Capital Markets in China - Fundamentals Quiz

Fundamentals of Financial Markets

• The course is titled "Capital Markets in China"
• The course is COR1306
• The instructor is Dr Wang Jiwei
• Reading material includes Mishkin and Eakins (2024)
• Chapter 2: Overview of the Financial System
• Chapter 7: Why do Financial Institutions Exist?
• The older edition textbook is also acceptable
• Part of the notes are adapted from Mishkin and Eakins (2019) supplemented slides

Exporting the Chinese Model?

• China's model has several key characteristics
• Authoritarian governance
• Perceived stability
• State-guided industrial policy and finance
• Massive infrastructure investments
• Rural industrialization supported by small-scale agriculture
• Openness to foreign trade and technology
• This model led to rapid economic growth lifting millions out of poverty over three decades

Overview of Financial Markets

• Financial markets channel funds from those without investment opportunities to those with them
• "Lender-Savers" to "Borrower-Spenders"

Segments of Financial Markets

• Direct Finance: Borrowers borrow directly from lenders by selling financial instruments (claims on future income/assets)
• Indirect Finance: Borrowers borrow from lenders via financial intermediaries (banks) which issue financial instruments (claims on future income/assets)

Flow of Funds

• Funds flow from "lender-savers" to "borrower-spenders" through direct and indirect finance
• Direct involves borrowing directly from financial markets
• Indirect involves a financial intermediary

Importance of Financial Markets

• Financial markets efficiently allocate capital from those lacking investment opportunities to those with them
• Price discovery occurs through buyer and seller interactions in markets
• Consumers benefit by better timing purchases and sales
• Transaction costs are reduced in financial markets

Structure of Financial Markets

• Primary Market: New securities are sold to initial buyers (investment banks underwrite the offering)

• Secondary Market: Previously issued securities are bought/sold (examples include stock exchanges like NYSE, SGX and SSE and over-the-counter markets with dealers)

• Both brokers and dealers (market makers) are involved

• Debt Markets: Creditors are paid interest (compulsory)

  • Short-Term (maturity < 1 year)
  • Long-Term (maturity > 10 year)
  • Intermediate terms (in-between)

• Equity Markets: Dividends are voluntary (payment to shareholders)

  • Ownership claim in the firm
  • Claiming assets is also permitted here

• Money Market: Short-term securities (maturity <1 year) (e.g., T-Bills)

• Capital Market: Long-term securities (maturity >1 year) and equities (no maturity)

Economics of Financial Institutions

• Intermediaries play a crucial role moving funds from lenders to borrowers

  • Reduced transaction costs
  • Risk sharing via asset transformation
  • Reducing information asymmetry
  • Adverse selection
  • Moral Hazard

• Transaction Costs: reduced through economies of scale (mutual funds), and expertise

  • Providing liquidity services (easily conducting transactions, e.g., bank checking accounts)

• Risk Sharing: creates and sells assets with lesser risk to one party

• Asymmetric Information: one party lacks crucial information about the other (e.g., adverse selection and moral hazard)

Rational Expectations: Adverse Selection

• Adverse selection occurs when one party in a transaction has better information than the other party
• This is the "lemons problem" where one party in a transaction has a better idea of the value than the other (e.g., used cars)

Moral Hazard

• Moral Hazard in Equity Contracts (Principal-Agent Problem)
• Result of separating ownership (stockholders - principals) from control (managers -agents)
• Managers may act in their own interest rather than stockholders' interest

How to Mitigate Asymmetric Information

• Production of information: monitoring
• Government regulation to increase information
• Financial Intermediation (e.g., venture capital)
• Debt Contracts (due to information asymmetry)

Conflict of Interest

• Conflicts of interest are a type of moral hazard (when a person/institution has multiple interests and serving one harms the other); occurs in
  • Underwriting and Research in Investment Banking
  • Auditing and Consulting in Accounting Firms
  • Credit Assessment and Consulting in Rating Agencies

Financial Institutions and the Real Economy

• Financial institutions (mainly banks) play an important role in economies
• Banking services are indispensable
• General Equilibrium approach
  • Initiated by Leon Walras (1834-1910)
  • Became a major tool in economics
  • Built on Nobel Prize contributions by Kenneth J. Arrow and Gerard Debreu (1950s)

Arrow-Debreu Economy

• Two-period economy with consumers, firms, and banks
• One physical good (initially owned by consumers)
• Firms produce consumption for the second period; finance from markets & banks
• Bank profits are zero in equilibrium

Efficient Market Hypothesis

• Stock prices reflect equalized supply and demand
• Informational efficiency
• Markets don't earn abnormal returns
• Efficient markets do not imply investors cannot earn a positive return

Reaction of Stock Price

• Inefficient markets may show overreaction and correction in stock prices
• Efficient markets instantaneously adjust prices to new information
• Delayed reaction shows price partially adjusts to new information

What Makes Markets Efficient?

• Many investors conduct research
• New information is analyzed, trades are made based on this
• Prices reflect all available public information
• If investors stop research, markets lose efficiency

Forms of Market Efficiency

• Strong: Information (public or private), insider information is of little use.
• Semi-strong: Publicly available information. No abnormal return on public information (fundamental analysis is of little use).
• Weak: Past prices and volume data. No abnormal return on past trading information

Evidence of Market Efficiency

• Much evidence supports primary securities markets’ high efficiency
• Quick reactions to public announcements
• Difficult to identify mutual funds/analysts consistently generating abnormal returns.

Debate on Market Efficiency

• The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013 (Fama, Hansen, Shiller)

Facts of Financial Structure

• Stocks are not the most important source of financing for businesses

• Issuing marketable debt and equity securities is not primary way to fund business operations.

• Indirect finance is more important than direct finance; financial intermediaries (banks) are the most crucial in raising external funds

• Financial systems are heavily regulated

• Large established companies can access securities markets more easily

• Collateral is often a key feature of debt contracts (both household and business)

• Debt contracts have complex legal stipulations

The Power of Capital Markets

• Capital markets are crucial, and many countries rely on them more than natural resources

Case: Fosun

• Billionaire with $2.7net worth as of 16/8/2024
• "China's Warrant Buffet," "Mainland's Hutchison Whampoa"

Fosun International

• Established in 1992 with marketing consulting
• A conglomerate in insurance and investment, with revenues over US$28B
• Rooted in China and expanded overseas

Going Out

• Fosun's overseas dealings involve major investments

Corporate Structure of Main Businesses

• Detailed breakdown of Fosun's various business holdings

Why Fosun is Successful

• Details of Fosun's rapid growth from 1992 to 2023

Journey of Fosun

• Timeline showing key acquisitions and investments

Fosun's Ownership Structure

• Diagram of Fosun's complex ownership structure (with key individuals and entities)

Challenges to Capitalism

• Thomas Picketty: Capitalism has a natural drift towards high inequality
• Karl Marx: Capitalism has internal tensions leading to self-destruction

How to Get Cheap Cotton

• Details linking cheap cotton to the wealth of the capitalist world and the Industrial Revolution

Jeffrey Sachs' Speech

• A speech at the UN Food Systems Pre-Summit

How Did China Succeed?

• Discussion about China's economic success.

Common Prosperity

• China's push for a fairer distribution of wealth amid high-quality development

How Large is China's Low Income Population

• Data on China's income distribution in 2019

Kahoot! Game use real names for tracking.