Detailed Summary

Achieving 2020: An Assessment of Shanghai’s plan to become an International Financial Center by 2020

Part 1: Building a Global Financial Center in Shanghai: Observations from Other Centers

Definition: A financial center is a location where a substantial amount of financial business is conducted.

A global financial center must have a high level of financial expertise and a full range of infrastructure including globally-oriented law firms, a trusted legal system, and connections with a wide range of investors around the world.

At the heart of any global financial center are the institutions that arrange capital raising and financial risk management transactions for firms around the globe. Capital raising could consist of issuing debt, equity, or a more exotic financial instruments such as bonds for the purpose of raising funds. Risk management would involve either locking in a future price for a commodity or it could be the purchase of protection against an adverse price movement. Financial centers exist to bring together the two sides to these capital raising and risk management transactions.

According to a Global Financial Center Survey by Mckinsey, a successful global financial center will have the following qualities and attributes:

Availability of high quality finance professionalso High quality of life in the city o English speaking staff

Rule of Law (fair and predictable legal environment) Appropriate regulation (not too little or too excessive regulation, financial stability, toughness,

predictability, speed) Avoidance of excessive taxation Proximity to the customers Core infrastructure (pre-existing telecommunication networks, electricity, running water) High quality support services Reasonable operational costs Openness to foreign entry (foreign personnel should feel comfortable and fairly treated) Favorable time zone

It is much easier to maintain status as a global financial center than it is to obtain it. London for instance has an advantage of being one of the first global financial centers in the world and both its government and financial industry will do whatever is necessary to maintain its current status. The reason that Frankfurt and Paris are dwarfed by London in terms of global financial transactions is because London was already there, just one time zone away, with all the necessary infrastructure, services, and proximity to clients in place. It is much easier for an existing center to maintain its relative position than it is for a new center to lure business away. Considering this theory, Shanghai may have issues drawing away business from Hong Kong as it is relatively close and within the same time zone. Additionally, Hong Kong already has the necessary infrastructure in place as well as a large English-speaking population.

Why London has also triumphed over Frankfurt and Paris

London has (or had in the past) a looser regulation policy making it attractive for companies to be stationed there, while Frankfurt and Paris were thought to be too closely influenced by the government and hence, have a tighter grip on government regulation on the economy.

London is also considered by most to be a more exciting city than Frankfurt, and poses as the preferable choice to live and work.

London’s native English speaking population provides an abundance of adequate workers while the faltering English language level in Paris increases the risk of miscommunication

Shanghai’s advantages and disadvantages in becoming a world financial center (According to the Mckinsey Survey)

Advantages Disadvantages

Access to a huge and growing Chinese financial market

The clear backing of the national and municipal governments

Existence of futures and options markets A vibrant and diverse city Great progress with “hard” infrastructure

Limited ability to use sophisticated financial products

Limited global use of the RMB Opaque political decision processes Concern with political favoritism Distance from Beijing’s financial institutions Hesitation about use of Chinese Law for global

transactions Modest presence of related services Further need to develop “soft” infrastructure Proximity to Hong Kong, an already

established financial center in Asia Non-English speaking population and poor

standard of English in the workplace

Part II: Focus Areas for Developing an International Financial Center:

Debt Capital Market, Equity Capital Markets, and Derivatives

I. Debt Capital Market

Basic Facts:

In mainland China, the debt financing instruments are offered and traded in two different markets: the exchange market and the interbank market, both of which have been independent markets since 1997.

o The interbank market is the most important primary and secondary market for debt financing instruments. 90% of new bonds are quoted and traded in this market.

Over the past decade, China’s bond market has grown to become the second largest bond market in Asia following Japan, with a total of RMB 7.8 trillion issued in 2011.

Most bonds are backed by the government and lack the sophistication to support the private sector

Due to China’s complex regulatory system and still-developing market infrastructure, companies have a hard time raising RMB-denominated capital to serve their business operations.

Challenges:

Complex regulatory structure Imbalanced debt capital market Infrastructure development

Recommendations:

Establish a transparent regulatory structure with clarified roles between regulatory bodies in China’s bond market. The promotion of self-regulatory bodies such as NAFMII would encourage market participation because of their dual functions as a self-regulator and an administrator.

Clarify criteria and requirements for issuers and investors to enter the bond market. Further develop the exchange bond market by encouraging institutional investors such as

commercial banks to participate in the exchange bond market. Implement a credit rating system that provides accurate and transparent rating processes

o Open to foreign credit rating agencieso Increase restrictions that forbid companies with lower credit ratings to issue corporate

bonds, thereby enhancing the integrity of the bond assessments

Debt Capital Market Products:

Central Bank Note: Notes issued by the People’s Bank of China (PBoC) with a maturity of 3 months to 3 years

Financial Bond: Products issued by financial institutions, usually one type of corporate bond in the world financial market. In 2011, six companies had issued financial bonds in China, amounting to a combined RMB 5 billion

Non-financial corporations use 3 types of bonds:o Enterprise Bondo Corporate Commercial Papero Corporate (MTNs)

Government Bond: RMB-denominated revenue generating instruments issues by the People’s Bank of China, usually only issued on a national level.

Panda Bond: RMB-denominated bonds sold in the mainland market issued by foreign companies. Panda bonds were used to attract foreign investors/companies looking to raise capital in China.

Dimsum Bond: RMB-denominated bonds that are sold in an offshore market in Hong Kong. The offshore yuan market has rapidly grown with issued bonds reaching a total of RMB 131 billion in 2011.

II. Equity Capital Markets

Basic Facts

The most common and efficient way for companies to raise large amounts of capital is through equity markets.

Equities include stock trading on the Chinese Stock Exchange as well as transferring financial instruments in the over-the-counter (OTC) market. Market participants include individual retail investors as well as institutional investors such as mutual funds, banks, insurance companies, and hedge funds.

The Qualified Foreign Institutional Investor program (QFII) allows foreign companies to invest in highly-restricted Chinese mainland capital markets by allowing them to invest in Chinese stocks traded in the “A” share market. So far, 135 foreign institutions have been granted QFII licenses with a combined invested amount of USD 20 billion in 2011.

The equity market’s internationalization has made progress with the off-shore RMB Qualification Foreign Institutional Investors (RQFII) program, which helps offshore RMB funds return to China’s domestic stock markets through local brokers or fund houses. This system encourages investors to repatriate money they have made abroad.

Challenges:

Chinese Stock Market:

Companies must endure a very long and complicated listing process which includes a prolonged examination from several regulatory agencies including the regional governments, the China Security Regulatory Commission (CSRC), and the State-Owned Assets Supervision and Administration Commission (SASAC). The process takes anywhere from 6 months to several years to complete, which discourages many Chinese firms from listing in China.

The majority of equity traders are individual retail investors (as opposed to banks, insurance companies, and investment funds), and as individuals, are more easily swayed by misleading financial news causing volatility in the market. This abundance of individual investors can also lead to a large number of opportunities for insider trading.

Over-the-Counter (OTC) markets

The OTC over-the counter market is China’s other major equity capital market and involves stock transfers and private equity transactions.

China’s decentralized OTC market is composed of over 200 regional markets across branches, all under regional government regulation. Because of this, it is difficult for companies to follow a standardized rule when they engage in cross-regional businesses in China.

Recommendations:

Enforce a unified and clear set of policies and regulations established by government regulators regarding information disclosure, trading standardization, and defining fraudulent behavior.

Allow foreign-owned companies to enter the market as issuers, underwriters, and investors, and attract well established foreign financial services providers such as investment banks, accounting firms, and law firms.

Remove the requirement that foreign investment banks must form a 50-50 joint venture with a Chinese firm to participate in local security and IPO activities.

This influx of foreign investors, companies, and underwriters will provide China the foreign know-how to implement international standards in the country’s financial markets.

III. Derivatives Market

A derivative is a contract between a buyer and a seller entered into today promising that the transaction be fulfilled in the future. Derivatives include such things as futures, options, forwards, and swaps. Derivative markets offer financial institutions and corporations access to products that allow them to hedge against market, currency, and commodity risks in the future.

Derivative Products in China

Commodity Futures Stock Index Futures Foreign Exchange Derivatives Credit Derivatives

Challenges:

Product Marketization.o Although China has dozens of regional commodity exchanges, the commodity

derivatives market lacks a single on-shore commodity exchange with indices, thus, commodity futures contracts must be traded on existing overseas exchanges. This poses a problem for Chinese investors who do not have foreign currency reserves, due to China’s highly restricted capital controls.

o The interest rate for small institutions and individuals is set by the People’s Bank of China (PBoC), leading to an absence of market driven derivative products. Since the interest rate is not determined by the market, it is difficult to accurately price credit derivatives.

Regulatory Inconsistency o Companies trading derivatives in China must contend with an overlapping web

of regulatory bodies which may have inconsistent market access criteria and approval processes. Such inconsistency has led to confusion among foreign companies regarding compliance issues on trading derivatives and designing products, hindering innovation and development of China’s derivative market.

Ineffective bankruptcy law protectionso The bankruptcy laws are tilted in favor of the debtor, who upon default can

appoint an insolvency administrator who holds the right to “cherry pick” which

executed contracts to terminate and which to minimize the amount the firm has to pay to creditors.

Recommendations:

Simplify the regulatory structure to avoid confusion and inconsistency across multiple regulatory bodies

Gradually liberalize the interest rates to grow China’s interest rate derivatives market. Establish a single on-shore commodity exchange and centralize trading with market-

driven indices. Establish an adequate legal framework that enforces bankruptcy laws.

Conclusion:

The AmCham report mainly focuses on Shanghai’s challenges and shortcomings as a world financial center, comparing Shanghai to current established global financial centers such as New York and London and holding it to the standard of the Mckinsey Global Financial Center Survey. Most of Shanghai’s financial market challenges lie in inadequate, unclear, or overly complex regulation, unreliable legal protection, or unstable markets and undeveloped infrastructure. Although the report seems to lean on the more critical side, it concedes that Shanghai has already made tremendous improvement in terms of infrastructure development and has the potential to continue to improve until it reaches international standards.