Opinion: Stock market, financial governance and China’s innovation

10 Jan, 2021 06:04
source: Hong Kong International Finance Review

Singularity Financial Hong Kong January 10, 2021 – Stock market, financial governance and China’s innovation (Source: Hong Kong International Finance Review)

About this author: Li Chen is Assistant Professor of Centre for China Studies & Lau Chor Tak Institute of Global Economics and Finance from Chinese University of Hong Kong.

How to develop a financial system that effectively supports innovation and real sector economic growth has been a key challenge facing China’s financial reforms. This chapter examines the role of stock market and financial governance in China’s national innovation system. Within less than three decades, China’s stock markets have grown rapidly from a negligible size to become one of the world’s largest markets. However, consistent with the general pattern of developing economies, China’s financial system remains overall bank-based. Stock markets have been instrumental in facilitating China’s state-owned enterprise reforms and the rise of China’s ‘national champion’ corporate groups which are a key pillar of China’s R&D (research and development) expenditures. However, stock markets have only played a limited role in directly financing China’s investment in innovation. Moreover, China’s stock market development has been embedded in a hybrid financial governance regime, characterized by substantial tensions among state control, market innovation and stability maintenance. The recent launch of the Science and Technology Innovation Board (STAR) is a new milestone in the development of China’s stock markets. It represents a major effort of China’s reformers to generate new institutional and policy solutions to better finance China’s innovation drive. However, further reforms to strengthen regulatory governance are needed to balance innovation and stability in the process of stock market development.

Innovation, Financial System and Stock Market

Innovation is crucial for the competitiveness of business firms and nations, but how to effectively finance innovation poses challenges to entrepreneurs and policymakers globally. Promoting innovation typically requires long-term investment in a radically uncertain environment. Innovators have to confront idiosyncratic risks and high chances of failure (Holmstrom, 1989). With asymmetric information, investors and policymakers face profound barriers in evaluating and selecting potential winners beforehand. Financial systems in different countries vary substantially in their institutional arrangements and capabilities to address these generic challenges of financing innovation. Some countries such as Germany and Japan rely more on long-term relations between large banks and non-financial enterprises, while stock markets feature more prominently in the US and UK. In developing countries, governments often play a direct role in guiding financial flows to support their national economic catch-up. While the neoliberal orthodoxy tends to assume that innovations in developed countries are largely driven by the private sector, the reality is that innovations at the frontier in the advanced economies are shaped by a complex three-player game between markets, speculators and the state (Janeway, 2018).

All policymakers face two sets of fundamental questions on how to deal with the problems in financing innovation. First, what are the causal linkages between financial system and innovation? To what extent should policymakers intervene and use financial system as leverage points to promote innovation in the real sector? There have been long debates among economists on the direction of causality between finance and real sector dynamics (Hsu et al, 2014). One camp argues that financial development shapes the trajectory of innovation and leads to economic growth, as Schumpeter (1912) put it, the banker is the ‘capitalist par excellence’ and the ‘ephor’ of the capitalist system, while the other camp suggests on the contrary that “where enterprises leads, finance follows” (Robinson, 1952: 86).

Second, to the extent that policymakers are justified and able to marshal financial system to promote real sector innovation, what are the appropriate mixes of financial institutional arrangements and governance mechanisms? Are market-based financial system superior to bank/credit-based system? Given the cross-country differences in history, culture, resource endowments, institutional environment and stages of economic development, how to design and develop appropriate financial system architectures to promote innovation? The literature on comparative financial systems has shown that both market-based and bank-based finance have their advantages and disadvantages. They tend to generate different patterns of corporate ownership, governance mechanisms, capital structures and borrower-lender relations as well as different evolutionary properties (Zysman 1983; Dosi 1990; Christensen 1992). There are complex trade-offs among different financial system architectures in terms of static and dynamic efficiency, stability and distributions of risks and rewards (Allen and Gale 2001; Hugh 2014).

The policy diagnoses provided by neoclassical economics focus on identifying and mitigating generic market failures in financing innovation, and in particular, how to overcome moral hazard and adverse selection problems caused by information asymmetry, therefore reducing the cost of capital and encouraging innovation (Hall, 2010; Hall and Lerner 2010). The alternative Schumpeterian approach of evolutionary economics calls for more holistic policy diagnoses on the institutional system within which innovation and finance take place. There are fundamental complementarity between financial markets and other institutional components of national innovation systems, so the financial arrangements of innovation cannot be separated from wider system-level dynamics (Lundvall 1992; Nelson 1993; Hall and Soskice, 2001; Hugh 2014). From this perspective, the challenges of innovation lie not just in market failures but wider system weaknesses and capability failures (Lee 2019). The potential solutions are less about developing “deeper”, “thicker” financial markets per se than building innovation capabilities through improvements in various complementary components of national economic systems.

Innovative environments are characterized by two key processes: learning and selection (Dosi 1990). The performances of different firms, industries and economies in innovation reflect different balances and modes of learning and selection. The influence of specific financial structures on innovation and industrial dynamics depends on how finance affects the learning patterns of firms, the selective allocation of resources among firms and technologies, as well as the disciplining of managerial behaviors that sets boundaries of adjustment for inefficient firms. The appropriate financial arrangements to support innovation vary substantially according to the sizes, technological features and the life-cycle stages of firms and their industries (Dosi et al, 2016). They also depend on the broader national institutional environments. Market-based systems emphasize impersonal exchanges of ownership claims and rely more on the entry/exit mechanisms of selection, while bank/credit-based systems generate institutionalized ownership and control relations with more space for “voices” mechanisms (Hirschman 1970; Zysman 1983; Dosi 1990). As a result, market-based systems tend to have more dynamic trial-and-error processes through birth of new firms and exits of old firms, whereas bank/credit-based systems tend to facilitate cumulative learning under more discretionary allocation of resources by financial institutions with specialized competences. To be innovative, both types of systems require persistent exploration of new technological paradigms and trajectories (Dosi, 1982; Dosi 1990).

Historically, the industrialization of late development countries has been generally built upon bank/credit-based financial systems (often placed under state guidance) to mobilize and commit resources for technological learning and catch-up, while stock markets are unimportant in most countries. As Dosi (1990) suggests, market-based financial systems tend to be more effective operating in countries that are at or approaching the technological frontiers. Moreover, stock markets typically require sophisticated legal frameworks with credible commitments in investor protection and contract enforcement to sustain the expansion of impersonal transactions, which developing countries often lack (Pistor, 2001).

The period since the 1980s has witnessed the rise of a financial reform paradigm for developing countries and transition economies that emphasizes the superiority of market-based finance, especially the role of stock markets in financing innovation. This paradigm is built on the US model of shareholder capitalism that combines large and liquid stock markets with active venture capital (VC) investing and corporate takeovers. It has been associated with a process of “financialization” characterized by “the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein, 2005:3). Governments in many countries have actively promoted equity ownership and “equity culture” under the belief that “a plentiful supply of equity capital” can promote innovation and hence economic competitiveness (Dore, 2008:1106).

However, the relations between stock market and innovation are complex and controversial (Acharya and Xu, 2017). On the one hand, stock market can potentially serve crucial roles in capital raising, risk diversification and price discovery. It provides avenues for mergers and acquisitions that may serve as a disciplinary mechanism to penalize inefficient firms. It also provides exit channels for venture capital funds that finance innovative start-up firms. On the other hand, unfettered stock market tends to breed short-termism, predatory corporate practices as well as financial instability characterized by speculative bubbles and crashes, which are particularly detrimental to developing economies (Stein, 1989; Singh 1997; Deakin and Singh, 2008). Even in advanced economies, value extraction behaviors on stock markets have substantially undermined innovation and increased inequality, with “an increasing separation between those economic actors that take the risk of investing in innovation and those who reap the rewards from innovation” (Lazonick and Mazzucato 2013: 2). The key lessons for policymakers are that both financial market under-development and over-growth can harm innovation and real sector growth. To make stock market an engine for innovation and value creation, instead of a casino for speculation and value extraction, it should be governed by appropriate regulations and development strategies to serve the real economy.

Stock Market in China’s Hybrid Financial Governance Regime

China’s financial governance regime has combined learning from institutional arrangements of Western advanced economies with a distinctive model of bureaucratic administrative control in governing the financial system (Heilmann 2005; Walter and Howie 2009; Pistor 2012). In the 1980s and 1990s, following the mainstream policy approach, the financial reforms of Russian and East European transition economies focused on rapidly launching financial market development by mass privatization programs plus the replacement of existing Communist bureaucracy governance by the Western-style court-cum-regulator model of legal governance (Boycko et al 1995; Pistor and Xu 2005a, b). China has followed a different path, with the reforms to jump-start financial market development closely guarded by administrative governance of existing state bureaucracies. The legal-regulatory framework for financial markets has been gradually established in China as the markets evolve, and despite considerable improvement, the law enforcement remains relatively weak (Allen and Shen, 2012).

Unlike stock markets in the Western advanced economies, China’s stock markets are primarily a creation of the state-led efforts to reform and develop its former central-planning economy. Moreover, unlike the “big bang” reforms in Russia and East Europe, the transplantation of a standardized institutional blueprint played a much less important role in structuring China’s stock markets than the adaptive process of “crossing the river by feeling the stones”. The contemporary stock markets in Mainland China originate from various spontaneous policy experiments encouraged by local governments for state-owned enterprises (SOEs) to raise capital in the 1980s. Later in the early 1990s, China’s central government centralized the control over the emerging stock markets by establishing two stock exchanges in Shanghai and Shenzhen and requiring stock trading activities nationwide to be restricted in these two stock exchanges. From its very beginning, China’s stock markets were positioned as a set of institutional instruments to serve the state’s broader development strategies and policy goals under the Chinese Communist Party (CCP)’s guidance. In particular, stock markets functioned as a key tool to finance and facilitate state-owned enterprise reforms in China. The dominance of administrative control in favor of state-owned enterprises had been a key structural feature of China’s stock markets until recently. The state bureaucracy controlled the process of selecting enterprise candidates for public listing first by an administrative “quota allocation” system and later by an alternative “review-approval” system. In screening the potential candidates for public listing, the state prioritized the needs of large state-owned enterprises. Indeed, over the past three decades, the central plank of China’s industrial policy and SOEs reform strategies was to restructure and amalgamate the core SOE entities in the “commanding height” industries into a small number of giant corporations listed in the stock markets (Nolan 2001; Li 2015). This led to the corporatization and initial public offerings (IPOs) of China’s “national champions” companies such as China Mobile, PetroChina, Sinopec, FAW, China Railway, CRRC and China’s giant commercial banks. These “national champions” have dominated China’s stock markets in terms of market capitalization and trading volumes.

Nevertheless, contrary to the mainstream analyses, on many standard measures of stock market performance, China performed better than those transition economies transplanting the Anglo-American model of financial governance, especially in terms of the ability of raising funds for listed companies and the liquidity of stock markets. In less than three decades, China’s stock markets have grown rapidly from a negligible size to be one of the world’s largest markets in terms of market capitalization and total equity funds raised by listed companies. As Pistor and Xu (2005a, b) argue, China’s relatively superior performance is based on its administrative governance structure that “used and refined pre-existing governance mechanisms” and served as an effective substitute for the legal governance during the early stage of stock market development (Pistor and Xu 2005a: 9). However, there are also intrinsic defects in relying on administrative control in stock market governance which can fundamentally constrain China’s financial market development in the long term (Pistor and Xu 2005a, b). The continuous mixing of top-down control by the state bureaucracy with bottom-up dynamics driven by market development has given rise to unusual features in the policy processes and market dynamics in China’s stock markets, creating peculiar institutional complexity. As Li et al (2020) shows, the hybrid architecture of China’s stock market governance regime can be characterised as a hierarchical institutional network, with Shanghai and Shenzhen Stock Exchanges, key financial market trade associations such as the Securities Association of China (SAC) and the Asset Management Association of China (AMAC), as well as major securities firms and asset management companies, nested under the China Securities Regulatory Commission (CSRC) and Communist Party organizations. Majority ownership of state-owned financial institutions are held by Central Huijin, which forms part of China Investment Corporation (CIC), whereas ownership of non-financial state-owned enterprises are held by the State-owned Assets Supervision and Administration Commission (SASAC) under the State Council. Each province or municipality has its own equivalent local agencies to supervise their local SOEs.

As a result, China’s stock market governance regime is not a pure administrative hierarchy dominated by vertical commands, but a complex institutional network linking multiple layers of market participants with the central and local state agencies. Major stock market financial institutions are typically linked by strategic equity ownership and personnel networks with various state institutions and non-financial state-controlled enterprises at both the central and local levels (Li et al, 2020). Li and Zheng (2019) have identified five different and co-existent institutional logics and policy rationales in China’s stock market governance: 1) state-led developmentalism; 2) political loyalty and party discipline; 3) market-oriented liberal reform; 4) stability and investor protection; 5) financial industry competitiveness. They tend to generate conflicting identities, incentives and behaviors among regulatory officials and top cadres in state-owned financial institutions.

Among former central planning economies undertaking market-oriented transition, China has created the most dynamic and rapidly growing stock markets. Between 1992 and 2017, the total market capitalization of China’s stock markets grew over 540 times from RMB 104.8 billion to RMB 57 trillion and the number of listed companies increased around 65 times from 53 to 3485. China’s stock markets raised a total of over RMB 11.3 trillion for listed companies through IPOs and secondary issuance during this period (CSRC 2017). However, consistent with the general pattern of large developing economies, China’s overall financial system remains bank-based. By the end of 2018, the outstanding balance of equity financing on the domestic stock markets by non-financial enterprises only accounted for around 3.5% of the aggregate balance of funding from China’s financial system to the real economy, while RMB loans accounted over 67% (Table 1). Five giant state-controlled commercial banks, including the Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, Bank of China, and Bank of Communication, dominate China’s banking sector. In 2017, their total assets reached around RMB 93 trillion and accounted for nearly 37% of the total assets of China’s banking institutions; they had over 1.6 million employees, accounting for around 40% of total employees in China’s banking industry (PBOC, 2018).

Overall, bank-based finance has effectively served China’s industrial catch-up based on its latecomer advantages. As IMF (2019) shows, during the past two decades, China’s industrial productivity has converged from 15% of the frontier to about 35%, driven both by industrial upgrading from low-tech to high-tech sectors and productivity advancement in each industrial sector. While China still has huge potential for catch-up growth, it’s also approaching global frontiers in many industrial sectors. The dynamic trial-and-error process of market-based finance should become increasingly important in the next stage of China’s economic development. There is vast space for stock markets to grow and play a larger role in financing China’s real sector growth and innovation.

Research and Development (R&D) Expenditures in China’s Corporate Sector: A Firm-Level Picture

The general pattern of financing innovation in China is reflected in the composition and sources of China’s research and development (R&D) expenditures. China’s science and technology innovation system used to be dominated by the state central planning, relying on direct government funding support. Driven by market-oriented reforms, China has developed an increasingly vibrant corporate innovation economy during the recent decades. Business enterprises in China invested a total of around RMB 1.4 trillion in R&D, contributing over 77% of China’s R&D expenditures in 2017.  Among them, companies listed in the domestic stock markets accounted for around 38% of China’s total enterprise funded R&D. In particular, around 700 state-owned listed companies contributed over 50% of the total listed companies’ R&D expenditures.  Looking at the composition of R&D expenditures funded by business enterprises, China’s rapidly growing corporate innovation economy has three key pillars, with different financing features. The first is China’s information technology (IT) sector led by highly innovative private entrepreneurial firms such as Huawei, Alibaba, Tencent and Baidu. They have been at the forefront of China’s internet technology revolution, with each of the leading firms creating an expansive business ecosystem connecting numerous smaller enterprises through supply chain and equity investment linkages. However, most of the leading firms in China’s IT sector have not yet been listed in China’s domestic stock markets. The second pillar is China’s large state corporations which occupy the commanding heights of China’s industrial economy, such as aerospace, aviation, automobile, oil & gas, electricity, nuclear power, infrastructure construction and railway. Following the corporatization reforms of state-owned enterprises, most of these “national champions” corporate groups have now been listed in domestic and international stock markets, with diversified ownership structures. Supported by strong access to domestic financial system, they have played a critical role in China’s infrastructure and energy sector innovations. The third pillar is China’s private enterprises in traditional sectors especially manufacturing. With increasing investments in automation and IT-related technology upgrading, China’s manufacturing enterprises have been moving away from lower-end labor intensive operations towards higher-end capital and innovation intensive businesses. Their access to domestic banking system and stock markets has broadened over the years, but remains inadequate in comparison with their contributions to China’s GDP and employment growth.

Accord to the 2018 EU Industrial R&D Investment Scoreboard (the Scoreboard) which comprises the 2500 companies investing the largest sums in R&D in the world in 2017/18, the global top 2500 companies invested a total of €736.4 billion which is approximately 90% of the world’s business enterprises-funded R&D. A total of 438 Chinese companies rank among the global top 2500, compared with 778 US companies, 577 EU companies and 339 Japanese companies. These Chinese companies invested €71 billion in R&D in 2017/18, accounting for around 10% of the total R&D expenditures of global top 2500, compared with 37% for the US, 27% for the EU and 14% for Japan. In terms of R&D sectoral specialization, China has around 44.7% of its top companies’ R&D in information & communications technology (ICT) sectors, 11.4% in automotive & other transports sectors, 7.9% in industrials, and only 3.4% in health. In comparison, the US has 51.4% of its top companies’ R&D in ICT, 26.7% in health, 7.8% in automotive & other transports and only 3.4% in industrials, while the EU has 30.5% of its top companies’ R&D in automotive & other transports, 22.4% in health, 20.1% in ICT and 5.6% in industrials. Business R&D expenditures are highly concentrated both at the global level and at the major country level. A small number of companies and industries account for the dominant share of the total R&D expenditures. Globally, the R&D concentration (share of the total R&D expenditures of top 2500 companies) for the top 10, top 50, top 100 and top 500 companies is respectively around 15%, 40.2%, 52.9% and 80.8%. In China, business R&D expenditures are even more concentrated in a small number of large firms. The top 10, top 50, top 100 and top 500 companies in China respectively account for around 38.2%, 66.4%, 77.2% and 87.6% of the total R&D expenditures of 438 Chinese companies that rank among global top 2500 (Exhibit 1.). In particular, as China’s largest corporate R&D investor and one of the world’s five largest companies ranked by R&D expenditures, Huawei invested over €11.3 billion in R&D in 2017/2018, accounting for around 16% of the total R&D expenditures of the Chinese companies that rank among global top 2500 (European Commission, 2018).

The relations between China’s top companies in terms of R&D and China’s domestic stock markets have varied substantially. Table 2 shows the top 20 Chinese companies ranked by R&D in 2017/18. Among them, six are private ICT companies (including Huawei, Alibaba, Tencent, Baidu, Ctrip and Lenovo) which invested a total of over €20 billion in R&D, while eleven are state-controlled national champions such as ZTE, China State Construction Engineering, PetroChina, China Railway and CRRC, which in aggregate invested around €14 billion in R&D in 2017. None of China’s top private ICT companies ranked by R&D are listed in Mainland China’s stock markets. Alibaba, Baidu and Ctrip have been listed in the US stock markets, while Tencent and Lenovo have been listed in Hong Kong Stock Exchange. As a private employees-owned company, Huawai is committed not to be listed in any stock markets. Ren Zhengfei, the founder of Huawei, has described stock market investors as greedy and short-term profit oriented, and firmly rejected the possibility of public listing for Huawei. As he commented: “In reality, (public) shareholders are greedy and want to squeeze every bit out of a company as soon as possible”; “Not listing on the stock market is one of the reasons we have overtaken our peers” (Financial Times, May 02, 2014).  In comparison, all of the state-controlled national champions among the top companies ranked by R&D have been listed in Shanghai or Shenzhen Stock Exchanges, and most of them have also been dual listed in Hong Kong Stock Exchange. While stock markets have played major roles in the corporate restructuring and managerial system improvement of China’s national champions, they rely primarily on retained earnings and credits from large commercial banks in financing their investment expenditures. Under the state’s majority ownership and control, these national champions are not active in equity financing and stock market takeovers. Overall, the firm-level picture of China’s business-funded R&D expenditures corroborates that domestic stock markets have only play a limited role in financing China’s corporate innovation economy.

China’s Multi-Layer Stock Market Architecture and the Launch of the Science and Technology Innovation Board (STAR)

The development of China’s stock markets can be characterized as a process of continuous “institutional layering”, with new institutional elements layered upon existing arrangements instead of replacing them (Thelen 2003). Since 2003, China has accelerated its pace of reforms to liberalize its financial system and promote stock market development. Given large SOEs’ dominant status in China’s stock markets, small and medium sized enterprises (SMEs), especially non-state enterprises, have no adequate access to funding from stock markets. To improve the access to capital for SMEs and promote innovation, the Party launched a series of pilot reforms under the slogan of “building a multi-layer capital market system”, including establishing the SME Board (Small and Medium Enterprise Board) and ChiNext Board (Growth Enterprise Board) at Shenzhen Stock Exchange (SZSE) in 2004 and 2009 respectively. It also encouraged financial innovations such as the introduction of margin financing and stock index futures on an experimental basis to improve market liquidity and efficiency. In the 3rd Plenum of the 18th CCP Central Committee in 2013, “developing multi-layer capital markets” was positioned as a key strategy to push forward further marketization and make China’s financial system more balanced and inclusive (CSRC 2007; 2016). The recent launch of the Science and Technology Innovation Board (STAR) in Shanghai Stock Exchange (SHSE) in 2019 is a new milestone of China’s stock market development. It is designed to help financing growth-oriented technology innovation firms and aims at becoming the Chinese version of Nasdaq. With a clear positioning to support China’s high-tech and strategic emerging industries, STAR represents a major effort of China’s reformers to generate new institutional and policy solutions to better finance China’s innovation drive.

To evaluate the challenges and opportunities facing China’s stock markets (and STAR in particular) in promoting innovation, it’s crucial to analyze the institutional features of the existing multi-layer architecture structuring China’s stock markets. As shown in Exhibit 2, China’s stock markets now consist of four hierarchical layers. At the top of the hierarchy lie the Main Boards of Shanghai and Shenzhen Stock Exchanges, which have the highest listing requirements and are dominated by large “blue chips” companies (especially state-controlled national champions). The basic requirements set by CSRC for reviewing IPOs for the Main Boards create fairly high barriers. Among others, it’s required that when a company submits its IPO application, it must have positive earnings in the past three consecutive years with accumulated earnings over RMB 30 million, and accumulated operating cash flows no less than RMB 50 million or with accumulated operating income exceeding RMB 300 million. In addition, the ratio of intangible asset to net asset value cannot exceed 20%. The second layer consists of SME Board, ChiNext Board and the new STAR Board, all of which aim at broadening the access to stock markets for smaller, innovative growth firms that cannot yet get listed in the Main Board. Targeting to become “China’s Nasdaq”, ChiNext Board provides more space for smaller growth firms to get listed than the Main Board. It requires companies applying for IPO either generating positive earnings for two consecutive years with accumulated earnings over RMB 10 million, or generating positive earnings in the most recent year with operating income over RMB 50 million. In addition, the net asset should exceed RMB 20 million. The SME Board sets lower listing standards than the Main Board but higher listing standards than the ChiNext Board. Also positioning to become “China’s Nasdaq”, the new STAR board allows innovative enterprises to get listed before they make profits. With a registration-based system, it does not require government approvals to get listed and imposes no administrative control over the pricing of new issuances (versus 23 P/E cap on other boards in SHSE and SZSE). It also allows the short-selling of individual stocks to facilitate more efficient price discovery. These institutional designs render STAR a potentially highly dynamic complement to the existing multi-layer architecture of China’s capital market.  The third layer is the over-the-counter share quotation and trading system named “New Third Board”, operated by the National Equities Exchange and Quotations based in Beijing. Also aiming to support innovative and high growth firms, the New Third Board does not set minimum financial requirements for firms to apply for listings. Over 11,000 firms had been listed on the New Third Board market by 2017. Despite its rapid growth in recent years, the New Third Board remain very illiquid and have poorer information disclosures than Shanghai and Shenzhen stock markets (Allen et al, 2019). At the bottom of the hierarchy are some regional over-the-counter equity exchanges.

China’s stock markets have a number of well-known structural weaknesses. For example, trading activities are dominated by retail investors who tend to trade frequently and are highly susceptible to short-termism and speculative herding. The turnover ratios of SHSE and SZSE were over 160% and 260% respectively in 2017, compared with around 60% for New York Stock Exchange and 104% for Japan Exchange (Allen et al, 2018).  Short selling and hedging tools are limited and cumbersome, preventing efficient price discovery and valuation. There is also a general lack of market depth and liquidity except the Main Board. Moreover, China’s listed companies typically have concentrated ownership. Under a relatively weak legal enforcement environment, corporate governance and minority shareholder protection mechanisms are often dysfunctional. China also lacks an active market for corporate control. Between 2003 and 2017, the number of transactions that result in change-in-control in a listed company accounted for less than 1% of all listed companies in China (Wang, 2019). Many listed companies were engaged in value extraction through tunneling and related-party transactions at the expense of minority shareholders, including issuing long-term intercorporate loans to parties related to the controlling shareholders (Jiang et al 2010).

From the perspective of promoting innovation, however, the most crucial weakness of China’s stock markets arguably lies in the malfunctioning of the selection function of stock markets in allocating resources. The regulatory bureaucracy has penetrated deeply into the markets by filtering the potential candidates for public-listing and intermediating between enterprises and investors in the stock markets based on state industrial and innovation policies as well as the past financial performances of the firms. The state-oriented approach of “picking winners” for stock markets has served important roles in restructuring China’s incumbent state-owned enterprise sector and facilitating the organizational learning, innovation and capital raising of China’s national champions. However, it tends to undermine the dynamic trial-and-error processes of stock markets in channelling the growth of new firms and exits of old firms. It’s intrinsically difficult for government to assess and monitor the innovation capabilities and potentials of business firms, which are often not related to their past financial performances. As a result, China’s stock markets have been systematically biased in favour of large firms (especially SOEs) operating in the existing technological paradigms and technological trajectories. Smaller private firms exploring more radical ideas of innovation face very high barriers to get listed. Moreover, China’s stock markets have been rather ineffective in weeding out inefficient or even zombie firms. Firms are rarely de-listed from stock markets in China. According to Allen et al (2018), between 2000 and 2014, the average percentage of delisted firms was only 1% in China’s stock markets, compared with 33% in the US and 13% in Brazil. Less than 10 companies were delisted each year due to poor performance during this period in China’s stock markets.

A key mechanism by which stock market may stimulate innovation is through encouraging venture capital (VC) investing. The past decade has witnessed rapid growth of venture capital in China. Now China has the world’s second largest VC market in terms of deal value. Nearly 30% of global VC deal value was directed to Chinese start-ups in 2018. While foreign funds dominated China’s VC market in the 1990s and early 2000s, the recent growth has been primarily driven by China’s domestic VC funds, including traditional VC firms, government-guided funds and corporate VC subsidiaries by giant IT companies such as Baidu, Alibaba and Tencent (Huang and Tian, 2019; Pitchbook, 2019). The direction and pace of China’s VC growth are closely linked with China’s domestic stock market development and reform policies as IPO is the preferred exit channel. For instance, China’s VC investment increased dramatically following the launch of ChiNext Board in 2009, which provided a new channel for domestic VC to exit through IPOs, but the growth in the number of new VCs established in China collapsed between 2015 and 2018 following China’s 2015 stock market crisis. As a reflection of the structural weaknesses of China’s stock markets, China’s VC funds tend to be rather impatient in comparison with their counterparts in the US and UK. The incubation period (defined as the amount of time between the initial investment date and exit date) for Chinese VC funds is much shorter than the VC funds in the US (Huang and Tian, 2019).

Overall, China’s approach of stock market development and reforms is based on an institutional layering process that on the one hand has accommodated some vested interests in the existing layers of China’s stock markets, while on the other hand has also been continuously developing new layers of markets to promote innovation and incremental institutional changes. There is substantial competition among the multiple layers of stock markets as well as regional governments where these stock exchanges are located. It is within this context that China launched the new STAR market in Shanghai. It’s an important policy and institutional experiment for China to reform the IPO system and create more dynamic trial-and-error market processes in the growth of new firms and exits of old firms. It will likely stimulate a new wave of growth for VC investing in China. More importantly, it represents a major step in China’s long-term efforts to establish a more balanced and inclusive financial system architecture.

Innovation and Stability in China’s Stock Market

In China’s stock market development, there are substantial tensions and complex trade-offs among state control, market innovation and stability maintenance. Policymakers, investors and financial professionals face profound challenges in navigating the increasingly complex interaction between top-down state actions and bottom-up market dynamics in China’s hybrid financial governance regime. The difficulties of balancing innovation and stability in stock market development are illustrated most clearly in the evolution of China’s 2015 stock market crises. Between 2012 and 2015, the Chinese government launched a series of policy initiatives to “mobilize financial system to support small and micro-enterprises”, “promote enterprise mergers, acquisitions and restructuring”, and “promote financial innovations”. In 2014/15, it further launched a major policy campaign for “Mass-Innovation; Mass-Entrepreneurship”, which aimed not only at mobilizing the mass to innovate and start entrepreneurial ventures but also at mobilizing the entire state bureaucracy to come up with new policies to stimulate and guide the bottom-up mass initiatives in innovation and entrepreneurship. Stock market regulators were mobilized to experiment and expand novel policies to promote entrepreneurial finance, relax regulation, stimulate financial innovation and speed up the growth of SME Board and ChiNext Board. These policy initiatives and campaigns led to an increasingly accommodative regulatory environment that allowed a proliferation of financing tools such as margin-financing, stock-collateralized lending and internet-based borrowing platforms, which increased leverage and risks in the system. In this environment, investors formed widespread expectations that the state endeavoured to generate a bull stock market and maintain rising stock prices to achieve its policy goals promoting “Mass Innovation; Mass Entrepreneurship”. In 2014, the state-controlled propaganda media, such as the People’s Daily and Xinhua, increasingly published bullish commentaries on the stock market, encouraging investors to buy shares. Starting from July 2014, China’s stock market started a continuous rally. Later, the stock market boom was further fueled by the loosening of monetary policy by the People’s Bank of China with a series of cut in interest rates and reserve ratios, which further expanded liquidity and credit in the system. Between July 2014 and June 2015, China’s stock market rallied rapidly with Shanghai Composite Index surging over 150% and ChiNext Market Index also tripled. In particular, the stocks of enterprises involving the policy themes of promoting “Mass Innovation” and “Mass Entrepreneurship” (mostly small-and-medium sized technology related companies listed in the SME Board and ChiNext Board) became extremely popular among investors and their stock prices skyrocketed (Li and Zheng, 2019; Li et al 2020).

However, the stock market boom was achieved by a rapid building up of leverage and risks, with an explosive growth of margin financing. In June 2015, CSRC’s decided to toughen monitoring and control over margin lending and the practices of borrowing money from outside the regulated brokerage systems to purchase stocks through shadow financing. This triggered major crashes and market panics, with the Main Board indices dropping over 30%, SME and ChiNext Board indices dropping over 40% within three weeks. Numerous leveraged investors suffered margin-calls and were forced to liquidate their shareholdings, and in turn worsened price decline. Over 1,440 listed companies filed for suspension of trading on 8 and 9 July, which accounted for more than 50% of all the listed companies in the Shanghai and Shenzhen Stock Exchanges. By then, China’s stock market had stopped much of its functioning due to the chaotic process of deleveraging. A constellation of disparate state agencies including the central bank, financial regulators, local governments, the police and security force as well as state-controlled medias were all mobilized to come up with ad hoc responses to help stabilize the stock markets. In particular, CSRC led a “National Team” of share buyers to purchase stocks and stabilize the market. For instance, Citic Securities, one of the leading state-controlled securities brokers participating in CSRC’s bailout program, bought over RMB 62 billion worth stocks, including equities of 76 small and medium-cap companies listed in the Shenzhen Stock Exchange’s SME Board and ChiNext Board in a single day on 8 July (Jiang and Liu, 2015). There were no clear mechanisms of accountability on the purchasing decisions, which were arbitrary and focused on shoring up the market in the short-term. Apart from buying shares, extraordinary changes in regulatory and market rules were adopted to rescue the market as well, such as stopping IPOs, restricting short selling, prohibiting large shareholders of listed companies from selling shares and altering market trading rules. These measures heavily undermined the credibility of China’s financial regulation and market-oriented reform programs. Only as the market gradually stabilized did CSRC start to unwind the emergency policy measures implemented during the bailout efforts, including stopping the suspension of IPOs and allowing new listings in November 2015 (Li and Zheng, 2019; Li et al 2020).

The 2015 stock market crises have profound impacts on China’s financial stability and stock market development. In particular, it undermined the market ecology of ChiNext Board by severely squeezing its investors. It has also stimulated a new round of financial regulatory reforms to reduce arbitrary administrative interventions in China’s stock market governance. Piloting with a full registration-based IPO system, the establishment of STAR in Shanghai Stock Exchange serves as a major experiment to enhance the self-regulation of stock exchanges and reduce administrative control over the markets. In 2019, China has further launched major initiatives to accelerate its financial sector opening up to foreign investors and financial intermediaries, eliminating the existing shareholding limits facing foreign institutions in owning banks, securities firms and investment funds in China. The acceleration of financial opening up will increasingly bind China’s domestic financial governance regime with global financial markets, changing the structures of investor base in China’s stock markets. This new era of China’s financial opening up will inevitably present new challenges for policymakers to balance innovation and stability.

Conclusion

The adequacy of a given financial system depends on the compatibility between a country’s financial system arrangements and the developmental stage of its real sector economy. Financial systems in different countries are embedded in different political-legal institutional structures and they address the generic problems of financing innovation in different ways. What functions well in some systems and at certain stages of economic development may not work properly in different contexts. Among former central planning economies undertaking market-oriented transition, China has created the most dynamic and rapidly growing stock markets, which have been instrumental in facilitating China’s SOEs reform and the rise of China’s state-controlled national champions. However, despite the rapid growth of stock markets, China’s financial system remains bank-based. Stock markets have only played a limited role in directly financing China’s investment in innovation. Banks and the internal capital allocation of a relatively small number of large business firms (including giant private technology companies in the ICT sectors, state-controlled ‘national champions’ in heavy industries as well as large firms in traditional manufacturing) are critical in financing China’s investment in innovation. They account for the lion share of China’s business-funded R&D expenditures. To the extent that the proportion of domestic stock market financing continues to be small in China’s aggregate investment expenditures in science and technology innovation, how to improve the efficiency of China’s banking system and the internal capital allocation of large corporations remains crucial in the development of China’s innovation economy.

The combination of socialist state control with rapidly growing and increasingly open stock markets has generated unusual features in China’s hybrid financial governance regime. China’s stock market architecture has been biased in favour of large corporations especially SOEs, while private sector SMEs face high barriers to access equity financing through domestic stock markets. The state bureaucracy has penetrated deeply into the stock markets, filtering the potential candidates for IPOs and distorting the markets’ selection function. The growth of China’s venture capital industry is closely linked with China’s stock market development and reform policies. The relative impatience of China’s VC funds reflects the structural weaknesses of China’s stock markets in channelling the growth of new firms and exits of old firms. The development of China’s multi-layer stock markets can be seen as an institutional layering process that gradually broadens the access to stock markets for innovative private sector SMEs. In particular, the recent launch of the STAR market in Shanghai is a new milestone in the development of China’s multi-layer stock markets. As China narrows its technological gaps with global frontiers in many sectors, the dynamic trial-and-error process of market-based finance will become increasingly important in the next stage of China’s development. However, there are inherent tensions among innovation, state control and stability in China’s stock market evolution. As shown in China’s 2015 stock market crises, it’s a profound challenge for policymakers and market participants to navigate the increasingly complex and volatile interaction between top-down state actions and bottom-up market dynamics in China’s hybrid financial governance regime. It remains to be seen how China’s further financial liberalization and opening up will alter the dynamics of China’s stock markets. A systemic approach of strengthening regulatory and legal governance is needed to balance innovation and stability in China’s stock market development.

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