China expands its OTC market allowing SMEs to raise capital

China expands its OTC market allowing SMEs to raise capital
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China’s latest financial regulation has made it easier for small-medium enterprises to list on its over-the-counter market and raise capital.

Seven years after the establishment of its over-the-counter (OTC) market, China has gone a long way towards upgrading the market’s institutional settings, hoping one day to compete with the main-board market.

It has been a fruitful year for China’s equity market reformers: They overhauled old delisting rules, streamlined the application process for mergers and acquisitions of public companies and promised to reopen new initial public offerings (IPOs) next year. On 14th December, the State Council made a further move to expand access to credit for small and medium-sized enterprises (SMEs), the impact of which will be felt in the next five years.

According to this new plan, companies with 200 or fewer shareholders that want to be quoted on the national equities exchange and quotation system (an OTC exchange platform founded in January 2013) will no longer face approval requirements prior to their quoting. Different from China’s main board stock markets in Shanghai and Shenzhen, the OTC exchange was designed specifically for non-public firms to seek capital and investors to trade equities over the counter. These non-public firms are too small to list and too risky for regular bank financing. Essentially, this new liberalization reform of China’s OTC market may give small companies something to look forward to in the coming years.

Rome was not built in a day, nor was any reform in China. In 2004, the State Council published Some Opinions on Promoting the Reform, Opening and Steady Growth of the Capital Market, which proposed the creation of a “multi-tier capital market.” The upper layers consist of several stock exchanges including the Main Boards, and Shenzhen’s SME Board.

Today’s OTC market is the third layer (also known as “the new Third Board”), which aims to help companies at an even earlier stage of their development. The new Third Board was originally set up on 23 January 2006, only covering companies incorporated in Beijing’s high-tech zone. By early 2013, high-tech zones in Beijing, Shanghai, Shenzhen and Wuhan were eligible for such privileges. Six months later, the OTC market started to cover the whole country, soon followed by the loosening of approval requirements.

Admittedly, China’s OTC market has been extremely small since its inception. In early 2009, 55 stocks were traded on the OTC market, with a total market value of RMB 11 billion, compared to a main board 1,000 times its size.

But that’s changing. By December 2013, there were 339 companies quoted on the new Third Board, with a total market value of RMB 40 billion, and more than 2,000 enterprises are waiting to get on board. About 7,000 companies with a total market value of RMB 1.4 trillion are expected to be quoted in the next five years. Meanwhile, the market value of China’s main board stock markets stood at RMB 24 trillion as of September 2013.

On the demand side, institutional investors should also welcome the formation of a more mature and liberal OTC market in China. The State Council made it clear that institutional investors are encouraged to take part, specifically private equities, insurance companies and brokerages. To mitigate any potential risks, higher entry bars will be set up for each investor.

The OTC market serves as an alternative investment channel for institutional investors such as private equity funds. Due to the total freeze-up of China’s IPOs, private equities lost their preferred method of cashing out their investments. The growing OTC market could be their next playground, however, the utility of China’s OTC market for institutional investors is highly dependent on its liquidity and thus requires more development before institutional investors can reap the benefits.

And challenges still abound for the OTC market development. One argument is that the development of an OTC market may divert money from the main board, kicking stock indexes further into the abyss after the reopening of new IPOs next year. Yet, the sheer difference in market size between the main board and new Third Board diminish the threat. However, this series of reforms might just end up like many other Chinese regulations and reforms: They look great on paper, yet their implementation is another story.

Categories: Asia Pacific, Finance

About Author

Roger Yu Du

Roger works for a strategic advisory group that provides services to investors focused on Asia. He holds a master’s in International Political Economy from the London School of Economics and received his BA in International Relations from Fudan University in China, with a focus on East Asian affairs.