China’s Capital Markets: Poised to Develop
I began my remarks by observing that one of China’s biggest problems today is its lack of developed capital markets. At the same time, I pointed out that China’s single biggest opportunity is to develop better mechanisms for channeling the country’s growing pool of capital resources into the hands of those individuals and companies that can use them most effectively.
Whether it’s toothpaste, car parts or capital, one of the biggest problems in China is distribution. For consumer and industrial products, the problem is an extremely fragmented distribution system with literally hundreds of thousands of wholesalers and retailers for any product. In the case of capital, it’s the opposite—the task of distributing capital in China is concentrated in the hands of a small number of large banks, most of which are state-owned. By and large, China’s banks are not trained to lend to entrepreneurs and private enterprises, the backbone of any economy. Instead, they are most comfortable making “policy loans” to government backed organizations. China’s stock markets in Shanghai and Shenzhen are merely extensions of the policy loans made by the state run banks. The government, not the markets, decides which companies can list and issue shares.
If only China’s entrepreneurs and small and medium-sized enterprises could gain more access to capital, there is no telling how fast the country’s economy would grow. Putting aside Bear Stearns, Lehman, AIG and the other events of the past year, which ultimately will go down as but footnotes in the economic history of the United States, the capital markets in the United States have enabled the country to become the world’s largest economic power and to maintain its status as the globe’s leading innovator. Say what you will, but the U.S. capital markets have done a good job over the years of getting capital to those who can use it best and taking it away from those who destroy value.
I saw this first hand in my career on Wall Street during the 1970’s and 1980’s. When I graduated from Harvard Business School in 1973 and joined the investment banking department at PaineWebber, the Dow Jones Industrial Average (DJIA) was just above 800. By the end of the decade, it hadn’t budged and was still barely above the 800 level.
During my first seven years on the Street, there were few initial public offerings of equity, virtually no public debt offerings for companies rated less than single A, and mergers and acquisitions were few and far between. There were only a handful of venture capital firms, private equity firms (known then as leveraged buyout firms) were just getting started and the hedge fund industry didn’t exist. Goldman Sachs and Morgan Stanley, two Wall Street goliaths today, each had less than $50 million of capital back then. The U.S. capital markets were rudimentary, to say the least.
In the early 1980’s, though, innovation came to Wall Street and things began to change. Drexel Burnham developed high yield debt securities for lesser rated companies (known as “junk bonds”) that not only provided small and medium sized businesses with expansion capital, but also helped unleash a wave of merger and acquisition activity. With more diverse and fluid capital markets, equity values were unleashed and the DJIA soared, tripling to over 2900 by the end of the decade. At the same time, derivative products such as interest rate and currency swaps were introduced, increasing market efficiency. Securities firms prospered, ever larger pools of capital began to be raised for venture capital and private equity, and companies had more financing choices than ever before.
For most of my time here, China has been more like the Wall Street I knew in the 1970’s in terms of its capital markets. Financing alternatives for most companies are extremely limited, and capital, while now plentiful, is still limited as to its availability.
But like the dawn of the new decade of the 1980’s in the United States, things are changing in China. Over the past two years alone, a wide range of Chinese private equity firms, funded by local institutions and investors, have sprung up, and local governments are gearing up equity investment programs to stimulate economic development. Financial futures were introduced in 2006, and though only mock trading has occurred since then, China has at least begun to head down the path of more sophisticated capital markets.
Now is the right time for China to begin to develop its capital markets. The government’s emphasis on increasing private consumption, spending and investment will be enhanced as more diverse pools of capital are created and small and medium sized enterprises gain increased access to funding. In fashioning the future development of its capital markets, China also has a unique opportunity to learn from the events of the past year, avoiding those aspects of the global financial markets that were the cause of the crisis.
If China is successful in taking this next step in the development of its capital markets, the country’s economy will be able to continue its fast development, but do so in a way that is more balanced and sustainable. Conferences like the one sponsored by Institutional Investor that provide a forum for a broad range of expertise will help pave the way.