China's Financial Markets: What They Need

The lack of robust capital markets hasn't yet hindered development of China's economy, Duhamel noted. But the country is reaching a point where a shortage of financial innovation and investment alternatives will start to needlessly handcuff companies and the burgeoning investor class. As Chinese entrepreneurs rack up gains in their ventures, they are looking to diversify their personal investment holdings, and they are seeking a broader array of financial tools for their companies. So far, their government has circumscribed their options.

"A high proportion of China's [domestic] assets -- about 63% -- are now in bank deposits," Duhamel pointed out. "Equities are another 31% and the rest of the asset classes are underdeveloped."

Bonds , for example, account for only about 6% of domestic assets. Here, too, overregulation has played a role, Duhamel said. Chinese bureaucrats have insisted on setting interest rates on individual bond issues. By doing that, they have thwarted the development of a bigger bond sector. "How can you have appropriate pricing of risk in that situation?" he asked. "Without freedom in setting rates, the market can't create appropriate pricing."

Other asset classes barely exist at all. "China has a futures exchange , but the depth and liquidity is insufficient," he noted. "Whatever China doesn't develop domestically, someone else will develop. You already have renminbi contracts trading on the Chicago Futures Exchange."

Without a stronger, broader financial sector, Chinese companies can't share and shift risk -- a process that is necessary for companies to manage their finances effectively. Consider the insurance sector, Duhamel said. "Insurance companies in China have 40% to 50% of their assets in bank deposits, which doesn't make sense." The portfolio of a big American insurer would typically include a high proportion of stocks and bonds and a relatively modest allocation of cash deposited in banks. But Chinese regulators have elected to allow their banks to dominate the country's financial landscape, leaving few alternative destinations for money.

At least one of those banks has implicitly acknowledged the shortcomings of its country's capital markets. "When ICBC [the Industrial and Commercial Bank of China, with no ADR ] went public in 2006, in the largest IPO ever, the bulk of the stock was distributed outside of China," Duhamel pointed out. "Outside investors had the skills to assess the risk and the appetite for it. The Chinese retail market didn't, and Chinese institutional investors couldn't price it, either." In addition, the bank's managers wanted foreign institutional investors to hold their shares, so they could learn cutting-edge financial and management practices from them. They therefore first listed their company on the Hong Kong stock exchange, which is popular with Western investors. Only later did they sell stock in China's A-share market.