China's stock market unique features

First, the government used itlargely as a fundraising vehicle for funding state-owned enterprises, As a result, most listed enterprises were state controlled,
with only one-third of the enterprises' equity capital sold to private
shareholders during initial public offerings (IPOs). The other two-
thirds of the equity capital raised was held either by state asset man-
agement agencies or by SOEs themselves. In an effort to prevent the
loss of state control over listed enterprises, the government forbade
trading of state-owned shares on China's two exchanges, and the
shares could be transferred only after approval from state asset man-
agement authorities had been obtained, which made these shares
effectively nontradable. The transfer of state-owned shares to private
shareholders was rare in the 1990s. At the end of the 1990s, more
than 90 percent of the enterprises listed on China's two stock ex-
changes remained state controlled, with state-owned entities as their
controlling shareholders. The rapidity of the development of China's
stock market seems to suggest that a stock market (which is regarded
as the incarnation of capitalism) can coexist with state ownership
(which is regarded as the defining institution of socialism) and does
not necessarily require the presence of private enterprise.
Second, China's stock market developed under a repressed finan-
cial regime. Financial repression was created through a combination
of capital controls on international capital flows and administrative
measures imposed by the central government to dampen potential
competition among different financial assets (e.g., bank deposits, en-
terprise stocks, enterprise bonds, and various kinds of government
bonds) within the domestic financial sector. While the capital con-
trols helped to prevent capital from flowing out of the country, the
competition-mitigating administrative controls sought to avoid the
driving up of returns on various financial assets and thus to allow the
government to maintain a source of cheap capital for financing SOEs'
investments
Financial repression is therefore a disguised form of invest-
ment planning. In theory, this form of investment planning was to be
gradually phased out with the emergence of a stock market that
provided a forum for direct transactions between investors and fund
seekers. However, China's central government imposed a host of
administrative controls aimed at preserving its monopoly over the
uses of funds long after the emergence of the stock market, thus
grafting the socialistic investment planning institution onto the stock
market. Such a unique institutional structure is intriguing for studies
on financial repression as well as the functioning of stock markets.
Furthermore, the traditional economics literature generally views fi-
nancial repression as an obstacle that limits financial market devel-
opment, because, under a repressive financial regime, holders of fi-
nancial assets are not rewarded for real growth in their portfolios
The rapid growth of China's stock
market during its first decade seems to offer an interesting alternative
case study.
Third, China's stock market was developed under a weak legal
framework that offered shareholders little protection. On the widely
used indicators for shareholder rights protection developed by La
Porta et al. (1998), China scored 3, compared with the average score
of 3.61 for all other transitional economies (Pistor and Xu 2005: 191).6
The actual protection for shareholders in China, however, is lower
than what the index suggests because of the weak legal enforcement
in China (Tenev and Zhang 2002; Allen, Qian, and Qian 2005; Pistor
and Xu 2005). The development of China's stock market therefore
presents a puzzling case for economists and financial analysts who
hold that legal shareholder protection is a prerequisite for the devel-
opment of a functioning capital market (Shleifer and Vishny 1997; La
Porta et al. 1997, 1998; Pistor and Xu 2005).
This article attempts to explain how China was able to develop a
large, active, and technologically advanced stock market in the 1990s
while maintaining its salient socialistic institutions of state ownership
and monopolistic control over financial intermediation, and offering
shareholders only weak legal protection. I argue that the marriage of
socialism and capitalism took place when China's poorly regulated
stock market was becoming a venue whereby local governments and
SOEs issued shares to capture economic rents created by financial
repression, and traders bought and sold shares based on speculativemotives rather than investment value.