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By Zhang Chenghui

I. Inadequate Funds: a Major Impediment to Industrialization of High Technology

Experiences of foreign countries have proved that, in technological development system, transformation of technology into commodities is most time and money consuming. Huge amounts of financial support are needed to turn into productive forces the scientific research achievements made by scientific research institutes, universities and other departments and then to develop them into a hi-tech industry. In China, the ratio of transformation of research achievements has for years been around a low level of 5%, an important reason is the lack of funds.

1. Insufficient fiscal allocations and indirect financing

Over the past decades, we paced along the old path to transfer scientific research achievements into productive forces solely by fiscal allocations. As financial resources were limited, the funds provided by the government were far from sufficient to support the transformation of research achievements, so, some with market potential had to be shelved at the later stage of research or intermediary test for want of funds. Furthermore, due to the lack of real investment bodies and mechanisms of limiting cost, and encouraging better economic returns from investment in particular, the effect of the funds used for the transformation of research achievements was very low, therefore, it could hardly pose a virtuous cycle of investment - recovery and profits - and reinvestment on a larger scale. As a result, the reality is that scientific research and hi-tech industry are separated as if they belonged to different sectors: Scientific researchers do not care for commercial benefits for their achievements and are only concerned about how to get prizes and publish papers. The market, meanwhile, has no way to arouse the enthusiasm of researchers in upgrading products and promoting the development of enterprises and the hi-tech industry as a whole. Although the government has tried time and again to guide and promote the integration of the two segments, no remarkable improvement has been achieved.

From the mid 1980s, the government made tremendous efforts to encourage banks to support the transformation of research achievements with credit funds. Apart from approving the establishment of scientific and technological credit co-ops in various areas across the country, the government spared no efforts to adjust its credit policies and increase credit investment in scientific research. Much to our regret, however, these efforts have not achieved results as expected. Scientific and technological credit co-ops set up for scientific and technological enterprises did not operate as originally required, but turned into non-banking financial institutions to specialize in traditional credit business. Most of these co-ops were changed into urban cooperative banks in the process of restructuring credit co-ops that was launched later. Meanwhile, commercial banks became not so "obedient" as before when their reform toward commercialization was accelerated and their awareness of risk enhanced. A study report from the People's Bank of China in 1998 showed that the enterprises located in the hi-tech development zones in Beijing, Tianjin, Jilin and other provinces and municipalities were universally haunted by shortage of funds, and a big gap existed between total demand and total supply of credit funds. Tianjin, for instance, planned an increase of RMB100 million as special loans earmarked for scientific and technological development in 1997, but the amount made available was less than RMB10 million. A recent questionnaire given out by the Management Committee of the Beijing New Technology Industrial Development and Test Zone has also revealed that only 7% of the enterprises located in the zone listed credit funds as their first choice for financial source.

The unsuccessful practices mentioned above have indicated that the financing method mainly in terms of government input or bank credit does not work as expected. On one hand, plans and administrative measures can hardly cope with disperse and diversified market demands effectively. On the other hand, commercial banks, obliged by their promises of repaying the principals and interests to depositors, have to operate in a steadfast way and seek profitability only under the precondition of safety and liquidity. This principle featured by stable business operations does not tally with the characteristics of high-tech enterprises that are unstable, lacking guarantee assets, and in need of funds for long-term equity investment. In practice, therefore, banks appear to be very prudent in their selection of target projects and would never lend unless they are fully assured of expected success. Furthermore, they would extend only short-term loans and be reluctant to long-term ones. According to a model survey conducted by the People's Bank of China, the short-term loans within one year accounted for more than 95% of the total launched to high-tech enterprises in Tianjin in 1997.

2. Existing capital market unable to satisfy hi-tech enterprises

After the central government established the principle of actively promoting development of hi-tech industry, there has been a common understanding in recent years that the capital market should be fully utilized to make funds available to hi-tech enterprises. Departments concerned are also active in preparing for a secondary market at the Shanghai and Shenzhen stock exchanges to provide cashing services to venture capital. Nevertheless, the status quo of China's capital market still falls far short of meeting the demand of hi-tech enterprises. The situation of Beijing New Technology Industrial Development and Test Zone is a typical example:

a) Of the 2,343 joint-stock enterprises located in Beijing's Zhongguancun area, only three raised funds totaling RMB860 million from the stock exchange by issuing A-shares in 1998. (Study Report of Beijing New Technology Industrial Development and Test Zone, 1999)

b) There has been no example so for that any scientific and technical enterprise pooled funds through issuance of bonds or other valuable papers.

c) The property rights market in Beijing has been kept by painstaking efforts since its establishment, with less than 10 transactions concluded each year. Among these deals, no high-tech firms are involved.

d) The Beijing Municipal Government pooled RMB500 million in 1998 and set up Beijing Scientific and Technological Venture Capital Investment Co. Ltd.. With other funds earmarked for venture investment, the total amount of venture capital available in Beijing is around RMB1 billion. As these funds and the said company by and large remain at the start-up stage, the projects they support are limited. A superficial reason is the difficulty of finding promising projects, while the deep-rooted cause lies in the incompleteness of market and risks assessment systems and in some problems with the operational mechanisms of the venture investment company.

e) At present, there are three guarantee funds in Beijing for small and medium-sized high-tech enterprises, set up by the municipal government and the new technology industrial development and test zone respectively. Plus those established by district and county governments, the total amount of resources is about RMB430 million. The actual performance of guarantee transactions is far below their capacity. Many small and medium-sized enterprises generally share the view that the formalities for obtaining guarantees are too complicated and difficult, whereas the guarantee funds feel it too risky and difficult to run the business.

Without the data on total assets and capital of the enterprises located in the zone it is very difficult for us to go further with our analysis. A sample survey in the zone has revealed, however, that more than half of hi-tech enterprises agree that shortage of funds poses a major obstacle to their development and that 72.6% of enterprises have taken self-accumulation as their first choice among other financing channels. This fact indicates that the amount of funds raised from the capital market is indeed very small.

II. Why Regional Capital Markets Vital for Development of Hi-tech Industry

1. Major problems in the existing capital market

Viewed from the point of supporting hi-tech enterprises, the major problems lying in China's capital market are manifested in the following four aspects:

a) Unitary layer. China's current market with a unitary layer can neither meet the financing demand of a large number of small and medium-sized high-tech enterprises, nor cater to the investment preferences of different investors. Affected by various factors, China's capital market has developed towards high centralization and simplified to be two stock exchanges, one in Shanghai and the other in Shenzhen. Trading has either been banned or forced to go underground. Since the trading and management capacities of either trading system are limited, it is inevitable to exclude certain market players and give priority to the superior ones in the process of trading. Under the circumstances where the capital market has only one layer, namely, the stock exchange, this market is bound to favor big enterprises with prejudice to numerous small and medium-sized businesses. Among the latter are burgeoning high-tech enterprises. As they can't raise sufficient funds from the capital market, they have little hope to grow rapidly into such giants as Microsoft. Although the secondary market now under construction in China will add a new layer of trading, its capacity would be limited due to its nature as an affiliate to the Shanghai and the Shenzhen stock exchanges. It is imaginable that a long line of enterprises queuing up for listing, a phenomenon at China's stock exchanges, will also appear at the secondary market. On the other hand, investors line up at different layers due to their diverse preferences to risks. A market with a unitary layer will then keep off a number of investors and hinder a considerable amount of social funds from entering into the capital market, thus leaving them idle.

b) Rare tradable securities. The market cannot optimize its attraction to investors or borrowers because of rarity of tradable securities. Tradable items available at China's capital market at present include merely stocks, state bonds, and a small number of funds. Tradable corporate bonds are limited in terms of both variety and quantity. The market for the non-security property rights trading is small in size and non-standard in operation. No capital dealings are registered in terms of other instruments such as long-term notes and stock futures. Under such circumstances, investors can hardly disperse risks according to the principle of "never putting all your eggs into one basket", to say nothing of fending off risks. At the same time, the rarity of tradable products has made it very difficult for small and medium-sized high-tech enterprises to raise funds in a most favourable and flexible way.

c) Low market efficiency and high trading cost. Efficiency is the core and lifeline of a capital market because its paramount task is to allocate financial resources most effectively. There are at least three factors that determine the efficiency of a capital market: firstly, a large enough scale; secondly, availability of sufficient financing instruments to both investors and borrowers in full compliance with their respective capacities; and lastly, full competition.

With merely a unitary layer, that is, the stock exchange, China's capital market is subject to limitation in terms of scale, number of financing instruments and competition. For this reason, its overall efficiency can never be very satisfactory. So far as small and medium-sized high-tech enterprises are concerned, the innovative characteristic determines that they cannot have patience to undergo the long listing process because any products they have developed would lose creativity and vitality if the money in urgent need is available one or even several years later. On top of that, the listing cost of tens of millions of yuan, a heavy burden, scares away small and medium-sized high-tech enterprises.

d) Resources are not allocated according to the principle of maximum efficiency. A capital market is essentially a place where resources are allocated according to the principle of maximum efficiency. Under the precondition of equal risks, only those generating the biggest profits will get the capital, or at the same profit level, only those least exposed to risks will seize the capital. Viewed from the status quo of China's capital market, however, this principle of maximum efficiency is far from applied for want of a just and fair risk assessment system, a sound information system and a market monitoring mechanism.

In a certain sense, the principle of maximum efficiency governing capital markets can lead to the value judgment of hi-tech enterprises. Because the products of enterprises are usually innovative, there are more than often no ready evaluating standards or system to go by in the objective assessment of the innovative activities of these enterprises. The judgment and choice by the market will then signal the direction, to a great extent, for the technical choice of these enterprises and for the development of the hi-tech industry. In China's capital market where distortion of market information and violation of rules and regulations are common, however, it is difficult not only for investors to make correct investment choices on the basis of accurate judgment of risks and returns, but also for enterprises to get equal financing opportunities. As a result, the capital market can by no way play its role as a guide. Under such a circumstance, it is most likely that a product or an enterprise with genuine developing prospect or potential may lose its opportunity to develop.

2. The role of regional capital markets

The problems listed above have indicated that the centralized capital market now operating in China can neither meet the financial needs of hi-tech enterprises nor create ample opportunities for investors to put money into these enterprises. More importantly, these problems cannot be solved merely by improving the operational mechanisms of the stock exchange or by strengthening supervision and control. This is because the root cause of these problems does not lie inside the stock exchange but has resulted from the defects of the organization, design and institution of China's capital market as a whole. For those hi-tech enterprises still at their burgeoning stage, regional capital markets may offer greater support to them. This is due to three factors as follows:

a) Lower threshold of regional markets. Compared with the national market, regional markets have a lower threshold for local superior enterprises to gain access, particularly for hi-tech enterprises which are unable to compete with superior enterprises for resources on the national market because of heavy risks, small size, uncertainty in developing prospects, high ratio of invisible assets, lack of operational experience and creditability records. Establishment of regional capital markets will create new opportunities for high-tech enterprises to expand.

b) Regional capital markets can provide flexible financing means. For similar reasons, hi-tech enterprises have a higher requirement for the flexibility of financing means. They need more flexible arrangements, for instance, for the ratio and form of investment returns, interchange between shares and bonds, and definition of the management authority of investors, because only in this way can they attract more investors and share risks and benefits with them on an equal footing. With its unique characteristics, such financing instrument is hardly adaptable to the national market which are highly standardized and under strict supervision and control.

c) Low cost of funds on regional markets. An enterprise hoping to be listed successfully on the national capital market will have to resort to a first-class intermediary agency. For new enterprises that are small in size, services available from such intermediaries would be too expensive. This is because under the condition where the related cost is fixed at a given level, the bigger the enterprise, the smaller its trading cost, and more superior its position in the market. At regional markets, however, the pertaining costs for enterprises to be listed would be smaller because enterprises operating there are generally small. On the other hand, it is easier for investors and borrowers to understand and communicate with each other within a limited region where a large number of hi-tech enterprises and venture investors are concentrated. The operational costs of intermediary agencies and the charges of administrative departments would also be relatively small, which will help reduce trading costs within the locality.

What should be stressed is that regional capital markets are not only needed for the development of high technologies, but also constitute an important part of the national capital market. They are needed for the development of capital markets themselves as well. Some people may question the necessity of regional capital markets at present when information technology has developed to such a degree that distance no longer poses any obstacle to trading in theory. The answer from this author is affirmative because so long as there are diversified financing and investment demands, all capital transactions cannot be accepted by a single market just as ordinary commodities cannot be all traded on the Internet. Furthermore, distances will continue to affect the trading costs in a fairly long period of time. The United States is the world leader in terms of information technology and capital market, and the New York Stock Exchange has developed into an international arena for securities trading. Even so, local stock exchanges, store-based markets, and other types of regional markets still exist. In comparison, China has not yet reached the advanced world level in terms of information technology development and has no time to lose for developing its hi-tech industry.

With regard to the capital market of a country, a regional market plays a role in three main aspects. Firstly, it can multiply the layers of the capital market and extend the range of its roles. Since a stock exchange cannot (and is unnecessary to) meet investment and financing demands at all layers, a regional market can make services available to more investors and borrowers, and at the same time absorb various kinds of securities in large amounts; Secondly, it can facilitate further development of market centralization. Once the market is classified into different layers, it will be possible to trade securities of different natures according to their categories, and this operational mode can heighten the centralization of trading of securities in the same category and help improve the negotiability of securities and market efficiency; and Lastly, it can reduce overall risks of the capital market. If securities widely different from each other are transacted by one trading system, it will not only create difficulties in supervision and management, but also affect the stability of the whole system. Establishment of regional markets will be conducive to the categorical management according to market characteristics and then to the reduction of market risks as a whole.

III. Tentative Thinking About the Model of Regional Capital Markets

In view of China’s realities, it will not do to rush headlong into the establishment of regional capital markets. Instead, efforts in this regard should be made step by step and in a prudent way. Here is a tentative model to be followed:

1. Experiments in a few areas with hi-tech enterprises highly concentrated

Given the need of developing hi-tech industry in China, the realities in some areas with high concentration of hi-tech enterprises and great intensity of venture capital, it is suggested that several high technology development zones be chosen, say, in Beijing, Shanghai, Shenzhen and Wuhan for pilot programs. The regulatory authorities can relax control, to some extent, over the regional capital markets in these areas, and allow them to transact new kinds of securities in new forms. Hi-tech enterprises may be, for instance, permitted to issue bonds, convertible bonds, or commercial papers. Experiments should be also allowed on the borrowing of securities by hi-tech enterprises, and trading of such securities within regional capital markets.

2. Private placement and over-the-counter transaction in the main

As the creditability of major players is relatively low and the control over them is relatively relaxed, regional capital markets face higher risks. For this reason, the trading forms adopted at these markets should be limited. On the securities issuing market, public placement should be banned in principle and private placement be adopted as a major form. It is so proposed because the general public lack the ability to foretell, analyze and sustain risks. Some institutional investors and individuals whose properties have amounted to a given size would like to be adventurous and have the ability to make venture investment. Even if they fail in investment, no big social risks will be incurred. As a matter of fact, the mode of private placement has been used fairly commonly at present (venture investment has been usually conducted, for instance, in a private way), though it has not yet been officially affirmed or standardized. At the markets for negotiable securities, the trading form of concentrated offering under a membership system should not be adopted in principle, instead, the form of over-the-counter trading should be applied in the main. This is because over-the-counter trading is more suitable to securities trading in small amounts and in diverse categories when compared to the trading system of concentrated offering. This practice also conduces to dispersing market risks. Whether a certain part of over-the-counter trading should be networked on a regional, trans-regional or even national basis should be an issue for future consideration.

3. Introduction of the over-the-counter dealer system into the market

A fairly big number of over-the-counter dealers will be needed to provide intermediary services for over-the-counter transactions. For this purpose, qualified institutions should be selected to act as over-the-counter dealers. The regulatory authorities can examine the qualifications of these dealers according to relevant systems and regulations formulated, decide on their access to and withdrawal from the market, and exercise supervision and control over their operations. Once the market has developed to a certain level, some of these dealers may be turned into market dealers.

IV. Suggestions on the Construction of a Regional Capital Market System

Lying behind numerous problems that dog China’s capital market are some serious institutional defects of the capital market itself. For this reason, establishment of regional capital markets is by no means merely an issue concerning liberalisation. Regional capital markets can develop healthily only when earnest efforts are made to learn from experiences and draw lessons from others at the very beginning.

1. Formulation and readjustment of pertinent laws and regulations

To create a sound legal environment for the healthy operation of regional capital markets, pertinent laws and regulations should be formulated and readjusted. During the development of China's capital market, curb-exchange once had its day. The reason why curb-exchange markets were banned in the end lies in the fact that they had given rise to heavy financial risks for lack of a regulatory system and unified standards. With this in mind, efforts should be made to standardize trading behaviors through intensification of the legal system during the construction of regional capital markets so as to ensure a normal market order and avoid the old path leading to failure. Construction of a legal system for regional capital markets should include two aspects:

a) Laws and regulations should be formulated to govern the construction and development of regional capital markets. These regulations should include those regarding certification of the qualifications, market access and withdrawal of the main market players, particularly intermediaries, and information disclosure institutions; those regarding private placement of securities (including the definition, object, range, form, and amount of placement); those regarding the over-the-counter trading and the examination of dealers qualifications; and those regarding the settlement of disputes and punishment on offenders.

b) Supplementary laws and regulations should be enforced. As activities conducted at capital markets usually involve various aspects, supplementary laws and regulations should be formulated to govern them. With rapid changes in China's economic life as a result of the development of market economy, some of the existing laws and regulations have become non-applicable to the economic activities and even posed obstacles to institutional renovation in some cases. Such defects appear More or less in some important laws including the Company Law, the Law on Commercial Banks, the Guarantee Law, and the Securities Law. Some legal obstacles also exist in taxation, registration of enterprises, and other aspects. As the situation stands, it is necessary to find out what provisions are no longer improper in the prevailing laws and regulations and have them amended.

2. Establishment and intensification of a credit system

For market economies, creditability is the basis of all market activities. It is also the prerequisite and condition for the sound operation of capital markets. Under China's unique circumstances, however, creditability has posed the biggest obstacle to the economic life. Our survey of the Beijing Hi-tech Pilot Zone reveals that, with an enhanced awareness of risks by various investment bodies and the establishment of interest-restrictive mechanisms, credit risks have become a major factor restricting investment. The key point lies in that, spurred by personal interests, violations of laws and regulations are inevitable under any economic system. In order to minimize the activities compromising creditability, it is necessary to establish a credit identification system (including investigation and appraisal of creditability and publication of related information) covering the whole society and a rigid mechanism for the punishment of violators. All mature market economies have resorted to such system and mechanism to maintain social creditability. What China lacks at present is exactly such a system.

Since it is impossible to build up a national credit-restrictive system overnight, a credit system should be firstly established in regional capital markets. To this end, the following three jobs should be done:

a) All major market players within a region are urged to intensify their sense of credit, and credit rating is used as a major criterion for market access and withdrawal, for business development, and for preferential policy treatment in the local development zone.