Beijing's decision to further liberalize the financial sector by allowing foreign investors greater trading rights is a welcome development. For the first time, qualified foreign institutional investors (QFIIs) will have the right to buy A shares, but majority control will remain with the state. Previously, foreign investors were limited to the B-share market, in which stocks of Chinese companies have to be exchanged using foreign rather than domestic currency. The B-share market has already been opened to local investors, so the latest policy change is one step closer toward unifying the A- and B-share markets.
In addition to opening the A-share market to selected foreign investors, Beijing will allow foreign investors to buy previously non-tradable shares of state-owned enterprises. Non-tradable shares include "state-owned shares" and "legal person shares," with the former owned by government and the latter by SOEs. Initial sales will take place outside the official stock exchanges; foreign investors will have to hold their shares at least one year; and resale will apparently take place through the government not the market. The tight restrictions on salability mean that foreigners' appetite for the shares of SOEs will be quite limited.
If China is to create real capital markets and maximize the value of invested capital, individuals must be allowed full tradability of their shares, and all shares must be tradable. China has reneged on earlier promises to allow the sale of non-tradable shares to domestic investors because of a concern for diluting market values of existing shares. The new measure will apply only to foreign investors and will not directly affect share prices on the Shanghai or Shenzhen exchanges. This policy option may be a politically feasible way for the state to begin exiting the share market. The ultimate goal, however, should be to have a unified private share market with prices that reflect the true values of the listed companies. Until that happens, China's capital markets will be more socialistic than capitalistic.
Privatization is the key
The dominance of SOEs on the stock exchanges and the fact that 70 percent of state-owned shares are non-tradable mean there are no real capital markets in China. Moreover, the government fixes interest rates on savings accounts in state-owned banks at artificially low levels and prohibits capital outflows. The lack of investment alternatives means domestic investors are more reckless in picking stocks than if they had deeper and broader capital markets. The high price-earnings ratios, of 40 or more, in the A-share market reflect this speculative fever.
The lack of capital freedom also means that government officials, not private investors, are the controllers of capital assets. So long as that is the case, investment decisions will be politicized, and the threat of bankruptcy will be a hollow one. Socialist managers will continue to lack strong incentives to be efficient. Consequently, until the institutional incompatibility that characterizes China's socialist market economy is resolved, the nonperforming loans of state-owned banks will continue to mount.
China needs to transform its financial architecture and give security to private property rights—that is, there must be a legal system that safeguards private owners. Individuals must have the effective right to buy and sell shares, to freely invest abroad and to transact at market-determined interest rates. When individuals are allowed the freedom to specialize in ownership and risk bearing and face market-determined interest rates, capital will flow to its highest-valued uses, and the market value of firms will be maximized for the benefit of both shareholders and consumers. The government will also be rewarded as tax revenues increase.
China needs to allow its institutional infrastructure to evolve; private property rights must enjoy equal protection under the law. Consumers, not government officials, will then determine what firms remain in business. At present, the lack of fully transferable shares in SOEs means that share prices are distorted and do not reflect the true value of state assets. Only by allowing individuals to freely exchange all shares of SOEs can their true value be discovered.
So long as the state holds the majority of shares and SOEs dominate the stock market, the Chinese people will be denied the opportunity to specialize further in ownership and risk taking. Those who are most skilled as entrepreneurs will be denied the opportunity to acquire SOEs and privatize them. As such, resources will be prevented from moving to higher-valued uses.
Maintaining the dominance of state ownership will protect the power of the Chinese Communist Party, at least temporarily, but will reduce China's potential wealth. Allowing widespread privatization, or what can be called "marketization" since markets are impossible to develop without private property rights, would create new wealth as inefficient SOEs disappear and workers move to jobs that consumers value more highly. That process has been occurring in the special economic zones, as witnessed by the rapid growth of the private sector.
The challenge is to bring about political liberalization that is consistent with economic liberalization. President Jiang Zemin's endorsement of greater protection for private property rights at the 16th Party Congress in November is a signal that China is moving in the right direction. According to Jiang, "We need to respect and protect all work that is good for the people and society and improve the legal system for protecting private property."
Depoliticizing investment decisions
To depoliticize investment decisions in China, there must be constitutional protection for private property rights, and private owners must be given access to both domestic and foreign capital. The renminbi must be made fully convertible as soon as possible, and interest rates must fully reflect market forces. Discriminating against the private sector has led to overinvestment in the state sector and a low rate of return. Meanwhile, growth in the private sector has been hampered.
Artificially supporting share prices of SOEs is a recipe for disaster. Government support of the market only compounds the difficulty of trying to evaluate socialist firms. Without real owners with fully transferable shares, there can be no way to know the capitalized values of the listed companies and no way to discipline socialist managers for failing to maximize profits. Restructuring SOEs is not sufficient; they must be fully subjected to market forces, which means they must be privatized along with state-owned banks. Only then will China transform its socialist capital market into a true capital market.
Chen Mingxing, senior researcher with the State Information Center, has recommended more rapid ownership reform: "The government should leave the adjustment of share prices to market forces, but put more effort into establishing a marketplace that is 'just, fair and transparent,' and reforming the ownership systems at the listed companies." China's accession to the World Trade Organization will put pressure on SOEs to "jump into the sea of private enterprise." It will take political courage, however, to do so.
The nonstate sector now accounts for more than 70 percent of the gross value of industrial output, yet private firms are being starved of capital. Peking University economist Fan Gang has pointed out, "The most serious policy mistake in the past 20 years of reform has been the lack of development of nonstate financial institutions that could adequately provide for the growth of the nonstate sector. … Experience shows that the longer the state sector exists, the worse its financial situation and the lower its profitability."
Safeguarding economic freedom: A winning strategy
The benefits to China and to foreigners from liberalizing the financial sector are great: China would achieve a more efficient use of its capital by reallocating funds from the state to the nonstate sector; new funds would flow into China as foreigners became more certain about the security of property rights; the Chinese people would have an important part of their human rights, the right to own property, protected by law; and foreigners would be able to deal with private firms and offer a greater choice of investments to China's savers.
The more secure rights to future income streams are, the more confidence individuals will have in the future, the more breadth and depth capital markets will have, and the more liquidity will be created. Likewise, any attenuation or weakening of private property rights—including the rights to use, to sell and to partition property—will mean less trust, less liquidity and less wealth.
Mounting evidence shows that private property rights, protected by the rule of law, are a key ingredient in the recipe for economic development. In a study of 150 countries, Lee Hoskins and Ana Eiras found that those countries in which private property rights are secure and transparent have created more wealth, as measured by real GDP per capita, than countries in which private property rights are insecure and corruption is high.
China has done an excellent job of alleviating poverty since the economic reform began in 1978, but the main engine of the reform process has been the nonstate sector. Now is the time to cement and extend those gains by giving greater constitutional protection to the private sector. Increasing economic freedom is a win-win strategy—both China and her trading partners will gain. Free trade and privatization can help normalize China and transform it into a modern economy and a civil society under the rule of law. China's accession to the WTO will help move China in that direction.