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COR1306 Capital Markets in China

Final Exam Guide

The COR1306 final exam will be online with Lockdown Browser and will be held on
campus. Please test your computer in advance and bring your computer to exam venue on
campus. The exam arrangement will be handled by the University.

The exam paper carries 100 marks and adopts the following format.

Multiple Choice Questions (MCQs): 25 MCQs, 2 marks each and 50 marks in total. Each
MCQ has four choices and there is only one correct answer. There will be no penalty for
incorrect answers.

The coverage of the MCQs includes all the seminar notes contents, excluding reading
materials with external links, individual studies/videos and group projects. We will not test
on the exact years and dates and the questions will focus more on facts and concepts. For
cases discussed in class, we will focus more on concepts rather than details such as years
and things happened.

Long-Form Questions: 3 long-form questions and 50 marks in total. Some readings from
newspapers, magazines and/or journals will be provided and students are required to
answer questions based on the readings. It may also include simple calculations to
illustrate basic ideas we discussed in class.

The coverage of the Long-Form Questions is all the topics we have discussed in class. The
more you read, the more perspectives you may provide to answer the open questions.
Questions will be largely qualitative although there could be some simple calculations.
Thus, you need a non-programmable calculator for the final exam if you are not
comfortable with simple additions and multiplications.

Some sample MCQs are provided below for your reference.

1. Which of the following statements regarding the importance of financial markets is

incorrect?

A. Financial markets are critical for producing an efficient allocation of capital,

allowing funds to move from people who lack productive investment opportunities
to people who have them.
B. Financial markets determine the price of the traded asset through the interactions
of buyers and sellers.
C. Financial markets also improve the well-being of consumers, allowing them to
time their purchases and sales better.
D. Financial markets increase the search and information costs of transacting.

2. Which of the following statements regarding A share and B share in China is incorrect?

A. Both A share and B share are denominated in Chinese Renminbi.

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B. A share is denominated in Chinese Renminbi and B share is denominated in US

Dollars or Hong Kong Dollars.
C. A share is traded in Chinese Renminbi and B share is traded in either US Dollars
or Hong Kong Dollars.
D. Currently all eligible Chinese citizens are allowed to trade both A share and B
share.

3. Which of the following statements regarding the going-public restructuring process of

state-owned enterprises (SOE) in China is correct?

A. Partial of a state-owned business group is restructured into a share company and

gets listed on stock exchanges.
B. Several independent SOEs are combined into a share company and gets listed on
stock exchanges.
C. A whole SOE is completely restructured into a share company and gets listed on
stock exchanges.
D. All of the above are possible restructuring process in China’s SOEs.

The following is an example of long-form question.

Read the following article titled “Raising the bar” which was published in the Quantum
Magazine in 2012 and answer the following questions.

(a) Summarize the main idea of the article in your own words.
[10 marks]

(b) Do you agree or disagree with the government intervention of regulating capital
markets? Explain your idea.
[10 marks]

Raising the bar

STANDFIRST
Should governments step in to regulate capital markets? Wang Jiwei argues that
intervention will often worsen the outcome in developed markets, but in emerging markets
may accounting-based regulation deliver benefits that exceed the costs.

One of the most controversial questions in economic policy is whether governments

should intervene in or regulate capital markets. Pure free-marketeers believe that the
“invisible hand” is a self-correcting mechanism, while advocates of intervention say that
regulation enables governments to correct market failures and maximises social welfare.
When it comes to regulating stocks after their initial public offerings (IPO), many
governments adopt a “disclosure-based approach”, involving limited government
intervention. No official approval is needed before additional shares are issued so long as
companies provide adequate disclosure. Nor is there an accounting-based profitability
threshold that the company has to meet before issuing stock – the rationale is that such
thresholds would create additional costs for investors.

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There are inevitably costs associated with accounting-based regulation. In a world without
transaction costs, parties will naturally achieve an efficient outcome without any
intervention. Regulation, then, can only worsen the outcome, at the very least by imposing
undue costs. Where there is regulation, governments must devote considerable amounts of
money and time to the screening of new entrants, resources that could have been allocated
to other government projects to enhance social welfare. Applicants also incur costs related
to compliance.

Moreover, when an accounting-based threshold is a key element of a regulation, there may

be agency problems for investors. Regulations based on accounting numbers, such as a
minimum return on equity (ROE) threshold, can provide incentives for contracting parties
to manipulate accounting data opportunistically to meet these thresholds. Corporate
managers may do so because they believe it will be costly for regulators to “undo” such
behaviour. If a manager manipulates accounting data to meet criteria for issuing additional
shares to the public, this action will trigger inefficient allocation of capital resources, and
hence damage the interests of investors.

However, there are considerable benefits from using accounting-based regulation in the
correct way in the right markets. In efficient capital markets, investors are sophisticated
enough to weed out poorly performing firms, so accounting-based regulations are not
needed to gauge the performance of new entrants. However, the situation in emerging
markets can be very different; here accounting-based regulation may deliver benefits that
exceed the costs. At the early stage of capital market development, investors do not have
enough sophistication to distinguish between the good and bad companies in the market.
Moreover, firms can manipulate the selling price of stocks at a big discount. This means
existing shareholders have to choose between either buying additional shares, irrespective
of the firm’s performance, or seeing their ownership diluted. Finally there are severe
“adverse selection problems” in emerging markets, especially in comparison with
developed markets. That is because managers, as insiders, know more than market
participants about the true value of the firm and have an incentive to issue additional
shares when stock prices are overvalued.

These market failures cannot be automatically corrected, because the market per se is
inefficient. In these circumstances, governments should help by intervening and imposing
accounting-based regulation. This helps investors to differentiate between good and bad
firms and can minimise adverse selection by managers. These benefits may exceed the
costs associated with the misallocation of capital resources.

China is an example of where this approach has been adopted. The government has used
accounting-based methods to regulate shares issued by listed companies, and its
experience sheds light on the costs and benefits in emerging capital markets. In the early
1990s, China’s listed companies could only issue additional shares through pre-emptive
rights offered to existing shareholders. Due to the lack of other means of raising capital
and the Chinese investing public's insatiable demand for stocks at this time, rights
offerings were excessively abused. To curb this, the China Securities Regulatory
Commission (CSRC) issued regulations to restrict rights issues after November 1993.
From that date, listed companies were only allowed to issue rights to existing shareholders
if they had been profitable in the previous two years.

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Then, in September the following year, the CSRC decided that listed companies that
wished to issue additional shares must show at least three years’ profits and a minimum
three-year average return on equity of 10 per cent. The CSRC decided on this measure
because they had found that listed companies wanting to make rights offerings were
manipulating accounting numbers to report a profit. In January 1996, the threshold was
increased to a minimum return on equity of 10 per cent in each of the previous three years,
since the 1994 regulation was failing to curb the abuses.

Further changes were required in 1999, when the CSRC lowered the threshold to a
minimum three-year average return on equity of 10 per cent and a minimum of 6 per cent
in each of previous three years. This decision was taken because the 10 per cent annual
return on equity threshold regulation introduced in 1996 triggered significant opportunistic
earnings manipulation.

The evidence for this comes from the sharp increase in reported return on equity, which
was between 10-11 per cent for 1995-1998 (see chart). It marked a sharp contrast to the
pattern between 1992 and 1994 when there was no ROE requirement. The CSRC
responded to public criticism by lowering the threshold – though the principle of a
threshold was still contained in the regulations.

The next stage in extending the options to raise additional capital came in 2000, when the
CSRC allowed large-scale seasoned equity offerings (SEO) by issuing regulations similar
to those introduced in 1993 to govern rights offerings. The CSRC believed that China’s
capital market had become more efficient during the first seven years and would
automatically correct market failures. This regulation did not impose a strict profitability
threshold, and any company with profits in the previous three years could apply to the
CSRC for SEO authorisation.

However, there were to be changes in these regulations over subsequent years.

Amendments to the regulations for seasoned equity offerings followed a similar path to
those introduced for rights offerings. The original regulation issued in May 2000 which
allowed listed companies with three years’ profits to apply for approval to conduct
seasoned equity offerings was replaced 10 months later with rules which increased the
threshold to a three-year average ROE of 6 per cent.

This was not a definitive threshold, in that a company which did not meet these standards
could still qualify – for example, if the management and underwriter provided detailed
evidence of the healthy state of the company. But introducing a threshold had become
essential to curb abuse by some Chinese listed companies.

Then in 2002, the CSRC raised the bar to a three-year average ROE of 10 per cent and a
minimum ROE of 10 per cent in the previous year. Since the threshold introduce in 2001
allowed some exemptions, management and underwriters were able to collude to help poor
companies to gain additional market resources. For example, Wuhan Department Store
Group announced a SEO proposal immediately after the 2001 regulation went into effect –
even though its ROEs between 1998 and 2000 had been 3.16 per cent, 2.72 per cent and
2.41 per cent, all below 6 per cent.

So what lessons can be learnt from the Chinese experience? The various regulations on
rights offerings and SEOs detailed above imposed at least two types of cost on China's

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capital markets. The first was the “earnings management” needed to achieve the numerical
accounting threshold. Managers of poorly performing companies could manipulate
accounting numbers to meet the threshold in order that they could then raise additional
capital from investors. Thus investors’ capital may be allocated to less efficient projects, to
their disadvantage.

The second cost of a numerical threshold was that it could exclude firms with a potential
for good future performance, and allow firms with probable poor future performance to
conduct rights offerings or SEOs. Despite the costs that have resulted from adopting
numerical rules, the Chinese government continues to use a similar approach to establish
rights issues and SEO qualifications, arguing that accounting-based regulation helps to
minimise resource misallocation, and that regulation can reduce the adverse selection
problem in equity offerings.

The message is clear. Any emerging market government that wants to introduce
accounting-based regulation must have an excellent understanding of the status of its
capital markets. Governments need to promote rigorous capital market research by
academics and consultants and undertake other investigations to ensure that they
understand the demand and supply of their capital markets. They need to impose a strong
threshold when the first regulations are introduced, but also actively to monitor market
reaction and adjust their rules to take genuine concerns into account. In this way, they can
maximise the benefits of accounting-based regulation and avoid imposing unnecessary
burdens on the markets.

POSSIBLE PULL QUOTES

There are inevitably costs associated with accounting-based regulation. In a world without
transaction costs, parties will naturally achieve an efficient outcome without any
intervention.

Where there is regulation, governments must devote considerable amounts of money and
time to screen new entrants – resources that could have been allocated to other
government projects that would enhance social welfare.

Any emerging market government that wants to introduce accounting-based regulation

must have an excellent understanding of the status of its capital markets.

【THE END】