Today’s securities firms in China are absolutely lawless, and so are the publicly listed companies and the government administration organs. Recently, Mr. Zhang Weixin, a financial expert in China, filed a lawsuit against the State-owned Assets Supervision and Administration Committee of State Council (SASAC). The Chinese government purposely encouraged publicly listed companies to illegally swallow smaller companies. The incident involved reported that TV & Broadcast Intermediary Co. used its stocks to pay down its debts, and this clearly reveals how the Chinese government violated the law and deceived ordinary Chinese investors of the company. After Mr. Zhang filed his lawsuit, a Chinese court rejected his case, with the excuse that “state-owned shares” have already been written off.

According to Section 186 of the current Corporate Law, when a company needs to write off registered capital, it must compile the balance sheet and a list of resources. It must inform debtors within 10 days after its decision to write off registered capital, and within 30 days it must publish a notice at least three times in newspapers. Within 30 days after receiving the official notice or 90 days after the first public notice, debtors are eligible to demand that the company pay back the debt or provide appropriate guarantees. The registered capital after the write-off cannot be lower than the legal minimum. Based on this section, at least the following processes have to be followed to write off assets: the notice should be published after the board meeting is held and the write-off decision is approved, and, 90 days after the public notice, the write-off can proceed if there is no dispute from debtors. In stark contrast, in Zhang’s lawsuit, it is clear that China’s legal entity, SASAC, and the publicly listed company, openly ignored the law without even covering up their crimes. And, all for the sake of their own interests. How shameless and corrupt!

When a country openly tramples its own laws and ignores the interest of its own citizens, in what way can it have any credit or dignity? By the same token, when a one-trillion-yuan industry took only a dozen years to accomplish the “mission” from a “flourishing” system to a bankrupt one, isn’t the root cause clear enough?

Faced with the trauma of China’s securities industry, some people once questioned whether the challenge the Chinese government faces is to treat the patient or save his life. Some people in China once criticized that the western securities theories and practices are not applicable to China’s special situations.

Is China really so different from the rest of the world? Shall we really toss out the existing theories and practices completely and reinvent the wheel only because of “China’s special situations?” “China does not have to reinvent the wheel,” as one Chinese official concluded. In some sense, I agree with his viewpoint very much. What China needs is to renovate itself, not to ignore the experiences of other countries with the excuse of “special situations.” It is not that western economic theories are inapplicable, but that China lacks self-renovation, and appropriate political and legal systems.

Treatment is certainly essential to the Chinese securities industry. Yet to truly cure the industry, one must first cure the Chinese political system and strengthen and perfect its legal system. It requires the Chinese government to follow its own laws, rather than to trample them. Only through such changes can the Chinese securities industry really get out of the current critical condition. Unfortunately, this is not what the Chinese government is willing to do.

Lifesaving is apparently the choice of the Chinese government. First of all, with the nose-dive of China’s stock market, the present government has applied desperate measures by introducing the policy of allowing bank funds and social security funds to enter the stock market. It is obvious that the government has given up the plan for China’s long-term interest. It is well known that, even in the United States and many European countries where the legal systems have better integrity, allowing bank funds to enter stock markets is strictly regulated. In the United States, social security and benefit funds are extremely restricted and regulated against entering the equity market. Ordinary people choose to deposit their funds into banks only because of the low risk of the banking system as compared to the high risks of the equity market. In contrast, once the boundary between commercial banks and investment banks is blurred in China, how can Chinese people have any sense of financial security anymore? In exchange for today’s stability and for the interest of its communist party and a few groups, the present government is willing to sacrifice the future of the country and of its citizens. Ironically, this is what the Chinese government calls, “the innovative economic reform” and “maintaining social stability.”

As a matter of fact, ever since China opened its first stock market, it has been aiming at the huge private savings of its citizens. The functions of China’s equity market can be roughly categorized as follows: The first step is to let some local powerful entities issue stocks to shift the tremendous risks and potential crisis of the state-owned enterprises to the ordinary citizens; the monopolized capitals are used to steal the wealth of the society via the stock market; once the central government realized the tremendous gains in this avenue, they started to offer slices of the pie to their local governments; and then many government entities began to be actively involved in the equity market, and become the market makers who openly deceive and rob the Chinese people. Meanwhile, the participation of the small to medium investors in the market practically covers up the two functions above, and in fact, they become the symbolic decoration to validate the legality of the equity market.

When the state-owned banks and the central government are in trouble, the Chinese securities market becomes the best resource for slowing down the crisis of the state-owned enterprises. Evidently, large state-owned enterprises now become the dominant force in the raising capital game of the stock market. From Sinopec to Baosteel Group, to investment banks, the big killer whales are busy butchering the innocent shareholders in Chinese stock markets. In spite of their shrewd slogans of “perfecting the corporate administration structures,” their intention to use the equity market to relieve their financial troubles is very obvious. Today, raising capital in the equity market becomes the single most important goal of most Chinese enterprises. The critically ill Chinese state-owned banks are also fighting to climb onto the already shaky boat of the Chinese equity market. It is very likely that these enterprises are too heavy to stay afloat. The result could be that the equity market will not only fail to save the humongous state-owned banks, but it too, will capsize.

In China, the only functionality of the securities market is to create a deficit in China’s future, without any restriction.

Xinhua News Agency reported on October 17, 2004, “The authorities explained the reason to purchase individual debts and customers’ securities exchange settlement funds. During the take-over process, individual debts will be purchased at discount and the debtors can use this to participate in the asset allotment.” (Author’s note: Debt up to 100,000 yuan (US$12,077.3) will be purchased entirely, while the amount in excess of this limit will be purchased at a 90 percent discount.)

Although the report did not elaborate on the cause of the practice, one can understand that under the threat of takeover, resolving the issue of individual debts for the highly risky securities firms is just part of a series of strategies from the Central Bank to treat the firms that have long been in the red. The Chinese securities industry is truly in a bloody phase. Despite the life-saving remedy from the central government by using the public funds of the country, I am still doubtful of the future of China’s securities industry. The drastic move by the central government to use public funds to save the Chinese banking system has only, based on my years of observations, piled up the mountain of bad loans without improving the fundamentals of China’s banking system at all. So, how can this life-saving action for China’s securities industry lead to any different results?

A Chinese economist argued, “the conflicts in China’s economic reform are accumulating upwards (towards the central government).”

Can ordinary Chinese avoid the disaster that streams upward? I have no answer for such a serious question, as I don’t know how the Chinese government handles these issues.

So, again, I ask, do we need treatment or life-saving measures for the critically ill Chinese financial and securities industries?

[1] The 2.54 trillion yuan comes from 1) 1.68 trillion yuan of NPLs in four big state banks; 2) .86 trillion yuan of NPLs transferred to asset management companies. They add up to 2.54 trillion yuan.

Cao An is a private entrepreneur with business experience in China and interest in the Chinese economy.