China's Financial Markets: What They Need

Asking Difficult Questions

China could speed its financial maturation by giving foreign institutional investors more freedom to operate in the country, Duhamel said. So far, the government has carefully controlled the entry of foreign institutions like hedge funds , investment banks and insurance companies. Giving them freer rein would likely bring a host of benefits, including improvements in the governance and operations of all publicly listed Chinese firms. Because foreign investors are asking difficult questions, "the quality of Chinese companies is increasing and, in many cases, is now on par with Western companies," Duhamel said.

Institutional investors, for example, typically demand high standards of accountancy from companies whose stock they hold, and they often put pressure on managers to streamline operations. That might curtail inefficient practices like the recent tendency of some Chinese firms to devote as much effort to investing in the stock market as they do to their core operations, Duhamel said. That sort of conduct probably wouldn't be tolerated in a more developed market, where investors, for the most part, expect companies to either use their excess cash to make investments in their operations or return it to shareholders in the form of dividends and stock buybacks .

"A larger institutional investor base can increase the quality of the management of Chinese companies," he noted. "They will demand less focus on trading in the market and more on the operational businesses." On average, Chinese investors aren't as sophisticated as Western ones. About 70% of the investors in China's stock market are individuals with limited investment experience, and 30% are institutions, Duhamel said. In contrast, those numbers are roughly flipped in the United States, with 60% institutions and 40% individuals.

Duhamel warned that short-term macroeconomic forces may forestall any immediate financial market reform. For the moment, Chinese officials are grappling with two challenges. On the one hand, they are seeing inflation because of their economy's fast growth and rising commodity prices throughout the world. The Industrial and Commercial Bank of China recently reported that prices rose 8.7% in February -- the biggest inflation jump in more than a decade. Food prices, in particular, soared, shooting up more than 23%.

At the same time, Chinese manufacturers are facing the possibility that their biggest pool of customers, American consumers, will trim their spending. The U.S. economy seems to have slumped into a recession , and that could seriously dampen economic activity in China. "China is still export driven," Duhamel said. "People talk about decoupling, and maybe the U.S. and Chinese economies are more decoupled than they were 15 years ago. But China is still dependent on U.S. consumers."

The development of deeper Chinese capital markets could help Chinese companies better weather future slowdowns by giving them more ways to hedge their risks. "As China develops a strong domestic investment industry, it will be able to better allocate domestic capital, and it will decrease its cost of capital," Duhamel added. "It will also be able to create alternative investments and reduce its reliance on foreign capital for investment." Those steps should create a virtuous cycle: "China will eventually see the development of a full spectrum of financial products. That will increase the liquidity of markets and attract even more investors."

Editor's note: An exchange-traded fund (ETF) that tracks the performance of China's biggest public companies is the iShares FTSE/Xinhua China 25 Index Fund FXI. Financial companies currently make up 42.87% of this ETF's holdings.

Currently, the top five individual financial sector holdings are ICBC (as covered in this article), China Life Insurance LFC, Ping An Insurance (no ADR), China Merchants Bank (no ADR) and China Construction Bank (no ADR).

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