Keeping pace with China's rule makers

Author: | Published: 1 Jul 2005
Email a friend

Please enter a maximum of 5 recipients. Use ; to separate more than one email address.

IFLR: What are the main regulatory challenges facing investors in China today?

Hubert Lem, Morgan Stanley: Coming to grips with the complexity of the legal, regulatory, tax, accounting and operational environment and how to achieve optimal solutions given the constraints from each of these areas. The complexity is due to many factors, such as lack of clarity in the drafting of rules, the fragmented nature of the bureaucracy and the fact that new rules are being issued all the time. Keeping up with changes in rules and interpretations is a real challenge.

Rule making in China has become far more transparent than before and the rules are becoming more rationalized. At the same time, China's regulators are becoming more experienced, sophisticated and comfortable with stepping back and saying that, unless there is a statutory basis for regulation, they will not interfere with a certain activity. There are more rules than ever before and they are becoming more strictly and consistently applied. Despite these improvements there remain situations where rules are unclear and there is a need for an experienced guide that can provide added information or regulatory interpretation. Approvals always seem to take longer than expected and the process for receiving approvals is sometimes not transparent enough.

How do you work to overcome these challenges?

We try to maintain close and transparent relationships with the regulators so that they understand what we are trying to achieve and we are comfortable that we understand their views. We also rely on the advice of our outside advisers and service providers in a number of different areas, such as our legal, tax and accounting advisers and our local banks and custodians. We try to be flexible in terms of meeting unexpected challenges.

To what extent has there been consultation with market participants in the process of issuing new regulations?

There has been a great deal more consultation generally than in the past. For the financial regulators such as the CSRC (China Securities Regulatory Commission) and CBRC (China Banking Regulatory Commission) there has been increasing consultation with market participants. As China has opened up financial sectors to foreign participation, many foreign participants engage in direct consultation with the regulators and, through such consultation, have helped to develop the rules governing their industries. Regulators often welcome working with industry groups such as Isda (International Swaps and Derivatives Association) to advise them on drafting of laws and regulations. Regulators sometimes prefer working with industry groups because they are a source of technical expertise, which regulators might not necessarily have.

What benefits can strategic foreign investors bring to domestic companies in terms of risk management and corporate governance?

Foreign investors do not necessarily have a lock on effective corporate governance. However, due to their experience with public company requirements overseas, there is often greater sensitivity to issues of importance for public investors, treatment of minority investors and compliance with disclosure requirements. In addition, foreign investors can bring in more advanced technologies in the form of more sophisticated management tools and business techniques, for example, management accounting, technologies that measure productivity and business performance, and tools for monitoring credit exposure and financial position.

How have financial institutions been preparing for China's accession to the World Trade Organization?

Many domestic financial institutions have undergone restructurings to create more efficient and rational business organizations, eliminating non-core businesses and assets. Many have converted themselves to companies limited by shares to facilitate eventual stock listings. They have been seeking listings domestically and/or overseas and have been looking for strategic partners as a source of equity capital, technology and know-how transfers, and as business joint venture partners.

What specific measures are needed to solve the non-performing loan (NPL) problems of Chinese banks?

The Chinese banks' NPL problems are caused by a number of different factors. One factor is the combined policy role that state-owned banks have had together with their commercial roles. This policy role to support state enterprises will not disappear overnight, although it is expected to diminish over time as the state-owned enterprises restructure themselves into viable commercial entities. The continued restructuring of the state sector, if successful, should lead to a diminishment in the NPL problems.

NPLs are also brought about by uncommercial or fraudulent lending practices. Better internal controls and risk management technology will help to reduce these NPLs. Chinese banks are trying to attract more foreign technology to improve banking practices. Giving foreign banks a greater stake in domestic banks could help with ameliorating uncommercial or fraudulent lending practices and ultimately improve the domestic banks.

The creation of a nationwide credit reporting system will also aid banks in managing their credit exposure. Lastly, making legal and adjudication systems more efficient to facilitate workout of bad debts will make the resolution of NPLs less time-consuming and expensive.

What legal risks face a foreign investor wanting to buy non-performing loans in China?

Adequate information on the loan assets is often difficult to obtain. In many portfolios, there is poor level of documentation, which makes it difficult to identify and establish claim on the relevant assets.

Another legal risk is the uncertainty involved in obtaining judgment against the debtor or assets. That situation is improving, and it requires experienced local counsel. Some legal advisers advocate using the legal process as a first step to establish a legal claim over the relevant assets, rather than as a last resort. It is important to keep in mind local government interests and sometimes to involve local governments as a solution to the problem.

What role does foreign investment have to play in the restructuring of the financial sector?

Foreign investment could play a significant role in providing capital, technology, and management skills transfer. Permitting foreign financial institutions to provide services domestically will bring efficiencies to many parts of the Chinese economy, not just to the financial sector. It would help bring international best practices to the Chinese economy and the financial sector. Through foreign investment and participation in the financial system, China's financial sector could modernize and become efficient more quickly.

How will the listing of Chinese banks on overseas markets improve the financial system?

Listing on overseas markets will provide learning opportunities for Chinese banks in dealing with foreign regulatory systems and will give banks regular exposure to international standards and best practices. The need to comply with disclosure rules will force them to become more transparent. In preparation for foreign listings, many Chinese banks bring in strategic foreign investors as equity holders and as partners in certain businesses. Having strategic foreign investors brings in new ideas, management practices and experiences, and facilitates technology transfer. Listing abroad also exposes the banks to a larger community of analysts, and will make them more responsive on issues that matter to the investor community, such as shareholder value and profitability. These challenges will help make them into stronger banks.

How does the regulatory environment in a particular jurisdiction affect which overseas markets Chinese companies choose to list in?

The US market has become a more difficult regulatory environment from a compliance perspective for all listed companies, whether foreign or domestic. Although the US offers the world's largest and most liquid capital market, many Chinese companies will find it a challenge to manage the compliance requirements of the US regulations. These might deter some Chinese companies from choosing to list in US until they are comfortable with the compliance requirements. Many Chinese companies prefer to list in Hong Kong due to the widespread familiarity and comfort level with Hong Kong regulations, both by China's regulators and by Chinese companies.

What reforms are necessary to increase investor confidence and encourage foreign participation in the domestic capital markets?

China's regulators have been placing a high priority on improving corporate governance and disclosure, and there is a great deal of focus by the regulators on the listed companies. Over time, these efforts help to improve the general quality of listed companies. The recently announced experiment in the conversion of legal person shares to tradable shares is also a positive development that will have long-term benefits on the development of the equity markets. The loosening of rules governing acquisition of private Chinese companies will attract more foreign capital into M&A. The expansion of the qualified foreign institutional investor (QFII) system and gradual liberalization of the rules (as we have seen occur in Taiwan) will continue to attract more investors to China's equity markets. More specifically, the QFII system could be expanded by increasing available investment quotas, liberalizing the repatriation rules, increasing the scope of products that QFIIs can invest in and reducing the qualification requirements.

What sectors have experienced increased liberalization through new regulations that support foreign investment?

The banking and insurance sectors have opened up significantly to foreign investment under the WTO rules, and will continue to open in the coming years. Also, one of the key areas that opened last year is distribution, franchising and retail through the Foreign Invested Commercial Enterprise (FICE) rules, which allow foreign participation in the wholesale and retail distribution sector of the Chinese economy. We also expect to see increasing liberalization in M&A generally.

Where else do you see opportunities for further regulatory reform?

The service sectors in general, and financial services in particular, have not opened up as significantly as other sectors. In the brokerage and securities industry, the current regulations limit foreign investors in setting up local entities. Although there have been several new joint ventures announced, there could be greater liberalization in the industry with a view to allowing full foreign ownership of local entities. The financial services sector should be able to increase its openness to foreign investment and ownership and control. However, this will probably take some time to achieve.

The views presented are personal to the interviewee and do not represent the views of Morgan Stanley.