COR1306 Capital Markets in China Topic 2 PDF

SMU Classification: Restricted Topic 02: Fundamentals of Financial Markets COR1306 Capital Markets in China Dr Wang Jiwei  SMU Classification: Restricted Reading materials Mishkin and Eakins (2024) – Chapter 2: Overview of the Financ...

SMU Classification: Restricted Topic 02: Fundamentals of Financial Markets COR1306 Capital Markets in China Dr Wang Jiwei  SMU Classification: Restricted Reading materials Mishkin and Eakins (2024) – Chapter 2: Overview of the Financial System – Chapter 7: Why do Financial Institutions Exist? – The older edition textbook is also fine Part of this notes is adapted from Mishkin and Eakins (2019) supplemented slides © Wang Jiwei COR1306 Capital Markets in China 2  SMU Classification: Restricted Exporting the Chinese Model? China’s model comprises a number of key characteristics: – authoritarian governance buttressed by the perception of stability; – state-guided industrial policy and finance; – massive infrastructure investments; – rural industrialization backed by small-scale agriculture; – and openness to foreign trade and technology. This model has, no doubt, produced rapid economic growth in China over the last three decades, lifting hundreds of millions of people out of poverty. © Wang Jiwei COR1306 Capital Markets in China 3  SMU Classification: Restricted Part I OVERVIEW OF FINANCIAL MARKETS © Wang Jiwei COR1306 Capital Markets in China 4  SMU Classification: Restricted What are Financial Markets Channels funds from person or business without investment opportunities (i.e., “Lender-Savers”) to one who has them (i.e., “Borrower-Spenders”) © Wang Jiwei COR1306 Capital Markets in China 5  SMU Classification: Restricted Segments of Financial Markets 1. Direct Finance Between individuals – Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets 2. Indirect Finance Banks – Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets © Wang Jiwei COR1306 Capital Markets in China 6  SMU Classification: Restricted Flow of Funds Figure 2.1 Mishkin and Eakins (2024) © Wang Jiwei COR1306 Capital Markets in China 7  SMU Classification: Restricted Importance of Financial Markets Why is it so important? © Wang Jiwei COR1306 Capital Markets in China 8  SMU Classification: Restricted Importance of Financial Markets Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them. Financial markets determine the price of the traded asset through the interactions of buyers and sellers - Price discovery process Financial markets also improve the well-being of consumers, allowing them to time their purchases and sales better – trading mechanism Financial markets reduce the search and information costs of transacting – transaction cost reduced © Wang Jiwei COR1306 Capital Markets in China 9  SMU Classification: Restricted Structure of Financial Markets 1. Primary Market ─ New security issues sold to initial buyers ─ Typically involves an investment bank who underwrites the offering 2. Secondary Market ─ Securities previously issued are bought and sold ─ Examples include organized exchanges (trades conducted in central locations such as the NYSE, SGX and SSE) and over-the-counter markets (Dealers at different locations buy and sell such as Treasury Bills) ─ Involves both brokers and dealers (including market makers) © Wang Jiwei COR1306 Capital Markets in China 10  SMU Classification: Restricted Structure of Financial Markets Interests are compulsory 1. Debt Markets you need to pay interest to creditors ─ Short-Term (maturity < 1 year) ─ Long-Term (maturity > 10 year) ─ Intermediate term (maturity in-between) Debt holders have priority claim to company’s assets during a company’s liquidation 2. Equity Markets Dividends are voluntary, they are payment to shareholders ─ Pay dividends, in theory forever ─ Represents an ownership claim in the firm Claiming of assets is allowed here © Wang Jiwei COR1306 Capital Markets in China 11  SMU Classification: Restricted Structure of Financial Markets We can also classify markets by the maturity of the securities: Length of Maturity differs 1. Money Market: Short-Term (maturity < 1 Not the focus of this course** year) Example: T-Bills Equity has no length of maturity, it assumes that the companies have infinite longevity. 2. Capital Market: Long-Term (maturity > 1 year) plus equities (no maturity) Higher Risk, Higher Return © Wang Jiwei COR1306 Capital Markets in China 12  SMU Classification: Restricted Part II ECONOMICS OF FINANCIAL INSTITUTIONS © Wang Jiwei COR1306 Capital Markets in China 13  SMU Classification: Restricted Direct vs Indirect Finance Function of Financial Intermediaries Instead of savers lending/investing directly with borrowers, a financial intermediary (such as a bank) plays as the middleman: – the intermediary obtains funds from savers – the intermediary then makes loans/investments with borrowers This process, called financial intermediation, is actually the primary means of moving funds from lenders to borrowers. – More important source of finance than securities markets (such as stocks) – Needed because of transactions costs, risk sharing, and asymmetric information © Wang Jiwei COR1306 Capital Markets in China 14  SMU Classification: Restricted Transaction Costs Financial intermediaries make profits by reducing transactions costs 1. Take advantage of economies of scale (example: mutual funds) 2. Develop expertise to lower transactions costs A financial intermediary’s low transaction costs mean that it can provide its customers with liquidity services, services that make it easier for customers to conduct transactions 1. Banks provide depositors with checking accounts that enable them to pay their bills easily 2. Depositors can earn interest on checking and savings accounts and yet still convert them into goods and services whenever necessary © Wang Jiwei COR1306 Capital Markets in China 15  SMU Classification: Restricted Risk Sharing Another benefit is that they can help reduce the exposure of investors to risk, through a process known as risk sharing ─ FIs create and sell assets with lesser risk to one party in order to buy assets with greater risk from another party ─ This process is referred to as asset transformation, because in a sense risky assets are turned into safer assets for investors © Wang Jiwei COR1306 Capital Markets in China 16  SMU Classification: Restricted Asymmetric Information Another reason FIs exist is to reduce the impact of asymmetric information. – One party lacks crucial information about another party, impacting decision-making. We usually discuss this problem along two fronts: adverse selection and moral hazard Agency Problem © Wang Jiwei COR1306 Capital Markets in China 17  SMU Classification: Restricted Adverse Selection RATIONAL EXPECTATION: The quality of the car is uniformly distributed, the probability of purchasing a good / bad car is 0.50 Adverse selection occurs when one party in a transaction has better information than the other party ASSUMPTION: No flow of information Lemons Problem Used Cars – Akerlof, George A. (1970). "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism". Quarterly Journal of Economics (The MIT Press) 84 (3): 488–500. doi:10.2307/1879431 – Akerlof, Spence, and Stiglitz jointly received the Nobel Memorial Prize in Economic Sciences in 2001 for their research related to asymmetric information. Issue: Market Unravelling => Collapse of the car market => No transactions => Market Failure © Wang Jiwei COR1306 Capital Markets in China 18  SMU Classification: Restricted Moral Hazard Moral Hazard in Equity Contracts: the Principal-Agent Problem – Result of separation of ownership by stockholders (principals) from control by managers (agents) – Managers act in own rather than stockholders' interest © Wang Jiwei COR1306 Capital Markets in China 19  SMU Classification: Restricted How to Mitigate Tolls to Help Solve the Asymmetric Information Problem – Production of Information: Monitoring – Government Regulation to Increase Information – Financial Intermediation (e.g, venture capital) Due to information asymmetry – Debt Contracts © Wang Jiwei COR1306 Capital Markets in China 20  SMU Classification: Restricted Conflict of Interest Conflicts of interest are a type of moral hazard that occurs when a person or institution has multiple interests, and serving one interest is detrimental to the other. Three classic conflicts developed in financial institutions. Looking at these closely offers insight in avoiding these conflicts in the future. Between buyers and sellers – Underwriting and Research in Investment Banking – Auditing and Consulting in Accounting Firms – Credit Assessment and Consulting in Rating Agencies © Wang Jiwei COR1306 Capital Markets in China 21  SMU Classification: Restricted FI and the Real Economy Do financial institutions (mainly banks) really play an important role in an economy? Are banking services indispensable? The general equilibrium approach to the market economy may serve the purpose. This approach was initiated by Leon Walras (1834-1910) and became a major tool of economists after the contributions made, notably, by Kenneth J. Arrow (1972 Nobel) & Gerard Debreu (1983 Nobel) in early 1950s. © Wang Jiwei COR1306 Capital Markets in China 22  SMU Classification: Restricted Arrow-Debreu Economy Consider a two-period, competitive economy with three type of agents: i) consumers, ii) firms and iii) banks. Suppose that there is one physical good which is initially owned by consumers/households. Households can consume part (or all) of it in the first period or it can be invested by firms to produce consumption in the second period. Firms finance their investments (I) either by issuing bonds (Bf) or through loans (credits) from banks (L-) (Loan Demand). Banks finance their loans (L+) (Loan Supply) by collecting deposits (D-) or issuing bank bonds (Bb). Households hold their savings (S) either in the form of bonds (Bh) or deposits (D+) (Deposit Supply). © Wang Jiwei COR1306 Capital Markets in China 23  SMU Classification: Restricted Financial Markets Bh Bf Bb Households L+ Firms D+ Banks L- D- © Wang Jiwei COR1306 Capital Markets in China 24  SMU Classification: Restricted Markets In An Arrow-Debreu Economy In this economy there are four markets: – 1) Goods Market (Equilibrium Condition: I=S) – 2) Deposit Market (Equilibrium Condition: D+= D-) – 3) Loan (Credit) Market (Equilibrium Condition L+= L-) – 4) Financial Market (Equilibrium Condition Bh= Bf+Bb) In the (Walras-) Arrow-Debreu framework the general equilibrium of an economy is achieved when all four markets are in equilibrium. – bank profit is zero in equilibrium! IMPORTANT! Financial institutions are important in determining the financial eqm © Wang Jiwei COR1306 Capital Markets in China 25  SMU Classification: Restricted Part III EFFICIENT MARKET HYPOTHESIS © Wang Jiwei COR1306 Capital Markets in China 26  SMU Classification: Restricted Efficient Capital Markets The efficient market hypothesis – Stock prices are in equilibrium – Stocks are ‘fairly’ priced – Informational efficiency If true, you should not be able to earn ‘abnormal’ or ‘excess’ returns. Markets dont earn abnormal profits Efficient markets DO NOT imply that investors cannot earn a positive return on the stock market. © Wang Jiwei COR1306 Capital Markets in China 27  SMU Classification: Restricted Reaction of Stock Price Stock price should reflect the fair value of the company Inefficient Market => Deviation Vertical increment source: Ross et al. (2011) © Wang Jiwei COR1306 Capital Markets in China 28  SMU Classification: Restricted What makes markets efficient? Financial Intermediaries There are many investors out there doing research. – As new information comes to market, this information is analysed and trades are made based on this information. – Therefore, prices should reflect all available public information. If investors stop researching share prices, the market will no longer be efficient. © Wang Jiwei COR1306 Capital Markets in China 29  SMU Classification: Restricted Forms of market efficiency Strong-form Semistrong-form Weak-form efficient market efficient market efficient market Information = Information = Information = public or private publicly past prices and ‘Inside available volume data information’ is information No abnormal of little use No abnormal return on past No abnormal return on public trading return on any information information information Fundamental Technical Insider trading is illegal analysis is of analysis is of little use little use Example: United States © Wang Jiwei COR1306 Capital Markets in China 30  SMU Classification: Restricted Evidence of market efficiency Much empirical evidence supports the primary securities markets having a high degree of efficiency. Some evidence includes: – Market reactions to public announcements are quick – Specific mutual funds or analysts who consistently generate abnormal returns are difficult to identify Some studies in recent years have re-examined the widespread acceptance of the efficient market hypothesis. © Wang Jiwei COR1306 Capital Markets in China 31  SMU Classification: Restricted Debate on market efficiency EFFICIENT INEFFICIENT © Wang Jiwei COR1306 Capital Markets in China 32  SMU Classification: Restricted Part IV FACTS OF FINANCIAL STRUCTURE © Wang Jiwei COR1306 Capital Markets in China 33  SMU Classification: Restricted Facts of Financial Structure 1. Stocks are not the most important source of external financing for businesses. 2. Issuing marketable debt and equity securities is not the primary way in which businesses finance their operations. 3. Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in which businesses raise funds directly from lenders in financial markets. 4. Financial intermediaries, particularly banks, are the most important source of external funds used to finance businesses. © Wang Jiwei COR1306 Capital Markets in China 34  SMU Classification: Restricted Facts of Financial Structure 5. The financial system is among the most heavily regulated sectors of economy. 6. Only large, well-established corporations have easy access to securities markets to finance their activities. 7. Collateral is a prevalent feature of debt contracts for both households and businesses. 8. Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the borrowers. Information gaps are prevalent in China © Wang Jiwei COR1306 Capital Markets in China 35  SMU Classification: Restricted Part V THE POWER OF CAPITAL MARKETS © Wang Jiwei COR1306 Capital Markets in China 36  SMU Classification: Restricted Capital vs Natural Resources The Norwegian “oil fund” holds 1.3% of the value of the world’s listed companies. Norway is slowly moving from relying on natural resources to financial investments. Singapore’s Temasek and GIC © Wang Jiwei COR1306 Capital Markets in China 37  SMU Classification: Restricted Case: Fosun 复星 Billionaire with $2.7 net worth as of 16/8/2024 “China’s Warrant Buffet” “Mainland’s Hutchison Whampoa” https://www.forbes.com/profile/guo-guangchang/ © Wang Jiwei COR1306 Capital Markets in China  SMU Classification: Restricted Fosun International End of 1990, China’s capital market was set up Started with marketing consulting business in 1992 in Shanghai A conglomerate in insurance and investment with revenue of US$28 billion Rooted in China and expanded overseas © Wang Jiwei COR1306 Capital Markets in China 39  SMU Classification: Restricted © Wang Jiwei COR1306 Capital Markets in China 40  SMU Classification: Restricted © Wang Jiwei COR1306 Capital Markets in China 41  SMU Classification: Restricted Why so successful? 1992 2023 ¥38,000 assets ¥816 bil assets Health ？ Happiness Wealth Consulting Intelligent Manufacturing …… © Wang Jiwei COR1306 Capital Markets in China 42  SMU Classification: Restricted Journey of Fosun IPO and going overseas Expansion through domestic M&A Pharma Pharma Property Pharma Property Retail Start up Pharma Pharma Property Retail Steel Industry Pharma Property Property Retail Steel Securities Property Retail Retail Steel Securities Iron Pharma Retail Steel Steel Securities Iron Insurance Pharma Pharma Pharma Pharma Property Steel Securities Securities Iron Insurance Investment Property Consulting Property Property Property Property Retail Securities Iron Iron Insurance Investment Asset Management Sales 1992 1993 1994 1997 1999 2000 2001 2003 2004 2006 2007 2009 2010-2024 克隆生物 上实医大 朝晖药业 羚锐制药 国药控股 桂林制药 金安矿业 海南矿业 遵义世纪 Club Med Acquirees 天药股份 德邦证券 万邦制药 华夏矿业 Focus Media Folli Follie 友谊股份 南钢股份 招金矿业 山焦五麟 分众传媒 Pramerica (Prudential) 豫园商城 建龙钢铁 永安保险 同济堂 PeakRe 重庆医工 宁波钢铁 巨人网络 ST.JOHN 重庆药友 广西花红 爱仕达 Alma Lasers 海翔药业 陕鼓动力 Saladax 五指山 Caruso 佰利联 Youku 滨化集团 Secret Recipe One Chase Manhattan Caixa Seguros Studio 8 三亚亚特兰蒂斯酒店 完美世界 菜鸟 中国国旅 民生银行 Listed 1 1 1 6 9 10 11 14 18 35 (as of 2018) companies Assets 2,694 0.1 10 100 827 1,109 4,996 15,711 23,492 43,744 66,958 88,154 638,883 (Mil) © Wang Jiwei COR1306 Capital Markets in China 43  SMU Classification: Restricted Fosun’s ownership structure State Owned Enterprises of China also Guo Liang Wang has expanded overseas Fan Wei Guangchang Xinjun Qunbin Tuas Power is 100% owned by China 58% 22% 10% 10% Fosun International Holdings (BVI) 100% Public Fosun Holdings (BVI) Investors 79.03% Fosun International (HK) 100% Offshore Onshore/Mainland China Shanghai Fosun Hi-tech (Group) © Wang Jiwei COR1306 Capital Markets in China 44  SMU Classification: Restricted Part VI CHALLENGES TO CAPITALISM © Wang Jiwei COR1306 Capital Markets in China 45  SMU Classification: Restricted Capital to Inequality??? Thomas Piketty: Capitalism has a natural drift toward high inequality, as assets like real estate and stocks disproportionately held by the wealthy (capital) rise faster than the economy (growth). This is a bad thing, which should be fought through radical policy measures like a global tax on wealth. – http://www.nytimes.com/2014/05/31/upsh ot/everything-you-need-to-know-about- thomas-piketty-vs-the-financial-times.html Karl Marx: Capitalism produced internal tensions which would lead to its self- destruction and replacement by a new system: socialism. https://www.amazon.com/Capital-Twenty-Century-Thomas-Piketty/dp/067443000X © Wang Jiwei COR1306 Capital Markets in China 46  SMU Classification: Restricted How to get the cheap cotton? “The wealthy, capitalist world we Americans live in today was created by the Industrial Revolution; the Industrial Revolution was driven by massive productivity gains in textile manufacturing; cotton was the essential raw ingredient that powered textile manufacturing. Thus, if it weren’t for cheap and plentiful supplies of raw cotton, the world we live in today might very well look quite different.” https://www.amazon.com/Empire-Cotton-History-Sven-Beckert/dp/0375713964 © Wang Jiwei COR1306 Capital Markets in China 47  SMU Classification: Restricted Jeffrey Sachs’ Speech at the UN Food Systems Pre-Summit, July 2021 https://www.youtube.com/watch?v=WZ1xc491mnU © Wang Jiwei COR1306 Capital Markets in China 48  SMU Classification: Restricted How Did China Succeed? Economics professor Joseph E. Stiglitz, who received Nobel's Memorial Prize in Economics in 2001, held a lecture at BI Norwegian Business School and talked about the success of China. https://www.youtube.com/watch?v=Iaw4n9IZ Ddc © Wang Jiwei COR1306 Capital Markets in China 49  SMU Classification: Restricted © Wang Jiwei COR1306 Capital Markets in China 50  SMU Classification: Restricted © Wang Jiwei COR1306 Capital Markets in China 51  SMU Classification: Restricted Kahoot! Game Enjoy Use your real name for class participation tracking  SMU Classification: Restricted Topic Summary Q&A