If 2001 was the year of supervision, 2002 will be the year of corporate governance for China's financial sector as a new level of professionalism and transparency in financial reporting begins to take hold. Driven by market opening under the World Trade Organization (WTO), the foundation for a professional financial and managerial culture based on the rule of law will (hopefully) begin to take hold in sectors from banking to fund management to accounting. Domestic and foreign companies alike will face an increasingly transparent and competitive environment, though this will be tempered by the adjustment of operating capital and capital solvency requirements higher than many entrants are willing to pay.

The pace and scope of regulatory reform of the PRC's financial industries advanced markedly in the leadup to China's WTO entry. More stringent information disclosure requirements, mandatory auditing by foreign accountants, and independent board of director appointments were only a few of the many reforms brought online in 2001. Investor confidence has been strengthened by a crackdown on misdeeds by top fund managers and previously untouchable listed state-owned enterprises (SOEs). Sector by sector, the combination of stricter supervision and market demand for true accounting has begun to reshape the financial landscape. Other key financial sector developments include the following:

Emergence of institutional investors
Led by the establishment and initial funding of the PRC National Social Security Fund Management Council, stock markets are being pushed to develop the regularity and internal supervision required to support institutional investment. The national social security fund was valued at $7.4 billion at the end 2001, of which up to 40 percent will begin to be invested in domestic and international securities. The national fund is also tied to social security system overhaul and state-share reduction plans.

Crackdown that spares few
Regulators continue their indefatigable pursuit of market manipulators. Perhaps the biggest transgression uncovered in 2001 was the embezzlement by a subsidiary of Sanjiu (999) Group of 96 percent of the funds it raised through the market. Other firms that falsified records have been sued by investors (though China's courts have delayed hearing the cases for six months until regulations are made clearer), while fund managers in China have been lambasted for treating investor funds as their own. Momentum toward adopting international auditing standards has, however, lost some steam as critics have picked up on the Enron case and the Bank of China scandal to try to discredit those pushing financial market reforms.

Strengthening of bank deposits, foreign exchange regime
The entry of foreign players in the financial sector and introduction of investment funds does not indicate that exchange controls will relax anytime soon. Renminbi (RMB) capital account controls are not forecast to loosen for another five years at the earliest. The PRC leadership draws confidence from the country's strong foreign currency reserve holdings ($212.2 billion at year end) and liquidity in domestic banks--RMB deposits totaled $1.74 trillion and foreign exchange deposits topped $134.9 billion by year's end. The PRC Financial Work Conference was held for the first time in over three years in February 2002, though no major policy shifts emerged.

China's banking institutions are gearing up for foreign competition by courting potential foreign partners and upgrading information technology infrastructure to link up branches and automated teller machines built during the late 1990s. Bad loans that were shifted to asset management companies (AMCs) two years ago are finally being quietly sold off at less than 40 percent of face value with the help of foreign accountants and investment banks. China's big four banks are also developing plans to list shares and issue long-term bonds as new sources of capital.

Domestic banks seek partners
The first approvals for foreign banks to buy into Chinese firms have begun to move forward, first with the World Bank's International Finance Corp. purchase of 15 percent of Nanjing City Commercial Bank for $27 million, followed by HSBC's acquisition of an 8 percent stake in the Bank of Shanghai for $66.3 million. Probable candidates for similar buy-ins include the Bank of Communications, China Merchants Bank, Shanghai Pudong Development Bank, China Minsheng Banking Corp., and Beijing City Commercial Bank, but foreign banks will find it difficult to obtain adequate information to conduct proper asset valuation before partnering for all but the top few domestic banks.

WTO commitments and new barriers
The People's Bank of China (PBOC) and the Ministry of Finance (MOF) initially moved most quickly among the ministries to implement WTO commitments, announcing that auto financing and retail foreign exchange services for current account transactions were open to foreign entrants on the first day of WTO accession. Implementing rules for application procedures, however, have been slow to emerge. Local currency business for foreign clients was permitted from the first day of accession in Dalian, Liaoning; Shenzhen, Guangdong; and Tianjin, though banks could already conduct such activities on a provisional basis. Foreign banks will be able to conduct local currency business with Chinese enterprises in 2004 and with PRC citizens in 2006.

Fears that expansion of foreign bank loan operations would be slowed by high capital adequacy requirements and the need to hold such reserves in China have been borne out in revised regulations implemented from February 1, 2002. Though China's WTO commitments detail entry requirements in terms of foreign players' total assets, China is free to raise operating capital, registered capital, and capital adequacy ratios. The new rules set levels exponentially higher than in other markets.

And though China has begun to approve foreign bank operations in foreign currency business (such as Citibank in Shanghai and the Xiamen International Bank in Xiamen), new rules have been enforced to curtail the competitive advantages of new players. PBOC announced that the interest rate foreign-invested financial institutions may set for their foreign currency deposits in China for all deposit amounts under $3 million will be subject to PBOC interest rate management. The move to control fees charged by foreign banks in China is undoubtedly an attempt to protect the vast foreign currency deposits held by domestic Chinese banks from foreign competition. Foreign currency deposits held by individual Chinese in domestic PRC banks currently stand at $82 billion, while foreign currency held by corporate entities totals $46 billion.

China's stock market bubble burst after a banner year in 2000, with both A-share markets falling 32 percent during 2001. The combination of the corruption crackdown and confusion over a hastily instituted state-share sell-down scheme further battered markets, despite initial buzz over the opening of hard currency B-shares to individual investors in early 2001. The opening of trading to individual PRC investors boosted foreign currency B-shares nearly 50 percent, but the value of B-shares is miniscule compared to that of A-shares. The relaunch of open-ended mutual funds, the promise of joint-venture mutual fund firms, the launch of a gold exchange, and the introduction of foreign-invested enterprise listings and China Depositary Receipts may propel recovery in 2002, though price-to-earnings ratios remain relatively inflated.

Domestic markets take a hit in 2001
Domestic markets in China were hit as global markets plunged and Chinese initial public offerings all but vanished. The establishment of a NASDAQ-style high-tech second board never materialized and ambiguity over the future of the promised government sell-off of its shares further drained confidence. Market capitalization stood at $526 billion at the end of 2001, down from $560 billion a year earlier.

Key supervisory mechanisms instituted
PRC market regulators, including the China Securities Regulatory Commission (CSRC), MOF, and the State Auditing Administration, made specific attempts to force Chinese markets to move away from their casino-like image. Market regulators with international experience have been appointed to senior PRC government positions to guide the direction of reform. Key reforms instituted in the past year include the institution of quarterly reporting by listed firms. Regulators imposed a scheme requiring the appointment of two independent members on each listed company's board of directors by 2003 to represent small shareholder interests and instill a sense of corporate governance. (CSRC officials indicate full implementation will be delayed to 2005 because of the scarcity of qualified personnel). CSRC issued further regulations on information disclosure for insider trading and auditing and strengthened punishment provisions. CSRC has, however, seem some setbacks in pushing for reform -- a December 2001 requirement for mandatory auditing of PRC listed companies by foreign accounting firms was withdrawn in early 2002 due to opposition by domestic accounting firms.

State-share reduction scheme falters
Mid-2001 saw the introduction and quick withdrawal of a long-rumored scheme to require any company with partial state ownership that issues new stocks to sell an additional 10 percent of shares from the state-owned portion at the time of listing. The proceeds were to be transferred to the central government's National Social Security Fund Management Council. The media criticized CSRC for instituting the plan when markets were already depressed. As a result, CSRC instituted a public comment period through fall 2001, and a new version of the plan, meant to raise money for the central government as well as increase performance incentives by transferring shares to interested shareholders, could reappear in 2002.

FISC and CDR listings imminent
By introducing trusted foreign companies that operate under international standards of corporate governance to Chinese exchanges, China hopes to solidify and strengthen market reforms. Officials clarified the regulatory structure governing the listing of foreign-invested enterprises in 2001. Though never barred from listing, foreign-invested shareholding companies (FISCs) got the formal go ahead to list A-shares from the May 17, 2001 MOFTEC Notice on Relevant Issues of Foreign Invested Shareholding Companies and the November 5, 2001 CSRC Opinions on Issues Related to Listed Companies Involving Foreign Investment. Twelve foreign and Hong Kong companies are reportedly preparing to list their China ventures. A separate scheme to introduce China Depositary Receipts (CDRs) will allow the listing of shares in RMB that are nominally listed on overseas exchanges. Hong Kong "red chips" such as China Mobile and Legend Holdings are likely to be the first CDRs.

Long-discussed plans to open the Hong Kong stock market to mainland buyers are moving forward. The proposal would allow mainland citizens to deposit foreign currency in Hong Kong financial institutions, which would then invest in the Hong Kong stock market. PBOC, the State Administration of Foreign Exchange (SAFE), and CSRC are still looking at details. Economists speculated that the reform may take anywhere from two months to several years to implement and would initially involve only $5-$10 billion worth of deposits.

Mutual funds and brokerages
Following the approval to relaunch open-ended mutual funds in 2000, several funds began operation by late 2001. A total of 51 PRC funds (closed and open ended) are now offered by 14 companies. China committed under the WTO to allow foreign companies to set up mutual fund joint ventures with 33 percent foreign ownership at accession, to be boosted to 49 percent by 2004. The Rule on Management of FIE Fund Management Companies appeared in draft form in late December 2001. On the securities brokering and underwriting side of the business, China has committed to allow joint ventures with 33 percent foreign investment from 2004. Regulations on the Approval of Sino-Foreign Joint Securities Companies also appeared in draft form in late 2001, indicating that China may be phasing in foreign-invested securities companies and investment bank operations sooner than WTO commitments require. Some foreign-invested banks are already engaged in underwriting and have received licenses to engage in A-share brokering. The much-anticipated Investment Fund Law is scheduled for a National People's Congress reading in mid-2002 and may take effect sometime in 2003. Companies are already forming alliances, and competition to establish partnerships with the most experienced domestic securities companies will be fierce for some time to come.

China moved toward regularity and transparency in the licensing of foreign insurance companies in China with the issue of the Management Regulation on Foreign-Invested Insurance Companies in late 2001. Though the regulations still require firms to first apply for permission to apply for a license, the China Insurance Regulatory Commission has committed to respond to all applications with a formal explanation of the decision within a fixed period of time. Fiduciary and other requirements reduce the number of firms immediately eligible to set up operations, and the pace of change has been slower to date than many expected. Insurance companies are not constrained to domestic insurance companies for joint venture partners, and foreign insurers have been quick to seek alliances with non-insurance companies. Specific problems, however, remain in issues related to the establishment of branches and subsidiaries.

China's commitment to allow life and non-life insurers, while removing all equity and geographic restrictions, will not prevent PRC regulators from adopting a go-slow approach to ensuring stability in the expansion of insurance businesses. Moreover, the competitive environment is intense as insurance companies from developed countries vie for approval and partners.

The PRC financial sector in 2001 showed higher profile movements toward implementing the supervisory mechanisms necessary for functional financial markets. Indeed, PRC economic reforms, including social security reform and steps to meet WTO commitments, cannot move forward without such progress in China's banking and securities industries. Nevertheless, China's financial sector still has a long way to go. China's banking system maintains costly market-distorting elements of its pre-reform past and still sends state bank loans to failing state-owned enterprises; and the cowboy culture of China's early stock markets institutionalized fraud and embezzlement. Strides made by China's regulators in 2001, though significant, are only the first step forward.

Real change will come as China's market is further exposed to foreign competition in the form of portfolio investment and domestically listed foreign firms. Chinese WTO commitments will force Chinese companies to begin using effective corporate governance to gain competitive advantage, and Chinese lenders will increasingly demand that they do. The challenge for foreign financial firms will be to partner wisely and expand operations quickly in China's large, highly competitive market.